Research in Action Podcast: Investing in the renewable revolution

Carolyn Bigda: Welcome to Research in Action. I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron.

Bigda: In this new podcast series from Janus Henderson, we offer a behind-the-scenes look at some of the company- and industry-level research done by our analysts across the globe, research that is used to inform investment decisions in our equity portfolios. Matt is the Director of Research at Janus Henderson. He will be providing us with regular insights about major themes taking place in markets, with analysts and portfolio managers joining the discussion at times as we dive deep into different topics.

And Matt, in many cases, the story that comes across in headlines does not always 100% reflect what’s occurring in practice among industries and businesses. I mean, this is essentially the reason that we are even doing this podcast series, is to dive a little bit deeper and figure out more what’s going on in the markets, correct?

Peron: That’s right, Carolyn. It’s really important for our analysts and for our clients to understand so much more what’s going on beneath the surface. So, that’s a key point. I’m excited to be part of the podcast series to be able to expound on these and dig deeper into these types of issues and share our knowledge.

Bigda: I think that’s especially important today, where index returns have been climbing very high. But when you sort of dig down deeper into individual stock performance, there’s a lot of variation today, correct?

Peron: That’s right. There’s a saying, “There’s always something to do and there’s always something interesting going on.” So yes, even though the index might look calm, underneath the surface, there are lots of opportunities, risks and challenges, and that’s really what we’re all about, is uncovering those.

Bigda: So, to kick things off, we thought we’d start with one topic that has been capturing a lot of attention lately – renewable energy. Recently, the Biden administration released a study showing the U.S. could get 40% of its electricity from solar energy sources by 2035 if the nation makes a significant commitment to expanding solar capacity in the coming decades. Matt, I know this is an area where you and your team are spending a lot of time lately. So, how big is the renewables market today? And how big is it becoming for equity investors in terms of an investment opportunity?

Peron: Yes, it is a big opportunity. It’s a big area that’s unfolding. We’ve been doing a lot of work on this, as you mentioned, and dedicating a lot of our analysts’ time to understanding this and how this might unfold and play out. And it’s very complex, and while I’m sure we’ll only be able to touch on it today, as much as we can get into it though.

I’ll start by saying that’s a very ambitious goal and it’s – I would call it aspirational, is probably the best term. And that’s not because the will isn’t there; the will is certainly there, I think, by just about everybody to get there. It’s just there are real-life gating factors that we have to deal with, such as, reliable energy, such as managing storage, permitting of environmental issues and right of ways, etc. It’s all kinds of things we have to deal with.

But let’s just say, for argument’s sake, that we really, we have all the money in the world. The amount of money it would cost to do that would be enormous; and so, the investment, we’d have to probably triple our annual spend on renewables every year until 2030 to get there. And I don’t know that that’s realistic, that we can do that even if we had the money because we would have all these gating factors, such as the permitting and the grid reliability issues that I mentioned. So, it’s very aspirational. One industry participant told us that if we actually did this, it would have been the biggest infrastructure program ever.

Bigda: Ever.

Peron: Ever. And so…

Bigda: So more than the National Highway System, more than any other projects that we’ve done to date?

Peron: Yes, I didn’t go and verify in size and GDP-adjusted, and all that kind of thing, but I think there’s something to that. I just wanted to put that stat out there, as it’s something that is just to show the scale and the ambition involved. You’re really ripping out the fabric of our economy. Our energy sources are really at the base of everything. And you have to do it in a non-disruptive way. It’s fixing the plane while you’re flying it, so to speak. So, it is enormous. There’s no question about that. And the breadth that it impacts, touching every industry, is probably unprecedented.

Bigda: Are there any dollar figures that have been put out there to give us a sense of just how much has to be spent on this initiative?

Peron: Yes, I mean I think we spend about $300 billion a year now. We’d probably have to triple that, as I mentioned. You’re talking about almost $1 trillion a year just spent on renewables. That’s a big number.

Bigda: Those are some big numbers and, obviously, there’s a lot of investment and technology that’s still to come to make this all happen, if it happens. So, what are some ways that investors can gain exposure to renewable energy right now?

