Jeremy Grantham and Lucas White on Climate-Change Investing
Jeremy Grantham co-founded GMO in 1977 and is a member of GMO’s Asset Allocation team, serving as the firm’s chief investment strategist. Prior to GMO’s founding, Mr. Grantham was co-founder of Batterymarch Financial Management in 1969 where he recommended commercial indexing in 1971, one of several claims to being first. He began his investment career as an economist with Royal Dutch Shell. He is a member of the GMO Board of Directors and has also served on the investment boards of several non-profit organizations. Along with his wife, Hannelore, he runs the Grantham Foundation for the Protection of the Environment, which was founded in 1997.
Lucas White is the lead portfolio manager for the GMO Climate Change Strategy and a member of GMO’s Focused Equity team. Previously at GMO, he served in other capacities, including portfolio management for the Global Equity team and leadership of strategic firm-wide initiatives. Prior to joining GMO in 2006, he worked as a programmer and analyst for Standish Mellon Asset Management. The GMO Climate Change Fund (GCCHX) seeks to deliver high total return by investing in companies focused on climate change mitigation and adaptation. GMO’s Focused Equity team utilizes a valuation-based approach to select equities for investment. Its universe is predominantly comprised of companies focused on the mitigation of climate change, though companies focused on adaptation to climate change are also considered. Climate change mitigation and adaptation industries include clean energy, batteries and storage, electric grid, energy efficiency, agriculture, water, and companies that service these industries.
I spoke with Jeremy and Lucas on December 12.
What led you to launch the GMO Climate Change Fund and what is the fund’s mandate?
Lucas: The fund’s mandate is to make as much money as possible investing in solutions for dealing with climate change and understanding the science, technology and the companies themselves and their fundamentals. We are trying to figure out how to profit from the activity in this area, which we expect to ramp up considerably.
The idea flowed out of our natural resources fund more than anything else. There were a bunch of short- and medium-term risks or risks that we could diversify away. But the one long-term risk in our natural resource strategy was that fossil-fuel assets would end up being “stranded,” either because there is carbon regulation, carbon pricing or technological disruption and those reserves wouldn’t be produced. Part of how we dealt with those risks in our resources strategy is that we have a lower exposure to energy. We’ve always excluded the particularly offensive technologies, like coal, tar sands, kerogen oil and things that have a really bad carbon impact. But we have also targeted alternative-energy investments as part of our energy exposure. As the costs fell for solar, wind, batteries and storage, our research led us to think that there was a new strategy focused more directly on the solutions side.
Jeremy: I’ve been writing that I thought climate change was the issue of the next 20 years or maybe indefinitely, and suggesting that we develop financial products around this theme. That was a factor when we got into forestry and farmland. But the feeling was we were a bit ahead of our clients, so we better wait for the client world to catch up. In the end that’s what we did. It left me fairly impatient to get going with a climate product.
The good news is at the Grantham Foundation I have a couple of very smart helpers. We spend a good part of our time hobnobbing with serious climate scientists and technologists, keeping up with what’s cooking. We invest 20% of our corpus in what we call mission-driven projects. We are looking at batteries and similar investments. There is a very nice synergy. The foundation has a slightly longer horizon when we are looking at the climate implications, say 10 or 20 years out. The fund’s horizon is a bit shorter than that. But it’s nice to have my passion and hobby intersect beautifully with a commercial proposition.
Is there room for fossil fuel-type efficiency opportunities in the fund? For instance, the green-house gas (GHG) reduction from average mileage improvement (30 to 50 mpg) could reduce the oil consumption from automobiles, which is approximately 30 million barrels/day, by as much as nine million barrels/day.
Lucas: We are looking at companies involved in energy efficiency in all sorts of ways: energy-efficient building materials, energy-efficient lighting, electric vehicles and anything that reduces our energy impact on the world. Efforts focused on energy-efficient engines and efficient internal-combustion engine components also fit the bill. One of the easy ways to push clean energy is to focus on energy-efficiency efforts. You just have less of a need for energy more generally.
