Pelin Demir
As the world attempts to move towards carbon neutrality, companies and fund managers are facing increased scrutiny regarding emission levels. Unsurprisingly, listed infrastructure’s level of carbon intensity is higher than broader equities, owing to its exposure to the utilities sector. For investors seeking to limit heavy carbon emitters in their portfolio, an exclusionary approach to higher carbon assets may see many of these utilities excluded from their portfolios.
However, the investment that these companies make across generation, transmission and distribution assets throughout the journey towards net zero emissions targets, sees them at the forefront of global decarbonisation efforts. As such, we believe point in time analysis like carbon intensity fails to capture changes across time as companies make investments and energy systems adapt.
Accordingly, when we consider the pathway towards net zero, we can see the listed infrastructure sector provides investors with a unique opportunity to invest in the energy transition and access to growth potential for years to come.
What is net zero?
The concept of ‘net-zero by 2050’ originated from the 2015 Paris Agreement, an international treaty on climate change and a concerted effort by country participants to keep global warming to 1.5 degrees Celsius, from pre-industrial levels.
The power sector is pivotal to public policy, with the electricity and transportation sector comprising between 30% to 40% and 15% to 20% of global emissions, respectively. For countries to meet their climate objectives, significant investment is required across these sectors. With respect to the listed infrastructure asset class, a large portion of the underlying universe operates within these sectors.
Who are the beneficiaries and where are the risks?
The impact of net zero emissions across the listed infrastructure universe will vary depending on the sector the underlying assets operate in, resulting in different growth trajectories and challenges for companies.
The greatest opportunity lies within the regulated utilities sector, with a shift already observed in the reduction of greenhouse gas (GHG) from the decommissioning of coal plants and development of renewable power generation. This has largely been driven by lower renewable energy costs, government renewable targets and tax credits. The share of renewable generation is expected to materially increase in lieu of coal over the next decade, as can be observed below in the US utilities sector, which represents the largest cohort of securities in the listed infrastructure investable universe.
The acceleration in renewable generation will benefit electric utilities that own transmission and distribution assets (i.e. ‘poles and wires’) due to the additional investment required to connect renewables to the grid. These transmission and distribution assets are typically regulated, meaning they receive Return on Equity (ROE) on their Regulated Asset Base (RAB). Accordingly, these investments increase the RAB of a company and support earnings growth.
While natural gas is still expected to play a role in the energy mix, mitigating renewable intermittency issues, demand will eventually moderate with the increased movement towards cleaner energy and technological advancements in battery storage. Nonetheless, the impact on gas utilities’ (i.e. local distribution companies) assets will be relatively resilient over the medium term given its importance to the consumer and industry, especially in colder climates.
Energy infrastructure, namely North American oil and gas pipelines, have a more challenging outlook over the longer term given their primary activity is to transport high carbon energy. However, midstream companies are exploring other alternatives in their fight to remain relevant and hope to maintain a role in transporting cleaner energy using existing pipelines. While some pipelines will be capable of being repurposed to cater for technological developments, others are at risk of becoming stranded assets.
Further granularity of the impact on other listed infrastructure sectors is explored in the following table.
In sum, the pathway towards net zero will likely see winners and losers, with renewable generation, transmission and distribution and to a lesser extent railroads to experience the most growth potential.
Company level analysis is key
At the company-level, net zero strategies are considered essential by all market participants including listed infrastructure managers and broader equity investors. As such, these strategies are supported by all listed infrastructure sector participants through active ownership strategies like company engagement and proxy voting.
For active managers in the our peer group, company-level assessments of the energy transition are integral to stock selection. This typically includes an assessment of the impact on short and long-term cashflows, regulatory frameworks and management quality. These considerations are all incorporated differently across the peer group but typically influence valuations (cashflows and/or discount rates), quality metrics and environmental, social and governance (ESG) scores. Furthermore, we note that some sector participants specifically exclude non-Paris aligned companies which is an area we will continue to watch as company and manager commitments to net zero initiatives evolve.
Given the complexities involved for companies to navigate the transition to net zero, we highlight the importance of the allocation of capital by specialist listed infrastructure investors. While not discounting the role of index managers in undertaking company engagement, we also consider the transition to be a particularly favourable environment for active management. From both a valuation and risk mitigation perspective, there will be opportunities and threats as we continue to see society’s critical assets evolve and the underlying listed infrastructure universe change.
While listed infrastructure’s exposure to higher carbon assets is greater than general equities, the sector is very well placed to provide access to the energy transition, specifically through utilities, owing to the material levels of investment required to transform its assets in accordance with clean energy objectives.
By Pelin Demir, Investment Analyst
