PLAYING THE CLIMATE CHANGE THEME
In this edition of the Vigil, we review background issues and answer the critical investment question related to climate change: is now the time to make investment decisions based on the prospects for climate change?
«The investment universe is characterized by constant movement and change. To successfully navigate therein one must demonstrate intellectual conviction and discipline. One must be capable of reading signs on the distant horizon while avoiding shoals in the near and present. One must also show humility, realism and maintain a good dose of humor. In short we must never fail at being vigilant.
Those qualities are brought forward daily by Natcan’s team of professionals. The following commentary reflects the views and opinions of our team on issues impacting Canadian investors and their advisors. »
- Pascal Duquette, president and CIO
THE AUTHOR: FATOUMATA BARRY, CFA – Analyst, Global equities
Fatoumata obtained her bachelor of commerce degree (finance and marketing) from McGill University in 2000. Further to her studies, she immediately started to work with financial institutions, launching her career with TD Securities as an investment banking analyst, and later joining National Bank Financial as a research associate. In September 2006, we welcomed her to our team.
Founded in 1990, Natcan Investment Management Inc. is a subsidiary of the National Bank of Canada with approximately 32 billion dollars under management. Natcan is one of the premier institutional money managers in Canada. Our investment leaders follow their convictions with discipline and rigour to serve the best interests of our clients and their financial advisors.
Playing the Climate Change Theme
For the past two decades, there has been an ongoing debate over the veracity, extent, and potential impacts of global warming. Governments, corporations, and individuals have only recently started to accept the scientific consensus on climate change, and they are now taking action to mitigate its impact by lowering greenhouse gas emissions (GHG).
Source: World Resources Institute
Focus on Energy
Since carbon dioxide represents well over half of all GHG, curbing them is a major part of current mitigation efforts. The World Resource Institute estimates that 61% of total GHG comes from energy-related activities, most of which stem from fossil fuel combustion.
Coal is by far the largest fuel source in electricity generation (38% of global supply), followed by natural gas (20%), nuclear (17%), and hydropower (16%). The reason behind coal’s preference over other fuel sources is its lower generation costs. However, carbon emissions per unit of electricity are almost twice as large in coal plants as in natural gas power plants, while nuclear plants are virtually carbon-free.
Key Drivers of Opportunities
The regulatory framework will drive investment risks and opportunities going forward. As more regulatory driven economic incentives to reduce greenhouse gas emissions emerge, the outlook of investment opportunities related to climate change mitigation improves.
Investment opportunities resulting from regulatory action on climate change fall into two main categories:
- companies that are exposed to low carbon energy production; and
- companies that make products and processes expected to deliver improved energy efficiency.
Investors should pay particular attention to new technologies that have the potential to not only help reduce greenhouse gas emissions but also our dependence on fossil fuels.
While the growth prospects of renewable and alternative energies are attractive and seemingly endless (they currently account for a minute percentage of the global energy production), investors need to proceed carefully, as many of these technologies are not yet cost competitive in comparison with more traditional fuel sources. Without subsidies and tax breaks, the majority of pure plays in these sectors would likely go belly up.
Regulatory Considerations: Europe Leads by Example – The U.S. Follows Reluctantly
Europe has been at the forefront of legislation mandating the reduction of GHG, notably with its commitment to the Kyoto Protocol (signed in 1997). This Protocol is a binding commitment for 41 industrialized countries to reduce their
GHG emissions to 5% below the 1990 level by 2010, with separate targets for each country.
The European Union is so far the only region to have introduced a market-based measure ‑ EU Emissions Trading Scheme (ETS) - to reduce GHG. The ETS is a cap-and-trade scheme that sets a limit for emissions from thousands of installations across major industrial sectors in member countries, and allocates a permit based on this limit. The ETS allows participants to trade permits and benefit from their individual emission profiles relative to mandatory requirements. This program is followed by an active promotion of the use of renewable energy (wind and solar) and alternative fuels (ethanol and biodiesel).
Meanwhile, the United States has been slow to implement a climate policy and regulate GHG. The situation may be on the cusp of change, as increased political pressure is being felt at regional and state levels. In August 2005, the Energy Policy Act was signed into law. The Act essentially promotes the use of nuclear and cleaner coal technologies, as well as renewable energy and alternative fuels. In 2007, the spotlight was again cast on alternative fuels, following President Bush’s State of the Union address on January 23.
Favour “clean” over “dirty” generators – the nuclear option.
Since nuclear power plants emit virtually no carbon dioxide, they benefit from higher power prices (each MWh power price typically values 100% of the permit price) without being subjected to higher generation costs (the fossil fuel generators’ production cost increase due to the need to buy permits). As such, utilities that have exposure to nuclear and natural gas generation are better positioned in the long run than operators of coal-fired plants.