Peron: For an investment program of that magnitude, it’s really going to touch almost every part of the economy, certainly the industrial part of the economy, certainly manufacturing. New technologies are needed: battery, types of inverters, and solar panels or more efficient ones, etc. So, there’s going to be an investment in R&D, and there’s going to be investment in manufacturing just to start; and it really is going to touch anywhere.

Bigda: So, Matt, as you’re doing your research, where does the technology look like it’s sort of on the cusp of taking off and taking us to that next stage of the renewable transformation?

Peron: Yes, I think there are so many moving parts right now, but I’ll focus on one, which is really batteries. Battery technology is the linchpin for moving a whole host of projects and technologies forward. We really do need to solve the battery issue, battery storage in particular, so that we can enhance the reliability of the grid, so that when the energy is produced it can be time-shifted to when it actually can be consumed. And right now, the technology just really isn’t good enough to carry that load, so to speak. So, battery technology is exciting to watch, not just because of making investment in that technology, which is of course important, but because it is the enabler for so many other technologies to go forward. So, I would call that really the linchpin, the fulcrum of where the renewable energy story actually revolves around.

Bigda: And where does the battery industry sit right now? Are there lots of different players in the industry, at this point, trying to push batteries forward? Or are there just one or two players that are starting to take market share?

Peron: We believe that the companies that will likely solve the problem are newer companies that are approaching the problem differently than traditional chemistries and traditional battery players, and going to require a new type of company, new type of manufacturing process. So, we’re focused there on what is going to be the more innovative side of that business. We don’t think it’s a tweak to the existing battery technology as much. That always brings incremental changes, but I think we need a stepwise change, and so we’re looking for those technologies that will leapfrog what we have now.

Bigda: So, from a technology perspective, what is the problem that these companies are trying to solve?

Peron: Well, it’s really, I mean, it’s a number of technical challenges that current batteries have, from density to the way they discharge the thermal curves, so to speak, which is the temperature; how they react in different temperatures. So, there’s a number of deficiencies with current battery technology that make them difficult, if not too cost-prohibitive to really deploy practically. So, it’s quite a complex problem on a number of different fronts, and that’s why it’s been decades to try and get batteries to even where they are.

Bigda: Are any companies close to getting it across the finish line at this point?

Peron: We hope a few, we think in the next three to five years, there’ll be substantial improvements in battery technology. Probably won’t get us all the way there, but it’ll really move us forward in terms of pushing the new energy ecosystem meaningfully forward.

You know, batteries is really something people focus on a lot. But don’t forget, if we build solar grids, we have to connect them. So, the investment into just the transmission lines would be massive. And what’s that going to require? Probably a lot of copper. So, really, it just shows up and down the supply chain and the manufacturing chain, it’s really going to spur a lot of investment. So, it’s broad-base Carolyn, is probably the best way to say it. And it’s not always the sort of shiny object that is the most profitable. It’s often a couple of layers down where the opportunities are.

Bigda: When you and your team are thinking about the timeline, because you’re long-term investors, sort of what is the timeline for these initiatives? Is this you know, five to 10 years down the road? Is this multi-decade investment opportunities? Sort of, how do you frame it?

Peron: Yes, I think that is, that’s the key piece to this. It’s really the art of investing in these types of generational changes. Each part of the technology stack, if you will, is going to have its own cycle. So, there are things such as, okay, we know how to build a new transmission line and that might require copper, right, for example. But then when it comes to battery storage, well, we’ve got existing battery technology, right, lithium ion, and we may be transitioning to solid-state batteries. That’s going to be a five-year type of cycle. And then there’s hydrogen, which is behind that. So, you kind of look at it and you can kind of map it out. But it is in terms of a decade or more, and you have to align your risk/return objectives and your time horizon. So, it’s got multiple dimensions to it that you have to align, and that’s what makes this tricky. So, you can have an investment now. It’s going to be very volatile, but you know in 10 years, it will be higher. Whereas certain other investments should pay off in the nearer term.

Bigda: Okay, so let’s pivot a little bit to a sector that you might not always associate with renewable energy and that is fossil fuel companies. Chevron, for example, announced that it will triple its investment to reduce its carbon emission footprint to $10 billion through 2028. Do these kinds of commitments make fossil fuel companies more attractive? And is that amount of spending really changing the business model for something like a Chevron?

