Greece is aflame. Acres of the American Pacific seaboard have been consumed by fire amid heat plumes and enduring, tinder-dry drought. North-west Europe, parts of India and China have been inundated. Basements in south and west London have been flooded. Twice. All this in a few weeks. Tip in the continuing pandemic to the sum of human misery and it is easy to conclude Mankind has unleashed the full fury of the Four Horsemen of the Apocalypse.
Nevertheless, the world is still turning. But it was no surprise that this week’s long-awaited, much-delayed report from the International Panel on Climate Change (IPCC) was prefaced, trumpeted indeed, in terms of ‘Code Red’, drinking in the last-chance saloon both to save the planet and to save humanity from itself; we’ve done too little, too late; but with a concerted effort we can yet pull back from the tipping point and stop ourselves falling over the edge, pull our collective irons of redemption from the fire.
IPCC throws down the gauntlet
If the recent G7 meeting in Cornwall had not already prompted another round of I-can-reach-net-zero-faster-than-you among its members, the IPCC’s challenge to political leaders ahead of COP26 in Glasgow is to go even further and faster. Forget 2050 as some conceptual target date still more than quarter of a century away; exacerbated and accelerated by the pandemic and the specific strings attached to decarbonise swathes of industry in return for financial aid (think the government-backed Covid rescue packages totalling billions of pounds, dollars and euros for national airlines, airports, aerospace and automotive industries, all with explicit green targets as conditions for enduring support), the expectation is that the next great industrial and societal revolution must be under way immediately. It must be global. It must be substantially completed by the mid-2030s and fully complete by 2040. Or else. But the terminology is hardening too. Once mainly the province of Greta Thunberg, Extinction Rebellion and other protesters, the drift towards a carbon-zero society rather than net-zero is becoming mainstream. This is not semantics: to be thinking in terms of an economy that still includes carbon in thirty years’ time is increasingly being cast as an extreme view. Whether carbon-zero is either desirable, pragmatic or achievable is another matter.
But there is a problem. Time marches on inexorably; artificially-set dates with arbitrary targets, plucked from the air by politicians, consultants and consensus-driven ‘experts’ are almost daily being brought forward. The window in which to develop workable solutions at a manageable cost while meeting the demands of the 21st century society’s need for instant gratification and with no loss of living standards becomes ever narrower. Call it a ‘carbon climate compression clash’. It raises the risk of rushed, ill-thought-out policies being implemented, so often a recipe for disaster; equally procrastination is unacceptable. The political as well as economic risk is immense.
IPCC ideology and exhortation meet realpolitik
Despite all bar three (Iran, Iraq and Turkey) of the world’s main economies being signatories to the Paris Climate Accord, nevertheless the IPCC makes its exhortations in a political vacuum. Man is a competitive beast (two weeks of Olympic competition remind us of that) and in situations of dislocation there are winners and losers; there is economic, political and commercial advantage both to be gained, lost or squandered. The IPCC is striving for a Utopian unanimity on its climate crusade and, while there is broad agreement on principles, as time rolls forward and we move towards the detail of planning and execution, competitive tension is already evident. An obvious stumbling block, now removed, was Donald Trump’s US withdrawal from ‘Paris’ on the geopolitical grounds (leaving aside his own sceptical views on climate change) that he would not countenance the US suffering a clear loss of competitive position while China was continuing to benefit from low-cost exports produced with energy derived from cheap, dirty coal.
The five biggest of the world’s polluters are China, India, Russia, the US and Germany, together 51.6% of global GDP. Germany and the US are broadly on the ‘conformist’ path, both at very different points on the journey towards removing ‘dirty’ fuels; it is equally fair to say that the other three have a more elastic perspective on the goals from a nationalistic and self-interested standpoint. It remains a major bone of contention, to be discussed again at COP26 as it was at COP 25 in Madrid, that while many western countries are bending over backwards to cut emissions, China and India are undermining the effort with overall greenhouse gas emissions still rising; Beijing and Delhi see it otherwise: the West has been very happy to subcontract expensive, ‘dirty’, energy-intensive industry, abrogating its environmental responsibilities along the way; higher emissions in new centres of production are the price for cheap imports of materials such as cement and steel. As we discussed in an earlier column, the EU’s solution to tax the entire carbon footprint including production and transport of goods imported into the EU simply raises the stakes further; by any other name it is a tariff, a trade barrier adding to the frictional costs of supply.
The arguments are not confined to political and economic differences between developed and developing nations. As an example, even within the EU there are fundamental differences of opinion about future energy policy. Recent talks ended in acrimony about something as fundamental as the definition of ‘green’ energy, focusing on the environmental pros and cons of nuclear (the bedrock of France’s energy supply) and gas (Germany’s). If not maintaining a level playing field, this is a battle for competitive economic and political advantage between otherwise friendly neighbours.
