The path to clean, secure and affordable energy

The changing seasons are nature’s way of reminding us that time moves on. And it is the same in the Russell household, where my youngest is approaching 18 and his late weekend nights are his way of telling me change is arriving in our home too. There is a dawning that I am heading into a new stage of life. It is exciting, but after 20 years of bringing up a family, I also admit to being a little scared of what the next chapter will bring. In markets, we often get obsessed with short-term changes, but it can be the slow structural moves—such as a child leaving home—which can have a more profound longer-term impact.

Bear markets exist for a purpose. They expose the heavy misallocation of capital that in this bear market occurred because finance was too easy. While capital is now more rationed, energy too can no longer be taken for granted. Of course, management teams of energy companies have been aware of this for some time, as they have witnessed their own cost of capital rise as the shale revolution unwound and climate change took hold.

In bear markets, time horizons are compressed, and dreams are often shelved as rising costs force management teams to make difficult choices. These choices impact different stakeholders, often over different time horizons, which explains why companies adopting a stakeholder approach with purpose could be better equipped to navigate their way through difficult times and when the next bull market eventually begins, may be better placed to solve the significant challenges facing society over the coming decades.

Choice One: Energy affordability versus long-term energy transition

Energy markets and policies have changed as a direct result of Russia’s invasion of Ukraine and are likely to persist for decades to come. The environmental case for clean energy needed no reinforcement, but the economic arguments in favour of cost-competitive and affordable clean technologies are now stronger—and so too is the energy security case. But solving for clean, secure, and affordable energy is not straightforward.

Energy is input to making substantively everything in the modern world. So, when we have shortages—as we do now—the rising costs of everything act like a tax on consumption. Primary energy costs at the start of the last century were about 4% of global GDP. Today, primary energy accounts for about 12% of total GDP, which is similar to that achieved in the two oil shocks in the 1970s.(1)

Direct energy makes up about 45% of European inflation (Chart 1). However, we also know that 10%–15% of all primary energy goes into making food for the world’s population—which adds to inflationary pressure. If other associated links to energy are added, we can estimate that approximately 75%(2) of inflation is driven directly and indirectly by energy costs. Our current energy crisis is a core element of today’s inflation and until we solve energy supply problems, we expect inflation will remain stubbornly above most central banks’ 2% targets.

Chart 1: Headline inflation rate with component contributions - Eurozone

Source: Aurora Energy Research, GOV.UK, Eurostat, U.S. Bureau of Labor Statistics, MarketWatch

Today, for every US dollar (USD) spent globally on fossil fuels, USD 1.5 is spent on clean energy technologies. But by 2030, under the net-zero emissions by 2050 scenario, every dollar spent on fossil fuels will be outmatched by USD 5 on clean energy supply and another USD 4 on efficiency and end-uses.(3)

If clean energy investment does not accelerate, higher investment in oil and gas will be needed to avoid further fuel price volatility while also putting the 1.5 degrees Celsius goal in jeopardy. But, if we accelerate clean energy today at the expense of fossil fuels, we will only exacerbate our energy shortages, given the short-term draw on valuable energy sources made by solar and wind. These are long-term versus short-term choices that even the experts have difficulty reconciling (Exhibit 1):

Exhibit 1: IEA illustrates the challenge between short-term affordability and long-term energy transition

International Energy Agency (IEA) executive director Fatih Birol: “If governments are serious about the climate crisis, there can be no new investments in oil, gas and coal, from now – from this year”. (“No new oil, gas or coal development if world is to reach net zero by 2050, says world energy body”, (The Guardian, 18 May 2021)
IEA’s 2022 outlook: “A huge increase in energy investment is essential to reduce the risks of future price spikes and volatility, and to get on track for net zero emissions by 2050… an average of almost USD 650 billion per year ‘will be’ spent on upstream oil and natural gas investment to 2030, a rise of more than 50% compared with recent years”. (IEA “World Energy Outlook 2022”) 

The most suitable near-term solutions include projects with short lead times that bring oil and gas to market quickly, but also include areas such as capturing some of the estimated 260 billion cubic metres of gas that is wasted each year through flaring and methane leaks(4) to the atmosphere—a key driver of our investment in Emerson.

