FEATURING:

Alaina Anderson, CFA, Partner
Portfolio Manager, Global Research Analyst

Anil Daka, CFA, Partner
Global Research Analyst

22
Conservation Capitalism

August 27, 2021 | 34:00

Everything is becoming smart these days—buildings, grids, and cities. In the fourth installment of our Convergence series, which examines five growth themes that are shaping the future of investing, Hugo Scott-Gall speaks with Alaina Anderson, CFA, portfolio manager and global research analyst, and Anil Daka, CFA, Partner, global research analyst to discuss renewable energy, smart infrastructure, and new business models, as well as how environmental, social, and governance (ESG) factors are accelerating these trends.

Meet Our Moderator

Hugo Scott-Gall, Partner
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SHOW NOTES
00:31 Host Hugo Scott-Gall and his colleagues join to discuss conservation capitalism.
01:41 “The energy transition is as big as the dot-com bubble. Discuss.”
04:37 Are we experiencing fast enough tech changes to get cleaner at a reasonable price?
07:38 What are the constraints in delivering?
09:50 Not only is generation worth considering, but so is consumption.
12:43

Is there a real risk that our estimation of time is flawed?

16:59

Hugo wonders how meaningful the cost benefit from digitalization is.

18:36

The conversation shifts to electronic vehicles.

22:10

Hugo asks about ESG.

27:06 What are the biggest risks that threaten to derail the transition?
Transcript

Hugo Scott-Gall: Today I’m joined by two of my colleagues, Alaina Anderson and Anil Daka to discuss conservation capitalism in the next installment of our convergence series which examines five growth themes shaping the future of investing. So, in this installment we’ll cover renewable energy, efficiency gains, smart everything, new business models, and we’ll discuss ESG, how that is accelerating these trends.

Alaina is a portfolio manager and a global research analyst covering real estate and utility companies. Anil is a global research analyst covering mid-cap industrial companies. Hello, and thanks for being here to both of you.

Alaina Anderson: Hi, Hugo.

Anil Daka: Hey, Hugo.

Hugo Scott-Gall: Great. Let’s get started. We are going to start with a pretty big provocative question, but I think it gets to the heart of what we are talking about. The first question goes to Alaina, and it is this assertion which I’m sure you are going to take issue with, the energy transition is as big as the dot com bubble. Discuss.

Alaina Anderson: Well, it certainly is provocative. Thanks for kicking it off with a provocative statement, Hugo. I have heard queries or concerns that the energy transition and the resultant froth that we’ve seen in some of the valuation in the renewables companies is similar to that of what we saw in the dot com bubble of the 2000s. My assertion is that we’re talking about two very different phenomena here. Specifically, the dot com phenomenon was really driven by a push of technology from technologists to consumers. For instance, I’m not sure what the pull was for say Pets.com. I think it was a build it and they will come phenomenon with quite a lot of the dot com offerings that were developed in the 2000s.

Conversely, with renewables, what we’re seeing is a pull of demand. We have decided as a global community that we are reducing our commitment to hydrocarbons. We are reducing our commitment to generating electric power from coal. As a result, there is a very natural substitution effect that’s driving the growth of renewables. If 30% or so of the emissions that are created globally come from the power sector, we will decarbonize those emissions by generating power from green sources instead of from fossil fuels. And so, that’s a natural substitution effect and that’s a natural pull of demand.

The other two-thirds of the emissions that are generated globally come from transport, buildings, heavy industry. Renewables will have to prove themselves as being able to unseat the incumbents and that is already playing itself out. We are moving quickly towards electric vehicles for transport, for instance. We are trying very hard to commercialize hydrogen to decarbonize heavy industry. So, I think that while I understand where the sentiment is coming from, the dynamic here, the demand side of the equation is much more of a pull within renewables versus what we’ve seen from other similar high momentum phenomenon in the past.

