CONTENT BLOCKS
THE ENERGY TRANSITION
Sparking Opportunities
May 6, 2024
IN PARTNERSHIP WITH
I

A MODERN-DAY INDUSTRIAL REVOLUTION

The global march toward renewable energy resources and systems presents vast opportunities for institutional investors

The Energy Transition Webinar

Panelists will share insights into some current transition-related funds and strategies, and they will address challenges such as how investors are positioned for the long investment cycle, valuations, data and measurement issues, and wider economic impacts.

Featuring

Alicia White
Senior Product Manager
Morningstar Sustainalytics
Jennifer Boscardin-Ching
Client Portfolio Manager – Thematic Equities
Pictet Asset Management
David Boyce
CEO
Schroders Greencoat North America
MODERATED BY:
Gauri Goyal
Senior Director, Content & Programming
Pensions & Investments
Wednesday, May 8, 2024
2:00 p.m. ET

The worldwide transition to renewable energy is a long-term transformation of the global economy that’s akin to the Industrial Revolution. It demands a complete restructuring of electricity and transportation systems around the world, including the overhaul of existing economic systems built around legacy power generation.

That is good news for institutional investors. As the world moves in fits and starts toward reaching net-zero carbon emissions, investment opportunities will rise and fall. While the transition may seem slow, there’s already a wide range of emerging and dependable investments across sectors and regions that can deliver attractive risk-adjusted returns. Skilled asset managers who have deep research abilities, analytical prowess and trading resources are critical to helping institutional investors meet their portfolio goals while contributing to a greener world.

This transformation will have several stages. “Natural gas will play a key role because we need gas to replace large-scale coal generation as we go through the decarbonization phases,” said Mark Lacey, head of head of thematic equities at Schroders. “People think the energy transition is a sudden move away from oil and gas, but the transition involves phasing out coal, oil and then gas, which may take a few decades.”

Lacey said he expects investment capital to flow across the energy transition value chain, which includes industries such as battery storage, electrical equipment, transmission infrastructure and utility solutions.

International efforts are helping guide the transition, such as the goals of the United Nations’ Paris Agreement and Intergovernmental Panel on Climate Change to reduce greenhouse gas emissions and limit temperatures while aiming to reach net-zero carbon emissions by 2050. In addition, national government policies are a major supportive ballast, said Lacey, with many countries strongly focused on energy security. “Energy policy will move in the right direction to transition from a fossil-fuel world to a low-carbon or zero-carbon world,” he said. “While the focus is on energy security, the best way that energy security can be achieved is through the energy transition.”

A “massive” reallocation of capital toward the rewiring of energy systems will in turn drive evolving opportunities in climate resilience and adaptation, according to Alicia White, senior product manager at Morningstar Sustainalytics. Business models will change as companies reinvent themselves to manage the transition risks and position themselves to thrive in a future net-zero world. Institutional allocators are increasingly focused on understanding the nuances of the transition across industries and economies, as well as acknowledging that they have a key role to play in the transformation, she said.

The transition is creating investment opportunities all along the value chain of clean energy production and electrification of sectors, such as electric grids, building efficiency and electrification of transport, said Jennifer Boscardin-Ching, a client portfolio manager on the thematic equities team at Pictet Asset Management. “We look for companies that are providing clean energy and energy efficiency solutions for a variety of different end markets, ranging from buildings to industry.”

Multiple objectives

Morningstar’s 2023 survey of 500 global institutional asset owners found that within the scope of environmental, social and governance issues, the environment was their top concern, and within that, initiatives that aim to be net-zero by 2025 were their No. 1 priority, according to Thomas Kuh, head of ESG strategy at Morningstar Indexes. “It’s a very clear message that climate is top of mind for asset owners.”

“At the same time, what we think of as intersectional issues, like biodiversity and a just transition, are also on the minds of asset owners, but in the context of addressing climate change and climate risk,” he said. Digging deeper into investors’ thinking, he said other surveys show that institutional investors not only want to reduce the risk that comes from portfolio exposure to carbon-intensive assets, they also want to leverage their investments to hasten the transition to net-zero by reducing real-world emissions.

That doesn’t replace investors’ main objectives to earn a return on their capital and manage risk. “Everyone is aware that we need to decarbonize, but at the same time, you have a fiduciary duty to invest in companies and make a decent return relative to the market,” Lacey said.

On the flip side of the opportunities coin is managing portfolio risks. “On one hand, it’s about taking advantage of the opportunities; and on the other hand, it’s about mitigating the risks that might come from disruption,” Boscardin-Ching said. “Asset owners that we see are increasingly focusing on the climate risks that they might be exposed to in their existing portfolios,” such as transition risk and climate-related physical risk, she said.