Demand efficiency and productivity could also be key, and in this field there has been significant progress. A recent German IFO survey suggested that most companies—in this case, 75% of those that use gas as a primary energy source in their production—have found ways to reduce gas usage in the last six months while still meeting production targets (Chart 2).

Chart 2: Reduction of natural gas consumption in the production process (%)

Source: IFO Business survey, October 2022

Energy efficiency is the number one place to look for solutions to this energy crisis. While energy costs soar, CEOs are expected to look at ways to make their businesses more resilient and reduce their energy burden. Paybacks on energy-efficient investments will be very high, in our view, and are unlikely to be shelved if and when a recession starts. We see this providing tailwinds for long-term holding companies such as Schneider and opportunities within the energy services companies, where cash flow returns could accelerate to doubledigit levels. This is a significant part of the reason for our more recent investments in Worley & Schlumberger.

Choice two: ESG recession versus stakeholder capitalism

Recent market history suggests that commodity prices will correct with a recession and if central banks have their way, a recession is exactly what we may get. Our own experience tells us that we should prepare for where the cuts might be. Some are obvious—such as advertising and marketing. These cuts have already 4 IEA, “World Energy Outlook 2022”, November 2022 started as can be seen by the demise of Google (NASDAQ: GOOGL) or Meta (NASDAQ: META). For many others, their earnings recession is just starting.

Corporates are also expected to cut capital projects and Gartner’s July 2022 poll provides some insight into where these might be (Chart 3). The results are not surprising—but significant reductions in investment for improved sustainability and environmental impact are worth raising.

Chart 3: Investment categories to be cut first—surveys

Source: Gartner, July 2022

While corporates may sharpen the knife on sustainability, what is surprising to many is the backbone behind policy changes in Europe and the US (among others). Instead of accelerating fossil energy supply, these changes are expanding incentives and targets for alternatives, such as wind, solar, and hydrogen. The REPowerEU Plan was launched by the European Commission earlier in 2022 to reduce the European Union’s (EU) dependence on Russian fossil fuels in direct response to the Ukraine invasion. The plan calls for the EU to consume 20 million tonnes (mT) of hydrogen by 2030, instead of the 5mT target previously quoted in the Fit For 55 policy announced just a few months before, as an example. If we feared a clash between decarbonisation and short-term energy needs, decarbonisation seems to remain society’s number one target.

The bull market for ESG data and integration has been stratospheric. 

Changing demographics, rising inequality, the rise in the importance of externalities such as nature, and the increased influence of the state through regulation all have a part to play. Given the case in prior recessions, we should expect ESG to be less of a focus for management teams as they divert their attention to short-term challenges or for some to simply stay afloat (Chart 4). In our view, expensive virtue signalling does not perform well during recessions (e.g. Tesla).

Chart 4: Long-term bull market for ESG—with a few blips

Source: Bernstein Research and Bloomberg, October 2022

In terms of energy shortages, we may play out the 1970s again. We also appear to have returned to that decade to question the role of shareholder primacy, with both business leaders and politicians (e.g., business round tables and the Davos Manifesto) suggesting we are on the verge of a fundamental reshaping of society. This slow, structural change is of course not new and ESG is a key cog if stakeholder capitalism is to work.

