Transcript: Decarbonization and the Future of Global Infrastructure

Air Date: September 26, 2022 | 12:00 PM, EDT

Caroline: Good afternoon, everyone. Thanks for joining us. I’d like to welcome you to this week’s Monday Minute Live Chat hosted by the Canadian Leadership Congress. Today, we’re discussing decarbonization and the future of global infrastructure. And here to talk about this topic with me, I have Shane Hurst, who’s managing director and portfolio manager with ClearBridge Investments, a Franklin Templeton company. Welcome, Shane.

Shane Hurst: Thanks, Caroline.

Caroline: Excellent. Well, let’s dig right in and get some context about the evolution of infrastructure in the context of asset owner portfolios over the last decade. How has it evolved, and what approaches do you see asset owners considering a bit more right now?

Shane: Thanks, Caroline, for having me. And thanks, everyone, for listening in. Look, I think there is clearly a continued recognition that infrastructure assets are essential services, and their role in the portfolio is quite different to those in industrial companies that are more leveraged to the business cycle. What do they provide? Will they provide stable cash flows and dividends underpinned by regulation and long-term contracts?

They provide an inflation hedge; diversification, certainly, versus other asset classes; and then access to a significant number of thematic drivers, including the move towards net zero—which I’m sure we’ll talk about a little bit later—the mispricing of listed and unlisted, and a bunch of other very strong key thematics, going forward. Whether or not it is a listed holding or an unlisted holding, I think they have those exceptional defensive characteristics, and, really, it’s all about your definition of infrastructure which really guides what type of outcome you are likely to get.

Caroline: How do you define infrastructure?

Shane: In terms of our definition of infrastructure, what we aim to do is deliver those very stable returns, those stable cash flows, those growing dividends to investors. And, so, to that end, it’s really important to exclude those volatile cash flow assets. They are your energy retailers, your EMPs, your logistics-type businesses—those unregulated businesses that have supply and demand risk.

What do we include? Will we include regulated and contracted utilities? These are your water, your gas, electric-type utilities that have a regulated asset base, a cost of capital that’s determined by the regulator pass-through of inflation, and are, of course, very highly defensive.

When it comes to user pay assets that we include within our definition, these tend to be your airports, your roads, your rail, your ports, and these are user pay assets that are very much leveraged in the growth in the economy. They still pass through inflation. They are still on very long-term concession contracts, and, importantly, they still are able to deliver those very stable cash flow outcomes that we are after, really.

Caroline: You’ve mentioned ports, airports, inflation on top of that. I have to ask you, in your view, how did the pandemic impact some of these global infrastructure investments?

Shane: Look, it’s an interesting one. You go back really over the last two to three years, it’s been a net positive, and I’ll just talk about it a little bit why. I think the first point is, if you’ve got the marginal negatives that have come out of the pandemic, there was definitely a slowdown in road, rail, and airport spending back in 2020. As the pandemic hit, obviously, traffic in those assets dropped right off. Spending and capital spend really tended to fall off as well.

There are a number of positives that came out of the last two, three years. The first is greater spending on midstream and energy infrastructure assets. Obviously, the demand for commodities has increased, and you know that they’re in Canada, and, as a result of that, there’s been [a] greater amount of energy infrastructure spend on capital and on capital projects.

You have also seen spend on hydrogen and carbon capture backbone—especially in the West Coast of the U.S.

I think the biggest positive that’s clearly come out of the last two to three years is the greater spend on decarbonization, and with 36 trillion U.S. dollars expected to be spent between now and 2050, there is substantial upside, certainly, to the companies that we invest in. For assets we invest in, these are very much liquid assets. These are large assets, and these are assets that are very, very stable and deliver those stable outcomes.

Caroline: I want to pick up on your reference to the new bill in the United States. What kind of opportunity does this general push for net zero globally and, more specifically, the new U.S. bill represent for infrastructure?

Shane: There’s no doubt to us, net zero is the biggest opportunity within our asset class at the moment. Really, there’s no better way we think to access that theme through global listed infrastructure—in fact, infrastructure assets in general. As I mentioned, [a] massive amount of spend—36 trillion U.S. dollars of clean energy spending to 2050. Sixteen trillion U.S. dollars is actually expected to be spent by the networks, which then get wrapped into an asset base, and we earn a regulated return off that.

Massive amounts of spend—just to give you, just to throw out a few extra interesting stats. There’s a hell of a lot that needs to be done over the next seven or eight years. And, just to put that in context, if you look at power spending, it needs to increase to roughly $2.5 trillion per annum. There needs to be a massive ramp-up in wind, solar, and other renewables. We’re talking about almost a six-time increase.

The other thing that really needs to happen is the use of electric vehicles. Currently, about 10 percent of sold vehicles globally are electric. That’s likely to increase to about 60 percent by 2030. There is a massive opportunity there. And there’s a massive change in social views on these issues as well, to the IRA bill, or the Inflation Reduction Act, which was recently passed. Again, that has been a massive positive for the companies that we invest in. They get greater policy certainty—as I’m sure we’ll touch on a little bit more later—with tax credits, whether they be production tax credits, income tax credits.

