Page 8 – Top1000funds.com

Published in partnership with Pictet Asset Management

Only a fraction of all the water on earth can be used by humans. Not only is water both scarce and finite, but the United Nations (UN) also describes it as “vital to the functioning of the global economy”.

How water resources are managed and conserved as populations and economies continue to grow is a critical issue facing every nation on earth – developed, as well as developing.

Environmental reporting not-for-profit organisation CDP says less than 1.2 per cent of all the water on earth is useful to humans. Its very scarcity, and the need to manage it carefully, presents opportunities to invest in businesses or industries whose supply chain includes water – this includes agriculture, perhaps most obviously; in businesses that can reshape their processes to use less; in companies developing new ways to conserve fresh water and recycle used water; and in projects to clean up waterways and oceans.

There are reasons beyond simple risk and return issues and maximising pensions for beneficiaries as to why investing in water is such an important issue. Critically, investing in the better stewardship of water resources is also seen as fundamental to addressing climate change and ensuring the long-term health of the environment.

Fresh water is one of the nine so-called Planetary Boundaries (PB) framework (below) that the Stockholm Resilience Centre says are “processes that regulate the stability and resilience of the Earth’s system, and “within which humanity can continue to develop and thrive for generations to come”.

However, the centre notes that six of those nine boundaries have already been crossed – including freshwater use – which “increases the risk of generating large-scale abrupt or irreversible environmental changes”.

“Drastic changes will not necessarily happen overnight, but together the boundaries mark a critical threshold for increasing risks to people and the ecosystems we are part of,” it says.

In addition, the United Nations addresses access to clean water and sanitation in its Sustainable Development Goals (SDGs). The UN says that by 2030 there will be a global water availability shortfall approaching 40 per cent – so using what there is much better than it’s being used now isn’t optional.

Pictet Asset Management’s (Pictet AM) investment manager of active thematic equities, Charlie Carnegie says an investment strategy focused on water is “very much tied up in SDG 6 – this is access to clean drinking water and sanitation”.

“Water is now defined by the UN as a human right, and quite amazingly, over 40 per cent of the world still lacks access to this basic infrastructure,” he says.

“That’s something that we have no reason not to be able to provide going forward.

Investing in solutions

Carnegie says Pictet AM’s approach to water as an investment thematic is “really about investing in the solution providers to the water challenges that we face. We believe this represents around $1.4 trillion in annual revenues and is growing above GDP”.

Pictet AM has worked with strategic consultancies, academics and business leaders to devise a framework that tracks both the evolution and industry effects of 21 megatrends, which form six clusters: technology and science; environment; global governance; demography; economy; and society. Where megatrends intersect, Pictet AM believes investment themes emerge. The investment theme behind the water strategy comes from the intersection of the economic megatrends of commercialisation and economic growth; the demographic megatrend of urbanisation; the society megatrend of a focus on health; and the environment megatrends of environmental quality, climate change and resource scarcity.

“[Water] touches us all the way from human health, through to industrial activity and through to agriculture and our food systems,” Carnegie says. “Within that we have various constraints and human impairments on the water cycle that require intervention and investment to resolve.

“Our water strategy is playing at that intersection between the challenges and the solutions.”

Carnegie says a critical but sometimes overlooked aspect of investing in water is “not investing in certain parts of it”.

“We don’t, for example, invest in bottled water,” he says.

“That’s water, but it’s not a solution provider to a problem or a challenge that the water cycle faces. Ultimately, it’s a convenience product, that tends to come with significant environmental costs associated with it. So, we don’t consider bottled water a thematic growth opportunity.

“We also don’t focus on water users, the customers of the water cycle. We’re looking at the people who are providing solutions to them. You have big industrial users of water, whether it’s textiles, chemicals, the oil and gas industry; they need a lot of advanced capital goods to support their processes. We’re looking for companies that are providing that. Not stewards of water, so to speak, but more the ultimate solution providers.”