Given the shift to stakeholder capitalism is such an ideological shift, it shouldn’t surprise anyone that we are now seeing an ESG backlash, the most vigorous of which is targeted at greenwashing. Survey evidence around sustainability suggests trust is low. For example, three out of four institutional investors do not trust companies to achieve their sustainability targets and commitments.(5) And of course, the measurement of ESG data is fraught with difficulty; while credit ratings correlate with 99%, the correlation of external ESG ratings ranges between 38% and 71%.(6) For some, ESG is leading to a significant misallocation of capital and is morally bankrupt.(7, 8) The situation has prompted some regulators, such as those in the predominantly Republican US states, to try and ban ESG investing altogether.

Yet, many companies today are making major decisions, such as discontinuing operations in Russia and protecting employees in at-risk countries. They also continue to commit to science-based targets and to define and execute plans for realising these commitments. This indicates that ESG considerations are becoming more—not less—important in companies’ long-term decision-making. 

In fact, at Nikko Asset Management we believe companies should adopt a stakeholder approach. Companies must approach externalities as a core strategic challenge, not only to help future-proof their organisations but to deliver meaningful impact over the long term. Some companies that have already built purpose into their business models and are demonstrating they benefit multiple stakeholders are already showing success, such as Microsoft (NASDAQ: MSFT), or lesser-known companies, such as Compass Group.

In recent years, boards of directors have become increasingly focused on corporate purposes. This is partly driven by a sense that purpose drives corporate culture, helps attract and retain talent, and is increasingly a differentiator when it comes to customers and suppliers.

External pressure on corporate boards to better define purpose has come from investors, who are themselves being asked to justify their investments based on ESG as well as financial considerations.

A single, clearly marked path that every business should follow does not exist. Strong corporate leaders recognise that social expectations constantly evolve, and we believe that it is the company’s purpose that guides management, fund managers, and owners through difficult times. 

A recent McKinsey study developed a framework for summarising key ESG approaches. This highlights characteristics of those at the forefront of stakeholder capitalism, fully integrating ESG into strategy and operations—listed as “Next Level Practices”. Companies adopting stakeholder capitalism are seen to be enhancing their company’s competitive positioning. They have a purpose and can articulate why stakeholder capitalism is creating a competitive edge (Exhibit 2).

Exhibit 2: Corporate approach to ESG and stakeholder capitalism

Source: “How to Make ESG Real”, McKinsey, August 2022

They are a more attractive place to work for their employees—retention rates are higher than peers— successfully fighting the war for talent, while some are discovering new solutions needed to solve many of our current problems, such as climate change. 

We can already see success in many of our holdings—such as Danaher, Sony, John Deere, and Rentokil to name a few. These companies are creating their very own superpowers, enhancing their franchise and management qualities, and creating value (Exhibit 3).

Exhibit 3: Examples of Future Quality purpose statement

“Helping realize life’s potential” (Danaher)
“Fill the world with emotion, through the power of creativity and technology” (Sony)
“We must act with urgency today to make the lives of our customers, workforce, and all those we serve better tomorrow” (John Deere)
“To protect people and enhance lives” (Rentokil)

Our own experience is supported by academic research which links the importance of stakeholders and stronger operating performance across several metrics. (9) These management teams are committed, empathetic, and demonstrate through full and transparent disclosure of data that they are on a journey of continuous improvement. They invest with a long-term investment horizon and are prepared to make difficult decisions, some with potential trade-offs across different periods. But when backed by a clear purpose statement that creates value for all key stakeholders, these management teams can “walk the talk”.

Remuneration and incentive schemes are linked to measurable ESG targets and integrated reporting—such as diversity targets or emission reduction targets. And they are preparing themselves for further regulation such as the introduction of separate ESG reporting under what is known as “Double Materiality”.

Conclusion

In conclusion, clean, secure, and affordable energy is likely to be one of the major challenges of this decade. Given we need abundant energy to complete the energy transition, we believe fossil fuel companies that are actively enabling a transition to low carbon society can be part of the solution. They often understand how to deliver global energy at scale and have balance sheets capable of enabling the transition to clean energy. 

We also believe companies adopting a stakeholder approach will be better equipped to solve the significant challenges facing society over the coming years, and that a clearly defined purpose will help guide management teams through the challenges and choices they will have to make. 