Hugo Scott-Gall: So, I guess one of the big things here is that you’re dealing with real-world problems. You’re dealing with physics. The dot com era gave way I guess to the manipulation of digits, and now we’re going to have to start manipulating some assets. We’ve got a lot of will as you say, but are we getting fast enough change on the technology side to enable? So, we really want to get cleaner, but do we have the technology that allows us to get cleaner at a reasonable price?

Alaina Anderson: Well, that’s really been the catalyst to the uptake in renewables to date. The fact that the cost curves have been coming down so quickly as you get the feedback loop of big users or big developers deploying capital at scale, helping to create economies of scale, and driving out costs and helping to create technology that creates this flywheel, basically declining costs across the renewable spectrum. So, the expectation is that even though in many cases, solar and wind are at parity or cheaper than incumbent fuel types like coal, we’re still expected to see 50% cost decreases in offshore wind and in solar through 2030. We’re supposed to see dramatic cost decreases even in onshore wind which is pretty mature.

And so, that should continue to catalyze the penetration of renewables and the decrease of coal in our energy mix. At the end of the day, this is an economics issue, and if it’s cheaper, more and more developers and electric power utilities will rely on renewables.

Anil Daka: If I can maybe add a bit there, Hugo. It’s interesting. You are right to kind of bring up the point of the physics and the science behind some of this transformation. One example if you are to look at it is really the cost of a lithium-ion battery. Right? Because you go back to the late ‘80s or the early ‘90s when Sony first came up with this and this thing used to cost a few thousand dollars per kilowatt-hour, and today the best estimates, at least the leaders like your Teslas and Volkswagens of the world will probably do it at $100 or so. And you look at that long-term component of it and then you ask, “What’s allowed that cost curve to happen?” Most of it is really big technology improvements. The receptors get better. The anodes and cathodes get better, then you add scale on the top of that, you get the cost curves that I think Alaina was referring to.

The interesting thing is then you ask, “What is it going to look in the next five to 10 years?” We have a pretty clear roadmap because the cost curves of the future is really based on the chemistry and the science of what’s happening in the labs today, and you can look at what the capability of chemistry is or capability of an anode or cathode today in the lab, you can have a reasonable bit of confidence that that is what a production version is going to look five or seven years from now, and when you add that on the scale and all its benefits, you can have a pretty high level of confidence that the cost curves that you’ve seen will actually continue from here on out as well.

Hugo Scott-Gall: So, let me carry on with that, Anil. What are the constraints? And this question goes to both of you really. What are the constraints in delivering this transition? If it’s not so much physics or chemistry, is it capital? Is it political capital? Is it large amounts of some capital invested interest that don’t necessarily want change or don’t want change at a certain pace? What constraints? Because the energy transition that we’re discussing is pretty enormous. It’s the rebuilding of a supply chain and a front-end technology. So, it’s a big thing, but what are the constraints and impediments that you … And how do you handicap them? Alaina, I’ll start with you, but that question goes to both of you.

Alaina Anderson: Yeah, I think that you hit the nail on the head, Hugo. It’s a large transition and this is a very capital-intensive space, so the ability to deploy capital at scale to marshal this transition is the key to success. Making the cost of capital cheap, which we have seen. We have seen some financing subsidies and financing support for those who are doing green energy development. That’ll be important because the cost of capital staying low is going to be important for the deployment of resources and for the insulation of returns for the developers in this space.

Interestingly, in terms of energy transition and energy transformation, the companies that have really been able to deploy capital at scale over time have been the oil majors. If you needed big projects done, big capital-intensive projects done that have a huge science underpinning, that was the job of the oil majors, and it still remains to be seen what role the oil majors will play to deploy capital at scale as we transition from legacy and the hydrocarbon to green energy. There have been quite a few commitments, but I do still think that there is a strong legacy of a commitment to fossil, and it remains to be seen, I think, if the oil majors will play a significant role in the transition as it occurs.