Some investors view opportunities to invest in better use and management of water as part-and-parcel of an approach to tackling climate change. Peter Cashion, managing director of sustainable investments at the $500 billion CalPERS told the Top1000funds.com Fiduciary Investors Symposium at Stanford University there are two elements addressing climate change.

The first is the sheer scale of the required energy transition, Cashion said.

“In 2023, $1.7 trillion was spent on transition, up from $900 billion in 2019, so there’s really been a considerable increase, and that’s only going to grow,” he said.

“The second element is the importance of resource efficiency…so whether that’s water, power, energy efficiency – just inputs in general – that’s going to translate into lower costs, higher profitability and higher valuations.

“We’ve really seen, particularly in public equity, those strategies have really outperformed over the last years that are resource-specific measures.”

Not without risks

But despite the apparently compelling big picture, in practice investing in water isn’t without risks. Some pension funds have learned the hard way that they must pay as much attention to how utilities are regulated ans trsuctered as they pay to the fundamentals of water as an investment theme.

For example, the $100 billion University Superannuation Scheme (USS), the largest private pension scheme in the UK, revealed in its latest annual report that losses on an investment in the troubled UK utility Thames Water had led it to a “serious reflection” on investment in regulated assets in the future.

“Economically regulated assets should be a good fit for long-term patient investors like USS, particularly where, as with infrastructure, they require long-term investment to address historical challenges,” said Simon Pilcher, chief executive of USS Investment Management.

Pilcher noted that success is dependent on similarly long-term, consistent regulation that recognises the need for that investment and strikes a fair balance between risk and returns over the long term.

Pension fund investors have stepped-up investment in water-related assets and infrastructure, albeit from a very low base half a dozen or so years ago. A White Paper published by the World Water Council estimated that in 2018 that just 1 per cent of pension funds globally were invested in infrastructure overall, most of that was in transport and renewable energy, and hardly any in water-related opportunities.

But increasingly, funds are now recognising that the better use of water is a key plank in the sustainability of the businesses and industries they invest in, and is integral to the environmental health of the planet.

Norges Bank Investment Management, manager of the $1.78 trillion Norwegian Government Pension Fund Global sets out clear expectations of the companies and industries it invests in, including those with “operations or value chains in sectors with high water dependency and in regions exposed to water scarcity, water pollution and other water-associated risks”.

“Companies can seek guidance from relevant international principles, guidelines or industry initiatives, and UN Sustainable Development Goal 6 – Clean Water and Sanitation,” it says.

“Unilateral water management has limitations and may present companies with dilemmas. Collective impact assessments and action from multiple water users in a basin may play an important role in reducing risks.

“As an investor, we expect companies to be transparent about the topics raised in this document. For selected companies, we use such information to assess their water risk exposure, management and performance.”

While infrastructure and industrial companies tend to be at the core of Pictet AM’s strategy, Carnegie says a focus on impairments to the water cycle means the breadth of investment opportunities can be quite wide, and includes consumer-product companies, such as manufacturers of water-efficient home appliances and filtration systems; healthcare, where you find manufacturers of advanced analytical instruments for analysing water pollution; and even IT, “where we are finding a growing range of software providers building tools to help model and manage complex water infrastructure”.

Carnegie says investors in water solutions can choose between unlisted or private assets, and publicly listed assets. The route taken depends on the investor’s return requirements and risk appetite. Carnegie says Pictet AM’s water strategy invests solely in listed equity.

“Publicly listed equity gives us the necessary liquidity, transparency, disclosure and scale to tackle the sizeable opportunities ahead,” Carnegie says.

“We think it gives us a very good, clean route to the market. We’re not saying it’s the only one, to be clear; but it’s certainly the one that’s delivered very interesting, solid, compounding returns since inception in 2000.”

A lower-risk alternative

It’s also possible to participate as a fixed income investor with the intention of improving water quality while generating comparable investment returns to alternative opportunities that don’t share the same environmental objectives.

