In this roundtable discussion, Navindu Katugampola speaks with Morgan Stanley sustainability experts Jessica Alsford, Chris Ortega and Vikram Raju about the prospects and potential pitfalls that the energy transition faces at this critical time for the global energy industry. Be it pressure from high energy prices or the need for action to meet ambitious carbon reduction targets set by national governments and corporate leaders, the status quo appears increasingly unsustainable. With the energy industry at a crossroads, the key concern today is whether the transition to alternative energy will spring forward or fall back.

What are the roots of today’s energy crisis? Do you believe that rampant price increases will help to catalyze the energy transition?

Jessica Alsford (JA): The crisis has a couple of key drivers. To start, energy prices were already rising last year due to the post-lockdown surge in demand. Russia’s invasion of Ukraine exacerbated the situation. Russia, the world’s third largest oil producer, supplies roughly 40% of the EU’s natural gas imports.¹ The war, which led to a supply shock with knock-on price rises, may temporarily slow the transition if European countries resort to significant coal-based power generation to shore up their energy security.

In terms of carbon intensity, coal is approximately 2.25 times² worse than gas. For perspective, in 2021, roughly 16% of the EU’s electricity derived from fossil fuels, 27% from nuclear and 40% from renewables.² If you input the carbon intensity metrics, for every percentage point of power generation that switches from gas to coal, we calculate that total carbon intensity increases by roughly 2%. Aside from coal, European countries may turn to liquified natural gas (LNG). Germany, for example, is planning to construct two LNG import terminals. However, LNG projects’ typical three-to-five-year development timeline means that terminal construction is not a near-term solution.

In our view, in any future planning, governments need to think about energy security and the energy transition as complementary and not competing pathways. Ahead of 2030, we expect a significant acceleration in energy investment in Europe, with initiatives such as the REPowerEU strategy in the works. As part of the transition, nuclear may recede as an energy source; nuclear is losing attractiveness as a solution given the perceived risks and high actual costs. Beyond this, nuclear lead times are 10 to 15 years, far longer than the roughly six years for solar and wind.

Considering the infrastructure development timelines and urgency of current circumstances, how do you expect today’s situation to impact the process of energy transition?

Chris Ortega (CO): All considered, we expect the transition to accelerate with existing infrastructure playing a key part. There are two main reasons: costs and time. Costs can be split into the direct costs for converting infrastructure and the associated costs for building its surrounding value chain and ecosystem. To be candid, only modest savings can be achieved via these infrastructure conversions, but for many projects they are not far from a cost equivalency.

Cost benefits can be garnered, however, by reducing costs related to the support systems for new infrastructure. For instance, a terminal that frequently replenishes renewable diesel requires a whole intermodal value chain surrounding the port and storage tankage—e.g., rail and trucking transportation. If that existing infrastructure can be converted to be greener, that can be materially less costly across the value chain.

In terms of time, relatively quick and efficient solutions, such as blending hydrogen with gas, can be cost and time effective when compared to, say, building a new plant. We expect to see more easy-to-implement solutions like these in the near term.

In addition to converting legacy infrastructure, we expect upgrades to existing green infrastructure. For example, wind turbines in the U.S., which were built 15 years ago with first-generation technology, now require refurbishment to bring them up to modern standards. On a cost and time basis, we anticipate that the retrofitting and repurposing of existing infrastructure will form an integral part of the transition.

Have client demands changed in response to recent events? If so, does climate investing still resonate with asset owners?

Vikram Raju (VR): The short-term spike in commodity prices has obviously made people think about the energy transition. Consumers of traditional energy are a little panicked right now and are starting to rethink their reliance on fossil fuels. As a result, people are becoming more comfortable with shorter transition timelines. Moreover, putting aside geopolitical developments, the transition has been underway for years, with an array of stakeholders pursuing their own individual clean-energy agendas. We have seen companies, regulators, consumers and employees all vote with their feet and capital to advance the energy transition in their own way.

Corporate leaders, for instance, must incorporate decarbonization into their strategic vision for the future when thinking about potential cost increases, the security of supply lines and what plans will resonate with markets. Therefore, from a pure private equity growth investing point of view that looks beyond climate concerns alone, we see change afoot that should support the viability of these businesses over five, 10 or 15 years. In this way, we have not really seen the trend toward transition diminish so much as accelerate.