Anil Daka: Maybe if I can add my two cents on the consumption end perhaps, because I think Alaina touched on all the right points on the generation end. Maybe to use an example here, every year the world sells about 90 odd million cars. Now the average car in the U.S. lasts for about 12 years or so. We’re talking to close to about a billion cars or so on the road everywhere. Now you can buy an EV today, but then even if the cost were to be right on parity, everyone wants an EV. It is still going to take about 12 plus years for that entire fleet to get renewed, and of course, when you think about the cost offered, it is a non … Every year we bring the cost down, but they are not on parity with every price point on consumption.

In other words, if you were to buy a $30,000 car, you could replace it with an electrified vehicle today. If you are buying a $20,000 car, you’re not there yet. It will probably take another five-plus years or so. There are simply the elements of the cost curve that need to come down over time, and then there’s the entire fleet renewal elements of it, both of which I think add to a somewhat slower and a steadier pace of transformation than the right here, right now, element that people probably like to see.

Alaina Anderson: That’s a good point. Anil mentioned some numbers that are big, heavy numbers. When we talk about the capital that needs to be deployed to support this transition, the estimates are in the $90 trillions, or hundreds of trillions of dollars that need to be deployed from now to 2050 to effect the transition that we’re talking about here globally. So, when we talk about capital being an inhibitor potentially to this transition, I mean these are massive numbers with dates certain which I think is an interesting added obstacle. Right? We’ve put in these 2030 and 2050 kind of deadlines which also presents interesting obstacles.

I would also say that you mentioned, Hugo, political commitments and political will. There has been a very interesting argument occurring between developed market countries and emerging market countries regarding industrialization and ambitions around industrialization, and how that’s hampered by having a strong commitment to decarbonization. And how we are sensitive to that, how we manage through that, and how we acknowledge that emerging markets still need to industrialize, but yet we all need to balance our need to decarbonize, those will be interesting kind of diplomatic and philosophical questions for us to work through from a global community perspective.

Hugo Scott-Gall: Yeah, and I’m backtracking a little bit here, but is there a real risk? Do you think there’s been an overestimation of timelines? This can all happen faster. So, the point that Anil was making that you’ve got a lot of installed assets with a tremendous amount of capital invested in them whether that is power generation, whether that is aircraft, cruise ships, whatever, a lot of carbon-intensive assets with very high dollar price tags are in existence, and so to incentivize the switch takes a lot, and it takes a lot of capital investment, and you need to have very clear incentives. Now sometimes you need a wedge, which is provided by government, but the numbers are so big, as you said, Alaina, that I wonder whether just the economic life of the installed fleets of whatever asset we are talking about may prove stickier because green can be a political color, it can be a moral color, but it’s definitely an economic color.

Alaina Anderson: Well, just think about the age of the coal fleet in some of the emerging markets. If a coal plant has a life of, I don’t know, 20 to 30 years, the average age of the coal fleet in many of the emerging markets is still single digits because we’re still onboarding new coal mines in many emerging markets. For them to shutter those mines means just taking an economic loss. Is that what’s being asked? Basically, yes, and how do we think through subsidizing that as a global community? It’s a very difficult question. Sixty percent of China’s energy mix is still coal. Now that’s down from 80% in the year 2000, and 70% in 2010, but at 60%, that’s three times that of the U.S. It is the reserve fuel for electric power generation and heating. That’s not a ship you can right overnight, and the targets that the global community has put in place seem very aggressive when you think about it from that perspective.

Anil Daka: It’s an interesting question. If I can try and answer that from the consumption end again. Let’s use buildings as an example. I mean, most buildings last 100 years sometimes even longer than that, and you think about all kinds of heating and cooling systems. Heating and cooling within buildings I think are about a third or so of all carbon emissions anywhere, but what’s somewhat helping the transformation at least on the consumption end is really the digitalization of that infrastructure. What are we saying here? So, every 15, 20, years or so when you have big condensers, chillers, your air conditioning units, et cetera, that come up for a redo, the newer systems that go and don’t just do a better job of cooling and heating and providing the comfort, but I think they also do it in a much more efficient fashion.