Ulrika Linden, senior portfolio manager, fixed income and green bonds, at the $84 billion Swedish AP7, says the fund invests in programs aimed at cleaning up oceans, which it participates in by buying blue bonds – these are bonds that comply with green bond principles, but which have a specific focus on water-related issues.

The World Bank defines a blue bond as “a debt instrument issued by governments, development banks or others to raise capital from impact investors to finance marine and ocean-based projects that have positive environmental, economic and climate benefits”.

“What the blue bonds does is actually not only sanitation water, or what you would say would go to SDG 6, giving clean water to households, but it’s more like saving oceans programs,” Linden says.

“We’re not able to do things for charity, because we are managing pensioners’ money, so we’re not allowed to give money away. We need to get an investment return that equals what we would have been given otherwise.”

Linden says a “big advantage with green bonds from the start” is that the risk for investors is considerably lower than for equity investors. For a fund like AP7 that is restricted in the credit rating of the bonds it can buy, investing only in the highest-rated securities, it might otherwise be precluded from taking part in such projects because of the associated risks.

“We have big development banks that come in and take the risk that we would not be able to bear in cleaning up an ocean in a [location outside Sweden], because we only have to be very low risk,” she says.

“We have this development bank, like the Asian Development Bank or World Bank, to go in and take the risk.”

Linden says the motivation for investing in blue green bonds is as much environmental as it is financial – but with the important caveat that the returns must be competitive.

“That’s a purpose with it, when it’s from the fixed income part, that you actually have some environmental benefit from it, because otherwise you can get that investment return elsewhere,” Linden says.

“So when you’re a fixed income investor, it’s kind of that you get to do these good things, but not lose money on the way, and then you’re very happy if you get to do this project, but still have the same return as if you were investing in something that didn’t do anything for the ocean or for the sea.”

One of the major issues faced by fixed income investors is the credit risk of the bond issuer, but Linden says this is mitigated to a significant degree by the involvement of the World Bank or the ADB. Provided the bond is held to maturity, the capital risk is minimised.

Private infrastructure

For investors such as pension funds with very long-time investment horizons and risk appetites to match, “there are interesting private infrastructure assets, for example, that are out there”, Carnegie says.

“When you get down into infrastructure assets, a lot of them are unlisted, but they tend to be lower growth, low volatility, lower returns,” he saus.

“It’s just a slightly different profile.”

Investing in clean water distribution and sanitation might seem like it would be a bigger issue in developing economies than in developed economies, but Carnegie says investment in water management is required right around the world.

“Even in the developed world we still see a lot of interesting opportunities, in particular where you’re seeing significant urbanisation,” he says.

“Even in an advanced economy, we’re seeing urban population growth at almost 2 per cent annually, and obviously that creates a lot of pressure on the urban drinking water and wastewater systems. There, we see the need to invest incrementally.”

Carnegie says substantial investment is also needed to upgrade existing infrastructure, because in places such as the east coast of the US and in Europe a lot of the water network was built a century or longer ago, “which will provide a lot of opportunity to the water utility supply chain, and also the utilities themselves, as they make that investment with a guaranteed return through their water rates”.

There’s also the issue of polluted waterways and complying with growing regulatory demands to clean them up and maintain safe drinking water.

“The EU in 2020 dialled-up its requirements on water quality through the Drinking Water Directive, and they set a requirement on member states to comply by 2026,” Carnegie says.

“In the US, we’ve recently seen a pretty seismic ruling by the Environmental Protection Agency, setting an incredibly strict minimum contaminant limit on what’s called ‘forever chemicals’, and that’s going to drive tens of billions of dollars of investment over the coming five or six years, as water utility companies are forced to comply with this.”

US public pension funds should stop wasting precious time on thinly veiled political activism like vilifying the oil giant Exxon, ditch the ESG conference circuit, a sanctimonious echo chamber that does little to address the looming climate emergency, and repurpose most of their sustainability staff, says John Skjervem, CIO of Utah Retirement Systems (URS) which oversees $55 billion of assets on behalf of the US state’s public sector employees.

