Decarbonization has begun

The energy transition—the world’s efforts to replace fossil fuels with low- carbon energy sources—is well underway. Solar and wind generation now account for over 10% of global power generation, up from effectively zero just 10 years ago. This growth has been catalyzed by declining costs of renewables and broad political and regulatory support to decarbonize.

As part of ongoing decarbonization efforts, more than 70 countries globally have signed Net Zero pledges; these account for roughly 76% of global emissions, according to the United Nations.

Underpinning support for renewable investments are government-backed policies, such as the Inflation Reduction Act, which offers substantial tax credits for renewable development.

EXHIBIT 1

Renewables are cost effective

Estimated costs of generation resources by 2030 ($/MWh)⁽¹⁾

At November 2022. Source: NextEra Energy.
The information presented is for illustrative purposes only and does not reflect information about any fund or other account managed or serviced by Cohen & Steers. There is no guarantee that any market forecast set forth in this document will be realized.
1) NextEra Energy Resources’ estimate, based on current law (i.e. including the expected impacts of the IRA) 2) Near-firm assumes a 4-hour battery to achieve roughly equivalent reliability during peak hours for comparison with dispatchable generation sources 3) Represents all-in cash operating cost per MWh including fuel and ongoing capital expenditures 4) Range assumes $4-$5/MMBtu gas prices 5) Reflects modest CO2 cost consistent with existing state and regional CO2 policies and IOU planning conventions.

As a result, we see an increasing number of infrastructure companies, particularly electric utilities and renewable developers, as beneficiaries of the commercial opportunities the transition offers.

However, ambitious Net Zero timelines will likely not be met

Despite all the tailwinds renewables are enjoying today, we believe 2050 net zero goals are largely unrealistic given grid-reliability and structural supply chain challenges. This delayed energy transition will result in a long, useful life for conventional generation. Specifically, we believe natural gas will remain critically important for home heating and power generation. In essence, the market is understating the cash flow durability of traditional generation.

EXHIBIT 2

Renewables taking share from coal

U.S. Generation Mix

At January 2023. Source: U.S. Energy Information Administration, Annual Energy Outlook 2022.
The information presented is for illustrative purposes only and does not reflect information about any fund or other account managed or serviced by Cohen & Steers. There is no guarantee that any market forecast set forth in this document will be realized.

Investors must therefore strike a delicate balance between investing for the future and appropriately valuing critical fossil-based infrastructure today. It is our belief that traditional energy sources, such as oil and gas, will play an important role for decades to come, as completely shifting to Net Zero would be impractical for a number of reasons.

Challenges associated with the energy transition

• Low and unpredictable capacity factors: A capacity factor is the average output of a generating unit over a period of time. For example, nuclear plants are almost constantly running and thus have high capacity factors (over 90%). The simple truth is that weather patterns such as cloud cover or lack of wind impact the availability of renewables. Renewables therefore run less frequently than conventional generation (and output is unpredictable). Low and unpredictable capacity factors make for less reliable power production. This issue could be solved in the future with long duration energy storage, an investment opportunity that we continue to closely monitor.

• Supply and demand imbalances: The retirement of substantial conventional power generation comes at a time of increasing power demand from the electrification of transportation. Depending on the location, one new electric vehicle is often the equivalent of adding two new houses to the grid. Utilities must strike a delicate balance between decarbonization and also ensuring supply availability.

EXHIBIT 3

Average capacity factor by fuel

At May 1, 2020.Source: U.S. Energy Information Administration.

• Resource availability: Metals such as copper, polysilicon, silver, zinc and lithium are critical in renewable energy and battery storage construction. These scarce resources are often mined in regions that are geopolitically unstable, such as China and Russia. Reaching Net Zero would remove roughly 26 times more rare earth metals than we are using today.
• Durability of political support: Politicians have generally demonstrated strong support for renewables. However, future administrations could potentially be less constructive. In fact, we have seen the Biden administration maintain President Trump’s stringent tariffs on imported solar panels. We also saw the European Union reverse course and include gas and nuclear in the region’s sustainable finance taxonomy.
• Land use: The space needed to construct new resources is another challenge as there are difficulties finding optimal real estate for wind and solar generation.
• Cost inflation risk: Although 1 MWh (megawatt hour) of power generated from renewables is generally cheaper to produce than 1 MWh of power generated from fossil-fuels, there can be higher costs associated with mass adoption of clean energy. The challenges with scale stem from the fact that new generation typically requires new transmission, while existing sites already have transmission in place. Further, since renewables produce power less frequently than conventional generation, the world will need more total generation (megawatts) to support the same level of demand. Although the energy transition will likely be deflationary in the long term, upfront costs to build new resources will ultimately be borne by utility customers.