There’s a bit of a big step change because once you put sensors in different units of the building, and once you connect those sensors back to a more centralized unit, where you understand the heat zones, the cool zones, depending on different weather patterns, your ability to control the overall energy needs of that building go up pretty dramatically. And I think as the cost of digitalization comes down as we all know based on Moore’s Law and everything else that follow from that, it becomes that much easier for even older infrastructure to somewhat beat the pace of expectation as the cost of digitalization comes down.

So, again, you’re talking about I think a trend that’s well understood, but perhaps less applied in the context of energy, but I think as the cost goes on, the digitalization comes down, you marry that with what you’re seeing on the cost curves on carbon emissions. It tends to give you a bit of a one plus one is more than two kind of an effect here, and that’s something I think we see, at least on the consumption end, with some of the industrial names that we look at.

Hugo Scott-Gall: So, you are saying by making things smarter, digitalization could make dumb assets smart, and so it’s actually it’s the operational cost curve rather than the capital cost curve that can move?

Anil Daka: Right.

Hugo Scott-Gall: And so, I get it. You gave examples of things like making buildings smart. Once you can measure, once you can identify idle time, et cetera, you begin to shift operating cost curves. But how meaningful is that? Is that kind of a half of a half of a half of a percent, or is this sort of meaningful when we look at the whole emissions equation?

Anil Daka: We are talking about big numbers. Maybe the pace of the change itself when you kind of think about it on annualized terms, that would be more again on a slow and a steady basis perhaps, but within the building, heating and cooling costs are again about a quarter or so of the overall cost of maintaining a building. So, to somewhat put that in perspective, if you go from let’s say the SEER 10, SEER 11 standards—these are U.S. energy-efficient standards that were practically unchanged for a long time,—and you go to something like SEER 15, which is the somewhat more recent standard, you save about 30% to 40% on that energy bill. Again, 30% to 40% on about a quarter or so of the overall expenses, it’s reasonably material.

And I think the other part too is there’s a cost of financing element to it, right? If you were to make these assets that much more energy-efficient, your cost of financing obviously comes down as well as you can meet certain certification credentials. So, you add the operational costs, and then you layer in some of the financing benefits as well, I think increasingly so, you will see more and more people opt through that route. I think it’s material enough for people to make that switch would be my argument.

Hugo Scott-Gall: We briefly touched on cars earlier, but let’s, I don’t think I would remain in this podcast host’s seat if I didn’t ask you more questions on electric vehicles. We talked about the inertia which is, I’ve already spent money on my car and I don’t want to, I want to get my useful life out of that car.

Anil Daka: Yeah.

Hugo Scott-Gall: But reasons not to buy an electric vehicle usually range anxiety comes up as one of them. So, reluctance to switch, switching costs, yes, but around actually, “I want to buy an EV, but there are things holding me back.” What are the things holding me back? And then, how quickly do they change?

Anil Daka: Range anxiety is a good point, Hugo. Actually, it really comes down to the cost of buying an EV, right? That’s probably the first one. Part of it is just the weird way the math works here. partly because of the range question. Most people, I think 80% of commute in the U.S. is less than 40 miles a day, and so you would ask, how much range do people really need? But you translate that into real-world experience. Somewhere about at 250-mile range is when range anxiety seems to dissipate. But for me to get a 250-mile range, I need a really big battery, and of course, the larger the battery goes, the higher the cost of making the battery, which means the price point at which you would be happy to switch with no extra cost between an EV and a gas car is still in that $40,000 to $50,000 range.

Anything less than that at right here right now, you are probably still buying a gas car. Anything above that, you should probably get an equal in an electric car. You take out the cost end which I think will happen with time. Every year the cost of batteries is coming down. Scale is building up. Good things happen there. Range anxiety will be addressed as part of the cost thing, because I don’t think you will see cars with less than 250-mile range really coming at all.

The last one is more about I guess the infrastructure constraints where you still need a home charging facility if you want to keep your car ready to go at any point, or you need a battery charging infrastructure which is what Tesla has built out, and the others are somewhat still trying to catch up there. Those would probably be my top three things I think of. The cost end of it, the range anxiety, and charging infrastructure, as it gets better.

