Franklin Templeton: Opportunities in decarbonization disruption

Key takeaways

• Actions to mitigate and adapt to climate change will disrupt many sectors, creating both winners and losers as changing market conditions and policies affect business models, competitive dynamics, technology developments and capital allocation decisions.
• A wave of government commitments to net zero and technological advancements driving down the cost of decarbonization solutions are key pillars in the investment case for decarbonization, while challenges include grid interconnection, project permitting, raw material availability, climate justice and deglobalization.
• In addition to seeking out winners in industries most affected by decarbonization, active managers can encourage portfolio companies to make specific changes that lead to real-world emissions reductions.

Decarbonization is increasingly sparking debate about its urgency and possibility, as governments and corporations continue to commit to net zero. It is driving innovation in many sectors, with industries aiming to lower carbon emissions while still enabling the global economy to thrive.

Decarbonization, simply put, means reducing the global economy’s annual carbon emissions to net zero. Doing this by 2050 would enable us to meet the goal of limiting global temperature rise to 1.5° Celsius and help us avoid the worst effects of global warming (Exhibit 1).

Exhibit 1: Pathway to Net Zero by 2050 is Narrow but Achievable

Source: *Adapted from International Energy Agency (2022), World Energy Outlook 2022.

A significant portion of the global economy has committed to reaching net zero: roughly 92% of global GDP, accounting for 88% of global emissions and 85% of the world’s population has made net-zero commitments (Exhibit 2). Most countries have set 2050 as a date to reach net-zero carbon emissions, while some have earlier target dates (Germany and Sweden are targeting 2045) or later (China’s goal is 2060, and India’s is 2070).

Exhibit 2: Portion of World Covered by Net-Zero Commitments

As of March 2023. Source: Net Zero Tracker.

The investment case for decarbonization

The wave of government commitments to net zero is a key pillar of the investment case for decarbonization. The other key pillar is technological change, which continues to drive down the cost of decarbonization solutions. Decarbonization is a key secular theme that will have long-term implications on the global economy. It will drive an immense amount of investment: between $3 trillion and $4 trillion per year is required globally to meet the goals of the Paris Climate Agreement. According to BloombergNEF (BNEF), ~$1.1 trillion was invested in clean energy in 2022 (Exhibit 3). While this was an impressive 31% increase versus 2021, these investment levels still need to triple to get on track for net zero, so we expect the level of investment to ramp up over time. Importantly, this investment will span multiple sectors.

There is a clear opportunity for businesses — companies that can solve decarbonization challenges will get rewarded, as there are large addressable markets for companies innovating and finding new ways to perform almost any economic activity in a way that is lower carbon. This includes scaling up existing technologies, as well as commercializing new technologies; there is roughly equal need for both, according to analysis by Bank of America.

Exhibit 3: Global Energy Transition Investment by Sector

Note: Start years differ by sector, but all sectors are present from 2019 onward. As of Jan. 2023. Source: BNEF, “Energy Transition Investment Trends 2023.”

Which decarbonization industries are investable today?

Broadly, there are six components to the energy transition (Exhibit 4). The first major decarbonization transition is occurring in the power sector, where wind and solar are replacing coal and gas. While there are policies encouraging this transition in some jurisdictions, it is being driven primarily by economics as technology advancements are lowering the levelized cost of electricity from wind and solar (Exhibit 5).

Exhibit 4: Components of Energy Transition

Source: International Renewable Energy Agency.

Exhibit 5: Wind and Solar Now Cheaper than Coal

As of March 2023. Source: BNEF 2H 2022 Levelized Cost of Electricity.

Even with temporary cost increases for renewables in the form of higher interest rates, the gap to fossil fuel power generation continues to widen due to fuel and carbon prices rising even faster. New-build onshore wind and solar projects are now around 50% lower than BNEF’s global benchmarks for new coal- and gas-fired power. We have seen exponential cost reductions in wind (~50%) and solar (~90%) in the past decade. Solar and wind are now the cheapest forms of energy in countries with two-thirds of the global population and 90% of world electricity generation.

Accordingly, many industries offer ways to invest in decarbonization, including: mobility; renewable energy and storage; building efficiency; industrial efficiency and products; food and agriculture; technology and software; and materials. Across this wide range of industries, there are many different business models at different stages of maturity, suggesting the need for being selective. Key decarbonization industries include:

• Renewable energy and storage: This includes the solar energy value chain, with solar panels dominated by Chinese suppliers due to cheap polysilicon availability in China. There is perhaps greater differentiation among other parts of the solar value chain, such as solar inverters (the “brains” of the system) and other electrical components, as well as the software needed to manage a solar plant. Energy storage is less mature relative to solar and wind but is growing rapidly: batteries are beginning to play a critical role in stabilizing the grid and evening out the intermittency of renewable sources.
• Mobility: The auto industry will see continued disruption and the creation of new winners and losers as the industry transitions from internal combustion engine (ICE) vehicles to electric vehicles (EVs). While brand name EV manufacturers come to mind, companies making connectors and other electrical components for cars will also benefit from the transition to EVs because they have higher electrical content per car and represent a revenue opportunity 2x larger than for a traditional car.¹ Semiconductors for power conversion and sensing capabilities likewise will see more demand in EVs, with at least twice the amount of semiconductor content in an EV compared to an ICE vehicle.² Losers may include auto parts aftermarket companies, since EVs have far fewer parts and need less maintenance. Some related industries are emerging but the business models are unproven, such as EV charging infrastructure businesses, as well as alternative technologies like hydrogen fuel cells.
• Materials: Copper and rare earth minerals will play an important role in the energy transition. Electrification requires large amounts of copper, for conducting electricity, and battery materials such as cobalt and lithium, for storing it. EVs require nearly 3x more copper than ICE vehicles³, while solar and wind power require between 2x and 6x as much copper compared to coal, natural gas and hydro⁴. At the same time, mining these minerals entails substantial environmental and social risks that must be managed.