One of the most challenging problems over the next 25 years is India – tripling its electricity needs but continuing to build coal-fired plants. Have you seen any investment opportunities related to technology that could either convert or force combined-cycle gas turbines (CCGT) or more solar usage in India?
Jeremy: The outlook for solar in India is just spectacular. India is perfectly designed for solar. But one of the problems you get with solar is enormous seasonality. My wife comes from Bremen in northern Germany. There, the month of December gets half an hour of sunlight. My wife was completely unimpressed when I told her this. She said, “Yeah, so what? That’s why I’m here.”
But June gets five and a half. So, they have 11-times the sun exposure. Just imagine trying to balance that on a long-term basis. India is 1.2-times. They have a wonderful sun in the north and they have a wonderful sun in the south. That is a huge help if you need the sun to be 30% to 40% of your entire grid, which I’m sure they will have one day. Plus the sun is shining all the time and 40% is not on the grid yet. So here’s a marvelous opportunity to serve that community with localized solar.
They are used to having interruptible power. That is how India has functioned. The fact that it doesn’t deliver 24 hours per day doesn’t stop you from getting that part of the market. India is piling on solar now as we sit, with new deals every day being put out to auction. They have had some spectacularly low prices, not as low as in Chile and in desert locations, but four and a half cents per kilowatt hour, which is as cheap as the cost of coal without allowing a penny for all the pollution and sickness it creates from desperately awful air pollution. Delhi is worse than Beijing these days. Of course, there is the climate-change effect. But just focusing on pollution and respiratory diseases and cancer from coal and diesel, it’s not a surprise that they are pushing so hard on solar. They will have a glorious future.
Many of the opportunities in climate-change investing will be manufacturing businesses, such as companies that make solar panels, wind turbines and batteries. Manufacturing businesses have been historically more vulnerable to competition than service businesses, particularly from overseas markets that can benefit from favorable exchange rates. In your paper, you mentioned the example of the Chinese “dumping” solar panels in the U.S. How does this affect your investment thesis?
Lucas: I’m not sure that it changes the investment outlook that much, except you have to be careful about what you invest in, as when you make any investment. You have to pay attention to the industry dynamics, and whether it is plausible that these companies cannot just grow in terms of having more square footage, more employees or growing their sales and revenues, but can they grow what you care about as an equity investor, which are cash flows, profits, earnings and all that good stuff that they can convert to their bottom line.
Jeremy: Foreign competition is business as usual. What we can bring to bear is that the aggregate longer-term demand is going to be bigger or less than the world thinks. The world is really behind on the level of technological change in climate change, and that is a great vulnerability. It is an opportunity for us, because other things being equal, if you have an unexpected topline demand you are going to do very well.
There are many exercises where the goal is to forecast energy demand and help develop policies and technological strategies to meet climate-change targets (such as 450 ppm of carbon dioxide, zero-net carbon, etc.). Which scenarios and what are the most significant conclusions do you draw from these exercises? At what point and where in your investment selection process do you or might you consider adaptation versus de-carbonization of the world economy?
Lucas: It’s not clear whether the world will be able to address climate change effectively, so it’s important to consider adaptation efforts as well. In terms of adaptation versus de-carbonization, both are part of our investment universe. Our opportunity set – what we are calling the climate-change sector – are those companies that are attempting to mitigate climate change, such as alternative energy companies, battery and storage companies, electric grid and smart grid efforts, and things of that nature. But we also look at companies involved in helping the world to adapt to climate change. The big things there are food and water, both of which are expected to be dramatically impacted by the effects of climate change.
There is significant opportunity for reduced emissions from a smarter utility grid – the ability to store intermittent renewable sources for “discharge” during peak demand (or vice versa). This may drive the “utility of the future” to develop a massive network where it can control storage and discharge. Have you seen any opportunities related to smart-grid technology?
