When discussing energy as part of the environmental component of ESG,1 people often focus on the types of energy used, as we did in Will Schumpeter’s Gale Clear the Air?2 But that is only one side of the story, and both sides need to be examined. The other side–how that energy is used–is equally important.
Halving energy use through efficiency
The levelling of greenhouse gas (GHG) emissions in recent years has been driven more by improvements in energy efficiency than the shift in energy types being used. Strides in energy efficiency are disrupting traditional patterns of capital expenditures and consumption, with significant implications for sectors across the economy.
The International Energy Agency (IEA) forecasts that by 2040, global energy usage is going to grow by 30%. In the absence of energy efficiency improvements, that increase would be 60%. Most of this growth will come from emerging markets, especially in India, where rapid population growth and greater access to technology will drive energy demand higher. In developed markets, energy efficiency improvements will drive reductions in energy use–even as economic growth continues.
Carrots and sticks
Both carrots (incentives) and sticks (penalties) are driving energy efficiency. Except for the U.S., regulations to meet commitments under the Paris Climate Agreement are largely in place. Therefore, what is needed from the “stick” side is better enforcement.
On the enforcement front, Europe is establishing a carbon trading programme. China–now the largest emitter of fossil fuel carbon gases (Display 1)–is also planning a carbon-trading market, potentially the world’s largest. Other enforcement initiatives in China include steeper penalties for pollution, consolidating energy policymaking in a newly formed Ministry of Ecological Environment, closing inefficient coal and steel plants, and banning waste imports.
Recent data from the IEA indicates Chinese energy demand growth has already slowed a great deal, “from an average of 8% per year from 2000 to 2012, to less than 2% per year since 2012”, and is forecast to average 1% per year through 2040. Globally, over the last decade there has been an increase in energy efficiency regulations which has undoubtedly contributed to the slowdown, and this includes China. However, if new regulations do not continue to be put in place the IEA predicts that “end-use consumption in 2040 would be 40% higher”.3
Globally the regulatory stick is thus fairly obvious. The carrot is the boost in productivity resulting from efficiency. For each unit of energy, businesses in industries across the world can increase their profitability and competitiveness by improving energy efficiency.
Indeed, CO2 emissions are produced by nearly every sector globally: industry, transportation, building, agriculture and forestry, electricity and heating (Display 2). All of these companies have an incentive to reduce emissions, but there are still many that may not make major changes in their sources of energy. Instead, they will shrink their carbon footprints—and improve profitability—primarily through capital investments aimed at increasing the efficiency with which they use energy.
We discuss three key areas of the economy where energy efficiency is driving capital investment and reduced CO2 emissions.
1. STEEL PRODUCTION
The steel sector, which accounts for 6.7% of total worldwide CO2 emissions,4 provides a good example of the implications that energy efficiency can have for business fixed investment. To meet the Paris Climate Agreement objectives by 2050, the sector needs to reduce emissions by over 70% per tonne of steel produced.
A straightforward approach would be to shift from traditional basic oxygen furnaces to electric arc furnaces (EAFs), which produce half the CO2 emissions per tonne of steel. Electric arc furnaces also entail lower capital costs and more flexibility in production volumes. They tend to work mostly using scrap steel, whereas basic oxygen furnaces tend to work using iron ore. So it is natural for a country that is just developing its infrastructure—and does not yet have much scrap steel—to use basic oxygen furnaces. But once a country starts to amass scrapped automobiles, appliances and obsolete infrastructure, it is logical for steel producers to transition to EAFs.
In China, nearly 95% of steel production is through oxygen furnaces (Display 3). If the country transitioned a meaningful percentage of its steel production to electric arc furnaces, the benefits of lower emissions and significant new business fixed investment would be striking. This transition requires available scrap and regulatory support, and on both these fronts the signs are encouraging.
