CPD: Climate – Three tailwinds converge to support the investment case

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Investment opportunity in companies enabling the decarbonisation of the planet.

Climate change is one of the most pressing issues of our time, and it’s clear that serious action is required to address it. One way to make a difference is by investing in companies that are at the forefront of decarbonising the planet. These companies are working to reduce greenhouse gas emissions and transition to cleaner, more sustainable energy sources. Investing in them not only helps to combat climate change but also offers potential financial returns. In fact, the race to decarbonise the planet by 2050 presents a US$50 trillion investment opportunity.

The case for climate

The key issue confronting countries, companies and individuals worldwide is attaining the “net zero 2050” goal, which should ensure a maximum of a 1.5 degree temperature rise between now and 2050. This has been determined as the maximum temperature rise to avoid catastrophic economic, social and geographic consequences.

Although achieving this goal will be expensive, governments and corporates have realised it will cost a lot more if action is not taken. Consequently, a number of countries and companies around the world have announced net zero targets to try and achieve this 1.5 degree target.

As illustrated in figure one, the current trajectory of ‘business as usual’ has the world on target for a temperature rise of 2.9 degrees, which has an estimated US$23 trillion hit to GDP per annum. That does not take into account the broader non-economic impacts of the consequences, such as mass extinctions, displacement of populations and an increase in natural disasters.

It has been estimated that it will cost at least US$50 trillion to decarbonise the planet; some estimates are as high as US$150 trillion. From an investment point of view, decarbonisation presents a compelling opportunity. The money that needs to be spent to attain the net zero 2050 goal will be spent across a diverse range of industries.

The $US50 trillion (or more) to be spent across the next 30 years ultimately adds that figure in revenue to those companies providing the solution. As illustrated in figure two, there are a broad range of industries that will be the recipient of this expenditure. While most people think of electric vehicles or solar energy, it’s so much more: energy efficiency, renewable energy and transmission, battery technology, waste management and the circular economy, the use of hydrogen technology.

Investment in companies that are decarbonisation enablers provides an investment opportunity because these companies will be the recipients of this this spending; they will grow their revenue and that will result in share price growth. At the same time, these investments will help provide the solution to mitigate catastrophic climate change.

As illustrated in figure three, there are three tailwinds converging to support the move to net zero 2050: country targets, corporate targets and investor targets. As a global problem, climate requires a global solution. Among those countries that have committed to net zero, the global GDP allocated to solving this problem has risen from 16 percent in 2019 to over 92 percent in 2023. In essence, every large global economy has made the commitment to decarbonise.

These countries meet at the annual ‘conference of the parties’ (COP), an international climate meeting held each year by the United Nations. It’s a meeting of countries at which government representatives report on progress, set intermediate goals, make agreements to share scientific and technological advances of global benefit, and negotiate policy[1].

The second tailwind comes from corporates making the move to net zero. In some cases, independent of government, corporates are setting their own science based targets for decarbonisation, which are aligned with warming capped at 1.5 degrees.

The number of companies putting out targets aligned to the science-based targets initiative is growing exponentially. That is supported by regulators that require disclosure of these targets.

So, why are these corporates setting targets? A key reason is investors.

Investors – fund managers, pension and superannuation funds, asset consultants and investment groups – engage in stewardship. As they meet with companies, questions are asked about climate change and what each company is doing to mitigate their impact and attain net zero targets.

In addition, investment groups such as Climate Action 100 – the largest collaborative investor initiative – are specifically targeting the largest emitters and speaking to them on a regular basis about climate change and actions to mitigate it. Investment managers around the globe are positioning their portfolios to net zero and then collaboratively engaging with the companies they invest in around net zero and other related issues. This also feeds into meeting ESG requirements for portfolios.

US Inflation Reduction Act

One of the key things underpinning policy support in the US is the Inflation Reduction Act. This Act was introduced in 2022 and is wide-ranging legislation focused on lowering carbon emissions. It provides new US$400 billion plus of policy support over 10 plus years. These pluses are important because neither of them are ceilings; instead they are linked to particular milestones of decarbonisation.

The combined investments puts the US on a path to roughly 40 percent emissions reduction by 2030 and represents the single biggest climate investment in US history[2]. Some key items include in the Act include:

  • a methane penalty per metric ton of methane emissions
  • carbon capture and storage tax credit
  • $30bn for solar panels, wind turbines, batteries, geothermal plants and advanced nuclear reactors, including tax credits over 10 years
  • $27bn for ‘green bank’ to support clean energy projects particularly in disadvantaged communities
  • $20bn to cut emissions in the agriculture sector
  • $9bn in rebates for Americans buying and retrofitting homes with energy-efficient and electric appliances
  • $60bn to support low-income communities
  • $10bn in investment tax credits to build manufacturing facilities that make electric vehicles and renewable energy technologies
  • tax credits for the purchase of new clean vehicles.

This Act provides a decade of regulatory certainty in the world’s largest economy and significantly supports those enablers, the companies that will help the decarbonisation of the planet. The Act has also spurred action from the EU, which had been the leader in this space for decades. To avoid the loss of industries to the US, the EU is responding. This too will create investment opportunities.

