The journey to net zero

The world’s energy mix is changing, but the transition to renewables is a process that demands the coordination of all stakeholders. Investing through an evolution such as this requires a nuanced approach, says Mark Hume, Co-Portfolio Manager of the BlackRock Energy and Resources Income Trust plc. 

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

The transition from fossil fuels to renewable energy sources is one of the greatest challenges faced by policymakers today. Like any challenge, this brings both risk and opportunity for investors.

In June 2020, we started to incorporate companies specifically involved in the transition to a low carbon economy in the BlackRock Energy and Resources Income Trust. This proved well-timed, coinciding with increasing investor interest in the energy transition. A third of the portfolio is now allocated to this area, but we have remained flexible in the allocation, increasing our weighting to traditional energy companies in November, for example, as tailwinds for the sector emerged off vaccine news.

We are often asked why we have not moved fully to become a fully ‘energy transition’ portfolio. We outline the key reasons why we have chosen a more balanced approach, investing across the energy mix.

To most appropriately manage a portfolio in such a dynamic sector it is important to have exposure to all parts of the energy mix.

Traditional energy companies have a role

Hydrocarbons today remain an important part of the energy mix and any transition will take time. Infrastructure needs to be developed, for example, and the entire energy value chain will be required to adapt to support a new energy mix while also ensuring reliability. The magnitude of this transition will need to be managed and will take time.

The move to renewable energy sources is likely to be incremental, particularly in the early years. This shift will, when combined with ever-changing macro-economic factors, have implications on commodity fundamentals and price, and thus company valuations. The most recent World Energy Report found that oil consumption declined by 8% in 2020 and coal use by 7%1. This includes the profound impact of the pandemic and economic lockdowns. To most appropriately manage a portfolio in such a dynamic sector it is important to have exposure to all parts of the energy mix.

Starving hydrocarbon companies of capital is not expected to be a responsible way to progress the energy transition.  Many of these traditional energy companies understand the imperative to transition their business and have been important investors in renewable energy. For example, leading energy companies have committed to become a zero-carbon business by 2050 and to increase their renewable power generation capacity 20-fold over the next few years2. These companies will need capital to deliver on this transition successfully and responsibly.

2020 was a critical inflection year for energy companies and this forced a high-grading of portfolios, increase of operational efficiencies, and change in dividend policies. The improvement in the commodity price environment since has amplified the impact of those decisions and now positioned many companies in high cash flow generation mode. This increased cash flow is expected to enable increased diversion of capital to renewables initiatives for many of these companies. As investors, we are wary of greenwashing and rely on our analysis of a company’s balance sheet and its disclosures to assess whether it is meeting its commitments to this increased allocation.

Investment balance

2020 was also a formative period for sustainable energy investment. The pandemic demonstrated the urgency of having a better relationship with the planet. Companies with exposure to the energy transition did extremely well, being seen by investors as high growth at a time when growth was scarce.

2021, however, has brought new dynamics. Many of the traditional energy companies whose valuations suffered in 2020 under the intense and rapid shift in fundamentals, and subsequently price, that came with the global shutdown have seen a reversal in 2021. Some traditional energy companies have emerged as ‘value’ companies, being supported now by more stabilized fundamentals and stronger commodity prices.

Market sentiment can shift between high growth and value depending on a range of factors, such as the economic backdrop or outlook for interest rates. A portfolio with exposure to both, and with allocation flexibility, is well-positioned to navigate through fads and fashions and provide cushion against volatility for investors.

The energy transition is multi-layered. We believe it is more productive to invest across the energy complex, creating a rising tide, rather than limit ourselves to those already at the top.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of June 2021 and may change as subsequent conditions vary.