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Real assets and net zero: Now for the hard part

There is no lack of willingness among investors in real assets to play their part in helping countries reach net zero by 2050. But much needs to change – and quickly, as Laurence Monnier explains.

Real assets and net zero: Now for the hard part

October was a big month for net zero announcements in the UK. On October 6, Prime Minister Boris Johnson used the Conservative Party conference to unveil the first part of the government’s plans to ‘make the UK the world leader in green energy’, including £160 million of support to upgrade ports and infrastructure in Northern England to ‘hugely increase our offshore wind capacity’.1

Two days later, the £55 billion BT Pension Scheme committed to achieve net zero carbon emissions across its entire portfolio by 2035, bringing forward by ten years an earlier commitment to reach that target.2 The UK’s largest corporate pension scheme in October also became the 30th member of the UN-backed Net Zero Asset Alliance, an international group of institutional investors representing a collective $5 trillion of assets under management that have committed to transition their portfolios to net zero emissions by 2050.3

Achieving net-zero emissions within three decades will be a monumental challenge

These are undoubtedly welcome announcements but achieving net-zero emissions within three decades will be a monumental challenge, requiring the full alignment of public and private capital and government policy.

This was laid bare in a report published by the Institute for Government in September, which warned the UK still has not grasped the scale of the task.4 The authors wrote: “Meeting the commitment is a more difficult challenge than responding to the coronavirus crisis or getting Brexit done, and will require transformations in every sector of the UK economy, sustained investment over three decades and substantial changes to everyone’s lives.”

Despite the government’s ambitions for a green revolution, the Institute noted referenced a “lack of co-ordinated policies, constant changes of direction, a failure to gain public consent for measures and too little engineering expertise and delivery capability has left the UK off track”. This, it added, has deterred private investment and left people confused.

Major UK infrastructure decisions need to be made in the near future and quickly implemented

The Committee on Climate Change (CCC), an independent statutory body providing advice to government, was just as damning in its 2020 Progress Report, which might just as easily be renamed the Lack of Progress Report.5 It noted the government has only met two out of 31 milestones set out in the 2019 report, with progress “generally off-track in most sectors”. Referring specifically to the country’s infrastructure requirements to achieve net zero, the Committee said: “major decisions need to be made in the near future and quickly implemented”.

This is the environment that investors in real assets will have to navigate as they too look to align their investments with the goals of the 2015 Paris Agreement. This will impact every portfolio decision; the type and location of the assets they acquire; the ongoing management of those assets; and what they choose to divest from.

Everything to gain

The UK passed the Climate Change Act in 2008, requiring all greenhouse gas emissions (GHGs) to be reduced by 80 per cent compared with 1990 levels by 2050. In 2019, the bar was raised to 100 per cent after the Intergovernmental Panel on Climate Change (IPCC) warned of much worse to come if we exceed 1.5 degrees of warming.6

Figure 1: Global emissions pathways
Global emissions pathways
Source: Daniel Huppmann, Joeri Rogelj, Volker Krey and Keywan Riahi, ‘A new scenario resource for integrated 1.5 °C research’, Nature Climate Change 8, 1027–1030, 2018

We use energy for a wide variety of purposes: to drive vehicles, power machinery and heat our homes for instance. Electricity today represents a relatively small part of our energy provision; approximately 20 per cent of our energy needs are met by electricity, with the remainder fuelled by carbon sources. Even with substantial electrification of transport and heat, the growth of renewable energy alone will not be enough to meet the ambitious targets.

The amount of energy people use has been falling since 2000

More positively, the amount of energy people use has been falling since 2000. Some of this is due to structural factors (warmer winters, slower growth, deindustrialisation), but human intervention (more efficient homes and appliances) has also played a part.

Figure 2: Energy consumption by activity type
Energy consumption by activity type
Source: BBC, BEIS

The UK has specific asset advantages when it comes to initiatives to reduce emissions, including the largest wind resources in Europe, an extensive railway network, and over 70GT7 of potential storage under the UK seabed where CO2 could be stored.8 At the same time, the country must grapple with its historic reliance on fossil fuels for heating homes and transport. Infrastructure and real estate owners have therefore much to gain or lose from this transition (see Transitioning to a low-carbon economy: a challenging target at the end of the article).

Political intervention

Many of the technologies needed to achieve this transition are technically proven, but do not make commercial sense in the current market environment. For example, while hydrogen is a good way to store energy over long periods, the use of green hydrogen (the production of hydrogen from zero carbon electricity) is not viable in economic terms.

Even the most established and efficient technologies still require significant incentives to attract the level of investment needed

Even the most established and efficient technologies, such as onshore wind and solar power, still require significant incentives to attract the level of investment needed. This was demonstrated in the collapse of the greenfield onshore wind market when subsidies were removed a couple of years ago. The government has acknowledged this and is proposing to open the Contract for Difference mechanism (which guarantees a certain price for electricity) to onshore and solar from next year.9

The real estate sector faces similar challenges. According to the CCC, only 4.5 per cent of buildings were heated by low-carbon sources in 2017 – this needs to increase to 100 per cent by 2050. The transition from a gas network to a hydrogen network to heat buildings will require substantial investments and support from the government.

More clarity on government policy is likely to be given when the much-delayed UK energy white paper is released later this year. This will be crucial in providing a detailed pathway to net zero and to manage private investors’ expectations on the part they have to play. It must also provide more clarity on which technologies or markets are likely to be relative winners.

