Geopolitical Uncertainty is a Game-Changer for Energy Transition
Roger Mortimer, Portfolio Manager
KGHG Positions Investors to Potentially Benefit from the Unprecedented Investment Response
European nations have committed to energy transition to meet climate objectives, but now urgent energy security issues are causing them to accelerate their plans. This rapid scale-up should bring costs down faster than previously expected and lay the groundwork for the global rollout of the energy transition.
The KraneShares Global Carbon Transformation ETF (Ticker: KGHG) is designed to capture this market opportunity, a super-cycle of capital spending that is just beginning and we believe will drive huge growth globally across a range of industries. Energy importing regions like Europe, Japan, and Korea will feel the greatest pressure from high energy prices. A global fund, KGHG takes you to where the need – and energy transition opportunity – is the greatest.
While first and foremost a human tragedy, the Russian invasion of Ukraine is a defining event in global decarbonization. Triggering the biggest disruption in global energy markets since the 1973 oil crisis, the events have given Europe a stark reminder of its energy dependency – and set off alarm bells among energy importing nations globally.
In the past month, Europe has substantially increased the scope and breadth of its decarbonization activities, recognizing that greater energy independence is within reach with the deployment of green technologies. Europe’s new targets we surmise are big enough to drive significant scale in energy transition technologies and processes, and the resulting falling costs should accelerate the global energy transition. The companies that lead the European energy transition can build experience and scale that advantages them globally.
In the multi-year rebuilding of Europe’s energy infrastructure, both legacy energy producers and renewable companies can win – and the objectives of energy security and energy transition can co-exist. The transition period will be marked by persistent high energy prices – benefiting the incumbent fossil-based players, but also enhancing the relative economics of renewable-based systems, expediting their development and that of associated industries like green steel.
Europe’s “REPowerEU” plan, launched on March 8th, calls for substantial increases this decade in the installed base of solar and wind generating capacity and large new demand for green hydrogen. The annual investment in these areas for the rest of this decade is forecast at €170 billion (€1=$1.09*), more than six times the €25 billion annual run rate of the past five years.2
KGHG is invested in the companies that will potentially benefit from this spending, like German electric utility RWE (3.05% weight in KGHG), which plans to invest €30 billion to triple its net capacity by 2030 and is forecast by Goldman Sachs to grow its earnings at more than twice the average of European utilities over the next five years.2
Europe’s urgent necessity for energy independence is also the catalyst that should trigger a global acceleration of the energy transition, allowing leading decarbonization players and processes to scale faster, driving costs down. This is a game-changer for the energy transition, as reaching cost parity faster will likely speed global adoption.
KGHG seeks to capture this market opportunity, a super-cycle of capital spending that is just beginning and we believe will drive huge growth globally across a range of industries.
Europe’s Race for Energy Independence
In 2020, the European Union (“EU”) imported 58% of its energy needs from Russia, its largest outside supplier of oil, natural gas, and coal.3 Natural gas is the dominant source of energy for European households and is also used in power generation and industry. 90% of it is imported with 45% of imports coming from Russia.3 The Russian invasion of Ukraine has caused Europe’s gas prices to spike to a multiple of those in the US and brought its supply dependency into stark contrast. This has numerous implications and creates huge pressure for change. European leaders now realize clearly that they cannot be dependent on a single supplier for the energy source that is the lifeblood of their economies.
The price shock has an immediate impact on European industrial competitiveness and their consumer economies. According to Goldman Sachs, European energy bills have increased by more than €1.4 trillion since the summer of 2020, an amount equal to 10% of the region’s GDP.2 This is a massive disadvantage to European industry, coming at a time when there is already upward cost pressure.
For consumers, higher energy prices have a substantial impact on their spending power. A typical Italian family is seeing its gas and power bills rise by near €2,000 annually, or €165 per month. Just the increase is equal to more than 10% of the average salary in the country.2 This directly affects peoples’ ability to consume and creates significant and immediate political pressure.
European leaders need not only to find ways to bridge the gap – in energy and consumer expense shortfalls – but also to transition as quickly as possible to a new model.