They should instead focus on putting capital to work in proven energy investments that generate returns to pay current retiree benefits and finance new transition technologies.

These new technologies will then power future returns for beneficiaries, decarbonize the world economy and hopefully stave off catastrophic global warming, Skjervem says.

The URS alternative energy portfolio

URS is building a portfolio of alternative energy investments with the dual focus of hedging its commitments in oil and gas while also positioning the fund to support and profit from a decarbonized future.

“We know decarbonization will happen, but we aren’t smart enough to predict with any precision exactly how or when,” says Skjervem, speaking to Top1000funds.com from the fund’s Salt Lake City office, explaining how URS is assembling a diversified basket of alternative energy investments so it has exposure across multiple transition scenarios.

“We started with fusion which of course is the holy grail, but are now working backwards, filling in the transition spectrum with intermediate to nearer-term strategies that utilize hydrogen, ammonia, and fission-based technologies.”

Rather than participate in ESG conferences, the URS investment team attends events sponsored by the US Government’s Advanced Research Projects Agency-Energy (ARPA-E) where it gleans insight into potentially breakthrough energy transition strategies. These events are more important than ever, says Skjervem, now that financial support from the Biden administration’s Inflation Reduction Act is available.

“If institutional fiduciaries are serious about climate change as a threat to securing future retirement benefits, why aren’t they here?” he asks, adding that for the third year in a row, URS was the only large, institutional asset owner attending a recent ARPA-E event.

Utah’s commitments to alternative energy are often in the form of direct investments, a higher-risk approach that makes up a small but growing portion of the fund’s 5 per cent real assets allocation.

“The incubation and development period for these transition technologies might be measured in decades,” says Skjervem, “so the investments don’t always comport well with a typical closed end fund structure.”

Importantly, 60-70 per cent of the fund’s real assets allocation is currently comprised of oil and gas holdings, many of which URS acquired in the wake of other investors’ retreat from fossil fuels. Moreover, several of these stakes are held independent of private equity funds enabling URS to retain long-term ownership in high-yielding assets at reduced fee levels.

“My predecessor, Bruce Cundick and the rest of the URS team adroitly capitalized on the oil patch exodus by investing consistently through the financing void that began in 2015” he says.

Both/And

As an alternative to the either/or paradigm that forces investors to divest from fossil fuels (bad) in favour of renewables (good), Skjervem’s guiding mantra is both/and which allows fossil fuels to jostle alongside renewables and alternative energy strategies like fusion.

“As investors, and as a society, we won’t be successful if we remain anchored in either/or thinking. If we can make a profitable investment that moves energy production from coal to oil, that’s good. If we can make a profitable investment that replaces oil with natural gas, that’s better. And if we can make a profitable investment that displaces Russian gas with domestic renewables, that’s terrific! But too often we see activists, politicians and even some high-profile institutional investors reject profitable, environmentally sensible investments due to the tyranny of either/or thinking.”

Skjervem offers methane as an example.

“In terms of total greenhouse gases, methane is much worse than CO₂,” he says, arguing that in stark contrast to production in countries like Russia, Venezuela, Iran and Turkmenistan, home to the notorious Darvaza gas crater, US oil and gas production has among the world’s lowest methane emissions due to increasingly stringent regulation by the Environmental Protection Agency.

“Why wouldn’t you ‘Drill Baby Drill’ when US methane emissions are lower than other producers? Do you think Vladimir Putin or the Ayatollahs give a you-know-what about their respective methane emissions?”

It leads him to reflect on the paradox that finding solutions to complex problems requires both/and thinking but the political dynamic now affecting many funds’ governance encourages either/or decision making. Yet by supporting domestic oil and gas production he says “we can create jobs, fortify US geopolitical security and, at the margin, reduce aggregate, global methane levels. It’s a trifecta!”

