If climate change represents one of the largest systemic risks the global economy has ever faced, dealing with its ramifications is going to move a lot of money.
The world’s youth have taken to the streets calling on their governments for massive, co-ordinated policy change, but it hasn’t yet manifested. Any piecemeal regulatory shifts suffer the fickle impermanence brought by the end of one leader’s term and the beginning of another. And institutional investors watch, shifting their base case for the rise in global temperatures as new data emerges.
Leaving any moral imperative aside, institutional investors are observing and, in many cases, acting on the risk/opportunity set represented by the world’s transition to a lower-carbon economy, especially where its energy needs are concerned. But where is the money flowing and what’s getting in the way?
Pollution and policy
Governmental policy has been writ large as one of the key risks facing the energy industry as it prepares for its lower-carbon future. But uncertainty around when and how this shift will fully materialize has investors at a standstill because it isn’t clear whether energy companies will move into renewables on their own, says Mahesh Jayakumar, fixed-income research analyst at MFS Investment Management.
“If you’re a polluter and there is no external cost for polluting, why would you bother to shift? . . . There is simply not enough regulatory pressure or regime change pressure to make that happen.”
Thinking globally, investors have a lot to choose from when investing in the energy sector. Australia is still exporting billions of dollars’ worth of coal, while dozens of startups the world over are attempting to find that key piece of disruptive technology to alleviate the inherent volatility of solar and wind projects.
Meanwhile, some stalwarts of the energy sector are looking to a future in which they rely less on traditional fossil fuels and are able to position themselves to provide cleaner options, says Dustyn Lanz, chief executive officer of the Responsible Investment Association.
In 2016, NEI Investments made a shareholder proposal to Suncor Energy Inc., asking the company to “provide ongoing reporting on how it is assessing, and ensuring, long-term corporate resilience in a future low-carbon economy.”
Today, Suncor produces an annual climate report, which highlights how wind power and biofuels are becoming a bigger part of the company’s current and future business. “A few examples are not representative of the entire sector, but we’re starting to see the leaders make these big first moves, which I think is serving as a bit of a wake-up call to companies that had not been thinking about these issues,” says Lanz.
Keeping it clean
One of Canada’s biggest pension funds is throwing significant capital at renewable energy. OMERS Infrastructure Management Inc., the infrastructure branch of the Ontario Municipal Employees Retirement System, has a portfolio filled with transportation, health-care and social infrastructure. But its biggest slice is in renewables.
For the OMERS, keeping a close eye on the energy transition is the next chapter in its ongoing story of sustainability, says Ralph Berg, its executive vice-president and global head of infrastructure. “This isn’t a public image exercise. . . . It’s fundamentally embedded in the fact that we are a pension plan that manages the pensions of half a million municipal employees. Sustainability isn’t something we discovered in the last three or four years.”
Since 2003, the OMERS has held a stake in Ontario-based Bruce Power. The world’s largest nuclear power generation facility, it produces 30 per cent of the province’s electricity but no carbon emissions. The fund also has major exposure to wind energy. In 2018, it purchased Leeward Renewable Energy, a portfolio of 19 wind farms across nine U.S. states, building on the 49 per cent stake it already owned in Vento II, which boasts four U.S. wind farms.
But finding these opportunities takes the work of a large and active team, says Berg. With clean energy as a stated priority, the OMERS has a team of dozens that examines hundreds of potential deals each year, narrowing them down to the select few that are worthy of serious consideration.
As a recent example, Leeward presented some specific advantages, making it an attractive addition to the portfolio, he says. “I think we saw more value in the ability to take an operating fleet of assets and add elements to it that would turn this from what was fundamentally a large collection of operating assets into a growing vehicle that could accelerate the development and construction of new projects; where you’re marrying a very competent and ambitious management team with the advantages of having an investor with a long time horizon and the ability to provide capital in a competitive way.”
While OMERS Infrastructure doesn’t own any assets that produce fossil fuels, it doesn’t eschew carbon-connected assets entirely. Transportation is one key area where the transition to using less carbon is playing out.
The fund, along with a consortium that includes the Alberta Investment Management Co. and the Ontario Teachers’ Pension Plan, bought London City Airport in 2016. While the air travel industry has significantly improved its environmental impact, it remains a problem area for cutting carbon emissions. “It would be facile to say, ‘Well, we only own the airport. We’re not burning any fuel. It’s those airplanes that do,’” says Berg. “But equally, what’s the point in owning an airport if airplanes don’t come?”