Lucas: We see a lot of opportunities in companies focused on overhauling our electric grids, which are archaic beasts built around the idea of persistent centralized generation, long-distance transmission to local-distribution networks, and then distribution from there. We are in a world where all of a sudden we have solar panels on our rooftops, wind turbines all over the place and now we have distributed generation. Sometimes they are generating electricity, sometimes they aren’t. That intermittency and the distributed generation are both dynamics that the electric grid was not designed to handle. Trillions of dollars need to flow into overhauling our electric grids globally and making them smarter, so there will be much more efficient use of our energy resources. There are a lot of efforts that are interesting along those lines.
While some analyses suggest that a complete switch to 100% renewable energy (solar, wind, tides, water, etc.) is possible, most others believe that only with the addition of nuclear energy could electricity generation become carbon-neutral. Do you think that nuclear energy has a major role to play in climate-change mitigation, and do you believe there are attractive opportunities for investing in it?
Jeremy: That is one of the great unknowables: the next generation of fusion is anybody’s bet. If you are willing to go out a few decades it might be as high as 50/50 that someone will come in with a cheap enough fusion to help out. In the meantime, however, I think we can approach 100% renewables with improved batteries and new technologies, without nuclear.
I am completely against closing existing nuclear plants. Look at all the problems when you close an existing plant prematurely. You incur all of the significant disposal problems either way. You might as well wait and let it run out its useful life. It’s just a can of profligate waste under the name of some sort of environmental purity which is in the mind, since the real damage is disposing of the waste in the end. You are going to face that anyway. Having gone to the trouble of building the damn plant, let it run its useful life. The German behavior in that regard was unexpected and preposterous.
Lucas: If you would have asked us five years ago, we would have said that nuclear had a very important place as a possible transition technology. A lot of new nuclear development would have held us over until renewables were more mature. But in the last few years, the costs for wind, solar, batteries and storage have dropped by 70% to 90% and those costs are expected to drop considerably from here. It’s not as clear that you need nuclear as a transition technology.
Jeremy: I heard a lovely quote that I used at our client conference. The largest utility in the world, NextEra Energy, is a holding company. It owns Florida Power & Light. It also owns the largest trader of wind and solar. Its CEO is on the other team, if you will, the “polluting team.” He is also sitting in the right spot where he gets to look at both sides. He did a telephone recording session with analysts recently. We had a transcript of a chunk of that in which he was saying that he thought by the middle of the next decade, by 2025, the cost of wind and solar with respectable deliverability (which I think in the fine print is about six hours) would be no more than the marginal cost of running your existing nuclear plant. He claimed he had the cheapest one in the country. The marginal cost of burning coal – mining it, shipping it, burning it – was going to cost as much as building a new plant for wind and solar and putting in enough storage to give you six hours to move it into prime time.
Has nuclear been made expensive because of unnecessary regulation?
Jeremy: Definitely suboptimal regulation. The idea that if you didn’t regulate nuclear, it would be cheaper is no doubt correct. It would be cheaper and a whole lot more dangerous, and you would be courting disaster. I don’t think any serious person would recommend an unregulated nuclear industry, so it’s got to be regulated.
Did they sit around and brainstorm on a global basis? What are the two or three models that we could get behind and duplicate? They did a bit of that in France, but we did none of it here, so we were building two of this model from Westinghouse and one of this model from the French, at a nightmare of unnecessary expense. That was far, far more important to the uneconomic nature of nuclear than were the regulations, which are completely necessary.
The principal candidates to achieve carbon neutrality, if 100% solar energy-based renewables cannot do the job, are nuclear energy and carbon capture and storage (CCS). Do you believe that CCS can be economically viable and has a major role to play in climate-change mitigation, and are there attractive opportunities for investing in it?
Jeremy: I would have said very quickly there is no hope for carbon capture and storage. However, I’ve been impressed in the last year by technological leaps that are being made. You have to learn to say “maybe.” They may make carbon capture and storage cheap enough by some brilliant new concept. Anything approaching the current system is simply too expensive and too energy intensive. It needs too much capital and it takes too much energy to extract carbon. Then it costs too much to pipe it away and bury it somewhere effectively.
