Artisan Partners Growth Team is committed to finding accelerating profit cycles globally and investing in reasonably valued companies that are positioned for long-term growth. The team’s experience and broad knowledge of the global economy are key attributes helping it identify growth opportunities, wherever they occur, for the Artisan Global Discovery Strategy.
Here, the team discusses compelling opportunities it is finding among companies leading the transition to a sustainable energy economy. The team believes the world is in the early stages of a meaningful mix shift from hydrocarbon-based energy to renewables-powered energy enabled by improving economics, social awareness and increasing regulatory pressures. These dynamics have enabled the team to uncover several profit cycle opportunities globally. Before digging in, it is important to understand the historical milestones shaping and the drivers behind what can be a once-in-a-century transition.
The Industrial Revolution Laid the Foundation for Power Generation Today
The Industrial Revolution, which most argue began in Great Britain in the 18th century, led to rapid industrialization and urbanization of previously agrarian societies as science was increasingly applied to industry. Important breakthroughs were the use of coal to power electricity and innovations such as the steam engine—used in manufacturing production, trains and other machines. The petroleum-powered internal combustion engine (ICE), developed later, became the driving force behind automobiles and planes, changing the way people and goods move around the planet. These fossil fuel-burning activities played an important role in developing economies for several centuries, helping drive exponential population (exhibit 1) and economic growth. Today, fossil fuels remain a core source of power for most economies’ transportation and power grids (exhibit 1).
Power-Generating Activities Have and Will Continue to Negatively Impact the Environment
The Industrial Revolution was a transformative period for humanity and shaped societies for several generations, though many of the innovations from this period have had negative effects on the environment. In recent decades, scientists have observed exponential increases in heat-trapping greenhouse gas (GHG) emissions in the atmosphere. The lion’s share of these gases is carbon dioxide (76%, exhibit 2), primarily from burning coal, natural gas and petroleum for electricity, heat, transportation and in the production of goods from raw materials (exhibit 2). The cumulative effect of these activities over the past 200 years has driven carbon parts per million (PPM) in the earth’s atmosphere ~50% higher (exhibit 2)—levels not seen for ~3 million years when the Earth was ~2-3°C warmer and sea levels were estimated to be 50-80 feet higher—and the global surface temperature ~1°C above pre-industrial levels.
Many scientists believe continuing along the current path (without any mitigation efforts) will cause further warming and long-lasting changes in all areas of our climate system, increasing the likelihood of severe and irreversible impacts on human civilization. By the middle of this century, under a worst-case scenario (defined as Representative Concentration Pathway 8.5 by IPCC) annual GHG emissions could increase nearly 70% and the global surface temperature could be approximately 2.5°C above pre-industrial levels. The higher the average surface temperature climbs, the higher the likelihood of extreme weather events (heat waves, flooding, droughts, wildfires), decreasing crop yields, rising sea levels which would make certain parts of the planet uninhabitable, decreasing water supply, conflict over limited resources (food, water, etc.) and ultimately, population displacement.
A 1.5°C Warming Pathway Could Significantly Reduce Global Warming Risks
Many scientists consider a 1.5°C warming scenario pathway (above pre-industrial levels) to be an upper limit for the change in the average earth surface temperature. This ceiling reduces the probability of the most extreme climate change outcomes. However, achieving a 1.5°C warming pathway by 2050 (by getting to net-zero emissions) will require a rapid acceleration in both the development of sustainable alternatives and a reduction in GHG emissions (Exhibit 3).
Attractive Economics and Increasing Regulatory Support Should Accelerate Wind and Solar Adoption
De-carbonizing the power grid is critical to achieving the 1.5°C warming scenario, and wind and solar emit significantly less carbon than their fossil fuel counterparts per kilowatt hour of electricity produced (exhibit 4). These alternatives have not always been economically viable, but recent breakthrough developments have enabled both technologies to become more affordable than most fossil fuel alternatives.
An important catalyst was the 2011 Fukushima earthquake. Accompanying nuclear concerns, several European countries passed mandates which eliminated their own nuclear-power reliance. In Germany, this had the unintended consequence of forcing it to rely on the dirtiest burning coal, lignite. As a result, Germany (joined by other European countries) focused increasingly on shifting from coal to cleaner energy sources—namely, wind and solar.
The Europeans recognized a transition to wind and solar would require technological improvements to make these renewable energy sources economically competitive with their hydrocarbon counterparts. This drove an effort to reduce wind turbine material costs between 44%-78% from their peak between 2007 and 2010. Solar costs have also declined since 2010, namely, with Crystalline PV modules (the semiconducting material used in solar panels) approximately 90% cheaper. Further wind and solar cost reductions are expected through 2025 from increasing economies of scale, more competitive supply chains and further technological improvements.
