Supplements » ESG Report 2019

Electrification: Generation electrification

LightningThe human race depends on energy, writes Romil Patel. But in the race to decarbonise and build a sustainable future, how is its latest transition faring, and how can investors influence the process?

Historically, human beings have witnessed two major energy transitions. We started by burning wood, progressed to burning coal and then eventually moved on to oil and gas.

Coal was pivotal to the Industrial Revolution that originated in Britain, but with the invention of the automobile (and subsequently plastics), oil became the dominant fossil fuel, gaining the moniker ‘black gold’ in the process.

Yet in spite of rapid global development, not everybody has been swept along. In fact, “at least two billion people globally are living in abject energy poverty”, says Nick Stansbury, head of commodity research at Legal & General Investment Management (LGIM). “We know that one of the largest, if not the single biggest contributor to infant mortality is energy poverty,” he adds.

Each year, oil companies make billions of dollars in profits; and in 2018, a court case – The People of the State of California v BP et al – acknowledged that the various defendants cited were collectively responsible for more than 11% of the carbon and methane pollution that has accumulated since the Industrial Revolution. It transpires that the environmental burden on those who have not reaped the benefits is wildly disproportionate to those who have.

“Take a country like India, which is under international pressure to curb its own consumption of coal,” observes Tom Nelson, head of natural resources at Investec Asset Management. “That pressure is being exerted by Western countries like the UK and US, which flourished, modernised and industrialised, driven by their own consumption of coal in the 19th and 20th centuries. This is all part of the concept of the just transition.”

Energy is the dominant contributor to climate change, accounting for approximately 60% of global greenhouse gas emissions, according to the UN. A special report by the Intergovernmental Panel on Climate Change (IPCC) in late 2018 said that “limiting global warming to 1.5˚C compared to 2˚C could go hand-in-hand with ensuring a more sustainable and equitable society”.

Moreover, global net anthropogenic carbon dioxide emissions must reach net zero by 2050 in order to limit global warming to 1.5˚C above pre-industrial levels. This will require “rapid and far-reaching transitions in energy, land, urban and infrastructure (including transport and buildings), and industrial systems,” the IPCC stated with high confidence.

With scientific experts warning that we need to achieve net-zero carbon emissions by 2050, the third energy transition is perhaps the most pressing of them all – and a shift towards clean energy is indeed underway. But what does a just third energy transition that prizes sustainable decarbonisation in a limited timeframe look like?

Decarbonisation drivers
To achieve universal access to affordable, reliable and modern energy services – a UN Sustainable Development Goal known as SDG 7 – the rate of electrification must increase. According to Oxford Economics, global infrastructure investment needs are forecast to reach $94 trillion by 2040, and a further $3.5 trillion will be required to meet SDGs 7 and 6 (clean sanitation and water). Asset owners and managers both have a critical role to play in delivering these needs sustainably.

Businesses in the energy, metals and mining and agriculture sectors will be key in the energy transition and the move towards a decarbonised economy, presenting sustainable investment opportunities from an industrial perspective.

“Environmental businesses are the direct drivers of this decarbonisation process and stand to be some of the big industrial giants of tomorrow in the way that big technology companies have emerged over the past 20 years,” says Nelson.

However, traditional approaches of screening and divestment will no longer suffice to offset the degree of climate risk in the portfolios of institutional investors. The energy transition requires positive investment which, when applied correctly and holistically to a portfolio, enables asset owners to gain exposure to the enablers and beneficiaries of decarbonisation.

“The investment management industry is too preoccupied with the risk side of the energy transition and mitigating that risk,” says Nelson. “It is not spending nearly enough time on the opportunity side, because in terms of the capital expenditure in the electricity and efficiency sector and a number of others over the next few decades, we think this is going to be an enormously strong and consistent tailwind for these businesses,” he says.

“We suggest the industry would be well rewarded in spending its time looking for a positive allocation – in other words, who will be the winners here and directing capital in their direction.”

Amping up battery storage
The transition to a greener grid and electrification of transport can be considered in two parts. One aspect is the need to increase renewable energy capacity and the second lies in battery storage – grid storage and using batteries to power our cars and homes.

The question around increasing renewable energy capacity was more pertinent five years ago, but since then, solar panel prices have come down by 80%-85% and strides have been made in wind turbine capacity. Two or three-megawatt turbines were being discussed just a few years ago; today, ten to 11-megawatt turbines are in position offshore.

“The reduction in price and improvement in technology has led to the removal of clean-energy subsidies and feed-in tariffs in most countries,” says Aanand Venkatramanan, head of ETF investment strategies at LGIM. “That is clearly reflected in the drop in clean prices to the extent that in some countries, solar prices are on a par with or below coal, so people are turning off inefficient coal plants and switching to solar.

“There is more to cover and given that it makes far more economic sense right now, there is an increased momentum across the board and countries to increase renewable energy capacity.”