Peron: Right, that is the $64 million question for a lot of these companies. Can they pivot? Can they make the transition? And in particular, I think the way they look at it is can we achieve the same return hurdles that we’ve achieved previously? They are, oil companies in particular, are very disciplined about a project, and they take on a project if it hits a certain return hurdle or not. And so, the question is, are they chasing these projects – and they’re lower return projects – to be more appealing from an optical standpoint, or will they actually get that return? So that’s a key debate in the industry. They’re not the only ones going after these projects. There’s nothing about a particular incumbent oil and gas exploration company that gives it a natural advantage in building a solar farm, so it’s not clear that they have any reason to do any better than anyone else. These are all the considerations that have to be made.

I should mention, however, that oil and gas isn’t going anywhere, and they continue to have returns from their existing projects. So, when you’re valuing them, yes, you have to value a set of cash flows that might diminish over time and then layer on these cash flows from their new projects.

Bigda: So, what are some of the biggest challenges that you and your team think about when looking at green energy today?

Peron: Well, there are a number of risks. Let’s start with the real risks of failure, right. We will have certain things that will work that will be failures, right? So outright, you’ll invest in a new technology and it won’t pay off the way you expect. So, you could see outright failures of technology.

But I think another risk is, again, aligning with the fact that there will be fits and starts to this whole program. It’s not just going to be a straight line up because of, as I mentioned earlier, allow the real-world constraints. You can throw all the money you want at the problem but getting a permit for a new transmission line just takes a very long time. And so that’s a real issue. And so, things can be slowed down by that. It could look like we’re failing, but really on the longer timescale, I have high confidence we’ll succeed. But in the short runs, there could be a lot of setbacks. And then there’s other risks around getting the right valuation, is a real issue in volatile markets. Having a good conviction and doing work there, that’s certainly something we’re focused on. It’s quite challenging.

Bigda: And as an investor, how do I mitigate some of those risks? So, you know, some companies are going to succeed, some are going to fail, some technology will take off, some will go the way of the typewriter. How do I, sort of in thinking about this sector today, participate in this evolution but also mitigate the downside risks that could be there that you just talked about?

Peron: Yes, I think one tool you have is to diversify. And by diversify, I mean in several dimensions: in the time dimension, knowing that you’ll have a couple of short-duration projects that you’ll invest in, and then longer-duration projects. The same thing, diversify across technologies because picking a winner can be very difficult, promising technologies won’t always pan out, etc. And then along the supply chain as well, everywhere from copper on up through the latest battery technology, diversifying across the supply chain and the different manufacturing technologies and where that’ll impact. So, I think diversification is certainly going to be important when it comes to a generational infrastructure rollout like this.

Bigda: A lot of renewable energy stocks delivered eye-popping returns in 2020, only to pull back this year. What do you think explains the recent drawdown? And, in your opinion, do valuations now better reflect the sector’s risk/reward potential?

Peron: Yes, I think it was a situation where there was a lot of excitement about the fact that we are going to be stepping up our game here. And that lifted all boats and probably got a little frothy, maybe a little bit ahead of itself, in the short run anyway. And so, the pullback is a healthy sort of, you know, I would consider it a consolidation so that we can, okay, assess where we are and which ones are going to work better and on what timeframes, etc.

So, I think I’ll make two comments. One is, yes, there’s certainly some expensive stocks when you look in a traditional framework, and that gives us pause, but you have to keep in mind for these long-term type of investments, that what looks expensive now, in hindsight, will have looked very, very cheap if you get it right. So, we really are getting into the science. We’re getting into the commercial aspects as deeply as we can to see what will work, what will stick, what won’t. And then once you ride a wave, once you find something or once you identify a wave, then you can invest in that for the long term. That’s really the most productive thing, and that’s really what we want to identify are these long-wave, long-tailed investments that can drive us forward for years.

Bigda: Well, we look forward to seeing where this renewable wave takes us in the future. Matt, thanks very much for the discussion. It was quite interesting. And I’m sure it’s a topic we’ll come back to again and again in the future.

Peron: Thank you.

Bigda: And thanks to our listeners for joining us. I’m Carolyn Bigda. We look forward to bringing you more episodes of Research in Action in the future.