Do Something Useful

Skjervem knows it’s possible one, more, or perhaps all these transition technologies won’t work and accepts that he and his team will make mistakes in the still nascent alternative energy sector. But he also views the URS alternative energy allocation as a responsible and rational hedge against inevitable decarbonization.

“With a big chunk of our real assets portfolio in the ground in Texas, our alternative energy efforts are just portfolio construction 101.”

He also says these efforts symbolise everything he believes investors should be doing to tackle “the biggest challenge facing mankind.” Specifically, he’d rather do the hard work of “committing time, energy, and real money to decarbonization strategies” than add “yet another vapid voice” to what he calls the already shrill and counterproductive ESG cacophony.

This approach also reflects his belief that adverse climate change outcomes should be addressed separately from today’s myriad of sustainability initiatives. A self-proclaimed sustainability O.G., Skjervem joined the Investor Advisory Group (IAG) of the Sustainability Accounting Standards Board (SASB) over a decade ago, and still serves in that role for SASB’s successor organization, the International Sustainability Standards Board (ISSB).

Under founder Dr. Jean Rogers, SASB pioneered the idea of evolving modern accounting practices to better measure and assess the materiality of corporate externalities. ISSB continues that effort by promulgating accounting and reporting standards that capture and present sustainability factors in a decision-useful framework.

“I’m proud of my long tenure in sustainability and convinced the empirical approach developed by SASB and continued forcefully under ISSB auspices will advance capitalism by improving corporate accountability across an expanded list of operating and impact criteria,” he says. “But climate change is a 5-alarm fire that requires immediate action separate and apart from the methodological approach needed to evolve global accounting standards.”

Skjervem has other advice too. Investing in energy transition technologies is difficult and will require new and different skills. Successful investors will need more engineers who understand energy physics and fewer of the political science majors he says now populate the ESG scene.

He urges other institutions to invest in these technical skillsets rather than continue to pour resources into still more ESG grandstanding.

“You only need one, maybe two sustainability analysts to engage effectively with ISSB and help keep its good momentum going. You sure don’t need 12.”

See also

Utah Retirement Systems: Why ESG is a waste of time

Asset owners that are long-term investors should be wary of the conventional model of assessing the stock-bond correlation that is based on several “implicit assumptions”, said Stanford University Professor of Finance John Cochrane.

In a keynote speech at the Fiduciary Investors Symposium, Cochrane instead proposed a method that considers the economic situations which determine bonds’ status as a hedge or a risk.

Investors are conventionally trained to use statistical models to determine stock-bond correlations and look for the time-varying alphas and betas relative to that correlation, Cochrane said, but this model assumes a particular type of investor.

“You are assuming you’re talking to – or you are – an investor who cares about the mean variance of your portfolio, who holds only the market portfolio of stocks, has no job, no income, no liability stream, and cares only about one year,” Cochrane, who is also a senior fellow at the Hoover Institution, said.

“That’s a particularly bad assumption about bonds, because the one thing you need to know about bonds [is] when the price goes down, the yield goes up. A long-term bond, when you suffer a loss, you know it’s going to make it up in the long run.

“For a long-run investor with no immediate cash needs, who cares about mean variance?”

Cochrane encouraged the symposium to instead look at economic events when bonds were either hedges or risks, and to think about if they would have wanted to hold bonds ahead of time and how much they would be willing to pay.

“Just hedges or risks is not alone the question; the question is, are you the one who should be hedging or taking risk more than everybody else, because the average investor holds the market portfolio,” he said.

“I like to think about that in terms of fundamentals: where am I relative to everybody else who’s driving prices, rather than just statistical models, which I have learned over many years not to trust.”

The 2008 financial crisis is a classic case of bonds as a hedge, Cochrane said, because with inflation and interest rates both down, long-term government bonds got both a price and a real value boost “just as everything else was falling apart”.

But he said long-term bonds are risks when inflation comes into the picture, referencing how the $5 trillion US government fiscal expansion during COVID has been a “catastrophe” for long-term bond holders.