In the next three years, on a pure economic basis, generating a megawatt from a greenfield renewable power plant is expected to be more economic than operating an existing nuclear, coal and some natural gas power plants (exhibit 5). These dynamics have made it increasingly attractive for utilities to convert their power grids to renewable sources. When new-build economics can compete with the economics of the existing power fleet, we believe the next step-change of the transition to renewables will occur.
While post-pandemic inflation poses a risk to these economics in the near-term, particularly the raw materials of key wind and solar projects, we remain confident renewables will be cost competitive. We believe it would take sustained inflation for utility-scale markets to require a $1-2/ MWH increase of PPAs for these technologies.
In addition to economics, the Paris Climate accord has helped spur governments to increasingly implement mechanisms to accelerate the adoption of renewables in recent years. Two such tools are carbon taxes and emissions trading systems.
Carbon taxes are a cost levied by governments on each tonne of CO2 emitted. The taxes are intended to increase costs and raise prices on CO2 intensive industries which should promote conserving energy, switching to lower-carbon fuels and adopting low tailpipe emitting vehicles. In the US—the second highest carbon emitting country in the world behind China—researchers at MIT have estimated a $50/tonne tax on CO2 with a 5% annual increase could drop carbon emissions 63% by 2050. However, the investment team do not expect to see one from the U.S. Federal Government in the near-term due to lack of bi-partisan support.
Gaining political support for carbon taxes can be a difficult obstacle to overcome, but it doesn’t appear to be limiting progress in the US. The U.S. Energy Information Administration’s (EIA) latest inventory of electricity generators shows renewables (wind, solar and battery storage) are expected to make up a greater share of new electricity generation capacity in 2021 (81% vs 76% in 2020).
Emissions trading systems (ETS) are another mechanism that work on a cap and trade principle designed to drive adoption of renewable alternatives and a reduction in overall emissions. The cap places a limit on total GHG emissions—notably declining over time as emissions fall— and companies receive or buy tradeable GHG emission allowances. For example, a company undershooting its emission allowance can sell to a company who has overshot and needs additional allowances to avoid heavy fines.
The European Union (EU) has been an early leader implementing an ETS and the US has launched a program on the West Coast. The EU ETS was established over the past decade and currently covers nearly half of its emissions. The price of carbon allowances in the EU ETS have increased to new highs in early 2021 (exhibit 6; +700% over the last 5 years), which could further accelerate the transition away from carbon intensive regions. In the US, the California Air Resources Board’s cap and trade system could enable the state to make progress toward its 2045 net-zero emissions targets.
Finally, battery technology to harness the power generated by these renewable sources at mass scale will be required to pump power into the grid when demand exceeds supply. This should enable renewable energy to capture greater share of the overall power generation market and serve as a base load power source—a common pushback on the ultimate penetration rate of renewable capacity.
Hydrocarbons will play a role in the energy economy until battery storage capability is widely available. However, breakthroughs in battery technology within the transportation sector (discussed further below) leave us optimistic this capability will improve over time. In fact, there are several large-scale battery energy storage systems being put into place in parts of the US, notably, the Moss Landing Energy project in California.
Where To Find Growth in Renewable Energy
E.ON, a holding in the Global Discovery Strategy, is one of the largest European utilities companies primarily operating power and gas distribution networks in Germany, Sweden and other parts of central Europe. In Europe, the Green Deal aims for Europe to be climate neutral by 2050. To achieve this goal, the share of electricity in final energy demand use will continue to grow and displace petroleum and gas. E.ON is expected to be a vital player as the transition will require an acceleration in distribution network investments to better enable the transmission of wind, solar and hydropower to residents, businesses and other consumers. The company is also embarking on a significant internal restructuring following its merger with Innogy—another European distribution network—which the investment team believes can enable E.ON to capture meaningful cost synergies.
Aside from utilities companies, the team have also identified and invested in companies supplying the components these utilities companies are purchasing to develop their wind farms and transition their power grids. Vestas Wind Systems, a holding in the Global Discovery strategy, is the leading producer and servicer of onshore wind turbines globally. Vestas is considered to be particularly well-positioned given it is the low-cost producer and global market share leader.
Belimo , another holding in the Global Discovery Strategy, is a global engineering company that makes actuators, control valves and sensors primarily for non-residential (offices, education, hotels, health facilities, government) buildings’ HVAC, fire and safety systems. The company is known as an industry-leading innovator in the areas of smart buildings, including remote monitoring, temperature control, power efficiency and data monitoring to optimally run building systems—a worthwhile technology as governments, particularly in Europe, focus on reducing carbon emissions over the coming decades. Buildings consume 40% of the world’s energy, and HVACs consume 40% of building energy. Belimo’s control devices can generate up to 55% cost savings by running HVAC systems more efficiently. In addition, we anticipate the COVID-19 pandemic could spur further demand for the company’s digital HVAC controllers, which can ensure ideal conditions for reducing disease-spread indoors by monitoring air quality, temperature and humidity in real-time. These products make it easy to document compliance with health guidance or standards and carry out interventions such as adjusting indoor conditions in a timely manner (e.g., a change in a room’s occupancy). Given these industry tailwinds and the company’s pricing power, scale and leading market position, the investment team believe there is potential for a meaningful profit cycle ahead.