Increasing the renewable energy mix with respect to the grid requires more battery storage capacity to be built, so that power can be stored when supply is high and demand is low.

But batteries demonstrate how environmental, social and governance (ESG) factors can come into conflict with one another, given that more than 60% of the world’s cobalt – an integral part of a battery’s cathode, responsible for adding stability – is in the Democratic Republic of Congo, one of the world’s least stable countries. Its child labour, corruption and illegal mining operations constitute serious issues for investors.

“Simply put, the battery technology which is central to the imminent large-scale commercialisation of the electric vehicle industry and the revolution in consumer technology is dependent on Congolese supply to meet demand,” notes RCS Global, a consultancy that audits mining supply chains.

So, how are investors addressing this ESG issue as battery storage becomes increasingly important in the low-carbon transition?

Sustainable supplies
Cobalt demonstrates how the transition to a low-carbon economy will have social implications. Last year, Norges Bank Investment Management (NBIM), which manages Norway’s $1 trillion sovereign wealth fund, engaged in dialogue with companies in the automotive sector on how they can seize opportunities and manage challenges in the transition.

“The mining of cobalt, an essential component of lithium batteries used in electric vehicles, is associated with very poor working conditions, including the use of child labour,” says Carine Smith Iheanacho, chief corporate governance officer at NBIM.

“We contacted 14 companies to understand how they are managing the risk of human rights violations of this kind in their supply chains. We also asked them about their plans for electric cars and how they will ensure sustainable supplies of cobalt to realise these plans. Some of the companies we contacted are members of partnerships such as the Responsible Minerals Initiative, Responsible Cobalt Initiative and Drive Sustainability.

“As an investor, we are always asking for more transparency and data around ESG issues,” Iheanacho adds.

In the meantime, cobalt’s price has collapsed as manufacturers pivot away from it. The element cost more than $40 a pound in April 2018, dropping to $16 in August 2019 as attention shifted towards nickel, which improves the battery’s energy density. The trade-off from using less cobalt and more nickel is stability – the battery becomes less safe as the temperature at which it can malfunction is lower, presenting greater risks for the manufacturer and consumer.

“The big-picture challenge economically for electric vehicles to really accelerate into some of the more optimistic forecasts is to reduce dependency on cobalt by going to nickel,” says Court Gilbert, a senior credit analyst at LGIM.

“But eventually nickel supply tightens, so no matter where you go, looking over the next decade and beyond, there could be a meaningful impact on the price of these raw materials that could slow the economic break-even of electric vehicles versus internal combustion vehicles.”

Real estate
Real estate is well positioned to play a critical role in the low-carbon transition, bearing in mind that the construction and operation of buildings contributes about 40% of worldwide greenhouse gas emissions, according to the ESG benchmark, Gresb.

Moreover, properties are ideal for impact investment, since they can deliver a market rate risk-adjusted return and be used in a variety of ways – from addressing homelessness to disability needs (see roundtable, pages 22-29).

Asset managers are optimistic about the energy opportunities the sector presents – not just in terms of procuring green energy, but in terms of how they manage the building, the energy source and the carbon in the building – the imported carbon. “Owners and managers have a key role to play in developing net-zero carbon buildings and converting existing buildings to net-zero carbon,” says Abigail Dean, head of sustainability at Nuveen Real Estate.

That said, no great opportunity comes without its fair share of challenges.

Data drought
As landlords, asset managers are responsible for approximately 20% of the energy in the building, with the occupiers responsible for the remaining 80%. Yet procuring information from the occupiers is incredibly difficult, because managers have no legal right to that data.

“Energy consumption data from buildings – both landlord and tenant – is important in order to assess their energy efficiency,” says Dean.

“But this data can be very challenging to gather and verify as it is a time-consuming process. We would like it to be possible to directly access tenant data from utility companies.”

Dan Grandage, head of ESG for real estate at Aberdeen Standard Investments (ASI), agrees that converting the existing stock of buildings to make them as efficient as possible is part of the solution. Having long-term targets takes managers from looking at changing lightbulbs to fundamentally thinking about how the building is used – the heating, mechanical and electrical systems, glazing and, in time, the fabric of the structure.

As a landlord, ASI has been installing solar panels on its roofs for some years. “We will then sell the energy back to the tenant at the very low end of the market, so they get low-carbon, cheaper energy that is locally generated. They are happy and we get a return on our investment,” says Grandage.

“We are now getting an income from the space on the roof that we weren’t leasing previously. By also adding in battery storage, more energy can be captured, because what we typically generate may not necessarily be used,” he adds. “Going forward, there are hopes that as a result of demand-side response, we can store it and sell it back into the grid at times of peak demand, which without battery storage cannot be done.”

Managers believe this would enable far more dynamic management of that energy generation, which at present is reasonably passive.

“At the moment, we size what we put on the roof for the demand of the tenants,” says Grandage. “But if you can store more, you would put more on because there are opportunities to use buildings more as a local and micro generator.”

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