Nuclear operators that are well positioned to take advantage of carbon emissions restrictions include:
- Électricité de France, the largest operator of nuclear assets in the world with some exposure to renewable energy production; and
- Exelon Corp, which operates the largest and one of the lowest cost unregulated nuclear fleet in the U.S.
Biofuels, as green as it gets.
Ethanol and biodiesel now account for close to 1% of the global liquid fuels market, a sector that has experienced tremendous growth over the past couple of years. This can be attributed to the widespread political support from Europe and the United States, as a result of energy dependence concerns. The European Union is targeting a 5.75% market share for biofuels in transport fuel supply by 2010 (from 1-2% in 2005). In the U.S., the Energy Policy Act requires refiners to ensure that gasoline sold in the country contains a specified volume of biofuels, increasing the level from 4.0 billion gallons in 2006 to 7.5 billion gallons in 2012. President Bush is targeting 35 billion gallons of renewable and alternative fuels by 2017. Both ethanol and biodiesel are projected to grow at double-digit rates over the next five years, driven by government support programs.
Capital flows to the U.S. ethanol market have also increased drastically over the past year. In 2006, several pure-play U.S. ethanol companies raised equity capital through initial public offerings and private placements. With the rapid rise in ethanol production, corn prices, which account for over half of costs, have surged significantly, driving down margins.
The anticipated growth in the alternative fuel industry is more likely to benefit companies involved in the production process - e.g., seed and enzyme companies, major corn producers, or farming equipment companies - rather than pure play ethanol companies, which are faced with commodity risk and potential overcapacity issues. Key names include:
- Bunge, the largest vegetable oil producer in the world with an estimated global production capacity of approximately 16.6 billion pounds; and
- Archer Daniels Midland, one of the world’s largest processors of oilseeds and corn with a 20% production market share in the U.S. ethanol market.
On the industrial biotech side, Novozymes is well positioned to benefit from the ethanol boom, as it is a world leader in the manufacturing and distribution of industrial enzymes and micro-organisms used to convert starch into sugar, which is then fermented to make ethanol. Monsanto, DuPont, and Syngenta are very active in the development of traits (i.e. resistance to common pests) used to boost agricultural production.
Is Wind Only Hot Air?
Wind technology is one of the most competitive renewable energy sources. Yet, wind-generated electricity still accounts for less than 1% of global electricity production. Incentives to encourage the use of renewable energy are driving the market, which is expected to grow at 15-20% per annum (2005‑2010). The majority of installed generating capacity is in Europe. Growth in the U.S. is being driven by a production tax credit at the federal level and a renewable portfolio standard initiative organized by some states (requiring that a percentage of electricity produced comes from renewable sources).
- One way for investors to play this theme is via wind turbine manufacturers. The three largest manufacturers are:
- Vestas Wind Systems, global leader with 29% market share;
- GE Wind, subsidiary of General Electric with an 18% market share; and
- Gamesa Corporacion Tecnologica, the third largest globally and a dominant force in the fast growing Spanish market. Gamesa is also active in the solar field.
Will the Sun Keep Shining?
Solar technology allows for the generation of power from solar radiation using photovoltaic (PV) cells. Relative to other energy sources, PV electricity prices are not yet cost competitive. This is primarily caused by the high cost of manufacturing systems, e.g., silicon. The global PV industry therefore largely depends on government subsidies, which guarantee a minimum price per unit of energy produced.
Investors can gain exposure to the solar theme through the entire supply chain: from silicon production and equipment suppliers to cell production and installation of photovoltaic modules. Some of the companies involved in the sector include:
- Sharp Corpand Q-Cells,the world’s largest and second largest makers of solar cells;
- SolarWorld,a fully integrated solar energy company covering virtually all steps in the PV value chain, from wafer production to system distribution; and
- Conergy, the world’s largest PV system integrator.
Is the Climate Change Theme the New Bubble?
The global trend towards curbing GHG emissions is real and unlikely to abate anytime soon. As such, the renewable and alternative energy sectors are expected to experience high double-digit growth rates over the next few years. Notwithstanding the above, making investment decisions based on climate change is a rather complex process, as reducing emissions implies a net present economic cost but only future uncertain benefits. Investment opportunities thus rely on regulatory trends and developments.
Investors cannot buy into climate change as a sector or group. Long-term success will depend on in-depth analyses, and stock picking will be crucial. Given the high leverage of pure-plays to the regulatory process, investors will be better off looking at large global players that are active in the downstream part of the value chain, as they will likely be insulated from the extreme share price volatility experienced by the upstream companies.
This publication is intended for your personal use only. The information and opinions herein are provided for informational purposes only, and are subject to change based on market and other conditions. The views expressed herein should thereby not be used as the basis for your investment decisions. Past performance is not necessarily indicative of future performance. This document is not, and should not, be construed as a solicitation or offering of units of any fund or other security in any jurisdiction. No part of this publication may be reproduced in any manner without the prior written permission of Natcan Investment Management Inc.