Published in partnership with Pictet Asset Management
The energy transition is happening; the only real question is the pace at which it takes place. The long-term direction appears set, but it is likely the path will not be smooth and will continue to present challenges to solve and questions to answer as asset owners work through an investment theme that touches all parts of the economy and all parts of society in one way or another.
To grasp the challenges and the opportunities of investing in the transition, it helps to break this very big, all-encompassing issue down into smaller, more digestible chunks.
The energy transition will touch all parts of the economy and all parts of society in one way or another. It’s a transition that will not be linear in progression, but one which Pictet Asset Management (Pictet AM) senior investment manager, active thematic equities, Manuel Losa says is inevitable.
“There are several risks, but they would only serve to potentially delay or slow down the transition, not stop it, Losa says.
Losa says it’s basic economics.
“Renewables have become drastically cheaper over the past decade, and they will continue to see cost decreases going forward,” he says.
“On the other hand, coal power plants or nuclear power plants are getting more expensive. The competitive economics have turned in favour of renewables and nothing will stop this trend.”
That said, investing successfully in the transition isn’t a given without an understanding of what’s really happening across economies, across industries and across businesses.
It’s not just investing in renewable energy – it’s far broader and deeper than that. And so, it’s not a trivial task.
All industries, many geographies
California State Teachers’ Retirement System (CalSTRS) portfolio manager Nick Abel says that “when you think about a multi-decade investment opportunity and trend, such as the energy transition, the transition to a net-zero global economy, this touches nearly all industries and spans many geographies”.
“How you allocate across the [capital] stack, whether it’s public [or] private equity or debt, really depends on your investment policy and your cost of capital…predicated on the focus on cost-efficient, commercially viable technologies to help decarbonise the way we produce goods and services.”
CalSTRS’ Sustainable Investment and Stewardship Strategy (SISS), which Abel co-manages, had about $2 billion invested at the end of 2023.
Abel says that in some respects, large investors hold an advantage over small investors because “you need deal teams willing to innovate or organisations willing to give flexible capital, not concessionary capital but flexible capital, to take advantage of nascent but rapidly scaling opportunity sets”.
“This portfolio that I help co-manage is a public and, growing, private portfolio that is unconstrained and has the flexibility to invest across various stages of company growth in venture growth, equity buyouts, private credit, real assets, and then all the way into public equities,” Abel says.
“When we think about our investment opportunity set, it really is an unconstrained investment portfolio focused on where there’s relative value across industry sectors and the capital stack of companies, and then ensuring that we get, or are likely to achieve, a commensurate risk-adjusted return for the risk that we’re taking with those investments.”
Holistic approach
Pictet AM’s Losa says “if we really think about what the energy transition entails, what it requires in a very holistic sense is also just as much about electrification as transitioning the existing energy supply” from fossil fuels to renewables.
He says the transition will rest on three main pillars.
The first one is about transitioning existing power generation sources away from fossil fuels such as coal and gas towards cleaner energy production, such as renewable energy, wind and solar.
The second pillar is what Losa describes as electrification.
“It’s about the various sub-industries and sectors that are also transitioning away from direct combustion of fossil fuels towards electrified alternatives because it’s more energy efficient, cleaner and also becoming more cost-competitive,” he says.
“And the reason for this is because if you can transfer direct combustion towards electrified alternatives, and then supply that electricity, with cleaner, cheaper power generation from wind and solar, etc, that is a true energy transition.”
Losa says said the first two pillars relate to energy generation and supply and the transition of industries to adapt to the new supply sources.
The third pillar of the transition is related to energy consumption, and “how we use energy efficiently; how we use our electricity; and things like demand-response solutions that help us to bring down our overall energy-slash-electricity consumption”.
That objective is to create “a much smarter, much more responsive energy system that is ready for how that future energy system will look”, he says.
How investors define the energy-transition opportunity set is linked to how broad a view they take of the transition, how far they look past simply renewables and clean energy supply to consider everything that needs to be in place to make those three pillars happen: electrification, energy efficiency, infrastructure, grid networks, and other issues besides.
Breaking it down
Again, to understand the potential opportunities, it helps to break down that big-picture view into smaller chunks.