Declining Battery Costs and Rising Regulatory Pressures on Internal Combustion Engine (ICE) Vehicles Could Lead to Increasing Adoption of Battery Electric Vehicles (BEVs)
As numerous parts of the world have developed over the past couple hundred years, automobiles—most of which are powered by internal combustion engines—have become entrenched in how we live, work and go about our daily lives. In the US (before the pandemic), 87% of daily trips took place in personal vehicles and the average driver spent 55 minutes per day behind the wheel and covered over 10,000 miles per year. Unfortunately, the transportation sector is the second-largest contributor to global CO2 emissions (exhibit 7) and approximately 75% of these emissions come from road transportation.
With the number of cars on the road expected to double by 2040 (to over 2 billion), there is a strong sense of urgency to find an alternative to ICE vehicles to stay on the 1.5°C warming scenario pathway. Rather than dramatically alter how we get around on a daily basis, BEVs are an environmentally friendly alternative. BEVs do not consume gasoline and have zero tailpipe emissions. Furthermore, as the power grid supplies a higher portion of energy from renewable sources, the overall carbon footprint of BEVs will move towards zero, while ICE vehicles will continue to produce tailpipe emissions.
BEVs are not a recent innovation, having been around since the 1800s, but only recently have they meaningfully closed the cost gap with ICE vehicles. Lithium ion battery packs are the source of power for BEVs and have historically made up a large portion of the cost. Luckily, as BEV volumes have ramped, manufacturing scale has been a key factor in the 85% decline in the cost of battery packs over the past decade. That being said, battery packs still make up ~35%-40% of the total cost of BEVs today, and the investment team believe several technological and process-related improvements over the next couple of years could drive the overall cost significantly lower (exhibit 8). This declining cost should enable BEVs to reach price parity with ICE vehicles by 2025 (exhibit 8), at which point the team believe BEV adoption will rapidly accelerate (exhibit 8).
From a regulatory standpoint, governments are increasingly supporting BEVs and pressuring ICE vehicle original equipment manufacturers (OEMs), making it costly for them to keep up with stricter emissions standards. Seventeen countries have announced 100% zero-emission vehicle targets or the phase-out of ICE vehicles through 2050. In Europe, the Green Deal is expected to tighten emissions regulations to achieve net-zero emissions by 2050. In Asia, China is targeting 5 million BEVs sold in 2025 and has announced a target to achieve net-zero emissions by 2060. In the US, President Joe Biden’s climate plan aims for all new vehicles sold by 2035 to be BEVs, and provides added consumer incentives via tax credits and subsidies. California has recently passed legislation to ban the sale of ICE vehicles by 2035—the first policy of its kind in the US. As more regulators get on board with supporting BEVs, ICE vehicle OEMs will likely experience lower sales volumes and margin pressures through increased costs via higher emissions and punitive taxes.
A robust charging infrastructure is another important consideration for widespread BEV adoption, and several initiatives are in motion to build this out over the next decade. The number of EV-related charging connections is expected to increase 10X (27% CAGR) by 2030 (exhibit 9), which the investment team believe will help reduce range anxiety. President Biden has set a goal of adding 500,000 electric charging stations over the next decade. Volkswagen’s Electrify America subsidiary has already committed and is currently building out its charging infrastructure, which is notably brand agnostic. Electrify America aims to invest $2 billion in the US over the next decade, adding charging stations across the country. Tesla is also ahead of the game, with more than 11,000 superchargers in place around the globe.
There are still meaningful charging infrastructure investments required, but the investment team are encouraged by the progress and the rising interest among the large auto OEMs to participate. Once in place, the expanded availability of charging stations is expected to prompt more drivers to abandon their ICE vehicles, and as the utility grid increasingly generates power from renewable sources, these stations will help lower the transportation sector’s overall carbon footprint.
Finally, widespread BEV adoption is not possible without buy in from the large auto OEMs. The investment team have been encouraged by recent evidence of a mindset shift among the auto OEMs to increasingly manufacture BEVs. Previously, they believed the transition would be subtle—ICE vehicles to mild hybrids, mild hybrids to hybrids, hybrids to BEVs. However, as Tesla has demonstrated an ability to make BEVs profitable and realize it is not cost-effective to pour capital into multiple engine types, the other auto OEMs have concluded they need to jump the gap. A notable example is commitments recently made by one of the world’s largest auto manufacturers, General Motors (GM). The company plans to invest an additional $7 billion ($27 billion total) to fund BEV development, launch 30 new models by 2025 and only sell zero-emission vehicles by 2035.