An uneven energy transition leaves room for coal and gas: COP26 debrief

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Lewis Jackson: COP26 ended last Friday. Organizers have pointed to agreements to cut methane use, phase down coal and end deforestation by 2030. Others say not enough was done. Today, I'm joined by Lazard's Aaron Binsted to talk through what COP26 meant for Australian investors. Aaron, thanks for joining me. Aaron Binsted: My pleasure, Lewis. Great to be here. Jackson: So, from the perspective of an Australian fund manager, what were you looking for going into COP26 and what was most relevant coming out of the conference? Binsted: Yeah. So, we think the energy transition is going to be one of the biggest, if not the biggest, investment themes are in markets for the coming decades. It's something that we've spent a lot of time on and built positions in our portfolio around our view on that. So, for COP in Glasgow, we were really seeking to kind of test our view that there's a real momentum here that there's real change happening, and then to sort of test our understanding of is it unfolding in the way we suspected. And I think we have seen that there is real global momentum. There are huge changes happening in markets, and very importantly, they're happening at quite different speeds in different parts of the world. So, that really was our sort of headline takeaway. Jackson: On that point about sort of the two speeds that have changes, one of the criticisms, for example, was that large emitters like China or Russia or India didn't sign up to all parts of the agreements, especially around coal. How does that factor into the fund's – let's take, for example, the Lazard Select Australian Fund – the fund's investment thesis around fossil fuels? Binsted: Yeah. So, we have four prongs to our big picture theme of the energy transition. So, the first of those is in terms of deployment of renewables. We have positions in metal companies that we think are going to be huge beneficiaries of the rollout of electric vehicles, of renewable energy and the transmission grid buildout that is going to be required to do that. There are also some parts of energy transition, you know, other types of metals where there are very high expectations built into commodity prices, and there's a lot of volatility. So, we have elected to take a picks and shovels approach as well. So, we're invested in two engineering and contracting firms in different spaces within the market. So, they're not going to be directly participating in doing the decarbonizing operations, or indeed doing new mineral extraction to support it. But they're the picks and shovels that are going to do this work for people, and we think that they have a really bright future in terms of building out their workbook, their order book. So, that's the second leg. The third leg is gas. Asia is going to be a structural growth story for gas for the next 30 years. It's a hugely coal-dependent economy and region, and they will need lots of gas to move away from coal and to support their renewables as they increasingly deploy renewables. And then, lastly, we do have an investment in a coal company just because there is going to be a tail of coal demand, and we think it's just going to be very high cash flow and we want that cash flow to be returned to investors as that asset is responsibly managed down. So, that's our the four, kind of, ways we're playing the energy transition today. Jackson: And turning back to what was agreed at COP, let's say, for example, around coal, how do the agreements factor into the fund's investment thesis when it comes to sort of those last two legs – so the gas and the coaling, energy transition in Asia? Was COP something that supported that or not? Binsted: Yeah, absolutely. In fact, I'd say, it was probably more positive than sort of the base case we have factored in. And just a couple of the small points – so, particularly around gas. The tradability of carbon offset credits has been a real issue to-date. There was some progress made towards Article 6 which will hopefully make it easier for companies and consumers – producers and consumers, I should say, in different countries to trade credits. Woodside Petroleum has one of the largest offset assets in Australia. They've spent $100 million building plantations for offsets that previously customers in Japan and Korea, for example, weren't able to utilize. That is an asset that now may with the progress on Article 6 be able to utilize. So, that was very important. That's not a huge step for the company, but it's a positive incremental step. And then, in terms of coal, given we all know that it's going away and it's just a matter of timeframe, we have some what we think of very conservative assumptions in there. What has come out of COP would suggest that that tail that I've talked about is probably going to be longer than we are factoring in. So, there may be a few extra years of high cash flow on that front. Jackson: So, just to clarify there, so more coal use for longer is the takeaway there? Binsted: Yes, relative to what we had assumed, yes. Jackson: And I suppose turning to the future beyond COP, the energy transition is underway. When we look at companies like Woodside or Whitehaven Coal, for example, how positioned are they to take advantage of this energy transition? So, you just talked about the offsets, for example, in the case of Woodside. But is the management of these companies prepared to lead them into this new future through the energy transition? Binsted: Look, I think, absolutely. So, at the end of the day, demand for their product is going to go up a lot. Just to give you some stats – gas is about 20% of the primary energy supply globally. It's only 10% in Asia. China is going to double their amount of regasification facilities over the next five years. So, that's the amount of LNG they're going to import. Gas is something like 6% of primary energy demand in India. The government is planning for that to reach 25% by 2030. So, a huge increase in share in a baseline energy market that's growing. So, there are huge, huge tailwinds. And obviously, as I mentioned before, this is a very coal-dependent region. They are going to need a lot of gas to move towards coal. So, Woodside knows that. They're planning for that. And Woodside also has some emerging energy investments that over time, I think, have the potential for paying off. So, they have a hydrogen business they're beginning to set up and build the groundwork for in Tasmania. That could be very interesting. And they've also announced a partnership for a solar thermal asset in California. So, the management is absolutely keeping their eye on the transition. The base business of gas will be there, but they've got these options going forward. And we've been working with the company on – talking to the company, I should say, about things like methane, carbon intensity. Obviously, one of their new projects, the Scarborough project is a very low CO2 reservoir. So, we think there are lots of positive trends, for example, with Woodside. Jackson: I think one of the things that characterizes the climate space is that the spate of announcements that can really change what's happening. When you think about the fund's investment thesis, especially that second, that third and fourth leg around gas and coal, what are the things that you're looking for? What are the things that could change that could undermine that thesis? What are the things that investors need to be keeping an eye on when we talk about the energy transition, when we talk about coal and gas use in Asia, for example? Binsted: Probably the most bearish thing would be a huge increase in investment in supply. That would be the most negative thing for the thesis for both those – for the second two parts of the energy transition thesis. We know in terms of us backing the new metals that are going to be part of the renewable rollout, there will be new investment and we're thinking about that. Particularly, with the second two, the more traditional fossil fuels, supply has been very constrained. We think we have a fairly solid view on the demand profile. These things take time to move. The biggest negative would be if, for example, there are a lot more investment in supply of both gas and coal. That's something I think the world has said they do not want to do and it's getting tougher and tougher to do. But if people are looking for the most obvious downside risk, I'd say an increase in supply. Jackson: Fantastic. Well, Aaron, thank you very much for your time today. Binsted: Pleasure chatting with you, Lewis.