The Energy Transition and What It Means for Institutional Investors
- The global economy is still overwhelmingly powered by fossil fuels, with more than 80% of primary energy sourced from coal, oil, and gas, as of 2021.
- Achieving net zero by 2050 would be a herculean task. This energy transition would need to be two times faster than the shifts towards coal, oil, and gas in the last 200 years.
- A slow transition would expose investors to physical risks. The most pressing physical risk for investors is agriculture. A fast transition would expose investors to large transition risks.
- How governments facilitate the energy transition will be critical for economies and markets.
On Oct. 24, Kris Nelson, Head of ESG Investment Management, Global Equity at Russell Investments, moderated a discussion on the complexities of the transition to new energy with two Russell Investments strategists: Paul Eitelman, Senior Director, Chief Investment Strategist, North America; and Pierre Dongo-Soria, Senior Asset Allocation Strategist. Nelson and Eitelman participated from the Russell Investments’ studio in Seattle, and Dongo-Soria contributed from London.
According to the panelists, the global economy runs overwhelmingly on fossil fuels—chiefly, oil, gas, and coal—but scientific literature has made it increasingly clear that if the planet is to avoid a significant warming, a transition to cleaner energy sources is critical.
During the one-hour long discussion, the panel pondered the following points: What are the short- and long-term implications of such a transition for investors? Should markets be bracing for persistent volatility? What role could private investing play in all of this, especially given the need for a significant increase in capital spending?
Following is a recap of key highlights from their conversation, which is based on the Russell Investments Energy Transition Report found here.
Eitelman began with a brief explanation of the energy transition. While fossil fuels—coal, oil, and natural gas—are abundant and very efficient energy resources, they emit into the atmosphere greenhouse gases, like carbon dioxide, ultimately warming the planet and creating adverse economic outcomes. The energy transition therefore, he explained, is about moving from fossil fuels toward potentially greener energy technologies—solar, wind, nuclear. and hydro—changing how the global economy works to avoid negative externalities.
Eitelman shared a slide called Climate Economics, showing the circular relationship among greenhouse gases, rising temperatures, physical damages, and the economy, factoring in mitigation, geoengineering, and adaption. “If we actually do transition here, the dollar amounts involved are going to be large. We’re talking in the trillions of dollars of new global energy investment over the next decade or so to move towards net 0 by 2050. That's a lot of money, and whenever money is in motion, particularly if it’s going to involve private capital markets, as this is likely going to need to, that's going to create risks and opportunities that investors need to be mindful of,” he said. “Finance is all about making decisions under uncertainty and, at a minimum, we need to be aware of these uncertainties and risk, as we're thinking about portfolios.”
Nelson introduced to the online audience a poll question: “What do you think is the most significant challenge facing the energy transition today?”
The poll results were as follows:
- Inefficiency of renewables (most popular response)
- High cost
- Poor policy
- Public resistance
- Supply risks
- Outdated infrastructure
The discussion then moved to significant challenges facing the energy transition. Nelson turned to Dongo-Soria to provide an overview of the current state of the global energy market, including the role of fossil fuels and renewables.
Dongo-Soria explained that the global energy market remains heavily reliant on fossil fields, accounting for about 82% of the world's energy supplies, and while that number is on a downward trend, it has decreased only slightly over the past two decades, despite increasing provenance of green tech and renewable energy. In the meantime, Dongo-Soria explained, it is a complex landscape where fossil fields continue to dominate and renewables are playing catch-up.
“Over the years, we've refined this technology and infrastructure around fossil fields to a point where they are not just abundant, but also economically viable. It's difficult to transition away from fossil fuels because their energy, density, versatility and affordability are hard to replicate,” he said.
Electricity alone cannot meet all industrial energy needs, Dongo-Soria said. “What we need to do is to think on a multi-sectoral approach that acknowledges and addresses these specific needs and challenges for each of those sectors. It’s not just about electricity.”
How would this energy transition that may be before us compare with historical energy transitions?
Dongo-Soria pointed out that humans have experienced many transitions in the past: the shift from wood to coal, and then to oil. “Past transitions were often driven by economic advantages, technology innovation and resource availability,” he said.
Today’s transition is motivated in part by the urgent need to mitigate the environmental impact of the current energy mix so, unlike previous transitions, which could afford to evolve naturally over extended periods of time, we have deadlines set by environmental goals like the Paris Agreement that require rapid change, he added.
Dongo-Soria shared a slide, Historical Energy Transitions and Expected Transition Under Net Zero 2050 Scenario, explaining, “what we are facing essentially, is the biggest energy transition in the history of humankind—under a ticking climate clock.”
How do you think portability, geopolitics, and supply chain issues might affect the pace and feasibility of transitioning to renewable energy?
On this topic, Eitelman said partisan politics in the U.S. has created a stop-and-go approach toward energy transition and further, on a global scale, there needs to be a sharing of resources around the world. “If you're looking at the United States, Europe, China, and Russia, at best, those relations are pretty tense, and we're seeing a lot of evidence of export restrictions and other things that will create obstacles, and probably slow down this transition from a geopolitical perspective,” he said.
