An underappreciated small cap worthy of an energy investor's interest

Note: This interview was taped on Friday 26 July 2024.

The energy transition is one of the most defining investment themes of our lifetime. And there is no doubt that the biggest money from institutional investors is not only investing in it but they are in it for the long haul.

Bloomberg data reveals global investment in the energy transition climbed 17% in calendar 2023 to a new record of US$1.77 trillion. Here in Australia, the Albanese administration's "Future Made in Australia" package will provide nearly $23 billion to a range of stakeholders who are involved in renewable energy, critical minerals, and clean energy projects.

For professional impact investors like Hari Balkrishna of the T. Rowe Price Global Impact Equity - I Class, the energy transition is far more than just a "net zero" mission. 

"If you think about the core energy transition, in terms of the mix of how energy has to change, it's too simplistic to say that renewable energy is the solution," Balkrishna says before adding that "an equally important part tends to be decarbonising heavy industries."

In this episode of The Pitch, Balkrishna goes deep into the subject of the energy transition and how companies around the world are making their mark on this important investment theme. Plus, hear his views on why old-world energy companies like Fortescue, BHP, and Woodside may not qualify as impact-worthy investments even if management teams are making concerted moves to expand their operations in new-world energy projects.

Edited Transcript

What does the “energy transition” mean to you as an impact investor and how has that meaning evolved over the three years that this fund has been running?

Balkrishna: To us, the energy transition is about how we get to net zero as a planet. But there's more to that than net zero, right? There are other things as well, in terms of transitioning away from utilising too many resources from the planet. 

For example, ensuring we have a circular economy loop in what we do and ensuring that healthy ecosystems are promoted along the way. But if you think about the core energy transition in terms of the mix of how energy has to change, it's too simplistic sometimes to just look at renewable energy as a solution. It is a critical part of the solution, but an equally important part tends to be decarbonising heavy industries. 

When you think about power, when you think about buildings and transportation, a lot of these contribute to more than 2/3 of greenhouse gas emissions. How can we find energy-efficient ways to reduce the emissions from those sectors in addition to also generating renewable energy and creating a renewable ecosystem? That's what we're focused on.

Here in Australia, we saw Fortescue Metals CEO Andrew Forrest recently cull 700 jobs from its workforce, adding the company’s goal of producing 15 million tonnes of green hydrogen by 2030 is now on hold. 

What does this move from a major global player with ambitions in the renewable energy space say to you?

Balkrishna: I can't comment on an individual company's decision, obviously. But I would say that if I look at outside of that if I look at the levelised cost of energy across a range of renewable technologies, like solar, wind, a lot of these are actually below that of fossil fuels today. 

There's the infrastructure build that has to happen. There's a storage builder that has to happen. But the incremental marginal decision to invest in renewable energy today makes a lot of economic sense in addition to obviously helping the planet, something like green hydrogen. Again, we're not seeing a sort of slowdown or a let-up in a lot of these investments. If you look at the Inflation Reduction Act in the US, for example, that's a classic example where a lot of these new technologies are actually getting incentivised and in many respects are actually accelerating. 

A lot of traditional energy players are now making significant inroads into the renewables space - representing one way to play this theme. 

Are you involved in those and if not, where are you looking for opportunities in that space?

Balkrishna: We're not. For us, it's all about making sure that there is a majority, so more than 50% of revenues, aligned to a positive impact activity. Energy companies wouldn't make the cut because of the fossil fuel exposure. 

Instead, we invest in, if you're talking about renewable energy, one of the biggest generators of renewable power in the world, Brookfield Renewable Partners (NYSE: BEP). And for us, the way we think about renewable power is that scale matters a lot. It's a pretty competitive space and returns can be under pressure at times, particularly in this high interest rate environment. Having scale, having access to large customer relationships, and having access to land and permitting rights and economies of scale and ordering equipment are really important when you're thinking about project IRRs. And so you've got to pick your spots in terms of where you invest in renewable energy. 

Your dual mandate allows you to seek long-term capital appreciation as well as companies that are making a positive impact. 

Can you tell us about two holdings - one long-held and one recent fund addition that fulfils this mandate?

Balkrishna: On the long-term holding, one we have held since the inception of the fund is Linde (NYSE: LIN). It's an industrial gas company, which ties in very closely to what I described earlier. It's equally important beyond generating renewable energy to decarbonise heavy industry. Linde does exactly that. They mitigate 90 million metric tonnes of CO2 equivalent in working with heavy industry, by helping them decarbonise solutions like carbon capture and storage, for example, or green hydrogen. 

When you put that together with the financial algorithm, good energy efficiency and decarbonisation solutions for heavy industry, we believe this is a company that can compound double-digit EPS growth for a long, long time and trades at a reasonable valuation. 

On the one that we've sort of started more recently, there's a French small-cap company called Spie SA (EPA: SPIE). 

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