The current state-of-the-art is hopelessly uneconomic, and it is not within engineering tweaking of being economic. Tweaking is always better than you expect, as has happened with battery progress, but you can’t get there from here. You need a completely new technology. They may come up with one, but it’s not a gleam in the eye yet.
Lucas: I don’t disagree. I want to address whether there are attractive opportunities for investing in it. To my knowledge, there are no pure-play carbon capture and storage efforts in the public equity market. It’s a nascent effort.
Jeremy: There is almost no government-sponsored research. They’ve closed them down one after another. It’s pretty well a dead letter for the time being, waiting to see if someone can come up with a new design.
There’s been a fair amount of academic research on SRI/ESG investing. The general finding is that investors give up some risk-adjusted performance because they are narrowing their investable universe. In your case, you’ve narrowed your universe to essentially a single sector, rather than just screening out “undesirable” stocks from a broad universe. Do you expect your results to be different from those studies? Will you be able to achieve risk-adjusted returns that are as good as value managers who can select from a broad universe?
Jeremy: Yes, we do. We think the supposition that narrowing your universe costs you a lot, which is the standard argument, is wrong. It’s never been proven. The starting supposition is that every major group of assets ends up with the same return, and that is what the market is paid to do. It is not paid to have twice the return from fossil fuels as it gets from consumer durables. It’s priced to equate them all and it does a pretty darn good job.
Last year I asked one of my colleagues to prepare a study of the market, looking at the S&P 500 excluding each of the 10 GICS sectors. So each of the 10 subsets was 90% of the market – the full S&P less one sector. The first go around was just 35 years, back to 1989. I was feeling a little guilty about the short time period, and it came out almost laughably as an exhibit. For every single one, to the eye you couldn’t tell the difference. Each one was all 9.7% to 9.9% compounded per year, plus or minus nothing. [This analysis is available here.]
I showed this to great effect a few times at conferences on various topics including divestment. When they talk about divestment, the conservative committees of every college in the world leap out of their chairs and say, “If you take out any name your return will go to hell!” This was absolute proof that that was nonsense. But it was only 35 years. Finally, Lucas extended it 20 more years to 1957 (the inception of the S&P 500), and then finally another 40 years, back to the 1926, using the S&P 90 (the S&P 500’s predecessor).
We ended up with 90 years of data. Each of those three time periods came out looking exactly the same, which was a wonderful test. I tell the story about how I got lucky on the first one and thought it can’t possibly be this good. Then it was, and it was again.
The supposition is that if you exclude a group, or you operate in a single group, you will make the market return plus or minus a much smaller the number than you think, and it is just as likely to be positive as it is negative. If you do without fossil fuels or you do without consumer durables, it is just as likely to help you as to hurt you. Then, step two, you may have an ax to grind: some long-term argument that the world is misunderstanding the negatives of fossil fuel, which we argue they do. That gives you yet another reason to divest.
But operating in an area that is going to outgrow the rest of the world, other things being even, is a bit of a tailwind. We don’t know much about the details, but we do know one thing: the total sales growth in the climate-change portfolio will be greater than the sales growth of the balance of the world.
This is going to be the big investment area for decades.
Your paper looks at the trends in consumption and demand in several areas, such as solar, wind and renewable energy. But you didn’t present much data on supply. What are the trends that you are seeing in supply, for example of solar and wind devices and batteries?
Lucas: In the paper we touch on the costs changing pretty dramatically. We referred to that earlier. That’s the biggest trend that you see on the supply side. Costs have just fallen by an incredible amount over a very short period of time, just five to seven years. They are expected to continue to fall. A lot of that is the industrialization and economies of scale of larger production, as opposed to huge technological breakthroughs, since technology has been improving incrementally.
Each wind turbine used to be individually manufactured, more or less by hand, going back 10 years. Now they have common production lines like you would expect to see at a real industrial facility. The improvements in the process and the better contracts they can lock in from suppliers and materials have led to dramatic drops in costs.
Jeremy: There is nothing to stop the ramping-up process in solar and wind towers. That plays to the real strength of the global manufacturing sector, and we have seen how rapidly they can do it in solar.