Based in London, Dongo-Soria provided a European viewpoint: “The perspective here is that there is a need to transition. People acknowledge that. There’s various forms of that. There are various degrees of how much commitment you want to do today, because it involves a cost, and it’s a meaningful cost, so they have to do it for the right reasons, and with the backing of the public.”
What role can technology play in facilitating the energy transition and preventing temperature increases?
Eitelman suggested that storage technologies for batteries could be an area for advancement since green energy sources like solar and wind are only intermittent. He also mentioned there may be promise with direct air capture—pulling carbon dioxide out of the atmosphere—citing the world’s largest air purification facility being built in Iceland. There is optimism regarding the facility, called Mammoth, yet the cost and long-term effects still need to be studied more closely.
Let's talk about the motivation for the energy transition. We’re going to dig into the damages a little bit and explore the physical risks that, of course, translate to human impact, but also corporate and economic impact. What would you highlight about the potential economic impacts and physical damages of climate change?
While Eitelman shared a slide, Physical Damages from CO2 Emissions and a Warming Planet, the discussion moved to crops, biodiversity, and global food security. “As the planet warms, that does pose some meaningful risk to global food security again at a time horizon that matters for investors right now. On balance, that threat to food security is probably one of the bigger adverse effects that we see in the short term,” he said.
Dongo-Soria added that he sees a direct correlation or relationship between food and security and social instability, which will impact markets and the economy.
How do you think about this in terms of quantifiable economic effects?
Eitelman started off by mentioning that human adaptation and tipping points are critical areas that are difficult to model. “For example, while corn looks like a crop that could be particularly challenged, it's entirely possible that scientists develop some kind of breakthrough modifying corn, so it can withstand warmer temperatures and withstand drought conditions. And so that would be a source of uncertainty that maybe damages could be lower than we currently think.” Further, using the Greenland ice sheet as an example, Eitelman described how warming temperatures that lead to melting and rising sea levels could mean physical damages could be larger than expected.
The discussion then moved onto the scenarios: orderly transition and hot house. From an investment point of view, Dongo-Soria pointed out, “We think that the best way to approach this … is not to think about forecasting a specific scenario and claiming that we have a lot of forecasting power and expertise on that. It’s more about thinking about different scenarios and trying to build resilience across those and trying to identify, where are the main risks to your portfolio and where are the main opportunities to your portfolio.”
Nelson introduced a second poll question: ““How are you incorporating the energy transition or climate risk you’re your investment plans?
The poll results were as follows:
- We are in early discussions. (most popular response)
- We have developed a climate action plan.
- We have made investments in climate solutions, such as renewables or decarbonization strategies.
- We are not yet considering this issue.
The discussion moved to policy response in both Europe and the United States, with mention of taxes, subsidies, and carbon pricing. Nelson pointed out that the European policy response has been a little bit more robust than in the United States, which has introduced the Inflation Reduction Act.
A third poll question was posed to the audience: “Would you be interested in an unlisted infrastructure product with a target return of CPI + 4%?”
The poll results were as follows:
- Yes, that sounds interesting.
- Not sure, but I’d like to hear more.
- No, we are already covered when it comes to unlisted infrastructure.
- No, we intentionally don’t use unlisted infrastructure and don’t plan on it.
How do asset allocators deal with the uncertainty of the policy landscape? How do we translate that into financial data?
Dongo-Soria referenced back to climate models and explained how he applies the scenarios to client portfolios, helping them address questions like: “How can I add portfolio resiliency in this? How can I protect my portfolio or build a solution around this that limits that shock in this particular scenario or that particular scenario?”
“This kind of modeling gives you some intuition, some direction of trouble that I believe is important for clients,” he said.
At this time, the panelists addressed a few questions from the online audience regarding the demand for green energy, whether it has peaked and whether there is agreement around where renewables might outcompete fossil fuel energy on cost.
Dongo-Soria said: “It's not that it has peaked. It’s more like a cycle, but I think the trend especially, let's say ten years from now, will be stronger toward trying to make the necessary changes from our energy consumption and energy supply to get there in terms of the energy transition, because the consequence of not doing it are quite dire.”
Finally, Nelson, who is Head of ESG Investment Management, Global Equity at Russell Investments, was asked: “What solutions are you seeing clients deploy? Systematic or active manager solutions? What can investors do if they are interested lowering their exposure to climate risk and/or in financing a green energy transition?”
Nelson started off by mentioning that a portion of Russell Investments funds are aligned to net zero goals. She talked about the global unlisted infrastructure fund, “where 55% of the assets are allocated toward managers that are providing capital to renewable resources, to digital solutions and to social solutions like schools.” Further, Nelson mentioned the Global Impact Fund, which has a climate solutions pillar.
Finally, the panelists each shared suggested reading relative to the conversation, as follows:
Eitelman: “The Climate Casino: Risk, Uncertainty, and Economics for a Warming World, by William Nordhaus.
Dongo-Soria: “How to Avoid a Climate Disaster: The Solutions We Have and the Breakthroughs We Need,” by Bill Gates.
Nelson: “How the World Really Works: The Science Behind How We Got Here and Where We're Going,” by Vaclav Smil.
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