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Five of the most common questions about climate change and sustainable investing

In this article Craig Bonthon from one of the worlds leading financial services business Kames Kapital answer five of the most common questions that investors asks about the investment implications of global climate change. The answers may surprise you.

Craig Bonthron, Co-manager of Kames Global Sustainable Equity Fund and author of the article.

Q1: When will renewables be cheaper than fossil fuels?
The short answer is that they already are. According to the latest annual Lazard Levelised Cost of Energy (LCOE) study, in most parts of the world renewables are already cheaper than fossil fuels without any subsidies. In some areas the most expensive form of solar energy is cheaper than the cheapest form of conventional energy on an LCOE-basis.

Chart 1 shows the changing cost of energy since 2009. The message is clear — renewable energy is cheap and getting cheaper.

Finally, from an engineering perspective renewables are a relatively simple undertaking. That means the projected cost at the start of a renewables project is much more likely to be accurate than for a conventional energy project. According to the Union of Concerned Scientists, the average nuclear power station project runs over budget by approximately 107%, while wind and solar project costs overrun by less than 10% and less than 1% respectively.

Chart 1: The changing cost of energy (2009–2017)

Source: Lazard estimates 2017. Levelised Cost of Energy (unsubsidised). Primarily relates to North American alternative energy landscape, but reflects broader/global cost declines.

Q2: Can we entirely replace fossil fuels with renewable energy?
We believe this is a question of ‘when’, not ‘if’. The reality is that it will take decades to completely wean ourselves off fossil fuels, even if we invest heavily now. But renewables should continue to become cheaper due to its relative technological immaturity and a scaling-up of the industry.
In the future, the areas with the best wind and sunshine will likely export renewable energy, much like they do fossil fuels today.

Below is a thought experiment from Quora, which was referenced by Forbes Magazine:

If we cover 43,000 square miles of the Earth with solar panels, even with moderate efficiencies achievable easily today, it will provide more than 17.4 TW of power. The Sahara Desert in Africa is 3.6 million square miles and is prime for solar power (more than 12 hours per day). That means 1.2% of the Sahara Desert is sufficient to cover all of the energy needs of the world from solar energy. The cost of the project would be about $5 trillion, a one-time cost at today’s prices without assuming any economy of scale savings.

If $5 trillion is anywhere near correct, this is very cheap indeed. A recent estimate (see chart 2 below) estimates a capital expenditure spend of $2.1 trillion on renewables by 2050.

Chart 2: Annual global renewable energy capital expenditure (US$ billions)

Source: DNV GL. As of September 30, 2017. Data from 2015 to 2050 is estimated or forecast.

We view this as a conservative estimate. To put it into context:

  • An estimated $7.9 trillion of capital expenditure has been spent on the oil and gas sector since 1998;
  • An estimated $1.5 trillion was spent on the recent US tax cut;
  • Global GDP is around $50 trillion annually; and
  • The equivalent estimated cost to generate 17.4TW of nuclear power would be $52 trillion (before any cost overruns)

The International Monetary Fund estimates that we are actually subsidising fossil fuels indirectly to the tune of €300 billion euros per year if environmental damage is taken into account. According to Munich Re, losses from natural disasters are on the rise; they estimate that the cost in 2017 alone was $330 billion. Like I said, a $5 trillion one-time cost seems cheap.

Q3: When will electric vehicles with decent range be cheaper than the equivalent oil burner?
For premium cars the answer is now. For mass-market cars it’s 3–4 years.

You can get an electric vehicle today that is equivalent to or cheaper on a three-year cost of ownership basis than the equivalent oil burner. For example, the Tesla Model S is cheaper on this basis than the BMW 7 Series.

With the release of the Tesla Model 3 in Europe, drivers will be able to get an electric vehicle for the equivalent price of a BMW 3 series. While this serves a broader portion of the economy and is a potential game-changer for the adoption of electric vehicles, it will probably take a further 2–3 years before affordable cars become available for mass adoption.

There are multiple manufacturers with production pipelines focused on EVs, so we will soon reach a tipping point. Remember, the largest proportion of an EV cost is the battery, which continues to decline in cost every year (chart 3).

Chart 3: Lithium-ion battery pack prices ($/kWh)

Source: Bloomberg New Energy Finance.

Q4: Will the electricity grid have the resources to cope with electric vehicle demand?
The disruptive adoption of a new technology requires innovation. In our view the prevailing assumption that the electricity grid of today will not adapt to renewables is flawed.

Utility-scale storage is becoming economical for storing excess supply and it can be fed into the grid during peak demand. New ways to offer on-street charging, such as lamppost charging points, combined with bi-directional charging (electric vehicles which return excess power to the grid during peak demand) are examples of innovations that enable charging and disrupt the traditional utility model. Furthermore, peak demand for electric vehicle charging is likely to be at night, when demand for other electricity is at its lowest.

Morgan Stanley has estimated that a capital expenditure of US$1.7 trillion will be required on electric vehicle infrastructure by 2040. As referenced earlier, this is just 20% of the US$7.9 trillion spent on oil and gas capital expenditure since 1998. The resources required to support the building of batteries and renewables are generally abundant and, as the industry scales-up, the vast majority of materials used will become recyclable and reusable.

Q5: Which companies will benefit most from these disruptive trends?
As active investors, this is what we spend all day every day trying to work out.

Experience has taught us that the companies most easily linked to a particular trend are rarely the best companies to invest in. Disruptive companies tend to come from the ‘left field’ and offer something new and innovative that the incumbents either haven’t thought of, have found too difficult to implement, or have tried to prevent due to the threats posed to their existing businesses. Mature incumbents are therefore the last place we look for investment ideas to play disruptive trends.

Furthermore, companies that become synonymous with a particular trend (such as Tesla for electric vehicles) might be good investments, but often suffer from two main issues:

  • They are very well known, so are intensely analysed by market participants; and
  • They tend to quickly attract elevated valuations, which can be very difficult to justify.

So where do we look? We have three key preferences when investing in disruptive trends:

  • We like growth-focused companies that are innovative and disruptive, typically not mega-caps.
  • We favour companies that are unheard of by the wider public and have little coverage by analysts.
  • We demand that they have a powerful enough position in the value chain to consistently capture a return above their cost of capital as they grow.

The final point is important because too often investors make the mistake of chasing a trend and investing in commoditised products and services which are temporarily benefiting from that trend, but which have no discernible competitive advantage.

About Kames Kapital
Kames Capital is a specialist investment management business with offices in Edinburgh and London. We manage €49.8 billion (as at 31 December 2017) on behalf of wealth managers, financial institutions, pension funds, charities and financial advisers.

Investment management is our only business, ensuring we have no competing priorities or distractions. We have a stable and experienced team of investment professionals, who have managed portfolios across numerous market cycles and have the skill and judgment to make the right investment decisions for our clients.

Kames Capital is a wholly-owned subsidiary of Aegon NV, one of the world’s leading financial services businesses and an international provider of life assurance, pensions and investments.

Further information about Kames Capital can be found at www.kamescapital.com

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