Batteries raise a short-term question. There is a transition flashpoint on electric cars. If it happens as fast as it might, there is no doubt battery production will be on the critical path. It will be squeezed and there will be a short-term rise in the price. But as you know from Tesla and others, as we speak they are constructing new mega plants to produce batteries.
I expect there will be two or three periods of battery shortages, because when the transition to electric cars gets going it could be very, very rapid. This is still under-appreciated by the general business community. In 2010, Tesla could deliver a kilowatt hour for $1,000; next year the insiders are whispering that it will be $150. That’s pretty spectacular in eight years. There are new technologies that work at scale and one day are very likely to halve the cost of lithium batteries.
You have two factors at work. You have scaling up. As they say, every time you double production, you knock off 18% of the cost. By the time you get to 20 million vehicles, the existing lithium-ion technology will have gone from 150 to 80. By that time this next generation of solid-state technology with less material will come in and that will make it 40. At 40 you are talking about a car that is cheaper to build than diesel or gas-based cars. It will be almost infinitely cheaper to run and very much cheaper to maintain. They will take over all the commercial fleets of taxis and very quickly trucks because of the operating cost. They will be a whole lot cheaper to produce than people realize.
That will put great stress on batteries from time to time. It will be like the early days of plastics, when they ramped up at incredible speed and there was a total glut, and then there was a surge, followed by a shortage, then the price tripled, and then they opened another army of factories and the price dropped again. It will be a very bumpy ride and there will be plenty of squeezes on battery production, but not on solar or on wind. That’s the kind of investing we do very, very well.
Will your fund invest in water-related opportunities?
Lucas: We will look at water-system engineering efforts, water-recycling efforts, and water filtration and treatment. We need to treat water like the valuable resource that it obviously is. Society in many ways has treated water as a free good, or one where we are destined to have access to cheap, clean and free water. There are more floods, droughts, downpours and dry periods, and water distribution patterns are going to change in such a way that having steady access to cheap but clean water will be very important.
Agricultural challenges are likely to be geographically concentrated, which will cause migrations, and there are already massive migrations. Do you see a positive investment opportunity in this development? Also, agriculture is trending toward a highly data-centric business, where, for example, companies can measure and optimize nutrient dosages and water, both of which can save energy. There are also energy savings from reducing water and food waste. Have you seen opportunities in those areas?
Jeremy: I’ve talked about this and we know that migrations are a dreadful risk factor. Thinking of ways to make money from it is difficult. It’s tough. We don’t have any brilliant ideas on that.
But in the venture capital world where I operate our foundation investing, we see plenty of these new farming techniques that are quite remarkable. They can tell you almost yard-by-yard what your farm needs will be in the way of nutrients and fertilizer. The rate of technological change is quite remarkable, given what they can do from satellite on the mix of your forest and on the type of your soil on your farm. It is full of new startups, several of which the Grantham Foundation owns. But very few of them have reached market liquidity.
Lucas: Something like 5% of the world’s farms have access to soil laboratories. We are pretty far away from a world where there is going to be precision agriculture on farms around the world. It’s still a very brute-force industry, generally speaking. But in terms of the long-term hope for the future, we have our eyes on those areas and are hopeful there will be more investable opportunities.
You mentioned Tesla, which is conspicuously absent from your portfolio. In your paper, you alluded to the fact that it has a valuation that does not appeal to a value investor. At what price would Tesla be a candidate for your fund? Musk’s vision is that a Tesla battery can store solar power from the rooves of homes. Do you believe this?
Lucas: I don’t see any reason why you couldn’t have solar power generated by panels or the roofing tiles that they are developing at Tesla. That can certainly be part of the solution. But it’s not the whole solution.
Tesla is a great company that is pushing the world forward in terms of clean energy efforts. I’m fully behind it. It’s exciting what they are doing. I admire their vision and what they are pushing, but that doesn’t mean I feel comfortable investing in it. It’s hard to figure out how to value a company that hasn’t proven that it can generate bottom-line earnings and cash flows. It would be a highly speculative investment, but I’m hoping they stay in business and continue to push the envelope.
