Fund managers and the path towards net zero emissions
By Juan Cruz, Founding Partner and CIO, Cygnus Asset Management – On the path towards a net zero emissions world, some sectors will multiply their activity (multiples), others will reduce it substantially (fractions), and others will disappear (zeros). How can hedge funds and other asset managers navigate the emerging investment opportunities?
At the Paris Climate Change Summit in December 2015, 189 countries reached a binding international agreement on climate change, with the aim of “holding the increase in the global average temperature to well below 2C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5C above pre-industrial levels.”
To comply with this engagement, the European Union announced its “Green Deal” in December 2019 and approved the Climate Law in June 2021. This regulation incorporates the philosophy of the Paris Agreements and sets the objective, which is not only ambitious but also binding, of reducing the European greenhouse gas emissions by 55 per cent by 2030, from 1990 levels, and to achieve net zero emissions by 2050. While Europe has been at the forefront of regulation regarding emission reduction targets, we believe that this is a global trend, as the US, Japan or China, among the most relevant, have also announced similar targets.
The energy sector, and the electricity sector in particular, accounts for at least 75 per cent of the solution to reducing greenhouse gas emissions in Europe. There are two sets of concomitant processes here: the replacement of fossil energy generation by renewables on one hand, and electrification, particularly in the mobility sector (electric vehicle, rail), industrial processes (steel, cement, aluminium) and buildings (heat pumps, electric kitchens) on the other hand. In addition, for those sectors where electrification is not achievable, the EU is pushing to develop other technologies such as green hydrogen (ie. Generated with renewable energy), blue hydrogen (generated with gas, but capturing the CO2 emissions produced) or biofuels.
We expect the trend towards electrification to result in a sharp increase in demand in the next 30 years, which should in turn drive greater interest in the sector. This is a big change from the perception a few years back that electricity demand would languish as improvements in efficiency outpaced underlying demand growth. In fact, we now expect electricity demand to grow by circa 3 per cent per year (equivalent to tripling the level demand in the next 30 years). This, in turn, should lead to investments in electricity networks, which will increase both in size and complexity, and which will rely on digitalization for their system management.
In this regard, we can say that the energy sector, and electricity in particular, will undergo a true revolution over the next decades; a scenario which we have called ‘multiples, fractions and zeroes’.
Zeroes, because there are things that may disappear (such as vehicles with internal combustion engines or the use of coal); fractions, since some raw materials could see their demand significantly reduced (in particular oil and natural gas); and multiples given that certain activities will see their volume of activity multiplied (wind generation, photovoltaic generation, electric vehicles, battery storage, heat pumps, electrical networks).
We see two distinct periods in this ambitious, but somewhat uncertain path. The first one, to last until 2030, should be dominated by technologies that are economically viable today (solar photovoltaic, onshore and offshore wind). Longer term, from 2030 to 2050, we expect technologies that are currently in their incipient phase to gain importance, supported by public investments (green and blue hydrogen, capture of CO2, floating offshore wind). What’s more, technologies that are not currently on the EU’s main roadmap, such as small modular nuclear reactors (SMRs), could gain visibility in the next decade.
This context offers an extraordinary and long-lasting opportunity, with total investments expected around EUR1 trillion until 2050, according to estimates by Goldman Sachs. We expect the following themes to be its main beneficiaries:
• Decarbonisation - renewable energies, CO2 capture, green hydrogen, biofuels
• Electrification - electrical grids, batteries / storage, electrified transportation, industrial electrification
• Energy efficiency - in particular around renovation, insulation, and heating of buildings
• Circular economy - recycling and responsible use of natural resources
From a geographic point of view, Europe is clearly leading this process, but we expect the US to follow the same path, as suggested by the infrastructure plan of EUR1 trillion dollars over the next 10 years that the Biden administration has recently secured.
We are currently at the dawn of an energy revolution which started in Europe but is spreading globally. This energy revolution brings with it many investment opportunities.
To benefit from them, fund managers will need not only to be able to detect winners and losers, but also to identify companies that can make a virtue out of necessity and rise from their ashes. They will also need to keep in mind company valuations and market expectations. Is a pure renewables play always the best way to get exposure to the tremendous growth in the renewables sector? What do we expect electricity prices to do when renewables entirely replace gas in power generation? What is the strategic positioning of a pure generation company vs. an integrated one? What will happen to the cash generation of an oil company, if it stops investing in new field development or if it decides to focus on the development of technologies such as offshore wind power or CO2 capture rather than refining or offshore platforms?
Experience and fundamental expertise will be key to navigate the path towards net zero emissions, avoiding overheating and valuation bubbles, which tend to be the greatest risks in this type of context.
Juan Cruz is Founding Partner and CIO at Cygnus AM, an independent asset manager firm founded in 2006. He has over 25 years of experience in the management of proprietary portfolios of financial institutions and in hedge fund management, specialising in the utilities, infrastructure and renewables sector.