“If you think about it from a supply-to-demand perspective, obviously the first segment is pretty intuitive: it’s really about renewable energy,” Losa says. He notes that this doesn’t mean only investing in renewable energy generation, but can also mean investing in traditional, fossil-fuel-powered generators that themselves will transition their supply to renewable sources.
“The next segment is what we call enabling infrastructure,” Losa says.
“Here, examples would be companies owning and operating electric grid infrastructure, or smart grid technology solutions, or any other types of infrastructure related to energy transition such as EV charging, et cetera.”
The third segment is what Losa describes as energy efficiency, “related to the demand side of the equation”. And here there are three subsets: efficient industry and manufacturing; green buildings; and smart transportation.
“And then the final segment is what we call enabling technologies,” he says.
“This segment consists of what we call the enablers of electrification, the enablers of the clean energy transition, which consists of the semiconductor value chain as well as energy storage or battery technologies.”
A driver of investment
The transition to a low-carbon energy and more climate-resilient world is an important driver of investment in a range of sectors, including infrastructure, real estate, growth equity and venture capital, says New Zealand Superannuation head of external investments and partnerships Del Hart.
Hart says investment opportunities in the energy transition are constantly evolving and NZ Super’s approach will “evolve as best practice evolves and better data is available”.
“For example, we are considering how to invest in carbon intensive businesses that are rapidly transitioning to sustainable solutions,” she says. And it’s also important to stay in touch with developments in the investment industry through formal and informal swapping of ideas and information.
“We regularly exchange knowledge with peers and external managers we consider to be leaders,” Hart says.
“We attend industry events to keep abreast of the moving landscape and evaluate how these insights impact our portfolio and/or strategy. The fund is also involved in several global target-based initiatives including Climate Disclosure Project, Investor Group on Climate Change, Climate Action 100+, [and] Net Zero Asset Owners Alliance (NZAOA).”
Local Pensions Investment Partners (LPPI) chief investment officer Richard Tomlinson says the energy transition is “easy to talk about, much harder to do and be practical” about.
“From an allocator and investment manager perspective, you’ve got three horizons,” Tomlinson says.
“There’s the short horizon, mid horizon, long horizon. The long horizon, think 10, 15, 20 years, it’s secular stuff. The short horizon, one or two [years].
“The long horizon stuff, I think, is quite well understood. There’s a direction of travel you’re going in, and people are saying that net zero by 2050, we’re going to decarbonise, you kind of know that.
“In the short horizon you’re really in the compliance and reporting-type stuff. It’s standards, it’s how do I get the data and all that good stuff. It’s the mid-horizon stuff that’s really challenging because that’s then actionable around how to execute. That’s the bit that’s hardest to define and most nebulous.”
While investing in energy-transition opportunities might seem like it naturally lends itself best to an active approach, it’s also possible for investors who adopt a passive approach to fine-tune their approach.
NZ Super’s Hart says the fund has changed the equity indexes it tracks for its passive strategies to indices that incorporate the Taskforce on Climate-Related Financial Disclosures (TCFD) recommendations, and which are “designed to exceed the minimum standards of the EU Paris-Aligned Benchmark, and [incorporated] equivalent ESG criteria into our multi-factor equity mandates”.
As a result, “more than 40 per cent of the fund’s net asset value shifted to a portfolio that is net-zero aligned”, Hart says.
Not without risk
While a broad energy-transition trend may be in place and, in Losa’s view, unstoppable, investing in an area that is technology-dependent and can be subject to regulatory disruption is not without its risks.
Losa – whose background is in aeronautical engineering – says some risks can be mitigated by focusing on investing in mature technologies.
“And by mature, what I mean is they are already commercially scalable without requiring subsidies,” he says.
“So, we are talking about solar PV, we are talking about onshore wind, where subsidies and policy support can act as an additional growth accelerator but in reality, they are already cost-competitive compared to other power production technologies without needing subsidies.”
Newer technologies continue to require subsidisation to be competitive investments.
“So that’s reason number one. Reason number two is from a regulatory perspective,” Losa says.
“Here, I’m not talking about subsidies, but rather other challenges for clean energy projects such as permitting.”
