Written by Niall Gallagher, Investment Director, European Equities at GAM Investments:
From the United Nations to the European Union, the commitment to hit net zero targets by 2050 has seemingly been set in stone.
In practice, beyond the sloganeering, achieving these hugely ambitious and very laudable targets will be much easier said than done. However, as managers of our clients’ savings, we believe that the decarbonisation drive represents a major opportunity to provide long-term returns for our investors.
Hitting net zero by 2050: A daunting challenge
The inconvenient truth is that energy demand will continue to rise; this demand growth will be driven by the increasing global population but more importantly by higher energy consumption per capita in emerging markets where energy consumption per capita is a fraction of developed markets’ levels.
And unless supply rises to meet growing demand developing nations could continue to use the source most available to them – coal, or even wood in the least developed countries. Coal is not only bad for human health given resultant air pollution but also releases double the CO2 per unit of energy generated by gas.
We believe energy/resource capex – particularly in gas, a key transition fuel and back-up for intermittent renewables – needs to pick up or the world will likely see higher prices for energy, and even shortages as well as higher coal consumption.
With some politicians already facing an element of voter pushback in their quest to implement net zero – while still standing a chance of being re-elected – we cannot rule out some further slippage in the realistic timescale.
The new capital investment journey – from rust to boom?
According to the IEA, to reach net zero emissions by 2050, annual clean energy investment worldwide will need to more than triple by 2030 to around USD 4 trillion. With decarbonisation a key policy priority in the US and Europe, physical capex across the OECD will need to pick up very significantly. When it comes to the question of how existing infrastructure is set to handle the decarbonisation transition, the reality is that capex was too low for an extended period following the global financial crises, with infrastructure and capital stock across many developed countries both old and in poor shape. In the US, the Inflation Reduction Act and other measures amount to circa USD 2 trillion of direct or indirect funding. Europe needs to respond – both financially and in terms of planning reforms – or will continue to fall behind.
Facilitating the energy transition – and having any hope of approaching, let alone meeting, net zero targets by 2050 – will require a surge in capex across a range of sectors and industries ranging from the energy industry itself, electrification (well beyond vehicles), residential and commercial building refurbishment, and industrial & process industries.
Capturing opportunities within the energy system
While some net zero advocates might want to abandon, or urge the divestment of existing energy businesses entirely, in the real world we believe that the existing, large companies have a huge role to play if we are to make meaningful progress on decarbonisation. Globally, these companies – many of which, like Shell and Total, we have been favouring for an extended period within our European portfolios – have the expertise of thousands of highly skilled engineers and project managers as well as market positioning, deep knowledge of how the energy systems work and hundreds of billions of dollars of operating cash flow each year to support and drive the energy transition. These companies should not be marginalised by the energy transition – they need to be front and central to the future of low carbon energy if we wish to have any prospect of success in decarbonisation.
The biggest bottleneck?
Global power transmission lines need to rise 5x by 2050, from 7m to 35m circuit kilometres, as electricity demand rises 2.5x and transmission intensity rises by 2.25x.
Another cost of decarbonisation of the energy system is the requirement for resiliency, energy storage and a source of backup power. Biofuels and synthetic fuels, which are often produced from renewable resources, can also play a role in reducing greenhouse gas emissions, with sustainable aviation fuel seen as a vital element of the airline industry’s commitment to meeting net zero goals. Meanwhile, green and blue hydrogen – which are respectively produced by electrolysing water using renewable energy and from natural gas using carbon capture and storage (CCS) – can be used as transport fuel, for industrial processes and as a form of energy storage. However, to date, many of these new technologies are still relying on government support, with costs far exceeding those offered by traditional technology. We are therefore wary to invest here outside of existing companies delivering attractive return on capital (ROC) such as Atlas Copco and Linde which can benefit by incrementally extending their product offerings in these segments. And natural gas, potentially with CCS, should have a large role to play in the back- up of intermittent renewable energy.
We believe decarbonisation and the capex super cycle will be key investment themes that can drive European equity performance.