The Green Alternative Doesn’t Look So Expensive Anymore
While the Russian invasion of Ukraine was the catalyst for energy prices to burst higher, multiple elements had been putting upward pressure on oil and gas prices for some time, not least of which was pressure from investors on conventional energy producers to exercise greater capital discipline.
This underinvestment became more apparent as the pandemic faded and has contributed to the surge in energy prices, making the ‘bogey’ for new technologies to meet much easier.
The rise in energy prices has rapidly leveled the playing field between legacy fossil-based industrial processes and green approaches. These higher prices increase the likelihood that green technologies could be deployed much more quickly than previously imagined, achieving scale economies sooner, driving costs down, and incenting faster adoption.
Europe’s Urgent Energy Needs Drive KGHG’s Opportunity
High energy costs will cut into the profits of European industry and reduce the spending power of European households. Building energy solutions to provide independence will take years, and high prices will persist, a burden on the region’s economy and for the valuation of European shares.
KGHG is invested in the industries and companies that are critical to putting domestic energy supply in place. These industries should see unprecedented demand for their services as Europe races to establish energy independence. They include renewable generation and areas such as green hydrogen, where the EU has pledged to more than triple the previous import target. KGHG portfolio names that may benefit include French industrial gas company Air Liquide, which is investing along with Italian KGHG holding ENI in the development of hydrogen mobility.
Europe’s objective is “affordable, secure and sustainable energy” and independence from Russian fossil fuels “well before 2030”. The post-Ukraine policy modifications build on Europe’s pre-existing climate objectives, and in fact accelerate their adoption, recognizing that sustainable energy solutions also reduce import dependency.
The substantial investment implied by the plan will go into –
- New renewable generating capacity – Goldman Sachs expects a “capital expenditure super-cycle” in renewables, with more than €1 trillion spent before 2030.2 The plan calls for 480 GW of new wind generating capacity and 420 GW of solar to be built this decade, with streamlined permitting allowing for activity to begin to accelerate by 2024-25.
- New gaseous fuel infrastructure – to import gas onto the continent rather than by pipeline from Russia. Some will be accessible by pipeline, but much will be in the form of liquified natural gas, including from the United States. Facilitating this requires significant new infrastructure in Europe to receive imported gas: including regasification terminals. Germany, for example, has none today.
- New fuels – Increasing the use of biofuels and renewables in the power grid to reduce gas use, including accelerating the development of the use of hydrogen as an energy carrier that can be blended with natural gas to reduce both emissions and imports and as a storage device for renewable-based grids. This entails modifications to existing gaseous infrastructure, new infrastructure, and new supply chains.
- Grid modifications – and upgrading electrical and transmission infrastructure to tie in new renewable capacity, reduce bottlenecks and improve system linkages and integrity.
- Electrification and efficiency – investment in efficiency gains and the broader electrification – all to be renewably powered – of industries like transport – should drive substantial spending in economic activity.
We believe the beneficiaries include companies that own existing infrastructure; those that make and install the incremental equipment; the technologies and processes that will be added, and the value chains that support them. This activity will take place on the European continent and in many instances, domestic entities should be best positioned to capture the value. The supply chain will extend around the world and will include many other specialized providers.
While many areas of the European economy will suffer from margin compression and reduced spending because of sustained high energy prices, the sectors that are the focus of KGHG are beneficiaries. KGHG seeks to provide investors with direct exposure to the key participants of this multi-decade secular capital investment cycle.
The KGHG portfolio is focused on those companies around the world that are expected to emerge as the future leaders of decarbonization, and on the key elements of their supply chains. It is our view that the emerging decarbonization leaders will be perceived and valued differently over time as their business models transform and grow into major green energy enterprises.
*conversion as of 4/13/2022
Holdings of KGHG mentioned:
- Air Liquide (EPA: AI, 3.06% of KGHG net assets as of 3/31/2022)
- RWE AG (FRA: RWE, 3.05% of KGHG net assets as of 3/31/2022)
- ENI (BIT: ENI, 2.99% of KGHG net assets as of 3/31/2022)
Holdings are subject to change.
- REPowerEU Conference, March 8, 2022
- Goldman Sachs Equity Res, “Electrify Now” March 30, 2022
- EuroStat Data Browser, 2020. Retrieved March 2, 2022