The prolonged energy transition will create ongoing challenges for companies straddling the line between investing for a low-carbon future while maintaining the infrastructure needed to support traditional energy.

Renewables require at least 10 times as much land per unit of power produced as coal and natural gas.

EXHIBIT 4

Balancing the energy transition

Source: Cohen & Steers.
The information presented is for illustrative purposes only and does not reflect information about any fund or other account managed or serviced by Cohen & Steers. There is no guarantee that any market forecast set forth in this document will be realized.

Investment opportunities in the energy transition

Two subsectors where we see considerable opportunity are electric utilities and midstream energy.

Electric utilities will not only be the largest owners of renewable generation, but they will also be tasked with upgrading the electric grid to accommodate and integrate new energy resources. These concepts—transmission and grid modernization—will create substantial investment opportunities and higher earnings power for the sector.

Indeed, the International Energy Agency’s 2022 five-year forecast for renewable capacity additions increased 30% over its 2021 forecast.

EXHIBIT 5

Substantial renewable generation is coming – 2027 outlook

Renewable capacity addition expectations (gigawatt), 2021–2022

At December 2022.Source: IEA 2022; Renewables 2022;
https://iea.blob.core.windows.net/assets/ada7af90-e280-46c4-a577-df2e4fb44254/Renewables2022.pdf; License: IEA. CC BY 4.0.

Select utilities may also benefit from extending the lives of existing conventional assets. Restarting nuclear reactors in developed nations underlines the point that traditional energy will be part of the longer-term generation solution. Specifically, Germany, France and Japan are assessing whether to extend the lives of their nuclear fleets. We note that the Inflation Reduction Act includes a tax credit for nuclear energy as well as renewables.

Despite the coming renewable buildout, it’s clear, in our view, that there is a long runway for the use of natural gas in both power generation and home heating. In fact, natural gas emits nearly 50% less CO2 than coal.

As a result, midstream energy companies are well positioned to expand
pipeline infrastructure networks, which should provide cash flow certainty for investors. However, the sector should also benefit from opportunities as the
world decarbonizes.

EXHIBIT 6

Pounds of CO2 emitted per million British thermal units (Btu) of energy

At November 20, 2020.Source: U.S. Energy Information Administration.

One opportunity involves the usage and blending of renewable natural gas (RNG)—which is created from biogas—with natural gas streams. Another involves transporting hydrogen through pipelines. These are early days for hydrogen transportation, however, and midstream companies will need to understand how to repurpose their legacy assets to accommodate lower- carbon fuels.

Carbon capture, utilization and storage (CCUS) is an example of a technology that midstream companies are investing in as the world decarbonizes. Specifically, these assets capture carbon dioxide emissions and ensure they do not enter the atmosphere. The carbon is then sent via pipeline to be stored deep underground or utilized and turned into a low carbon fuel. We believe certain midstream companies that are early movers in clean fuel and CCUS are well positioned to participate in growth from the energy transition, while also generating strong cash flows from their existing asset bases.

Finally, in addition to a delayed energy transition, we believe investors will have to directly navigate risks and opportunities associated with climate change. Infrastructure companies will have to strengthen and harden their systems to protect against coming hazards. We believe active managers are best positioned to manage climate risk, and are prioritizing investments in companies that are already taking initiatives to protect their asset base.

Physical risks

Physical risk to existing infrastructure is increasing. Below are examples of hazards that can cause financial hardships, along with the opportunities they present.

Conclusion

The world is undeniably moving toward a lower-carbon economy, but the question that remains is the pace of the transition.

We believe 2050 Net Zero goals are behind schedule, and this will extend the life of fossil-based assets. With that said, momentum is clearly building for renewables with broad political support.

EXHIBIT 7

Governments are focused on the transition

Global government support for the energy transition since 2020 by sector, USD billion

At December 2022. Source: IEA 2022; Renewables 2022; www.iea.org/reports/government-energy-spending-tracker-2/key-findings; License: IEA. CC BY 4.0.

Tax incentives, emerging technologies and increasing consumer demands are all clear tailwinds in the energy transition.

It is critical that politicians and business leaders—along with investors— understand traditional and renewable energy need to work hand-in-hand to solve the world’s energy problems. We believe that cheap, plentiful natural gas and an aggressive ramp-up in renewables are the foundation for the world’s energy supply.

There is a place in the market for both the renewable developers, who will benefit from the growth that the transition offers, and the owners of conventional resources that will generate strong and durable cash flows for investors.