Assets like nuclear assets in the U.S.—which are absolutely essential for the move towards net zero to guarantee that very stable generation load—have now 10-year guarantees or subsidies in place. There’s also huge incentive in areas like hydrogen production, which could actually see the U.S., globally, become a leader in this area. Certainly, we think it’s very, very positive, and, from our perspective, the best way to play it is through those very stable infrastructure and utility assets. Because you don’t take that technology risk.

Caroline: Clearly, in the U.S., public policy is evolving to really support the building of some of this infrastructure. How important is it broadly and, more globally, and incentivizing the kind of innovation and technology that’s needed to do all of these things you’re talking about?

Shane: It is probably the most crucial part of the puzzle, I guess, and, to your point, the best example is climate change. We look what’s happened over the last two to three years globally. You’ve had something called COP26, which saw 109 countries pledge to slash emissions. You saw developing countries commit to net zero targets. Then you also saw countries phasing out deforestation and stuff like that. Really, there was huge global support for the move towards net zero at those types of forums.

Regionally, you’ve seen similar types of incentives and commitments. We just have to look at places like Europe, which came out with the 55. That was really an acceleration of their move towards net zero by rolling out more renewables and retiring coal and gas plants. And, that’s obviously necessary, especially what’s happening with gas flow into the continent at the moment.

Then we’ve obviously talked about the inflation reduction plan, which, clearly, in the U.S., will continue to be a positive. Really, all of these public policy pledges and incentives really create opportunities for investment in infrastructure and security companies that facilitate that move towards net zero. They really encourage that innovation, which will lead to, firstly, I think, a faster move towards a net zero outcome, but also a move at a lower cost, which is obviously crucial to make these moves commercial.

Now, if we look at individual companies, they aren’t just throwing to which I’m familiar with and you’d be familiar with. If you look at Australia, Australia was pledging to move towards net zero by 2050, 45 percent cuts and emissions by 2030, with [a] A$20 billion low emissions technology fund, which has really started to spur a huge amount of investment and proposed investment.

You look at Canada, and they do have the Emissions Accountability Act. The plan essentially cuts emissions by 45 percent by 2030, from 2005 levels. They have ambitions to hit net zero by 2050. That includes items like mandates on electric cars [and] retrofit buildings, but there are still some key elements that need to be worked out in Canada, such as what happens with emissions capping, clean energy standards, and carbon capture.

Look again, the opportunity for our company—the opportunities for listed infrastructure companies—to invest with public policy support is certainly creating greater growth in our assets, and it also lowers, ultimately, the cost for customers, with our companies still able to achieve very attractive returns on equity.

Caroline: Shane, you’re in Australia. I’m in Canada. We’re two resource-based economies. Any thoughts on how, say, Australia is managing to balance this energy transition with the large portion that resources play in your economy similar to Canada?

Shane: Yes, you’re right. I think I looked this up. Recently, about 24 percent of Canadian exports are essentially resources, and, in Australia, it’s far, far larger. Australia’s heavily dependent on the export of resources and all types of resources, really. I guess advice, for what it’s worth, would be to work with what you have. If you look at what Australia’s trying to do, because it has large tracks of uninhabited land, very hot weather—not at the moment—but often.

What they’re trying to do is roll out green hydrogen-type projects with solar. As an example, there’s been A$250 billion that have been pledged to develop hydrogen and zero emissions, energy sources. That’s what Australia’s trying to do. Offshore wind is another focus, and they’re looking to roll out around about six gigawatts of offshore wind over the next few years.

Canada, I’d say, is lagging a little. I was reading an article recently from the [unintelligible 00:13:38] Institute, saying there’s actually not any sizable offshore wind industry at the moment. They are proposing, I think, 3.6 gigawatts, of offshore wind, but certainly nowhere near what’s happening in Europe and the U.S.

I think the other point to make—and certainly we’re seeing this where the assets that we invest in—is a lot of the energy infrastructure companies will lead the way in carbon storage and hydrogen projects, and you’re seeing that out of the Alberta energy infrastructure companies that we look at in terms of building backbones and other ways to facilitate that move to net zero.

In the end, look, strong government policy and commitments need to be made. You need to incentivize that investment. We are seeing that in both countries, just at different speeds. But no doubt, Caroline…look, you are walking a very difficult tightrope, which will probably mean both countries lag areas like Europe and other parts of the world, which were obviously more leaders.

Caroline: Let’s look at that a bit. We’ve talked about Canada; we’ve talked about Australia. Which countries do you think are really leading the way and promoting investing in the energy transition?

Shane: There’s no doubt Europe is the one that’s leading. If you look at the European Commission estimates, they expect a further €350 billion to be required in order to hit that 55 percent EU greenhouse gas emissions target by 2030. That takes really investment up to round about €1 trillion. I guess the obvious question is, why are they leading?