If investing in resiliency is beneficial through cycles from a corporate perspective, what are companies doing to respond to today’s challenging conditions? Are they inclined to curtail capital expenditure into cleaner energy projects or commit to this strategic, longer-term investment?

JA: Clearly, companies view the time frames for transition in a variety of ways. If heightened volatility and higher prices impact free cash flows this year, costly capital projects will arguably become less likely in the short term. That said, only eight years remain until 2030 and 28 years until 2050. The pressure is on for companies to act toward their net-zero targets. Consequently, we foresee significant innovation for the decade ahead, as companies test new solutions in the hope that capital costs fall by 2030 and onward.

Here, a look at a specific industry can be instructive. Cement producers, for instance, are moving toward decarbonization in two stages. Stage one is comparatively inexpensive, relying on the rollout of best-in-class technology to improve thermal efficiency. In this phase, producers can reap savings thanks to reduced fuel usage and lower carbon taxes. The second stage, however, requires investment in costlier, longer-term solutions, such as carbon capture and storage, which investors hope will become less expensive ahead.

Beyond timeframes, we believe that today’s energy crisis actually improves the economics for alternative energy solutions. Companies will carefully consider greener options in the current environment, and we may even see traditional energy players opt to invest their strong profits into clean technology.

How do you think about the role of fossil fuels in bridging the move to clean energy? For instance, does reliance on cleaner fossil fuels allow companies to avoid the more fundamental issues related to the energy transition?

CO: We believe LNG will be critical in moving the world toward cleaner energy. Remember that political and corporate leaders must balance the need to reduce their carbon footprints while sustaining growth; recent history shows that LNG can play a role here. Specifically, U.S. carbon emissions have remained fairly flat for 15 years even as economic output increased threefold, with improved carbon efficiency underpinned by the switch to gas from coal.

On a global level, however, carbon emissions continue to rise. In part, this reflects emerging markets’ high dependence on coal. Construction is underway to expand coal power capacity by 150 gigawatts, which will mostly offset capacity retired by the U.S. over the past 15 years. Clearly, the energy transition is a global project that cannot be thought of along strict geographic lines.

In the context of private markets, where do you currently see the greatest opportunities and how do you, in your investment practice, balance managing the dual objectives of climate-positive impact with returns?

VR: As private equity growth investors, we focus in areas where the technology has been proven, the market exists and the investee company has an order book. To the degree that a company may have a fundamentally carbon-negative component to their business model, there is no tension in having this dual mandate. If the company succeeds, the impact solution succeeds. If it fails, it fails on both counts simultaneously.

Ultimately, every company that we underwrite is carefully evaluated to ensure that it is viable, commercially attractive and has a stated commitment to net-zero emissions. For instance, we may invest in a company that supplies other businesses, helping them to avoid, reduce or eliminate the carbon footprint for their final products. In practice that might mean that we invest in a software developer that creates programs to improve energy transmission efficiency, a major constraint that has slowed the commissioning of greener energy production. In this hypothetical example, the investee company would become a crucial enabler in the infrastructure ecosystem for alternative energy.

How credible are corporate plans in emerging markets compared to developed markets in terms of the transition and the drive toward net-zero?

VR: On a pure economic basis, switching to renewables could be very powerful for many emerging markets. Be that for India, a net oil importer, or Nigeria, a large producer with insufficient refining capacity. We know, for instance, that for a local bank branch in Lagos, the number one cost is running diesel generators. Remarkably, introducing solar solutions could help to cut a branch’s energy bill by an estimated 50%.

Financing is another area where investors can make an impact. In India, for example, demand has always been there for solutions such as solar, but it simply has not been easy to translate that into greater profitability. Backing financiers to fund solar developers and buyers on the condition that they provide solar loans to these groups could help resolve this problem. As underwriters, they can discern the good from bad credits to determine the pain points and best areas to allocate capital. The cost-saving benefits can be immediate for energy consumers, while also making loan repayments manageable over a matter of years. We are seeing these types of financial services products being rolled out in places like India, where poor grid connections create demand for diesel generators, which, as we have alluded to, are ripe for solar replacements.