UK houses & cars: a microcosm of global issues
In the UK, two sectors stand out as illustrative microcosms of the problems. Both require the expenditure of significant political capital to drag electorates along the path. In France, President Macron knows the risks from the Gilet Jaunes riots in response to his environmental diesel tax, and in June the Swiss voted in a referendum to reject fuel and air tax levies specifically targeted at that country meeting its ‘Paris’ targets.
First, the UK’s private housing stock for which the initial proposed milestone is 2028 by which time any rental properties in England which fail to meet EPC Level C will be ineligible for renting to new tenants until remedial work has been carried out to meet compliance (it is estimated that currently, 80% of England’s 21m private homes would fail the test). Other milestones will follow, including mortgage lenders not being allowed to lend against a non-compliant property (which essentially means the property is unsellable until it is compliant and is therefore at least temporarily worthless, potentially a systemic problem in the asset-backed lending market). Remedies include roof and cavity wall insulation, removal of gas-fired boilers, and installation of double-glazing. The average cost for the average property is variously estimated at £18-30k. Who pays the cost? The homeowner? The taxpayer? Should there be supporting grants capped or fixed at a percentage of the works (£4,000 is being mooted as a subsidy for boilers)? What happens to Listed houses where to make alterations to the character is against planning and listing regulations? Can the demand for remedial work be met? Will a headlong rush for compliance lead to significant pressure on raw material, parts and labour costs, feeding inflation? If not gas heating, what are the realistic alternatives and is the technology proven? Why can we not use gas to heat our homes in the UK when Germany’s strategic energy plan for the next 50 years is supported by renewables but predicated on cheap gas piped from Russia? So many questions and, so far, so few answers and yet compliance is expected in little more than half a decade.
Cars are just as much a problem. New combustion-engine vehicles will be prohibited from sale in 2030. 80% of new cars in the UK are ‘purchased’ on fixed-term financing deals, usually of between 2-4 years in duration. By 2035, most UK households will have been faced with the decision about whether to buy their combustion-engine car outright and run it until forced off the road, or to ‘buy’ a new non-fossil fuel vehicle. Little over eight years to 2030 we are still wondering what the best future automotive technology is. The alternatives are battery powered electric vehicles (EV) or hydrogen. EVs are already proven technology with battery life improving and charging times falling. Hydrogen, potentially much more enduring and self-sufficient, is expensive and energy intensive to produce and very much in its infancy. But how ‘green’ is battery technology, and how sustainable? Lithium, nickel and cobalt, the principal rare-earth elements used in battery production are of limited supply, a finite resource. They are toxic (it is currently illegal to dispose of them in anything other than the most controlled conditions) and little thought has so far been given to their mass disposal, a potential environmental catastrophe in the making if sub-contracted to developing markets. They originate from some of the most ecologically sensitive and politically unstable parts of the world such as the Democratic Republic of the Congo, and industrial scale mining is a dirty business both environmentally and socially. Are we salving our own consciences with emission-free (at the point of use) electric vehicles simply by shifting the environmental cost somewhere else? Is that not moral greenwashing? Discuss. As for the supporting infrastructure, sufficient for every household to be able to charge its car(s) daily, not only at home or at work but also on the move, virtually nothing exists. More fundamentally, it is estimated that were every household to charge its vehicle(s) simultaneously overnight, the energy requirement would far exceed the Grid’s ability to meet demand. Would there be a need for rationing? Should there be premium tariffs for charging car batteries? And we have posed the question before about how the Treasury replaces the £34bn pa it currently collects through fuel duties; most likely through pay-as-you-go road pricing with all the inherent loss of privacy as your car’s GPS tracks and reports your every move (and automatically collects your speeding fines).
UK energy: strategic blindness
In the UK, we run the risk of putting the cart before the horse particularly when there is a significant switch to electric-powered transport and as we move from the 3/4G era to 5G and another factor-shift in technological and data applications and capabilities. Mixing metaphors, the environmental elephant in the room remains the lack of a secure, sustainable, strategic energy policy fit to meet the complex needs of a modern, post-carbon society.