Alaina Anderson: I think what I’ve been encouraged by, Anil, is seeing the legacy car companies deploying capital at scale to change their fleet.

Anil Daka: Yeah.

Alaina Anderson: So, understanding that capital at scale gives you the learning that you need to drive down costs just like in renewables deployment, so that they can drive down the cost of the battery, so that they can sell you a vehicle that will answer the questions of range anxiety and answer the questions of the sticker cost. They understand it. They have to push hard to drive those costs down, and the way they do that is by making commitments and deploying capital at scale to drive costs down.

Anil Daka: Absolutely, and I think the last 12, 18 months have been pretty profound really in that aspect. I think practically every top 10 carmaker in the world has come out with an ambitious target on what percent of their fleet they want to see, rather what percent of production they think will be fully electric. There’s a range of estimates between 2030 to 2035, but it doesn’t matter. I mean, you have most of car production in the world planning for that big shift electric over the next 10 odd years or so.

Hugo Scott-Gall: I want to take a bit of a right turn now into this question for you Alaina around sort of ESG and the huge growth and interest in ESG, and indeed the flow of funds towards ESG investing. To your mind, what’s the most important impact of that? Is it actually, not just changing allocation of capital, is it actually changing cost of capital? Is it sort of a self-fulfilling thing?

Alaina Anderson: Yes. I think it is changing. Allocation of capital, it is changing cost of capital. I think that naturally the oil majors might acquire their way out of the space that they see themselves in by acquiring the technology that they need to make their businesses fit for purpose for 2030, 2050. However, their cost of capital has gotten pretty high. It is tough for them to make acquisitions using their shares, getting bank financing. We have marshaled quite a lot of resources to make sure that we constrain the capital that fossil can access, and that has been, one prong of that has been certainly through the ESG efforts.

More specifically, they have been an acknowledgment of issues around climate change. There has been some global coordination, and this goes back probably beyond the Kyoto protocols, but certainly what gets the most press is the Paris Climate Accord to acknowledge that we need to try to stymie the increase in average temperatures that seems to have been driven by an increase of CO2 in the atmosphere, and decarbonize all kinds of emissions including power generation, buildings, transport, heavy industry, et cetera.

How do we make sure that we not only decarbonize, but we don’t grow it? We have to decarbonize what’s already installed, but we also can’t put more capital into the ground for these carbon-emitting spaces. Well, we starve the capital. We increase the cost of capital. We make it harder for them to grow and do business. So, it’s the ESG initiatives, it’s the climate change awareness, it is work that has gone back to the Kyoto protocol and all of that acknowledgment that not only do we need to be good fiduciaries, but we need to be good stewards of resources, all kinds of resources. And it’s really that evolution that I think has been very important, not just a shareholder focus, but a stakeholder focus. I think that people realize that it just makes sense. If we deplete our resources, our ability to create wealth will also be depleted.

Hugo Scott-Gall: Anil, can you see it as you look across your coverage area? Can you see I guess the effect of ESG or the effect of ESG interests? The effect of people using different lenses now to assess companies and their medium to longer-term prospects?

Anil Daka: Absolutely so, and because I think the way we try to ask is, well, because of the ESG awareness, what is that doing to the things that we particularly care about? Your organic growth, to your pricing, to the quality of your business models, strength of your competitive advantage, and I think in almost every one of these attributes, the names that we would have thought of as leaders in this space have actually expanded on that relative strength vs. peers. And the framework that we are somewhat using is if we want to be more ESG aware, when you think about the challenge here, every year you want to use a little less than what you did last year. Every year you want to use a more diverse stream of hydro energy in terms of sometimes the energy can be generated onsite versus offsite even if it’s offsite between different types of energy sources as well, while at the same time either maintaining or even increasing the comfort let’s say.