CO: At the country and corporate level, we have witnessed a broad movement toward less CO₂-intensive activities as political and business leaders aim to hit their given targets. In many cases, however, it could be argued that these actors are not necessarily reducing their CO₂ emissions at the global level, which ties into my response to your previous question. For example, if companies are simply offshoring certain activities, how do we count this? If a country bans coal-based power in their country, but imports electricity from neighboring countries with more relaxed standards, does that really equate to a reduction in the carbon footprint? Simply put, no it does not. We need to be thinking about this broader picture when defining our CO₂ targets because the goal is ultimately to reduce, not just shift carbon use by geography.

Will the rising costs and scarcity of resources act as a barrier to green energy demand? And how can the energy transition be inclusive and affordable to a broad cross-section of society if costs fail to come down?

CO: On the power generation side for wind and solar, we have seen a consistent reduction in costs alongside an increase in efficiency over time. For electric vehicles, prices primarily depend on battery costs. Unlike for internal combustion engine vehicles, batteries comprise roughly 50% of the electric vehicle value. As such, the residual value of one’s electric vehicle may change as the battery life declines over time.

In our opinion, this factor may spur breakthroughs in areas such as battery recycling. Recycling speaks directly to your point regarding scarcity of resources; for example, could recycling of lithium and cobalt help to meet rising demand for these key battery inputs? At the very least, we know it will help.

Supply constraints elsewhere may also advance recycling developments. For instance, the Russia-Ukraine situation is impacting nickel pricing and raises questions around alternative sourcing and, frankly, other ESG issues related to conducting business in areas that are complicated from a jurisdictional and rule-of-law perspective.

Thus, developing smarter ways to recycle inputs for use in next generation batteries looks like an attractive solution. The link to the value chain could help to sustain residual values in electric vehicles as well. Notably, we are only beginning to understand these dynamics better as we reach a milestone in terms of seeing trade-ins from the early adopters of electric cars.

VR: Picking up on that point, the cost curve definitely has its limits. Therefore, energy efficiency and finding small fixes to help derive value in the supply chain is key. Software that helps to lower energy consumption by households, vehicles and corporates is a good example; software can also be used for efficiency gains on the power generation side. Gearboxes in vehicles can even play a part too. Individually, these are all relatively small marginal cost-savings, but together they can play a critical role in boosting efficiency and bringing down costs across the spectrum.

In practice, how have you seen institutional investors address climate change within their portfolios?

JA: When I started in this space around 10 years ago, strict exclusion lists predominated. Gradually, investors became interested in companies that were allocating capital toward green solutions. In conversations we have today, there seems to be a recognition that companies pass through a phase of transition, which investors can support through engagement. Of course, such engagement implies working with companies that presently may be high emitters, but which possess the potential to reduce their carbon footprint. On balance, there seems to be a much greater willingness from investors to not only invest in solution providers, but also to engage the companies that would otherwise perpetuate the status quo.

VR: Five years ago, debates mainly revolved around whether climate investing could make money. From today’s vantage point, we think it is fairly clear that that debate has been settled. In the industry, we have seen investors rewarded for supporting companies across a diverse range of climate-related businesses. Moreover, we saw growth businesses earning growth-like returns without penalties to returns simply because the companies operated in climate-focused sectors.

Today, the adoption of climate considerations into a portfolio has become more mainstream. At the same time, debates have moved on. We see some questions around the magnitude of impact that a given dollar amount should create; currently, there is no universal metric for this. We can look at the CO₂ aims, but not in a way that is clearly linked to the per dollar unit of investment. We see progress toward this aim, but for the adoption of such a metric, more people active in the industry will have to embrace the idea.

CO: In our conversations with limited partners, these investors want to understand how we quantify impact. We are taking what 10 years ago was a qualitative conversation and putting numbers behind that. On a portfolio company by portfolio company basis, what impact are we having and how do we kind of continue to make sure, from a process perspective, that we are continuing to optimize? Of course, there is wide recognition that no true endpoint exists. The energy transition is more like a journey in which we continue to push forward and evolve.

¹ Source: Morgan Stanley Research, March 2022.
² Source: Morgan Stanley Research, March 2022.