The UK’s national coal-fuelled fleet of power stations will be fully decommissioned by 2025 (4% peak generation in 2020/1; average for the year, 1.25%); also in 2025, half the current nuclear fleet capacity will have decommissioned too, beyond its life-time safety limits (nuclear currently accounts for an annual average of 16.5% production, peaking seasonally last October at 21%). Wind and solar, between them averaging 20% of UK electricity generation are by definition variable rather than constant sources of power. Natural gas (40%) and biomass (7%), staples of controllable capacity, are under the ‘green’ microscope: in January 2021 the UK Court of Appeal ruled that the planned conversion of the Drax plant in Yorkshire from coal to gas (it would have been the UK’s biggest gas-powered plant) was legal and compatible with meeting UK targets agreed in the national plan to meet ‘Paris’; however, the company buckled in the ‘court of popular opinion’ only a month later when green pressure groups, arguing that the resulting emissions are a significant contributor to global warming, forced the company to abandon the plan; other gas plant operators remain vulnerable to similar pressure from the zero-carbon campaigners. Biomass (also operated by Drax) too has its detractors: although billed as carbon-neutral (trees absorb and store CO2 while growing, when pelletised and burned the same volume is released), however the total carbon footprint is positive thanks to most pellets being imported 4000 miles from North America. As for nuclear, we seem to dither perpetually, mired in indecision about over-reliance on French and/or Chinese expertise, the heavy development and end-of-life decommissioning costs, and all the safety connotations arising out of the environmental disasters at Chernobyl, Three Mile Island and Fukushima. A potentially revolutionary development led by Rolls-Royce with its new generation Small Modular Reactors, highly efficient units available at a fraction of the cost of a traditional ‘big’ plant could be a potential solution to providing constant ‘clean’ power but even if adopted, the first units would not be available before 2030.
It is not unthinkable that the UK, the world’s 5th largest economy, could potentially suffer power rationing were demand regularly to exceed supply (it really can happen in first-world economies: ask any South African who will have regularly experienced power ‘outages’, notably in Gauteng Province, the main energy-intensive mining area).
As the world becomes geopolitically less stable, what about security of supply? Currently we import more than 10% of our energy from the Continent, soon to be augmented by the world’s longest interconnector cable between the UK and Denmark to draw electricity from Danish wind farms. As mentioned, our new approved nuclear projects (e.g. Hinckley Point) rely heavily on expertise and technology from France and China. In an energy system in which demand and supply are on wafer thin margins with a minimal surplus capacity buffer, 10% of supply not directly under one’s own control represents a significant risk.
As for the costs, without any of these questions answered, arguably it is little more than informed guesswork. The Treasury and the Climate Change Committee play their cards close to their chests to the extent that independent analysts such as those from the Global Warming Policy Forum are forced to keep resorting to the courts and Freedom of Information requests to try and gain a better understanding of spending plans. This week, writing in the Daily Telegraph, former Climate minister Amber Rudd effectively said preoccupation with costs misses the bigger point of environmental and economic benefits. She ignores the fact that thanks to the pandemic, the UK is now nursing national debt as big as the economy; further, the government’s track record of mismanaging big projects with both cost and time overruns (aircraft carriers, Cross Rail, HS2 etc), Alice-in-Wonderland accounting allied to often poorly drafted, flaky or misunderstood financing structures (PFI contracts), an obsession with costs should be a pre-condition of embarking on the UK’s biggest infrastructure revolution since the 18th Century, particularly if future financing both adds to the debt burden and exacerbates inflationary pressures, potentially pushing up the cost of financing that debt.
Climate Change and the Merlin investment perspective
At the macro level, there are as many questions as there are answers. Complicating the matter is that the principal western central banks, the Federal Reserve, the ECB, Bank of England and most recently the Bank of Japan, now all have politically dominated ‘climate change consideration’ as a core mandate, sitting uncomfortably alongside existing economic inflation targets. Leaving aside the current debates about inflation risks in the economic recovery phase in the aftermath of the pandemic, longer-term there are two powerful forces, global digitisation and global decarbonisation, potentially pulling in opposite directions with regards to inflation. Which will have the upper hand or whether they cancel each other out remains to be seen. In this revolution by coercion there are no anchor-points, no precedents with which to extrapolate future price behaviour.
From a Portfolio perspective, bearing in mind we are one step removed from direct investments in individual equities and bonds, nevertheless the debates about climate change, the environment and the other factors in ESG are very important to us. As ever, we aim to try and maximise investment returns, commensurate with risk parameters, by taking advantage of the opportunities and avoiding as far as possible the torpedoes and landmines. Philosophically and pragmatically, we are not exclusionary when it comes to exposure to sensitive sectors. Among others including industrials, insurance and banks, arguably the most sensitive is oil; while many pressure groups would like to render oil companies un-investable, first, we believe such companies are crucial to the transition process from fossil-based fuels to alternatives; second, facing a long-term existential threat and being hard-wired for survival (though not all will make it), they become an important part of the solution in the race to develop new and sustainable clean energy sources, and thus an investment opportunity.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
Jupiter Independent Funds Team
13 August 2021
The value of active minds – independent thinking:
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
Fund specific risks:
The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.
Get in touch
This document is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. This document is for informational purposes only and is not investment advice. Past performance is no guide to the future. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Holding examples are not a recommendation to buy or sell. Quoted yields are not guaranteed and may change in the future. Issued by Jupiter Unit Trust Managers Limited (JUTM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ which is authorised and regulated by the Financial Conduct Authority. No part of this document may be reproduced in any manner without the prior permission of JUTM.