Transition risks include the potential for assets to become stranded because they might not be used in an economy moving toward decarbonization, and some might face regulatory risks in areas such as carbon pricing or pollution. Climate-related risks are physical ones, such as exposure to hazards that can increase in intensity and frequency as a result of climate change, like severe storms or wildfires, said Boscardin-Ching.

Read: Energy transition: Is the sector ex-growth?

Several themes

Given the size and scope of the energy transition, not to mention the lengthy timeline to reach net-zero, investors can pursue several themes and strategies. For instance, they could focus on the renewable energy value chain, which includes solar- and wind-power equipment manufacturers and related businesses; power distribution and management; legacy energy companies making moves toward decarbonization; and infrastructure that either supports the transition or supports industries that need energy-efficient power sources to fuel their growth, like data centers.

“At the moment, we’re seeing a major global trend to build up and restore local manufacturing capacity,” Boscardin-Ching said. “This includes enabling electrification and building out domestic demand-supply chains in industries ranging from semiconductors to batteries, data centers and power production. These are strategic drivers and industries that happen to be closely interlinked with the clean energy transition.”

“The initial focus is on these energy sectors, but investors are also considering transition risks from sectors that you don’t immediately connect with net-zero but are, in fact, really closely tied,” White said. For example, food companies that are figuring out how to decarbonize their supply-chain emissions. (See visual on climate transition risk management by industry below.)

An Industry-Level View of Climate Transition Risk Management
Source: Morningstar Sustainalytics. Data as of January 31, 2024.
On one hand, it’s about taking advantage of the opportunities; and on the other hand, it’s about mitigating the risks that might come from disruption.
Jennifer Boscardin-Ching
Pictet Asset Management

Long horizon

For Lacey at Schroders, a key concern for institutional allocators is time: How much exposure do they have to the energy transition over the long term? “When you have to change an entire energy system, it is a long investment cycle: It’s not linear,” he said. “So even though we see forecasts on energy transition with earnings growth at about 25% per annum for the next two decades, it’s not a straight line. What investors expect us to do is manage risk through the cycle.” It can mean, for example, maintaining flexibility in a portfolio to counter potential equity risk by moving to a significant cash allocation when the investment environment calls for it, he said.

Underlying all the investible themes is the size and scale of the opportunity through the required time horizon. “One dynamic is the expectation of an upcoming multiyear capital expenditure super-cycle in mega projects and infrastructure, driven by reshoring efforts in the face of geopolitics and supply chain resiliency considerations, and which happen to align very well with clean energy investment themes,” said Pictet AM’s Boscardin-Ching. For instance, most of the $860 billion of proposed mega projects announced since January 2021, per Dodge Data & Analytics and Eaton Corp., are related in some way to clean energy transition projects.

Lacey said that capital expenditure for the energy transition is likely to reach four to five times the current amount spent on fossil fuel investing. That could mean $4 to $5 billion a year, based on the International Energy Agency’s estimate that fossil fuel investment would reach $1.1 billion last year. The IEA also estimated that clean energy investment alone would total $1.7 trillion in 2023, with top destinations including renewable power, energy efficiency, grids and electric vehicles.

“The scale of investment is significant, and we need to increase global electricity generation capacity by almost 150% over the next 16 years just to meet population growth, per capita consumption growth, data center usage and EV demand,” he said. (See visual on growth of global electricity demand below.)

An Industry-Level View of Climate Transition Risk Management
Source: Thunder Said Energy, IEA, World Bank, Schroders; February 29, 2024. Forecasts may not be realized.
We focus on both the companies that have transforming business models as the energy sector changes and the companies that directly benefit from the capital expenditure that is needed to make this transition.
Mark Lacey
Schroders
II

BUILDING ON THEMATIC APPROACHES

From renewable energy generation to EVs, investors can tap a range of areas but they must keep an eye on valuations

Thematic equities can provide institutional allocators the benefits of targeted investments, ample liquidity and transparency. A number of these strategies are relatively easy to measure, a function that is especially important when investing across a decades-long horizon. A transition-related investment that is attractive today might not be as attractive in five or 10 years, and might become attractive again in, say, 15 years due to shifting economics and valuations.

Understanding the context of valuations is key, said Lacey at Schroders. For instance, the renewable energy sector was valued at about a 50% premium to the broad equity market in 2021, while today the sector sells at a 25% discount. “What’s changed in terms of the three- and five-year growth rates? Nothing,” he said. “Now’s the time to be bullish on renewable energy valuations.”