“The US government printed up $3 trillion, borrowed another $2 trillion, and sent it out as cheques to people,” he said.

“Whether good or bad, that $5 trillion, about half of it came from a 10 per cent haircut on long term bonds.

“The risk that happens is inflation. The risk that happens is the government decides we’re going to inflate away some of your debt in order to pay for something important.”

Instead of thinking about stock-bond correlations as fixed facts, Cochrane said investors will be better off with a simpler mindset – which is finding a stable economic structure and “understand changing times being we have different kinds of shocks”.

Responding to an audience question about the research view that it is the volatility of inflation and growth – instead of the level or the direction of them – that determines the stock-bond correlation, Cochrane said whether people need to care about it depends on what kind of investors they are.

“If you’re in a microsecond, millisecond, highly leveraged trading, short positions, long positions, posting collateral [kind of role], then you got to worry about these high frequency correlations,” he said.

But for long-term investors, “setting up the portfolio and thinking about the economic risks that your clients can handle should take more time than buying and selling at high frequency,” Cochrane said.

Analyses of the economic impact of artificial intelligence (AI) too often start with a top-down view of economies, industries or businesses, when a more accurate picture of the impact can be gained by examining the individual tasks that are bundled together to form jobs, the Fiduciary Investors Symposium has heard.

The Jerry Yang and Akiko Tamazaki Professor and Senior Fellow at the Stanford Institute for Human-Centred AI, Erik Brynjolfsson, said that “too often [we] think about how AI is affecting the whole economy, or industries or companies or jobs”.

“None of that is the right way to think about it,” Brynjolfsson told the symposium.

“You need to go all the way down to individual tasks. And when you do it at that level, you can get a much better understanding. Every occupation, every job, is a bundle of tasks.”

Brynjolfsson, who is also a director of the Stanford Digital Economy Lab, said that radiologists, for example, “do maybe 27 different tasks”.

“Or you can make it even more fine-grained than that, financial managers, economists, truck drivers, nurses, everybody does a whole bunch of individual tasks,” he said.

“Once you break it down to individual tasks, you can start understanding…the implications of AI for those specific tasks. Some of them it’s going to help with, and others it’s not. Then you can roll them back up, weight them by wages or value added, and you start getting an image, a picture of what’s happening in the company or the whole economy.”

Brynjolfsson said a task-based analysis makes it clearer that there are some tasks that humans can do better and some tasks that machines can do better, but he said his research has not found a single job in the economy where machine learning or AI did every single task better than a human.

“On the other hand, we didn’t find a single job where there was no effect at all of machine learning,” he said.

“So the takeaway is that instead of mass unemployment [or] mass joblessness, from these technologies, [or] complete elimination of occupations, what we’re seeing instead is mass restructuring, mass reorganisation.

“As some of the tasks get done by humans [and] some get done by machines, managers and entrepreneurs have to rethink how they organise the economy. That’s what we’re going through right now – the biggest transformation in the economy that I think we’ve ever seen as more and more opportunities, more and more places for machines to help out and supplement what humans are doing.”

Brynjolfsson said AI is the general-purpose technology (GPT – before ChatGPT appropriated the acronym) of our time, and it follows previous GPTs such as the internal combustion engine, electricity and the steam engine in moving the dial on economic growth and wealth creation.

“Tim Bresnahan and Manuel Trajtenberg, here at Stanford, defined GPTs as having these three characteristics: pervasive, able to be improved over time, and able to spawn complementary innovations,” Brynjolfsson said.

“That last one is probably the most important one: they trigger a whole bunch of complementary innovations.”

Brynjolfsson said there is a threshold that any new technology crosses where it becomes better, faster and cheaper than the process or technology it is designed to replace.

“That threshold is important because, just like when water crosses the boiling point and changes from a liquid to a gas, it’s a threshold,” Brynjolfsson said.

