Infrastructure is an enabler

Infrastructure provides heat, power, mobility, clean water, waste treatment and digital connectivity - all services that underpin a functioning society. It also has the potential to enable change: to improve livelihoods, reduce inequality, improve productivity and support environmental outcomes. When there's a societal imperative, infrastructure can provide the foundation for it to be achieved.

This is particularly true of our response to climate change. Economies must fully decarbonise globally by 2050 to give a reasonable chance of keeping the temperature rise below 1.5 degrees by the end of the century. This goal is a firm policy objective in many countries, including the UK and the EU.

The role of infrastructure in the transition

Using the UK as an example, infrastructure accounts for around 54%¹  of total annual emissions. The emissions that come from the construction and operation of infrastructure assets (capital and operational carbon, respectively) represent around 13% of the total. But by far the largest component, making up the remaining 41%, are emissions arising from using infrastructure - referred to as user carbon.

The carbon footprint of each business and citizen in the economy is highly dependent on the emissions intensity of the infrastructure they use - that is, the energy and physical resources they use, the data they consume, and the transport options available to them. Significant improvements have been made to the emissions intensity of some sectors since 2010. The energy and waste sectors, in particular, have been subject to ambitious policy packages over this period.

But progress isn't fast enough and other sectors like transport lag behind. The choices and behaviours of individuals can help, but without accelerated decarbonisation of the infrastructure services on which we all rely, the 2050 target will be hard to meet.

Without accelerated decarbonisation of the infrastructure services on which we all rely, the 2050 target will be hard to meet

Mobilising investment in the transition

This is a theme that came out strongly in the recent independent review of the UK's net-zero policies² and one that is central to the EU's Green Deal package³. An estimated £40 billion of annual investment in infrastructure is required over the next decade if the UK is to meet its net-zero commitment⁴. Across the EU, this figure is approximately €737 billion per year to 2030⁵.

These are substantial numbers that require unprecedented collaboration between policymakers and investors. Infrastructure assets are characterised by long construction lead times and decades-long operational lifetimes. If such investment is to be mobilised quickly and successfully, investors need a policy mix that provides sufficient confidence in long-term revenues and returns. This capital is required to develop new low-carbon infrastructure, but also to invest in decarbonising and repurposing existing assets that can play a role in the transition.

Many traditional infrastructure assets are inconsistent with the net-zero transition and lack a viable plan. In other words, high user carbon is locked in. For these assets, the clock is ticking on their functional life in the face of increasing carbon pricing, regulation and shifting customer sentiment.

Conversely, assets that are aligned with the transition and support reductions in user carbon will attract stronger policy support. This means they will not face the same functional obsolescence over time. As a result, they are likely to support stronger returns for investors over the long term.

Our role in the transition

We focus on small- and mid-market assets where we are either the majority shareholder or the significant minority partner, and we always have board representation. Small- and mid-market assets represent the majority of infrastructure assets - many utilities, energy generation, and fibre assets fall into this category. We take a long-term view that allows us to assess each asset's role in the low-carbon transition. And we position these assets to benefit from opportunities to create value. Our level of influence and proactive approach to asset management mean we can drive real change in this respect.

For example, alongside our investments in operational renewables in Poland and Norway, our Finnish utility Auris Energy has a strategy to phase out the supply of fossil-gas entirely by 2040. Additionally, our North Sea gas asset Noordgastransport has recently gained technical approval to transport hydrogen produced from offshore wind where the laying of electrical cables is not economical. In both cases, assets are being repositioned to support the low-carbon transition and to drive much-needed reductions in user carbon for their customers and the wider economy.

The vital role that infrastructure must play in enabling the low-carbon transition is clear. We believe our approach to proactive, long-term, direct infrastructure investment presents a unique opportunity to support the net-zero journey.

Author: Ruairi Revell, Head of Sustainability - Infrastructure

The "US equity market performance this year can broadly be characterised as a dash for trash," Bespoke declared on Feb 3. Our own analysis of ASX micro-to-mids shows a similar trend - CY2022 losers are now the winners, as are stocks on higher multiples. A case for higher cash rates was charted by Charles Schwab even as Moody's showed inflation is slowing in some countries. FactSet calculated that the decline in the bottom-up EPS estimate recorded during the first month of the first quarter was larger than the 5, 10 and 20 year averages. This follows S&P 500 Q4 GAAP earnings falling 13% year-over-year, as Creative Planning charted. Behind the earnings, JP Morgan found the strongest consensus for a US recession on record. Folkelore Ventures published data on the tough year that was 2022 for Australian VC. In the tech sector we have Apple & Microsoft trading above their 10-year average EV/EBITDA multiples while Google/Alphabet and Meta/Facebook are now below average. JP Morgan reckons households have been deploying into equity and bond funds in early 2023 after underinvesting in 2022. Crypto assets lost $US1.5 trillion in capitalisation says ARK. Finally, we take a look at corruption hot spots via Statista.