“Building renewables requires a relatively lengthy development process which includes gaining the required permits for wind farms or solar PV farms, or even new transmission or distribution grids. So, when these processes are delayed, they represent a risk to the project, causing bottlenecks at some point in time.
A third macro-issue is interest rates, but again, the impact is more to delay the transition in the near-term rather than derail it.
“One thing to bear in mind is renewables requires high capex, but low opex. You need an upfront investment, and then what you want to have is breakeven during the useful life of that asset,” Losa says.
“So the higher the interest rates, because you have the capex upfront, the less attractive it is for renewables at that point in time.
“On the flip side, the lower the interest rates, the more supportive the environment will be for renewables at that point in time. What we have seen right now with interest rates going up, was that the valuation for renewables might be going down.”
CalSTRS’ Abel says a major risk of investing in energy transition is that organisations lacking the “cross disciplinary and nuanced view on cost structures and business models and how technologies are maturing and how different industries are likely to decarbonise” may simply fail to capitalise adequately on the opportunities available.
“A generalist approach that largely buckets the clean energy transition into wind and solar underestimates the need to specialise, to find and achieved commensurate risk adjusted returns.
“It’s much bigger than just renewables, solar and wind story. It really does require that cross disciplinary view thinking about technologies. And so I think that’s one big risk because traditionally, not all investors have devoted time to in-housing engineers or very nuanced technical experts beyond the investment team.”
In addition to the risk that may arise from a lack of specialisation, NZ Super’s Hart says risks come from “all directions: regulatory risk, transition risk, physical risk, technology risk, changing market expectations”.
“We are very aware of the risk of greenwashing and mitigate this risk through thorough due diligence,” she says. “Thankfully, data quality is getting better.”
Return versus environmental impact
One of the challenges that arises reasonably regularly for investors grappling with the transition is the conflict between identifying an investment opportunity that stacks up on a risk and return basis, but which doesn’t measure up on immediate environmental or climate considerations.
LPPI’s Tomlinson says this issue is “very much an active conversation that we’re teasing out”. He says the discussion is being framed in an environment where investing in high-carbon assets isn’t frowned upon as greatly as in relatively recent years, provided there’s a credible transition pathway for the asset in question.
“We were debating if someone came to us with a coal fired power plant, or a business, which was essentially a coal-fired power plant, but they said they’re going to decommission it and here’s the transition plan and it’s going be green within five years, how would we feel about that?” he says.
Tomlinson says buying a coal-fired power plant today, for example, would understandably be “a challenging conversation” with some of LPPI’s stakeholders. He says earlier in the energy transition the investment approach was “exclusion: we just don’t want to own anything that’s kind of fossil fuels”.
“The reality is the world’s going to need fossil fuels for a long, long time. And not only that, you’ve got to power, provide energy, to build infrastructure for the transition,” he says.
“We’ve moved on to a much more thoughtful conversation now. And the more important piece to me it’s the forward looking pathway, credible pathway, to decarbonisation supporting that. That is the big one. The here-and-now and whether your carbon profile is a bit high or not [is] second order in many ways, even though that was the primary focus a few years ago. Just selling stuff isn’t necessarily the solution.”
Losa says Pictet AM prefers to describe the risks facing the energy transition as “headwinds”, and adds that they won’t last forever.
“It’s not a risk in the sense that none of this is going to happen anymore,” he says.
“It’s more like, okay, there’s challenges or bumps along the road, the growth might take a bit longer,” he says.
“That’s what thematic investing is about. It’s about investing in the megatrends of the future, where we focus on long-term, secular themes such as the clean energy transition.”
A significant part of the investor’s task is just figuring out where the winners and losers from the energy transition will emerge, and when. It won’t affect all companies or industries to the same extent, and they won’t all be affected at the same time.
“It’s a great question [but] it’s also a little bit of an unfair question – it’s a bit like asking in the 90s who’s going to benefit from the internet revolution in the next few decades?” CalSTRS’ Nick Abel says.
“The reality is, it’s such a massive and pervasive theme that’s obviously situation-specific on where there’s great investment opportunities, but it’s going to touch all parts of the global economy.”