Key challenges to decarbonization

While there are clear opportunities driven by decarbonization, there are also challenges to consider. Companies able to address and help overcome these challenges may see attractive market opportunities.

Grid interconnection and project permitting: Hooking up a renewable energy project to the grid can present a challenge to developing renewable energy. Currently, there are 1,900 renewable power projects in the U.S. awaiting interconnection⁵ while the Federal Energy Regulatory Commission (FERC) looks to reform interconnection procedures to reduce the backlog. Meanwhile, permitting remains a problem for renewable projects and for the additional transmission lines needed to move the power from its source to large demand centers like cities — both can face fierce local opposition from residents.

Raw material availability: Clean energy technologies such as solar panels, wind turbines, batteries and electric motors require more critical minerals than the conventional technologies they are replacing. This means the transition to clean energy will lead to significantly higher demand for minerals such as copper, lithium, nickel, cobalt and rare earth elements. In fact, reaching net zero globally by 2050 would require up to 6x more mineral inputs in 2040 than today.⁶ This creates significant challenges as some of these materials have limited geographic availability and entail meaningful environmental and social risks to produce. Securing enough critical minerals to enable decarbonization is a key hurdle to achieving net zero.

Climate justice: There are two elements to climate justice. Firstly, countries are experiencing differing levels of disruption from the physical impacts of climate change — such as sea level rise, or increased weather events like floods, wildfires and droughts. The cost of responding to extreme weather events can be a significantly larger burden for countries with smaller economies that are less able to afford the investments.

While climate change is already exacerbating hardships for vulnerable people in countries all around the world, the transition to a net-zero economy won’t be politically viable (or morally acceptable) if the transition exacerbates existing inequalities, for example by increasing energy costs at unacceptable rates. This is sometimes referred to as the need for a “just transition.” One-third of U.S. households already face some form of energy poverty, whether it is unaffordable energy bills, forgoing basic necessities like food and medicine, or the inability to keep the home at a healthy temperature.

There are also impacts to certain communities from the winding down of carbon-intensive industries such as coal mining. These communities will likely need to be supported through the transition. For example, in the U.S., the Inflation Reduction Act includes extra incentives for building clean energy projects or manufacturing plants in such communities — with the hope that these communities can receive some of the economic benefits from deployment of low-carbon technologies.

Deglobalization: Several related geopolitical developments are causing globalization to go into reverse. We are seeing a rise in trade tariffs and national industrial policies that prioritize domestic production for key industries like semiconductors and energy. For decarbonization to occur at the pace required to reach net zero by the middle of this century, however, we need more international cooperation, not less. In support of this, the International Energy Agency and the International Renewable Energy Agency (IRENA) call for common standards, technology sharing and the removal of trade barriers.

The role of active managers: Seeking strong investments and engaging for change

In addition to seeking out winners in industries most affected by decarbonization, active managers can encourage portfolio companies to make specific changes that lead to real-world emissions reductions.

While most companies don’t sell a product that directly reduces emissions, all companies can play a role in addressing climate change by changing the way they operate. Companies are significant users of power, and their buying decisions make a difference (Exhibit 6).

Exhibit 6: Global Corporate Renewable Power Purchase Agreements

Source: Science-based Targets Initiative.

Corporations have become a key demand driver for renewable power. Renewable power purchase agreements (PPAs) provide companies with both long-term price visibility and help achieve emissions reduction goals. Effective active management can include engaging with company management to share and promote best practices as well as proxy voting to encourage more ambitious climate action where relevant.

Summary

A broad mix of regulatory policy, strategic decisions by companies, technological innovation and investor initiatives is supporting the investment case for decarbonization, driving change in several industries. ClearBridge has been active in furthering these positive trends and is also well positioned to benefit from them, investing in companies enabling the transition and engaging with companies to help them thrive and create value over the long term.

Endnotes

1. Source: International Energy Agency, Global EV Outlook 2022.
2. Source: International Energy Agency, Global EV Outlook 2022.
3. Source: ConstructConnect, “Copper, other metal costs on the rise as EV demand heats up,” April 6, 2022.
4. Source: International Energy Agency, The Role of Critical World Energy Outlook Special Report Minerals in Clean Energy Transitions, 2021.
5. Source: Federal Energy Regulatory Commission, “Improvements to Generator Interconnection Procedures and Agreements," June 16, 2022.
6. Source: International Energy Agency (IEA), The Role of Critical Minerals in Clean Energy Transitions.

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