Three key implications for real asset investors

2050 is only 30 years away, and many of the actions and regulations needed to support this transition need to happen in the next five years. While much uncertainty remains, some preliminary conclusions can already be drawn.

1. Significant investment opportunity

The rise of renewable energy and the development of electric vehicles (EV) and EV charging points are the first steps in a complete redesign of the infrastructure required to support the green transition. Large investments will be required, not only in greener assets (for example, green buildings or renewable energy facilities), but also for refurbishing existing assets and the infrastructure needed to support this.

Large investments will be required for refurbishing existing assets and the infrastructure needed to support this

As an example, the development of carbon capture and storage is not possible without developing the infrastructure to transport and store carbon. The transition to hydrogen will also require large investments in new boilers and hydrogen storage and transport. The existing gas network could accommodate a higher blend of hydrogen into gas than is currently allowed by regulation, but the extent to which it could be adapted to allow pure hydrogen distribution has yet to be proven.10

The projected increase in electricity demand will also require reinforcing the power grid. On the plus side, for infrastructure investors keen to support the green transition, the net zero carbon transition could represent a scale of opportunity comparable in scale to the Industrial Revolution.

2. Higher power price uncertainty

Since the UK energy market was deregulated in the 1990s, wholesale power had been priced in a similar way to other commodities, based on supply and demand. Investors with exposure to power rely on price forecasts from third-party consultants to assess the value of their investments. Yet, consultants are faced with greater uncertainty than ever on the future composition of the power system, due to its sensitivity to the regulatory changes needed to achieve net zero.

The projected rise in intermittent renewable energy sources will greatly amplify power price volatility

The projected rise in intermittent renewable energy sources (for example, wind and solar power) will greatly amplify power price volatility. A solar plant is likely to receive a lower-than-average price because they generate when demand is low, and all solar plants are available. Investors are aware of this conundrum. Despite the so called “grid parity” of renewables, this has made many investors reluctant to invest in new capacity without some form of price stabilisation mechanism.

Bloomberg New Energy Finance referred to the discrepancy between market models and investor appetite in 2019 as the “missing money” problem, in that power forecasts assumed investments would be made ahead of investors having sufficient signals to make them.

Government policies will provide more clarity on market signals and how the structure of the market will need to adapt, which should help address the issue.

In the meantime, investors should be aware that the range of forecasts from consultants is wide and constantly evolving. As the zero-carbon transition has greatly increased uncertainty over the future of the energy market, investors should consider a wider range of possible scenarios alongside their central forecasts. Some may prefer to hedge this risk by selling the power in the burgeoning power purchase agreement market.

3. Early alignment of real estate needed to avoid obsolescence

Real estate investors are well aware of the risks associated with global warming. The devastating effects of floods and storms and the potential impact of rising sea levels on coastal properties are live debates for investors and their insurers.

Asset owners are focusing on improving the energy efficiency of buildings in their portfolios

Many asset owners are already focusing on improving the energy efficiency of buildings in their portfolios – in part because of government regulations rendering less efficient buildings obsolete.

These incremental changes are a step forward. Irrespective of future political choices, decarbonising heat will create new challenges and opportunities. Some harder to decarbonise assets could become obsolete, while greener assets will rise in value. The ability of a property to align with a net zero transition should not be ignored when buying in this market.

The need for change

For real asset investors, who are used to investing over the long term, these future changes are relevant today. As the impact on portfolios could come quicker than many anticipate, it is imperative that they put in place now detailed and robust net zero pathways of their own to protect their investments.

The question remains whether defensive actions from investors to protect their portfolios will be sufficient to drive the transition to a low-carbon economy. New energy solutions require significant research and development to take them from nascent concepts to investable solutions suitable for institutional capital.

Net zero can’t be reached without rapid redeployment of capital

But do real assets investors need to increase their appetite for risk to spur the changes needed? Net zero can’t be reached without rapid redeployment of capital. Investors must embrace this challenge to avoid far more damaging implications from the effects of the climate crisis over the long term.

Transitioning to a low-carbon economy: A challenging target

In May 2019, the Committee on Climate Change (CCC) published a report for the government on zero carbon pathways, recommending a net zero target for 2050 and exploring possible routes to achieving that.

Although GHG emissions have fallen by 40 per cent since 1990, the CCC envisaged that a further 89 per cent reduction in CO2 emissions was achievable if rapid policy decisions were taken to support it.

This target is extremely challenging and will not be delivered without radical behavioural and economic transformation. The most relevant for real asset investors are the extensive electrification of transport (including heavy goods vehicles) and heating, the rollout of the hydrogen economy and the development of carbon capture and storage.

The use of more experimental technology is required to remove the remaining emissions in sectors that are harder to decarbonise

Beyond this, the use of more experimental technology, such as direct air capture with carbon storage, is required to remove the remaining emissions in sectors that are harder to decarbonise.

Such radical change requires an integrated policy framework across all sectors. For example, the choices about how we heat homes will influence how much and when electricity is consumed, in turn determining emission levels in the power sector.

In the CCC decarbonisation scenario, UK power demand is projected to more than double from today’s levels. Decarbonising the power sector while demand doubles is no small task. A massive rise of renewables is required but will not be enough on its own.

Despite the benefits of nuclear power as a low carbon baseload energy, few consultants currently expect significant growth in the sector. To balance intermittent renewable sources, many still expect natural gas to play a role to maintain secure power supply when demand is high.

Figure 3: Electricity demand – CCC decarbonisation scenario
Electricity demand – CCC decarbonisation scenario
Source: Committee on Climate Change

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