Three changes in 2023

Three notable changes this year further support the investment thesis that companies enabling decarbonisation will provide a sound investment opportunity. These are the acceleration in the penetration of electric vehicles, the need for transmission and delivery grids to keep up with renewables and the reversing of 30 years of globalisation.

EV penetration

A key point in EV penetration is the inflection of its S-curve. The chart on the left hand side of figure four illustrates the S-curve. Compared to a couple of years ago, an inflection point has been reached where the penetration rate is increasing exponentially.

At the same time, the market is catching up to this. On the right hand side EV sales forecasts; in 2021, expected sales numbered just under 35 million units. That forecast was upgraded to over 40 million units in 2022. It’s expected that 2023 forecasts will show a similar upgrade. One of the key reasons for the uptick in sales and penetration are due to price cuts experienced to date in 2023.

Surprise price cuts from Tesla have been a big talking point and has accelerated the penetration of the EV vehicles versus internal combustion engine vehicles. On top of these price cuts, US residents are eligible for a $7,500 tax credit, further demonstrating the importance of the Inflation Reduction Act for this industry.

EV input costs are also falling. Lithium, other raw material costs and freight rates have fallen from their peak. Accordingly, EVs are getting cheaper to produce, which is why we see companies such as Tesla taking the initiative and passing that cost savings to increase the penetration of EVs.

Renewing the grid

That the US power grid isn’t ready for the transition to renewables (figure five) something that is likely indicative of power grids around the globe. Accordingly, this scenario will be played out world-wide as fossil fuels are phased out to achieve net zero goals.

Growing EV penetration is one of many factors that will put pressure on the grid. Using the US as an example, 70 percent of grid lines are over 25 years old. Interestingly, while the grid is a solution to climate change because it enables vehicles and other things to be electrified, the grid itself is actually at risk because of climate change. There have been an increasing number of blackouts due to climate change, resulting from bushfires, tornadoes and other natural disasters. As renewables are added, the grid needs to work in a bidirectional way, quite different to its historical purpose.

Electricity demand will increase with decarbonisation. On the right hand side of figure five there is an estimate that demand for electricity by 2050 will be 2.7 times what it is today. As demand on the grid increases, significant spend is required to upgrade the power grid to cope. This will be replicated globally.

Farewell globalisation

As illustrated in figure six, 30 years of globalisation is reversing. This affects not just climate related investment, but all parts of the market. It’s been highlighted by the US-China trade war as well as the geopolitical environment. For example, in the context of the Ukraine war, the EU quickly recognised the importance of energy security. This brought decarbonisation to the fore, because being reliant on fossil fuel imports from other countries carries risk.

The manufacturing of components to support decarbonisation, such as the solar energy components depicted on the left hand side of figure six, demonstrates a dominance by Chinese industry. As geopolitical tensions intensify between China and the US, and to some degree more broadly across the West, the opportunities for companies to offer solutions to their governments increases.

An example is US-based First Solar, a solar module manufacturer now being supported by the Inflation Reduction Act because the US government recognises the geopolitical benefit of having a domestically based solar supply chain.

The right hand side of figure six illustrates the new electric vehicle battery facilities that have been announced in the US following the Inflation Reduction Act. The US wants to decarbonise, but it also wants to ensure that it maintains or increases its industrial base to safeguard the supply chains for these important industries of the future. This is expected to be replicated in other parts of the globe.

Case study: Clean transport and semiconductors

Clean, or emission-free, transport is a significant growth industry of the future. However, EV manufacturers are not the only potential beneficiary of this trend. Other beneficiaries in the supply chain include companies providing:

  • Bbattery technology – e.g. Samsung
  • semiconductors – e.g. Onsemi
  • charging technology – e.g. Alfen
  • raw materials.

Many of the companies that will benefit from the shift away from traditional combustion engines to EVs will also prosper by providing technology to other industries focused on decarbonisation.

Of particular note, the shift to electric and autonomous vehicles requires semiconductors. Figure seven shows the average value of semiconductor content across traditional vehicles versus EVs. Inflection in the growth trajectory of EVs will flow on to increased demand for semiconductors.

However, semiconductors aren’t just used in EVs. Their application spans a range of industries and figure eight shows the value of the semiconductors used in a range of applications. Companies that provide semiconductors are well positioned to benefit from decarbonisation, as they form important componentry across a range of industries.

In conclusion, the importance of decarbonisation has become increasingly urgent as the impacts of climate change continue to intensify. Investing in companies that are at the forefront of decarbonising the planet not only benefits the environment, but also offers significant opportunities for investors. These companies are well-positioned to thrive in the transition to a low-carbon economy, as they provide solutions to the growing demand for sustainable products and services. By investing in these companies, individuals and institutions can play an active role in mitigating climate change and promoting a more sustainable future. Investing in decarbonisation is not only a responsible decision, but also a strategic one that can bring long-term benefits for both the planet and investors.

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Notes:
[1] https://www.climate.gov/news-features/understanding-climate/what-cop
[2] https://www.munropartners.com.au/news/a-letter-on-the-inflation-reduction-act
The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of GSFM Pty Ltd and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Munro Partners, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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