After all, it is the choices made today that will define the Future Quality returns of tomorrow. 

Learn more

We seek to uncover Future Quality investments – businesses that can attain and sustain high returns on invested capital to deliver better performance for shareholders over the long term. To find out more, visit the Nikko AM Global Share Fund profile below.

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(1) Thunder Said Energy, “Energy Shortage: fear in a handful of dust?”, November 2022 (2) Nikko AM estimates (3) IEA, “World Energy Outlook 2022”, November 2022 4 IEA, “World Energy Outlook 2022”, November 2022 (5) Edelman, “2021 Trust Barometer Special report: Institutional investors”, November 2021 (6) Florian Berg, Julian Kölbel and Roberto Rigobon, “Aggregate confusion: The divergence of ESG ratings”, Review of Finance, forthcoming, updated 26 April 2022 (7) Bérengère Sim, “Ukraine war ‘bankrupts’ ESG case, says BlackRock’s former sustainable investing boss”, Financial News, 14 March 2022 (8) Steve Johnson, “ESG outperformance narrative ‘is flawed,’ new research shows”, Financial Times, 3 May 2021 (9) Ariel Babcock et al., “Walking the talk: Valuing a multi-stakeholder strategy”, FCLTGlobal, 17 January 2022 This material has been prepared by Nikko Asset Management Europe Ltd (NAM Europe) which is authorised and regulated in the United Kingdom by the FCA, and is intended for viewing only by wholesale clients for the purposes of section 761G of the Corporations Act 2001 (Cth). NAM Europe does not hold an AFS Licence. This material is issued in Australia by Yarra Capital Management Limited (formerly Nikko AM Limited) ABN 99 003 376 252, AFSL 237563. This document may not be reproduced or distributed to any person without the prior consent of Yarra Capital Management Limited. The information set out has been prepared in good faith and while Yarra Capital Management Limited and its related bodies corporate (together, the “Yarra Capital Management Group”) reasonably believe the information and opinions to be current, accurate, or reasonably held at the time of publication, to the maximum extent permitted by law, the Yarra Capital Management Group: (a) makes no warranty as to the content’s accuracy or reliability; and (b) accepts no liability for any direct or indirect loss or damage arising from any errors, omissions, or information that is not up to date. To the extent that any content set out in this document discusses market activity, macroeconomic views, industry or sector trends, such statements should be construed as general advice only. Any references to specific securities are not intended to be a recommendation to buy, sell, or hold such securities. Holdings may change by the time you receive this report. Portfolio holdings may not be representative or future investments. Future portfolio holdings may not be profitable. The information should not be deemed representative of future characteristics for the strategies listed herein. Past performance is not an indication of, and does not guarantee, future performance. References to indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only and do not imply that the portfolio will achieve similar results. The index composition may not reflect the manner in which a portfolio is constructed. Portfolio characteristics take into account risk and return features which will distinguish them from those of the benchmark. There can be no assurance that any targets stated in this document can be achieved. Please be advised that any targets shown are subject to change at any time and are current as of the date of this document only. Targets are objectives and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any asset or asset class described herein. If any of the assumptions used do not prove to be true, results may vary substantially. These targets are being shown for informational purposes only. Whilst we seek to design portfolios which will reflect certain risk and return features such as sector weights and capitalization ranges, by accepting the document as a wholesale client you are taken to understand that such characteristics of the portfolio, as well as its volatility, may deviate to varying degrees from those of the benchmark. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided. Yarra Capital Management. Copyright 2023

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Johnny Russell
Portfolio Manager
Nikko AM

Johnny joined Nikko AM in August 2014 as a Portfolio Manager for Global Equities. Before joining Nikko AM, Johnny was an Investment Director at SWIP and was responsible for the management of Global Sustainable & Islamic mandates for both...

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