Read: From megatrends to investment themes

Accelerating opportunities

Schroders has two energy transition vehicles: One focused on conventional energy and another on pure-play energy transition companies. “The large, traditional energy companies will still be here in 20 years, and they will be part of the energy transition,” Lacey said. “We focus on both the companies that have transforming business models as the energy sector changes and the companies that directly benefit from the capital expenditure that is needed to make this transition.”

In fact, by investing in conventional energy companies, institutional investors are “ahead of the game” because they understand that through their ownership, they can influence how those businesses work through the transition. Investors’ strategies and objectives relating to the energy transition are unique for each client, said Lacey, and “some investors will have more stringent rules for their investment approach.” Most, however, understand that “at the end of the day, any company that lacks sustainability of its product has a negative impact on the environment.”

Pictet AM’s long-established active thematic equities approach considers opportunities across clean energy production and electrification of economic and industrial sectors, such as electric grids, building efficiency and electrification of transport. “We invest in public equities. When it comes to selecting companies and portfolio construction, we employ a bottom-up, fundamental stock-selection approach,” said Boscardin-Ching.

From the universe of listed equities, Pictet AM creates an initial investment pool by screening for companies that are relevant to the clean-energy transition theme. For example, companies that contribute to renewables or the electric grid, electric vehicles, energy efficiency in industry, electric infrastructure or green-building solutions. From there, its team uses three main filters to uncover the best opportunities: the business franchise, or its “moat”; the quality of management; and valuation, she said.

“We think it’s very important to have the discipline to be able to take profits when you see the valuation in a certain subtheme or subsector look stretched and reallocate that to other areas that look more attractive,” Boscardin-Ching said. “It’s important to note that in our portfolio-construction process, the objective is to maximize for performance and to manage the volatility of the portfolio.” (See visual on opportunities in the energy transition investment theme below.)

Opportunities in the energy transition investment theme
Source: Pictet Asset Management, 2024.

Morningstar’s approach to climate investing begins with the indexes it has developed to track the energy transition, Kuh said. These include indexes with Paris Agreement-aligned benchmarks and the recently launched Morningstar Global Low Carbon Transition Leaders index, which are suitable for core holdings. The firm also offers thematic benchmarks, such as the Global Energy Transition index, an Emerging Green Technologies index, a Hydrogen index and a Next-Gen Transportation index.

“All of these are designed to provide a transparent exposure to the particular theme” and are driven by the firm’s equity research, Kuh said. “There’s the opportunity for asset owners to access these themes along with the benefits of passive exposure — including its cost-effectiveness and the transparency from a rules-based approach.”

Follow the valuation

When discussing specific investment opportunities, Schroders’ Lacey again points to valuations: “Any investment opportunity has to come back to valuation.” Sectors that are relatively attractive today, he said, include energy generation companies, particularly in Europe, where electricity prices have declined; and renewable energy companies, specifically in solar. “That’s controversial because the solar space in the U.S. has been a terrible place to invest,” he said. “But you’ve got to look at the long-term growth potential in this market and the companies that will survive this downturn.”

The “standout” opportunity, according to Lacey, is in integrated energy companies. “You get the renewable energy business for free, and their yield with dividends and buybacks is close to 10%,” he said. “You get paid for holding the companies as well as the renewables businesses within these companies.”

For Boscardin-Ching, two attractive opportunities in today’s market are in electrical equipment, such as transformers and switch gears, given the electrification trend; and in certain types of semiconductor companies, notably those that have pivoted to supplying chips used in the energy transition from chips used mostly for consumer electronics.

“Certain types of semiconductor technologies, like power semiconductors, are now being driven by clean energy-related themes, like electrification — EVs for example — power-efficient solutions for computing and industry, and grid modernization,” she said. “The semiconductor sector is more important now as a key enabler of electrification and decarbonization. We’re seeing a lot more drivers in this space that are related to the growth in demand for power management in various industries, from electric vehicles to data centers and industrial manufacturing.”

White at Morningstar Sustainalytics pointed to sectors that are employing transition technologies that are commercially viable and scalable, such as electric vehicles and solar and wind power generation. “As we’re focusing on and moving toward electrification of the grid, many companies related to that sector present quite a bit of opportunity,” she said.

The initial focus is on these energy sectors, but investors are also considering transition risks from sectors that you don’t immediately connect with net zero, but are in fact really closely tied.
Alicia White
Morningstar Sustainalytics
III

EXAMINING BOTH SIDES

While transition opportunities abound, investors need to understand the complex and interconnected risks and challenges

Investors face a daunting challenge. The energy transition is such a massive shift that it will require trillions of investment dollars over decades. How can one harness a global movement that will touch virtually every business and sector, and find the winning investment opportunities — short, medium and long term — to deliver institutional portfolio objectives?

