DON’T COP OUT: COP WINS!! Long Live the Energy Transition!

Key questions

• Is the Energy Transition moving too fast? Is it too costly? Or is the rally in commodities exposing the normal supply and demand imbalances that occur in rapid global economic recovery?
• With COP 26 a key question is focusing on the bottlenecks in the energy value chain. What combination of private and public policy will get us to limit the temperature increase to 1.5 degrees Celsius by 2050? What are the investment opportunities?
• What more? What is the investment case for India, the Emerging Giant in Asia - the best performing major market in the world in 2021?

Is the Energy Transition moving too fast or is it not fast enough?

This question is reverberating globally as we recently went though a spike in many commodity prices, shortages of natural gas, as winter approaches. Can we afford the costs of climate change? The ongoing COP 26 meetings in Glasgow are at a crucial cross-road to discuss the most important societal and investment opportunity of this generation.

Commodities rally with cyclical recovery

First of all, commodities normally rise in periods of economic recovery. The current recovery is different in the sense that it arose from an exogenous shock, where governments globally shut down economies during the height of the pandemic. Hence, when the economies globally started reopening, we witnessed the fastest economic recovery in 50 years. 

Underinvestment in the previous commodity cycle

Secondly, there was a commodity bear market in the previous cycle, hence, capex and underinvestment exacerbated the supply side issues.  For example, it takes on average 6-8 years to build a greenfield copper mine.  Therefore, the 2009-2020 capex underspend laid the foundation of the supply side issues we suffer from today.

Stronger Demand And Lagging Supply = Rising Prices

Thirdly, the rapid economic recovery this year exposed the underestimation of supply. In Europe, the increase in natural gas prices has been caused by a prolonged previous winter, and lack of LNG cargoes over the summer which led to tight supply conditions. This was aggravated by poor domestic production and lower supplies from Russia. In fact, the UK & Ireland had a “Wind Drought” with the least windy time period in 60 years affecting windmill power.

In China, electricity demand has increased by double digits due to robust exports and shrinkage of coal supply by just 5%. As a result, natural gas as an alternative fuel has rocketed in price. Rules to lower energy intensity have since been loosened temporarily.  We have subsequently seen a correction in coal prices in China after the authorities acted to increase supply and reduce intensive energy usage in the past month.

Energy Transition Is A Multi-decade Process

Fourthly, the energy transition was always going to be a multi-decade process. The world currently relies on fossil fuels for 80% of energy needs. Oil and gas are transition fuels. Crucially, but not well understood, this transition is aided by the replacement of capital stock at the end of its useful life, which is easier and less expensive to execute.

For example, the average age of coal plants in North America and Europe were already advanced, therefore, swift replacement of aging coal plants made perfect economic sense. However, in Asia, the average age of a coal plant is only 13 years.  Another example is EV adoption rates.  The average life of a car is 10-13 years in developed markets, and it is natural to see an upgrade cycle over time as these cars age. At the end of 2020, while demand explodes, the global EV penetration was still only at 4.5%. However, this will likely accelerate with to 25% by 2030 and 70% by 2080. Higher commodity prices could also help boost adoption.

Climate Change Is Investment Risk & Return

The irony here is that the rise of commodity prices were due to a number of complex factors. That has now translated into a more pressing need for solutions with regards to energy infrastructure value chain versus pre-pandemic. For instance, one of the key bottlenecks is high capacity batteries for storage of renewable power, which would possibly help solve the “wind drought” issues.

Invest In Solutions To Energy Bottlenecks

100 GWs of these high capacity batteries will be in place by 2050 as an example. It is estimated the world requires $150 trillion investment over the next 30 years, which is twice global GDP to meet decarbonisation goals. Focus on the entire value chain which will create multi-decade investment opportunities including (1) renewable energy capacity, (2) energy storage, (3) batteries, (4) carbon pricing, (5) carbon capture and storage, and (6) grid connectivity and (7) HYDROGEN to name just a few of the key bottlenecks attracting significant investment. 

Global Public Policy A Key Driver

Furthermore, public policy is also driving this acceleration with the Europe’s “Green New Deal”, the US “Build, Back, Better” and China’s commitment to carbon neutrality by 2060. These  are fundamental building blocks, which can aid the acceleration of adoption, with the phasing out of petrol engines or early retirement of coal plants, even in emerging countries. At the COP 26, India stole the show by agreeing to carbon neutrality by 2070. Clearly, the momentum for energy transition is increasing, with EMs now coming onboard.

India The Emerging Giant

As for India, we have decided to take profits on largely due to the extremely strong price action, moving from Overweight to Neutral. The Sensex has appreciated circa 60% since the upgrade in end May 2019, 52% last 12 months, and 29% year-to-date as of October 28th. It is the best performing major equity market in the world in 2021. It trades at a record 60% premium to Asia stocks and near 100% valuation premium to China equities. The Sensex 30 Index trades at a 26x current year earnings and 22x next year earnings. Furthermore, higher energy prices and higher inflation will lead to RBI rate hikes as we are seeing globally.

Why Should India Trade At A Premium And It Has Historically?

India long-term fundamentals remain strong. (1) Improving business landscape under PM Modi, (2) Young population – demographics key to growth in an aging world, (3) Lower levels of debt compared to other major countries, (4) Large and growing domestic market, and (5) Strong culture of high return on equity with company returns. Two of the top three wealthiest people in all of Asia are located in India, reflecting the massive domestic growth catch-up potential. We would revisit the case on a market pullback. India also provides diversification potential from China, which was especially evident this year.

CONCLUSION / STRATEGY:

In summary, we have been long “green real assets” and profited by the increase in  commodity prices as consistent with a vigorous cyclical recovery. However, this only strengthens the case for further investment and acceleration of the private and public partnership driving the fight to limit global warming to 1.5 degrees Celsius. It is estimated the world requires $150 trillion investment over the next 30 years, which is twice global GDP to meet decarbonisation goals. National security and energy security go hand-in-hand. This is also one of the key issues where there is true global consensus. Investors should focus investments on key bottlenecks as well as adopt ESG integration across your mainstream investment portfolios.

Read October Issue of Investment Navigator :  Inflation, Stagflation, Debt Ceiling Concerns – How to Position?