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How do you invest in the global energy transition?


Mark Lacey

Mark Lacey

Head of Commodities

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Alexander Monk

Alexander Monk

Global Renewables Analyst

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The way we produce and consume energy is changing

Major tipping points in the energy landscape have been reached, spurring the uptake of cleaner technologies. Policy support has also improved, with ambitious targets set at both national and local levels across the world. Over the next 30 years, the world’s energy system will shift from one largely based on fossil fuels to one dominated by renewable electricity.

Renewable energy is only one aspect of the change – the way we use electricity, the way it is stored and how it is distributed must also be completely transformed.

The transition to renewables to provide new investment opportunities

Energy transitions are long-term structural transformations in the way energy is produced, distributed and consumed. They are caused by new technologies, superior economics and changing social trends. These “technological transitions” are rare and disruptive events that radically change the existing energy infrastructure and have significant implications for both companies and society as a whole.

Although the transition to renewables has only just begun, it is expected to be equally, if not more, transformational than the previous transitions.

Given the size and importance of this structural investment need, companies directly involved and actively contributing to the energy transition will be well-placed to generate sustained real returns on their investments, and grow earnings and cash flows in the long term. This should provide investors with the potential for strong and consistent returns on their equity. However, the complex, evolving and wide-ranging nature of the energy transition means that identifying those companies with the greatest potential to benefit from this theme (and those with the purest exposure) is not easy.

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Investment across the energy supply chain

Fully realising this energy transition will require significant capital spending. It is estimated that $120 trillion of new investment will be required in transition technologies by 20501, split between the supply and demand sides of the system to achieve the structural shifts such as decarbonisation of power generation, electrification of energy use and increase efficiency of energy consumption that will characterise the transformation.

The crucial point here is that the investment will need to be made across the entire energy value chain. We will need new renewables equipment, transmission and distribution lines, energy storage, electrical infrastructures and smart technology tools. It is all completely linked.

Just like the internet has facilitated the growth of new technology applications during the digital transformation, the growth of renewable power will stimulate the adoption of novel energy solutions. The energy transition opportunity is about more than just renewables, it is about the long-term, radical transformation of the entire energy system over the next 30 years and beyond.

Long-term active approach to capitalise on this structural trend

Identifying the companies with the greatest exposure to the energy transition is not easy. Although many of the forces which will propel our transition towards lower carbon power are coming to the fore, traditional approaches to stock market investing are unlikely to reap the benefits.

Achieving focused exposure to the energy transition is a broader concern. Consider a semiconductor company which makes parts for solar energy equipment but derives most of its revenues from other end users. Its performance is likely to be dominated by events in its other end markets, not global energy transition. Similarly, while large oil and gas companies are actively pursuing cleaner opportunities, their performance will largely depend on their traditional businesses and, with that, the oil price. A successful acceleration in energy transition would likely lead to them struggling, not prospering.

The focus needs to be on finding those companies that are best positioned to take advantage of the coming shift to a lower carbon powered future across the entire energy value chain. This involves a breaking of traditional regional, style or sectoral boundaries when putting together a focused, thematic portfolio. Moving away from market-capitalisation weighted structures is also essential.

A thoughtful and sustainable investment approach

The fast changing and evolving nature of technological transitions means that both top-down and bottom-up factors will play a part in determining the winners and losers. Weak companies in overly-competitive and disrupt-able industries need to be avoided. Conversely, strong participants in structurally attractive technologies will thrive.

Geography will be equally important, as the energy transition evolves in different directions across countries depending on their unique socioeconomic characteristics. At the company level, the quality of human capital management and the strength of relationships with customers, regulators and suppliers is key. Balance sheet management will also be important given that many clean energy technologies are in the early stages of their development and are subject to new industry risks. Other important characteristics include returns on invested capital, the path to free cash flow generation and the treatment of equity investors.

 

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1 Global energy transformation: A roadmap to 2050. IRENA, 2019. https://www.irena.org/publications/2019/Apr/Global-energy-transformation-Aroadmap-to-2050-2019Edition

 

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