The World Steel Association estimates China’s steel scrap availability will reach 220 million tonnes in 2020 (from 145 million in 2015), as the country’s products and infrastructure enter the replacement phase.5 On the regulatory side, the government is aiming to cut steel capacity, requiring that 1.25 tonnes of old capacity be closed for every one tonne of new capacity added in environmentally sensitive regions. If a steelmaker replaces its old capacity with an EAF, however, it can do so at a 1:1 ratio,6 creating a structural incentive to switch to EAFs.
2. COMMERCIAL: FOOD RETAIL
The implications of energy efficiency are not confined to heavy industry. In the food retail sector, we found examples in a leading UK supermarket group that cut back on electricity use by 11.6% since 2005, despite growing its floor space by 54.2%, and in a pure online supermarket that distributes its groceries directly to individual customers using electric vehicles—eliminating the need for chilled cabinets in a centrally heated store. Since energy consumption accounts for about 7% to 10% of a traditional food retail store’s total cost,7 using less energy is likely to have long-term benefits for their profitability. Energy efficiency is not only a direct competitive advantage: It also yields intangible benefits—improved brand image and greater demand—as consumers seek “greener” choices and low-cost alternatives.
3. RESIDENTIAL: ENERGY EFFICIENCY RENOVATIONS
Improvements in residential energy efficiency are changing household budgets. In Europe, where 97% of the building stock is not energy efficient, energy expenditure accounts for on average, 10% of household income. And heating accounts for 65% of average household energy use.8 Energy efficiency renovations include improved fixtures for heating, cooling and lighting, as well as insulation and water efficiency.9 Those with older homes in colder climates are leading the transformative shift toward greater energy efficiency.
Improved residential energy efficiency could lead to more disposable income and higher property values, along with jobs, growth, innovation and consumer spending benefits. Unfortunately, the payoff period can be quite long, especially for the most robust energy efficiency improvements. Further, with regulations mainly focused on businesses, individuals have fewer sticks (penalties) to incentivize them to action.
Nevertheless, improvements in household energy efficiency have reduced residential energy costs (Display 4). California’s recent requirement that all new homes include solar panels shows how regulations can be used to improve residential sustainability. Amsterdam has taken an even larger step with its Sustainable Amsterdam Agenda. By 2020, they want to generate 20% more renewable energy, use 20% less energy per inhabitant, improve air quality by switching to zero-emissions vehicles, and ensure that 65% of household waste is collected efficiently for recycling.
This waste collection is part of their emphasis on a “circular economy,” which seeks to reuse all their outputs and includes the Amsterdam Waste to Energy Company (AEB). AEB recovers household waste and other raw materials such as separated fruits and vegetables, and generates electricity from the heat produced by incinerating this waste. The biomass would release the same amount of carbon if it were to rot; therefore this source of energy is carbon neutral. AEB already generates enough energy for 300,000 households.10
Amsterdam expects to phase out natural gas by 2050. It provides both incentives and financing at the individual and business level, with low-interest loans for sustainability investments and grants to homeowners wanting to accelerate the process of going gas-free. It is a model of how cities can use carrots and sticks to improve their overall energy efficiency at the local municipal level rather than waiting for global or multi-country solutions.
Investing with a forward-looking lens
Now we see both sides of the environmentally-friendly energy trend: the choice of energy, as well as the efficiency with which it is used. The shift towards energy efficiency has the potential to disrupt virtually every economic sector. It has the potential to cut projected energy-use growth in half, improve corporate earnings and spur investment across the industrial, retail and residential sectors.
In our portfolio construction process, we look at environmental, social and governance ratings for each company using data from Sustainalytics.11 We also acknowledge a fourth “climate change” category, which doubles the scrutiny we give to the ‘E’ in ESG. Within the ESG framework, energy efficiency is an issue that falls in the environmental category. Our goal is to ensure that the average rating of the companies in each of our country and sector baskets falls within the top quartile in these four categories. We believe that ESG factors, broadly, are transforming the global economy. By considering these factors in our investment process, we aim to be on the forward-looking side of energy efficiency and other disruptive trends.
Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley. com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.