“It is a phase transition that’s happening in the economy. When you have two ways of doing something and one of them becomes significantly better, faster, cheaper than the other way, then managers, entrepreneurs, are going to switch over from one to the other.”

Brynjolfsson said we’re starting to see “this phase transition of machines outperforming humans in a broader and broader array of tasks”.

However, he said, it’s not yet true of all tasks and we’re still some way off developing artificial general intelligence, but “there are a lot of concrete tasks where we now have machines outperforming humans”.

This has profound implications for the occupations and sectors it touches, but not always in obvious or expected ways. Brynjolfsson said one example is medical imaging, where applications built on machine learning outperform humans in identifying pathologies. Around 10 years ago it was firmly believed this would lead to declining demand for radiologists. In fact, the number of radiologists has almost tripled, because while reading medical images is what radiologists do, they do a lot of other things as well.

“You end up having more demand for some of the other tasks, some of the complementary tasks,” Brynjolfsson said.

“And as the price goes down, if you’ve got a downward sloping demand curve, remember, from economics 101, lower price leads to greater quantity. So more medical images are being read than ever before, and they continue to require humans in the loop.”

Developing long-duration storage and digitisation of the whole energy system remain key challenges as the world struggles to slow the growing impact of climate change.

While the global energy transition raises these issues relating to technology, policy and financing, it also represents an enormous economic opportunity as industry races to unlock solutions, Professor Yi Cui, faculty director at Stanford Doer School of Sustainability, told the Fiduciary Investors Symposium at Stanford University.

Many scientists believe the world has already reached 1.5 degree Celsius warming compared to pre-industrial revolution levels, and at a 2 parts-per-million (ppm) per year increase of carbon emissions we will get to 2.0 degrees of warming in roughly 15 years, Cui said.

“This is a gigantic transformation we are facing that needs to be done within about 30 years,” he said. “This is very, very urgent.”

Over the past 20 years, the energy transition has recorded a number of successes. The primary one is clean electricity generation, with solar and wind power now being generated for cents per kilowatt hour, meaning there is no need to burn coal anymore, although coal-fired power plants still exist because they had already been built, Cui said.

Other related to long distance transmission lines, which are capable of transmitting electricity more than 2000 kms with very high efficiency; and low-cost LED lighting technology. Finally, the development of lithium-ion battery-powered electric cars over the past decade has been a major development.

Key Challenges

Despite these successes, the most important test for the energy industry relates to long-duration energy storage. It is the question of how to extend the storage of clean electricity from hours to days and weeks and months.

“If this works, you will help decarbonise the electricity sector and the transportation sector,” Cui said.

“That is basically 60 to 70 per cent of carbon emissions already. So it is a big deal.”

Cui said that in order to stop emissions rising in the next 15 years, we will also need negative carbon technology to capture and remove carbon and other greenhouse gasses like methane from the air.

The world must also develop a circular economy at scale to take care of reuse and recycling needs. For example, electric vehicles, existing gasoline cars, concrete, and steel will need to be recycled much more efficiently.

Another looming issue on the horizon is how to power the growing usage of artificial intelligence. Cui quoted Nvidia’s Jason Huang saying that power is very likely to limit AI’s development, given that by 2050 half of all electricity generated globally will be used to power AI.

“How do you build the AI power?” Cui said.

“Do you use nuclear reactor for the AI computing centre? Or do you build solar plus storage? This remains to be seen. And how do you build a transmission line to get to the AI centre? Depending on which country you are in, the degree of difficulty will be very, very different.”

Ambitious Plans

Cui said developing high-energy-density lithium-ion batteries is key to how much electrification is possible, with current innovations attempting to develop higher performing prototypes using new types of materials to store greater charge.

“The motivation is very simple, but it’s very, very hard,” he said.

“If you could do that, we can go from the bottom, that’s current technology, all the way up to being able to store four times more energy per weight of the batteries.”

