Market Commentary: The Train to Net Zero Carbon Emissions Has Left the Station—But It’s Moving Slow
Updated: Sep 23, 2021
On August 9th, the United Nations Intergovernmental Panel on Climate Change (IPCC) issued its sixth Assessment Report (AR6). The report is very important because it informs policy makers (195 at last count) across the globe. Its major conclusions are below:
1. Human behavior has “unequivocally” contributed to global warming.
2. The observed deleterious effects of climate change include extreme heat events, droughts, floods, wildfires, hurricanes, rising sea levels, and melting icebergs.
3. “Immediate, rapid and large-scale action” to reduce greenhouse gas (GHG) emissions is required.
4. Under the very low emissions scenario, global warming can retreat to 1.5C toward the end of the 21st century.
Spoiler alert! Not enough is being done to reach net-zero emissions by 2050. Countries will update their emissions mitigation plans in October when they meet in Glasgow at the 2021 United Nations Climate Change Conference (COP26). The Economist’s recent article, “Green Goals,” purports that under its plan, China (which accounts for about 25% of GHG emissions) will emit slightly more in 2030 than it does today. According to BloombergNEF, “An immediate acceleration in funding is needed if we are to get on track for global net zero.”
The Financial Times refers to the report as “landmark” and other media cite the report as an urgent warning that not enough is being done to reduce carbon emissions and save the planet. While several hundred scientists contributed to the report and most countries accept its conclusions as facts, there are some credible doubters.
Dr. Steven E. Koonin, former Undersecretary for Science in the U.S. Department of Energy under President Obama and author of “Unsettled: What Climate Science Tells Us, What it Doesn’t, and Why it Matters” is a skeptic. In an August 10th WSJ editorial, he notes that “humanity’s well-being has improved spectacularly, even as the globe warmed during the 20th century, it is absurd to suggest that an additional degree of warming over the next century will be catastrophic.” Temperatures globally have already increased ~1.0C since pre-industrial times. The Paris Accord targets global warming to no more than 2.0C and preferably no higher than 1.5C.
To be clear, we certainly want to climb aboard the zero emissions train, but we don’t want to get fall off the tracks. Sensible policies should be passed that encourage the advancement of new technologies such as battery, hydrogen, carbon capture, and energy efficiency. However, these policies should be practical, balanced, and not ignore the benefits that fossil fuels have on promoting human welfare and providing basic human needs such as affordable and reliable electricity and accessible medicine. Unintended consequences of bad policy are power shortages (California and Texas are recent examples), inflation (rising commodity prices) and lower economic growth. I can’t help but think that there is some confirmation bias at play here that is somewhat counter-intuitive for science-based research.
Confirmation bias is seeking evidence to support one’s conclusion, rather than forming an unbiased conclusion from the evidence. The energy transition or energy evolution will take time. The train has left the station, but it will take time to get to our destination. Let’s have a smooth ride and avoid a train wreck.
Additional conclusions from the IPCC report include the following:
1. There is a linear relationship between global warming and extreme weather conditions — the higher the temperature, the more extreme the weather.
2. Under all emissions scenarios considered, global warming will continue to increase until at least the midcentury.
3. From the period of 1850–1900, global temperature has already risen by about 1.0C and is very likely to reach 1.5C in the near term (2021–2040) under all scenarios considered.
4. Global warming can be kept below 2.0C under the very low and low scenarios.
IN OUR VIEW: CLIMBING THE WALL OF WORRY
The broad market indices continued to reach new highs in July despite worries about the Delta variant, inflation, and when the Federal Reserve will begin tapering. Markets have been propelled higher by another quarter of better than anticipated earnings by most companies in the S&P 500, upward earnings revisions, strong GDP, and strong investor inflows.
Energy (which is still the best performing S&P 500 sector year-to-date), was the worst performer in July as cyclicals gave way to growth stocks. While the S&P 500 gained 2.3%, energy fell 8.4% in July after posting gains for eight consecutive months. Year-to-date, the sector was up 30.3% vs. 17.0% for the S&P 500, but still down 18.3% from 2019, making it the worst performer of any S&P 500 sector over that period. The WTI oil price closed the month marginally higher at $73.68 per barrel ($73.50 per barrel on June 30). The utilities sector bounced back in July and appreciated 4.2% and is up 5.0% year-to-date.
The 10-year treasury retreated to 1.23% at month’s end, down from 1.47% the prior month. It’s quite possible that interest rates may have put in its lows — as higher interest rates pressure growth stocks, value stocks could again emerge as a market leader.
SAM Partners’ Infrastructure Income Portfolio posted its first monthly loss, -1.6% (-1.9% net of fees). All the loss occurred on the last day of the month. Strong outperformance in both utilities and renewables did not offset profit taking in the midstream sector. We remain quite bullish as fundamentals remain very constructive.
Here are some of our overall thoughts:
• Third quarter earnings reports were more of the same and boring. However, boring is good, and we now sound [unapologetically] like a broken record. Midstream earnings were generally aligned with or better than forecast. Across the energy sector, companies are maintaining financial discipline, generating free cash flow, paying down debt, and returning cash to shareholders. It’s a head scratcher. In a market starved for yield, one would think that energy stocks would garner more investor interest.
• Advantage OPEC: Goodbye U.S. energy independence. It’s a bit ironic that the Administration that shutdown the Keystone Excel Pipeline and put in place restrictive oil and gas policies has asked OPEC to produce more oil to combat rising oil prices. What should they have expected? Supply and demand economics dictates that if supply falls faster than demand, prices will rise. If supply falls and demand rises, prices will rise more quickly.
• Inflation generally doesn’t make for good politics. It could make it more difficult to pass expensive clean energy legislation. Most would agree that we need to reduce greenhouse gas emissions. We would argue that the pathway forward should be measured and prudently balance cost and benefits across a reasonable timeframe. Substantial progress to reduce GHG emissions can be accomplished without going “cold turkey” on fossil fuels.
• Delta variant impacting demand. In its August Oil Market Report, the International Energy Administration reduced its forecasted second half demand for oil by 500,000 barrels per day (bpd). July demand fell about 120,000 bpd after increasing by 3.8 million bpd in June, according to the report. Evidently, the Delta variant is impacting oil prices that have been weakening during August.
• Don’t take away my ICE, it’s hot! President Biden signed an executive order in the beginning of August calling for half of all new vehicles sold in the U.S. to be electric by 2030. Currently, EVs represent about 2% of the US market and the transportation sector accounts for 29% of US emissions, the largest of any sector. The auto manufacturers are on board with their own EV targets. Challenges remain daunting such as the need for charging stations, increased power generation (presumably from renewables) and consumer preference. I for one like my internal combustion engine (ICE)!
SAM Partners’ Infrastructure Income Strategy seeks to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality midstream energy companies, utilities, and renewable energy companies. In a world starved for yield, we believe these stocks offer a compelling value proposition. Our Infrastructure Income Strategy offers investors a current yield of ~6% (as of 7/30/21) and growth potential of 3% to 4%. The midstream portion of the portfolio has a sustainable yield of ~7% while utilities and renewables provide yields of 3% and 4%, respectively.