The fact remains that owning the airport — as opposed to being a major shareholder in an airline — holds far less transition risk. Looking at the longevity of the asset from a risk perspective, he says the demand for infrastructure to facilitate travel to London far outweighs what the current system can supply. “While you have a large affluent metropolis — one of the largest cities in the world, certainly the largest in Europe — that continues to grow and attract population and is a major business hub [and] millions want to travel to every year, that growth is not being met.”
Even as one of the longest-term investors in the game, the OMERS still needs to invest through the lens of how society functions today, adds Berg.
Fuel for thought
Apart from the more obvious sectors of energy, transportation and mining, the transition to a lower-carbon economy will be felt by every sector where Canadian pension plans put their dollars, as well as every asset class, says Rob Wilson, environmental, social and governance research analyst at MFS Investment Management.
On the public equity side, one straightforward opportunity is the transition to electric vehicles, he says. While he’s surprised the market has taken so long to ramp up this transition, the actual switch to electric vehicles is essentially inevitable.
The mind might jump to Tesla Inc. The electric vehicle and solar energy company’s public stock has skyrocketed in recent months, pushing its market capitalization higher than that of the Ford Motor Co. and General Motors combined.
However, Wilson says parts suppliers are a great way to harness the growth yet to come from the move to electric vehicles, since there are a number of reasons car manufacturers may take longer to start the transition to electrification. If the bulk of a company’s products are sport-utility vehicles or trucks, which are much harder to make electric, it will be even slower. As a result, Wilson’s firm has been tilting away from auto manufacturers because of concerns over how well they’ll handle the transition away from traditional combustion engines.
“What some of these suppliers are able to do is start transitioning their business and start straddling both areas in a way we think, over time, is going to be more effective,” he says.
The tipping point for the auto sector will likely be when the battery technology required for electric vehicles can be produced for a price that’s either competitive with, or even cheaper than, the internal combustion engine. While it’s difficult to tell how long it will take, both consumers and investors will also begin to realize the distinguishing factors, beyond being lower carbon, of electric vehicles once the prices are more reasonable. Wilson notes they perform better in certain aspects than traditional cars and they’re simpler to make, down to the fact that electric engines require fewer parts.
The urgency of the transition to a low-carbon economy is borne out by some startling statistics, says Steve Waygood, chief responsible investment officer at Aviva Investors. “If we hit six degrees by the end of the century — which, almost unconscionably, is actually plausible for us to do — if we do that, then $43 trillion gets wiped off the stock of capital.”
Even that calculation, estimated in a 2015 report by the Economist Intelligence Unit, is already out of date, he notes, adding that $43 trillion is an understatement of the amount of wealth that will be wiped out.
Asset managers have a fiduciary duty to address the physical, financial and transitional risks that accompany these dramatic figures. But at the same time, says Waygood, they must function, and find returns, in a world where $32 trillion in value would be wiped out in the fossil fuel sector alone if the world instantly switched to the full conditions of the Paris Agreement.
Stuck between those numbers, institutional investors find themselves playing a waiting game. But Waygood says the shift in their behaviour has already been seismic. In addition to ESG desks, mainstream investment analysts are demanding that companies provide more detail relating to their emissions.
For investors looking to dig deeper on the risk/opportunity set of the energy transition, a key problem remains: no one really knows what it will look like, says Emily Chew, global head of ESG research and integration at Manulife Investment Management. “There isn’t actually a definition of what this all means.”
For the time being, asset managers have two choices: either the institutional investor they’re working with defines what they mean when they say they want to be conscientious of the energy transition, or they ask the asset manager for help in co-creating a solution. She says that could mean a deep green thematic allocation, like buying into a renewable energy project or the retrofitting of a building to make it more energy efficient.
But other investors might be looking to straddle two worlds — the current high-carbon reality and the future, whatever that entails — and invest in assets that may not be carbon neutral or even negative, recognizing the transition won’t happen overnight, says Chew.
“We don’t know how we’re going to decarbonize the economy, but the economy simply has to be decarbonized in order for us to have any economy after 2050.”