Once this level reaches about 500 watts per hour per kilogram (Wh/kg), all ground transportation could potentially be electrified. If you get to 1000 Wh/kg then domestic flights, of about three hours’ duration, “I think it’s a done deal”, he added.

The second key requirement for decarbonising the entire energy industry is to make long-duration energy storage work, at a low enough cost and a large enough scale.

“The capital cost per kilowatt hour of the battery needs to be lower. We are very far away from that,” Cui said.

“That will be the technology that can give you very safe electricity storage, with a very long lifetime. These batteries could last for 30 years, and the initial cost will be low.”

The influx of capital and interest into the private credit market has spawned new managers and offerings, but asset owners are increasingly alert to the fact that not every one of them is built equal, and even tiny losses during the credit cycle can eat significantly into long-term returns.

During a panel at the Fiduciary Investors Symposium at Stanford University, HOOPP senior managing director of structured and private credit Jennifer Shum warned of the danger of “compound losses”.

“There’s a lot of managers out there that haven’t been through a full cycle. We have,” Shum said.

“The losses are going to be interesting, because right now, every single private [credit] manager that you talk to says, I don’t have any losses – it’s 0.5 or 0.8 basis points. Everyone has the same deck.

“If a manager has tiny little nicks over time during the credit cycle, those compound losses are going to get you.”

HOOPP has been investing in private credit for more than a decade and Shum said the most attractive aspect of the asset class is the current income. The presence of covenants also protects lenders and brings the board to the table when things don’t go according to plan.

“We are the debt investor, [so] we’re going to be able to have a conversation with the borrowers on the private equity side, so there’s really interesting downside protections on private credit versus private equity,” Shum said.

Illinois Municipal Retirement Fund (IMRF) chief investment officer Angela Miller-May said the $52 billion fund is similarly bullish on the asset class and has painstakingly gone through a manager selection process for that part of the portfolio.

It completed an asset liability study in 2022 and established a three-year implementation plan to reach a 4 per cent allocation to direct lending, asset backed lending, and opportunistic private credit, funded by reducing equities, Miller-May said.

“We evaluated various strategies across the credit spectrum to really look at managers that could complement each other, could diversify the portfolio, and have unique strategies with a competitive edge,” she said.

“We put out an RFP in April of 2023 we got over 200 applicants…we came down to 13 managers.”

Miller-May said the fund is expecting its position to change over the credit cycle, hence the number of managers it hired as the base of the portfolio. Now, the fund sees appealing income generation and risk-adjusted return prospects, and the role of private lenders as providing capital where it is scarce.

“Plus the exit environment that we’re experiencing in private equity, where private equity companies are seeking financing solutions as well to infuse capital or provide distributions to liquidity constrained investors,” she said.

“We think that increases the opportunity set for private credit.”

Looking ahead, though, HOOPP’s Shum said private credit has somewhat become “a victim of our own success” as with the capital injection, investors are seeing some “lighter covenants”.

David Geenberg, managing director and head of North American investment team at opportunistic credit manager Strategic Value Partners, said the winds of change are already blowing in the leveraged credit markets.

“We are already seeing an increased restructuring cycle,” he said.

“It started about a year and a half ago. You can see significantly elevated restructuring rates, where it is visible in syndicated leveraged markets and leveraged loans, and high yield.”

Depending on which data points investors are looking at, defaults rates for the LSTA US Leveraged Loan Index is between 4 and 6 per cent, Geenberg said. It was within that range last year, and SVP is expecting that to be the case next year.

“You’re going to see over three years, 10 to 12 per cent cumulative restructuring in these portfolios,” he said.

“In the US and Europe – just in corporates, private equity, leveraged loans, direct lending – there are ten trillion dollars. So we think you’re looking at a trillion dollars’ worth of assets that get touched however they’re touched by the cycle.

“We think that it has both been a profound opportunity for investors like ourselves, but it is also a profound risk. We’re not telling you it’s going to cause a giant economic cycle, but it is going to affect portfolios.”