And then you add this challenge. It becomes an increasingly complex operation, and the more complex the operation is, that much better the leaders in the space tend to get partly based on the relationships, partly based on their awareness and understanding of technology, et cetera. And where we are seeing that is that for the firms that are most aware of that, we see better organic growth, better pricing power than they used to do before, improved business models. Sometimes services, these things get more complex. Sometimes the building operators, they don’t want to do the service themselves. They are happy to outsource it to the manufacturers to do that, so there’s that element of a more one-time sale becoming a more continued annuity kind of relationship with the end user, all of which plays particularly well to the ones that have paid attention and have invested in understanding this transformation.

Hugo Scott-Gall: Okay, as we head towards the close, I want us to talk about risks because we haven’t really talked about risks much. So, I guess I’ll ask you both the same question which is what do you think are the biggest risks to this transition being derailed? And maybe within that, the specific risk which is we talked about the benefits of digitalization that you start making things smart, you add software on top of hardware, and you get better outcomes in terms of operating costs and efficiency and all those kinds of things, but does that create an extra risk? Cybersecurity and maybe that is good point, Anil, for you to talk about why you know lots about pigeons.

Anil Daka: So, I guess their context is we were all chatting about the Chinese military still apparently has a training regiment of about 10,000 pigeons just in case everything digital goes to hell. To maintain communications, they have a fleet of pigeons that can very reliably convey information across the network, and so this is as analog as it gets, I suppose. But to your point, Hugo, that’s obviously supremely high on the risk spectrum of every firm we talk to that is only going to get worse as you go towards more digital architecture. So, it’s a bit of a tug of war I suppose. I mean, every year all our firms try to get better at it. The opposite side tries to get that much smarter too, I suppose. That is a clear risk here.

But it’s a risk worth taking too because I think what you’re going here is there’s a cost of going digital, but the benefits far outweigh the risk that comes with it partly because of the challenge that you’re trying to solve, I think what Alaina referred to very early on, is that this is probably amongst the biggest challenges we all are facing. The magnitude of what needs to be accomplished is super large, and the net impact and the benefits it can have for everyone is too tremendous, but it will come with the sort of risks that will happen as you go digital.

Alaina Anderson: Yeah, I would agree, Anil, that there are risks, but the rewards are much higher here. Within renewables and renewables deployment, you can barely go to a conference or hear companies speak anymore without talking about cybersecurity being a significant risk. We saw the Colonial Pipeline hack. We saw the disruptions in Texas that were largely attributed wrongly to the install capacity of renewables. And so, I would say cyber is certainly a risk. As we electrify, we digitalize. As we digitalize, we potentially open ourselves up to these kinds of hacks, and now we have to think about hardening our infrastructure in a different way.

Hardening infrastructure for utilities used to be putting overhead power lines below ground. Now it also includes how do we harden our digital infrastructure to prevent against the kinds of cyberattacks that we saw with the Colonial Pipeline? I would also say lack of global coordination to the commitments that we’ve made. Any slippage in those global commitments would be a huge risk. There’s not a country or jurisdiction that can get there, so say mitigate the two degrees Celsius scenario by themselves. Developed markets can’t get there without emerging markets. U.S. can’t get there without Europe, et cetera. So, a lack of global coordination and collaboration is something that would cause that to slip would be a risk to making the goals that we’ve set out and the timeline that we’ve set out for those goals.

And I’m not even so sure that it is. I know that the scientists have modeled this out, and I’m not a scientist and 2050 seems to be a date certain. I think it’s most important that we are going to try like hell to make 2050 a reality. However, if we don’t meet the goals for deployment of renewables and decarbonization et cetera, I think it’s most important that we in a globally coordinated fashion, are trying very hard to push towards the goals and dates that have been outlined. So, in terms of risks, anything, any diplomatic risks that would kind of soften the global coordination that we’ve seen so far, I think that’s an even bigger risk than cyber frankly.

Hugo Scott-Gall: Great. Well, I think that’s a very important place to end. I just want to thank you both for taking the time and joining me on the podcast. I think we covered a lot, and I think it’s something we’re definitely going to return to. So, thank you both.

Anil Daka: Thanks, Hugo.

Alaina Anderson: Thank you, Hugo.

Meet Our Moderator

Hugo Scott-Gall, Partner
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