Investing with a conscience: energy

The war in Ukraine has shone a spotlight on the world’s energy markets. It has exposed the extent to which developed economies rely on politically or economically less stable nations for their energy needs and the cost of that dependence. Energy markets were already in flux as governments, businesses and individuals confront the difficult transition from fossil fuels to renewable or cleaner energy sources. What are the implications of the energy transition for investors?

The global energy transition was a critical element of governments’ deliberations at the start of 2022. The Paris Agreement concluded by the world’s leaders in 2015 set a target of ensuring that the rise in the average global temperature since the start of the industrial age must be kept below 1.5°C – even though climate experts are now convinced that the target is bearely feasible, but at least still technically possible. Countries across the world have announced commitments to decarbonisation, including the electrification of public and private transport systems, green infrastructure projects and incentives for renewable energy generation. But despite legally binding promises made at the 2015 Paris Climate Conference, UN Environment Programme alarm us that there’s “no credible pathway to 1.5C in place” as of today.

Europe has been in the vanguard on many of these initiatives, with a key role entrusted to the financial sector. In response to the drive to embrace sustainable and responsible investing among major institutional shareholders such as pension funds and insurance companies, the EU has created a transparency framework requiring financial market participants, and eventually a wide range of companies, to report on the environmental and social impact of their products, processes, distribution and supply chains – underpinned by the EU green taxonomy, a classification system, establishing a list of environmentally sustainable economic activities.

The impact of war in Europe

The Ukraine crisis has changed the landscape. European governments have recognised that heavy reliance on Russian fossil fuels creates fundamental sovereignty weakness. Many have been obliged to scramble to secure alternative sources of energy and, in the short term, some have fallen back on other types of fossil fuel – such as natural gas from the Middle East and the United States, and even coal.

“Bitter but … simply necessary” is how Robert Habeck, co-leader of Germany’s Green Party, deputy premier and the country’s minister for climate action, described the German government’s decision to increase coal use to make up for energy shortages.

Sources such as wind and solar energy are now increasingly competitive on cost with many traditional energy sources.

However, in the longer term, it has given new impetus to the push to adopt renewables. Sources such as wind and solar energy are now increasingly competitive on cost with many traditional energy sources, but there are still challenges in terms of intermittency characteristics, infrastructure and storage. Wind and sunshine cannot be turned on and off in respond to levels of demand.

Governments across Europe have set ambitious targets to increase the share of renewables in the energy mix. In the UK, for example, the government is committed to increasing Britain’s offshore wind power generation capacity fivefold by the end of the decade, and has set equally ambitious targets for solar power. The REPowerEU strategy, agreed by member states in May 2022, seeks to “rapidly reduce dependence on Russian fossil fuels and fast forward the green transition”.

Efficiency and renewables

The REPowerEU programme incorporates various long-term energy efficiency measures, including more demanding targets under the Fit for 55 package of European Green Deal legislation, and fiscal measures to encourage energy saving. It also aims to boost the adoption of renewable energy with initiatives encompassing power generation, industry, buildings and transport. One example is a dedicated EU Solar Strategy, designed to double photovoltaic deployment by 2025 and install 600GW of solar generation capacity by 2030.

There are now plenty of well-established investment opportunities within the renewables sector, including the development of infrastructure, with investors’ returns based on a combination of subsidies, energy prices and the value of the underlying assets.

There are now plenty of well-established investment opportunities within the renewables sector.

Such projects often offer a reliable inflation-adjusted income stream, with some capital appreciation over time, similar to returns on commercial property or other infrastructure assets. There is also equity investment in companies producing renewable energy equipment, including wind turbines and solar panels. Battery storage is another area of promise, as countries seek to address the intermittency of renewable electricity sources.

Investors looking for investments offering higher potential growth may consider earlier-stage technologies, such as hydrogen. The EU drew up a strategy to expand the use of hydrogen power in 2020 as part of the European Green Deal. It has now established the hydrogen accelerator concept for scaling up the deployment of renewable hydrogen fuel, whose only by-product is water. This is a promising technology, still at an early stage of adoption but under consideration to decarbonise carbon intensive industries as well as part of heavy duty transports.

Opportunities in infrastructure

Energy infrastructure also needs adaptation. As the sources of energy change, new links and networks need to be created. Connecting new renewable projects to the electricity grid also creates investment opportunities, for example in companies that manage large-scale electrical transmission systems.

New markets are also opening up for companies developing new generations of electrical cables and power equipment. By 2050, the world will need to more than double the length of power lines around the world, along with transformers to facilitate the adoption of renewable energy.

The electrification of transport systems is also a field that will throw up new products and processes. The Inflation Reduction Act adopted by the US Congress in autumn 2022 assigned $12.5bn for electric vehicles, creating incentives for the purchase of new and used zero-emission vehicles. Electric car adoption has accelerated anyway, in part down to soaring prices of petrol and diesel. Governments are also hurrying to roll out vehicle charging infrastructure.

Collective investment vehicles

The role of fossil fuels remains controversial. The Ukraine war has highlighted Europe’s continued dependence on fossil fuel; gas continues to provide over 20% of Europe’s energy needs despite widespread efforts to lower consumption. The transition to renewable energy will not happen overnight, but some energy groups are starting to hedge their bets and become major investors in renewables. BP, for example, is a major investor in the UK’s electric vehicle charging infrastructure.

A broad spectrum of collective investment options exists for individuals seeking opportunities arising from the energy transition: from ETFs specialising in clean energy equity investment to active funds targeting likely beneficiaries from the energy transition. Asset managers may take a pure approach, looking for companies having a direct impact on reduction of carbon emissions, or seek to promote the energy transition by engaging with enterprises to improve their carbon footprint and embrace sustainable production and business models.

It is a structural growth story that can be incorporated into any long-term investment strategy.

One way or another, the energy transition is creating a range of new ways for the environmentally-minded investor to express their moral and political principles through their portfolios. It is a structural growth story that can be incorporated into any long-term investment strategy.