The first point is necessity. They don’t have much in terms of natural resources. As we’ve seen in the case of Russia, they want to become far more energy independent. The way to do that is to use what they have, as I mentioned before, and roll out more renewables and invest more in hydrogen and other cleaner sources.

I think the other point is clearly politics. Large European bloc countries such as Germany have strong political support from their green parties for decarbonization. That’s clearly been one of the areas where you are seeing a greater push in public policy.

I’d say the other interesting one to look at is the U.S. Now, the U.S. obviously does have a plentiful supply of gas. They are pretty much oil independent aside from some of the oil they move from around the world, including places like Canada, in terms of their imports. Some of these incentives that came from a recent plan are substantial. If you look at the hydrogen tax credit, it actually makes green hydrogen very, very close to parity.

The green hydrogen is hydrogen produced from renewable energy. It puts it at parity with some of the dirtier productions of hydrogen such as grey or blue hydrogen, which still needs to be worked out. The grey is the production of hydrogen from gas plants. You could see—and this is honestly conceivable—you could see over the next five to 10 years the U.S. become a leader in the production of hydrogen. That’s quite amazing when you think of where they’ve come from over the last five and 10 years in terms of public policy support.

Caroline: That is a fairly stunning leap. Where are the risks right now that you see in global infrastructure, especially in this, I suppose, probably quite rocky move to a net zero economy?

Shane: There are clearly risks. There’s a huge opportunity. With every opportunity there are risks. I think the first one, which we’ve seen pick up lately—but it’s still a risk—is public policy support. The fact that, that could falter commitment set up at COP26 and other climate change forums may not be adhered to, especially in emerging markets countries. You could get a change in government in the U.S., as an example, in two, three years’ time. That could then go through a process of trying to repeal some of these very, very positive outcomes that have been released through the IRA plan.

I think the second very big risk is climate inflation, also known as green inflation, and that’s the increased cost to facilitate the move towards net zero. How that manifests is a difficulty to pass-through higher costs and higher inflation to the ultimate consumer. Now those increased costs could come through the rollout of renewable assets. They could come from the fact that we haven’t been investing in more hydrocarbon-based oil and gas assets for a number of years; the costs have actually gone up. The biggest issue is their ability to pass through that higher cost. If they can’t do that, that’s clearly a risk.

Everyone knows about this through the COVID period, but clearly supply chain issues and material delays will put pressure on the outcome. You’re seeing that around the world where you’ve seen six-month to one-year delays in accessing wind farm equipment, solar equipment. You’ve seen legislation in the U.S., anti-dumping legislation, which really works against importing goods from China. That’s also a risk. Unstable grids.

In the end, we have to remember to generate a very stable outcome in terms of electricity to people’s homes. You don’t just need renewables and solar, which are obviously more intermittent that don’t operate all the time. You also need stable generations such as nuclear gas and then ultimately batteries, which will backfill some of that intermittency. So that’s certainly another challenge.

Then finally, investors taking on too much risk. By allocating too much to the technology side of these assets, which we don’t invest in, but obviously that’s where some of the incentives are pegged. There’s a possibility you will get greater volatility investment that doesn’t generate attractive returns and then negative outcomes, which is what we don’t really want to see when we are trying to move towards a net zero outcome by reducing hydrocarbon dependency.

Caroline: That’s a really good point. There’s a lot of money needed here. I think you mentioned it somewhere in the trillions. Where’s this money going to come from, and are you optimistic that we can find that amount of capital or raise that amount of capital?

Shane: It needs to come from the private sector, ultimately, especially in developed markets, whether it be equity or debt, but the private sector needs to be comfortable. They’ll make an adequate return on their capital. According to the IMF, global climate finance currently adds up to about $630 billion annually, with most of that coming from debt funding.

As we move forward, that’ll have to substantially increase, and we’ll also have to see a lot of that increase come from equity finance. We’ve seen, whether it be unlisted strategies and unlisted funds raising billions and billions of dollars to fund the move towards net zero or listed companies, we really have seen that commitment.

If you look at our utility companies globally, they are committing hundreds of billions to decarbonize grids and achieve that net zero outcome. They’re very comfortable that these investments will generate 12 percent returns on their equity under regulatory constructs. Rather, the ability to get very attractive returns on equity off their investments ultimately. The key continues to be, and we’ve talked about this a number of times, Caroline, the key continues to be policy certainty. We are seeing this around the world. We’re clearly in the early innings, but I am very optimistic that capital will flow from all sources in order to work towards a net zero outcome.

Caroline: I like ending this discussion on an optimistic note. Thank you, Shane. It’s been a terrific conversation. I really appreciate your taking the time to speak to us today.

Shane: Thanks, Caroline. Appreciate it.

Caroline: That wraps this week’s Monday Minute. Don’t forget to send us your questions and we’ll get back to you right away with our speaker’s response. We’ve got a lot of exciting content and great interviews lined up for the rest of the year that you won’t want to miss. Be sure to hit the Like and Subscribe buttons below and visit us at leadershipcongress.ca to get our informative CLC newsletter. Thank you for joining us today and see you next time.