Jeremy: I have happily signed up for the model 3.
Surely there are other value-oriented managers who are focused on many of the same companies as GMO. What will give GMO the advantage in finding better investment opportunities?
Lucas: It is not as obvious to me that there would be a lot of value-oriented managers focused on what we are calling the climate-change sector. You’re talking about areas with a lot of uncertainty, but a tremendous amount of growth. As Jeremy alluded to earlier, this is going to be a growth area for decades to come, where you are going to have companies like Tesla.
Jeremy: It’s going to be less predictable with greater volatility. These are things that value managers hate. Lucas is also the manager of our resource fund, and he knows what the score is there. They are basically cheap-looking stocks that are owned about one-fifth as much by the leading value managers as their raw value would suggest, because they have the unpredictability of raw materials behind them.
Value managers hate unpredictability. But we love it, because it means you have less competition. Somewhat old-fashioned value techniques work in resources where they have had a very difficult 15 years. There is some evidence of that working in climate change for the same reason, and there is some overlap. Copper appears in both of Lucas’s portfolios, because copper plays such a big role in electricity. That is the very embodiment of what value managers hate – the copper industry. New technology is growing rapidly too, it’s just not their cup of tea.
And we are better, by the way.
I never doubted that. Jeremy, you have a deep personal commitment to environmental issues through your foundation and through your speaking. Some investors may be concerned that your personal commitment may influence or cloud your judgment as an investor. How would you respond to that concern?
Jeremy: I hope it doesn’t. That’s always a risk. I look back over 40 years and I ask myself, “Have there been occasions when what I wished would have happened has played too big a role, and what I expected to happen was quite possible?” But that happens to everybody and the old pros have to learn to watch out for it. That’s the best I can say.
What are the risks that concern you the most with climate-change-related investments?
Lucas: Are you paying too much for these companies? Do you pay too much for the growth? Are the competitive dynamics in the relevant industries conducive for generating profitability? Look at what’s happened with the solar industry. It’s been a terrible place to invest.
Some people worry about U.S. federal policies. What is the Trump administration going to do about clean energy? But I don’t really worry about those risks. This isn’t a federal government problem. This is a global problem. Even within the United States, cities, states, universities and businesses are all mobilizing to address climate change. It is not obvious that it is a U.S. federal government problem.
It’s also not a problem we are going to address in the next three years. It is a problem we are going to address, hopefully, in the next 40 or 50 years. I don’t worry as much about the public-policy support. The economics for these companies are increasingly compelling even absent subsidies and incentives.
The risks I worry about are the same risks I worry about for companies in other sectors where we invest. Are you buying companies at the right price? Are you buying companies that operate in industries with good competitive dynamics? Is there product differentiation? Are there barriers to entry? Do they have some sustainable competitive advantage? I don’t particularly think that there are unique risks to the sector if you are a long-term investor.
Jeremy: They are not unique, but the ability of the government to change its policy behavior about climate change exposes you to more government shifts in policy than is typical in an industry. There are other industries where it is important. But there are very few that will have greater significance from potential government shifts.
Lucas: From a global perspective, I would bet that the delta in public-policy support for climate-change efforts will be positive rather than negative.
Jeremy: But the fact that government clearly plays a bigger role than it does in a typical subset of the economy exposes you to possible risk.
Lucas: If we are saying that five years from now solar and wind without subsidies and with storage will be cheaper than the operating costs of a coal or nuclear power plant, then public policy support won’t be as important in that world.
Jeremy: But government policy may have moved on to subsidies for making changes to a smart grid. As governments begin to realize how important making these trillion-dollar investments are, they should get behind them. They should give you accelerated depreciation for capital spending and so on if they know what’s good for their economy. Some countries will. Once they do that, it’s a terrific idea, but it does expose you to the day when they decide to drop their support. So that is a potential, intermittent extra risk in return for which you get a net positive.