“The nature of these investments means that it requires higher upfront investment, but over the long term, because of energy savings and energy efficiency, you actually have cost cutting and efficiency gains, which can translate into an attractive payback for customers,” Boscardin-Ching said. Investors need to adopt a truly long-term view and practice patience on several levels, having a portfolio perspective and also seeing the broader economic implications of the energy transition.

“We do see that the understanding and awareness of investors around this idea is improving, but we are still on the journey to understanding the real, ultimate long-term benefits of the clean energy transition,” she said, noting there’s sometimes pushback that it’s expensive to invest in transition-related opportunities. “We say it’s an upfront capital investment, and the cost savings that you get in return, over the next couple of years, makes it an attractive investment.”

Read: Climate Investing with the Morningstar Low Carbon Transition Leaders Indexes

Blessing and curse

In today’s data-driven world, asset owners have terabytes of data to help them analyze the environment and identify investment opportunities. It can be a blessing and a curse.

For example, more companies are disclosing their carbon emissions as they respond to requirements by the International Sustainability Standards Board, the Securities and Exchange Commission and the European Union, among others. In addition, many are publishing decarbonization goals that show shareholders, regulators and employees how they plan to reach net-zero, or at least work toward it. But the reporting standards and guidelines vary, both across and within countries, creating headaches for institutional investors.

“We’ve heard from investors that among the biggest challenges they face is cutting through the noise of the many targets that companies have committed to, and understanding whether companies are taking the right actions to meet their stated targets,” White said.

Morningstar Sustainalytics has developed a Low Carbon Transition Rating, which is a comprehensive assessment of a company’s forward-looking greenhouse gas emissions and its management’s actions to transform to a low-carbon business model. “This offering provides a granular analysis on the management side to inform the credibility of targets and give insight into company actions, not just ambitions,” she said.

Some investors are using the rating to put disparate companies on an even ground when analyzing their carbon footprints and reduction efforts. “One of the big use-cases for our Low Carbon Transition Ratings is to make a cross-sector comparison, so that an investor looking at companies — say, one in food and one in energy — can understand how they’re doing with respect to the transition, even though those paths might look different,” White said. That’s important because, for example, a technology company will have very different emissions data than an industrial company.

“Emissions intensity very much depends on what kind of industry you’re in,” Pictet AM’s Boscardin-Ching said. “Any type of tech or software company will automatically have very low emissions intensity, or a very low emissions profile, compared to an industrial company that is manufacturing something or a power utility whose actual business is to generate power.” So simply having a low-emission portfolio profile based on the data on emissions of companies in the portfolio doesn’t provide all the necessary context on their progress toward the energy transition, she said.

One way to better understand a company’s net-zero approach is to have first-hand company contact, according to Lacey at Schroders. “We dig in with management teams to get a clearer picture of funding, product risk and costs, and understand how exposed they are to the regulatory side,” he said. “We can ask questions of specific company teams to get their take on what is happening in their markets.”

Face-to-face meetings with company management can also provide a window into how the company thinks about the preferences of its shareholders, an important factor for any investor, but particularly for those investing with an eye toward net-zero. If management is solely focused on compensation and growth without a consideration of return, their interest will not be fully aligned with asset owners seeking to invest in the energy sector, Lacey said.

Beyond data

Besides navigating the vast amount of data, allocators also need to take a close look at the financial condition of companies that they may be considering for a transition-themed investment. Specifically, the level of corporate debt. Low interest rates helped mask potential problems companies might have had while funding their operations and growth. Those days are over.

“As interest rates have normalized, it has exposed the companies with really poor balance sheets,” Lacey said. “So, first, do your homework on the balance sheet and avoid companies with horrible balance sheets that have very little flexibility to refinance at sensible terms.”

Additional material risks include global politics and regulations, such as tariffs or other trade issues between countries. In the U.S., it means identifying companies that are beneficiaries of the Inflation Reduction Act and determining whether those companies can “stand on their feet” without that support, Lacey said. Investors also need to be mindful of broader industry risks, he added, such as logistics and wage inflation.

If the first priority is identifying risks and challenges, both existing and emerging, what’s close behind is keeping track of them and knowing when a response is needed. To address these challenges, Morningstar produces two “signals” to identify market and policy risk that can alert investors to potential issues. “By using the management-assessment data that we have, as well as our forward-looking emissions trajectories, we can provide investors with a financial assessment of what the impact of market risk and policy risks might be on the value of their portfolio companies,” White explained.

She added that investors must understand that not all potential risks are evident today or even as big a factor as they might become as the energy transition continues to move ahead. “Not all of the risks associated with the transition are really material today — or easily quantified, like litigation and reputation,” she said. “We expect that those risks will likely rise as we get closer to completing the energy transition.”