An Uncertain Transition

Rising oceans and intensifying hurricanes threaten our coastlines, more frequent and severe droughts and floods threaten our food and water supplies, and wildfires threaten our forests and infrastructure. As temperatures have accelerated upward and the deleterious effects of rising temperatures have become more apparent, we’ve become increasingly worried about the impact of climate change on the world. We believe the problems and risks associated with climate change are much worse than the average investor or businessperson realizes. 

The challenge in heading off climate change is enormous and has profound investment implications. As Jeremy noted in 2010, “Global warming will be the most important investment issue for the foreseeable future.” Climate change poses many risks for investors. Carbon pricing, technological disruption in the energy, automobile and utilities industries, and stranded assets (i.e., the risk that fossil fuel producers will be forced to leave reserves in the ground) are just a few examples of climate-related threats that loom large and must be considered in constructing a portfolio. 

In this paper, however, we focus on climate change-related opportunities. Over the past few years, public policy support combined with the dramatically declining costs of solar, wind, and batteries have spurred unexpectedly strong growth in renewables and electric vehicles. We expect strong secular growth in clean energy efforts to continue in the coming decades and to provide investors with opportunities to invest in companies that both deliver impressive returns and help the world avert the potentially disastrous consequences of climate change. Over the past few years, our research into clean energy, batteries and storage, electric vehicles, energy efficiency, and other clean energy solutions has led us to believe there are tremendous investment opportunities for long-term investors willing to take on shorter-term risk. 

The climate change sector
As we think about businesses that stand to benefit from heightened efforts to address climate change, we see business models focused on the mitigation of climate change and the transition to a clean energy world. In addition, we see businesses that will help the world adapt to the impacts of climate change. In aggregate, let’s refer to this as the climate change sector. 

Mitigation: Industries involved in the mitigation of climate change and the transition to a clean energy world include solar, wind, nuclear, hydro, geothermal, batteries and storage, smart grid, and clean power generation. Importantly, we also look at the inputs into these efforts, so lithium, copper, and other critical materials fit the bill as well. Energy efficiency efforts are also within scope, including energy efficient building materials, energy efficient lighting, and electric vehicles. 

Adaptation: Climate change is already impacting the world, and these effects will become more pronounced as temperatures continue to rise. We consider companies helping the world adapt to a changing climate as part of the climate change sector as well.The impacts of climate change on agriculture and water are particularly worrying. A recent study published by the National Academy of Sciences concluded that as temperatures continue to rise, agricultural productivity could drop to levels last seen prior to 1980 by the year 2050. Good luck feeding 9 or 10 billion people in 2050 with productivity at 1980 levels or worse! Companies helping to support agricultural productivity through the production of seeds, fertilizers, farm machinery, etc., would find desperate need for their products. Droughts, floods, and changes in precipitation patterns also threaten our water supply. We believe companies focused on water recycling and treatment, water use minimization, and water system engineering will find their services in high demand as well. 

Secular growth opportunity 
The transition to clean energy will be no small task. The International Energy Agency (IEA) estimates that it will cost $9 trillion through 2050 to decarbonize electricity with another $6.4 trillion going into energy efficiency efforts in the buildings, industry, and transportation sectors. In order to meet the intended nationally determined contributions (INDCs) associated with the Paris Agreement, the IEA expects it will take another $4 to $5 trillion to overhaul the world’s archaic electric grids through 2030. The need for investment is somewhat staggering; however, these numbers pale in comparison with the potential costs associated with climate change, and despite considerable growth over the last few years and lots of media attention, renewable energy continues to represent a small fraction of the overall energy puzzle (see: Fuel for thought). Fossil fuel consumption continues to rise, and carbon dioxide concentrations in the atmosphere continue to hit record highs year after year. 

The good news is that wind and solar are expected to grow at a substantial rate for the next few decades. Importantly, the projections for renewables growth have continually been revised upwards, and we believe that current projections are likely to fall well short of the growth — that is actually realized as the world continues to mobilize — to address climate change. Unanticipated growth, of course, sows the seeds for great investment opportunities.

Two factors behind the repeated upward revisions to projections for renewables are general forecasting conservatism/anchoring and the falling costs of renewables. The latter factor is measurable and has been particularly impressive. Wind and solar costs have declined dramatically over the past few years, and renewables are increasingly competitive even without subsidies. Even better, the costs for renewables are expected to continue to fall into the future. While there are still challenges surrounding storage and the integration of intermittent, distributed renewables into the electric grid, we can now see the light at the end of the tunnel, a far cry from where we were just a few years ago. Imagine where we might be a few years from now.

We see a similar story in electric vehicles, where electric vehicle sales have grown rapidly in the last few years and are expected to do so for many years to come. Electric vehicles continue to represent a tiny sliver of overall vehicle sales, but once again, falling costs bode well for the future; lithium-ion battery costs have fallen by almost three quarters over the last few years and are expected to fall dramatically from here. Given that battery costs generally make up approximately 20-25% of the cost of an electric vehicle, declining battery costs will make a big impact on the competitiveness of electric vehicles. Various projections indicate that electric vehicles will be cheaper than internal combustion engine vehicles within 5 to 10 years; when that happens, electric vehicles will be an economic no-brainer. Why would you pay more for a vehicle that costs more to run (i.e., fuel costs) and to maintain and pollutes the environment? There could be a rapid transition to electric vehicles, much more rapid than generally understood. None of this, by the way, means that Tesla is necessarily a good investment. More on valuation later…

This is an excerpt from a GMO White Paper titled ‘The Good Thing About Climate Change: Opportunities.’ Copyright © 2017 by GMO LLC. All rights reserved