Russell 1000 Decile Analysis: CY2023-to-date % change

Source: Bespoke

ASX Micro-to-Mids - "Financial, Industrial & Technology" (FIT) factor performance in CY2023-to-date

Source: Equitable Investors

Proxy Fed Funds Rate

Source: Charles Schwab

Year-on-year inflation is slowing in some countries

Source: Moody's

Change in S&P 500 Quarterly EPS: 1st month of quarter

Source: FactSet

S&P 500 As Reported (GAAP) EPS Growth (Year-on-Year %)

Source: Creative Planning. @CharlieBilello

Survey of Professional Forecasters US Recession Probability

Source: Pitchbook, Morningstar, @macroalf

Australian Venture Capital raisings by number and amount

Source: Cut Through Venture, Folkelore Ventures

Forward EV/EVITDA multiples over 10 years for tech leaders

Source: TIKR, Equitable Investors

Global equity & bond fund flows

Source: JP Morgan

~$US1.5 trillion wiped out in crypto market capitalisation in 2022

Source: ARK Investment Management

Perceived public sector corruption in 2022

Source: Statista, Transparency International

February Edition

The Australian ESG world was sent into a flurry by changes to the Safeguard Mechanism and Australian Carbon Credit Units (ACCUs) that were proposed in January. The Safeguard Mechanism was put in place in 2016 as part of the Emissions Reduction Fund. It essentially set emissions limits (baselines) for high-emitting industrial facilities across Australia and required facilities to buy carbon credits to compensate for any emissions in excess of that baseline. The scheme covers more than 200 individual facilities, each of which emits more than 100 000 tonnes of carbon equivalents per year. These Safeguard Facilities generate almost 30% of Australia's total emissions between them and many are owned by some of Australia's biggest listed companies including BHP, Rio Tinto, BlueScope Steel, Santos, Woodside Energy, Orica, and South32.

Last year, when the new Federal Government made a commitment - and legislated - to reduce national emissions 43% by 2030 and reach net zero by 2050, it flagged the need to strengthen the Safeguard Mechanism which would continue to encourage Australia's largest emitters to reduce emissions. The Government finally released its position paper in January which proposed changes to the scheme. Although many expected this would be the final say on the changes, the Government has committed to one more round of feedback (due 24 February), before final changes will come into force on 1 July 2023.

There are a number of key changes to the scheme which may mean many companies will exceed their baselines at a facility level (at least initially), however, this will be more of an issue for companies which have most of their operations in Australia. The Safeguard Mechanism will have less of an impact on companies like BHP, that operate globally, since the facility level impact will be diluted at the group level.

Changes to the scheme

A few important changes to be aware of:

• Safeguard Mechanism facilities can no longer generate ACCUs: Historically, the scheme allowed companies to generate ACCUs for activities which promote carbon abatement. These ACCUs were then sold to the Government or into the market, and essentially helped fund energy efficiency projects. Now, Safeguard Facilities can no longer generate ACCUs. Safeguard Facilities which reduce emissions below their assigned baselines will instead be allocated Safeguard Mechanism Credits (SMCs) which they can either bank and use later, sell to another safeguard facility, or use to meet a baseline at another of its facilities. Any existing contracts with the Government would still be valid. The paper states that "it doesn't make sense to allow projects that reduce regulated emissions to generate offsets". We agree with this statement, and support the overall aim to improve the credibility of ACCUs, however we do have some concerns that introducing another crediting system is going to introduce complexity in pricing and trading.
• Baselines will decrease by 4.9% year-on-year and be set based on industry averages:
  • The Government intends to retain the existing production-adjusted (intensity) baseline framework, which allows baselines to grow and fall with production. However, baselines will now be set using a "hybrid approach". Initially, baselines will be tilted towards the historical site-specific emissions, but as 2030 approaches baselines will move towards industry averages. Baselines for any new facilities will be set based on international best practice.
  • Baselines will reduce 4.9% per annum from the industry average. This means that reductions of more than 4.9% will be required for some companies to meet the baseline if the current emissions are above industry average.

For example, the graph below shows the change to the baselines for Bluescope Steel's Port Kembla asset. Assuming its production remains largely consistent, there would be a 14% difference between emissions at the facility and the baseline requirements in 2030.

Source: Credit Suisse

• Lots of flexibility in the scheme: Recognising that emissions pathways are rarely linear, the scheme builds in a lot of flexibility so companies will be able to meet their compliance requirements without being unfairly impacted at any particular point. For example, unlimited banking of SMCs would be allowed to 2030. Borrowing of up to 10% of the baseline each year would also be allowed to 2030. Finally, multi-year monitoring periods up to 2030 would be available, whereby a facility that has exceeded its baseline emissions due to a lack of available technology, but has a firm and credible plan in place to reduce cumulative emissions before the end of the five year period, has room to move. There is also a proposed penalty for facilities which don't meet the compliance requirements, although we believe it is unlikely that this will be imposed on many companies when it will likely be much cheaper just to buy ACCUs or SMCs.
• Trade-exposed industry facilities (known as IETE) can apply for special considerations: 80% of companies under the scheme are considered to be trade exposed. If the cost impact of buying ACCUs/SMCs is more than 3% of revenues at a facility level, these companies can apply for funding support and a baseline adjustment to reduce the pace of baseline decline to 2% instead of 4.9%. The Government has also allocated some funding for these companies to support emissions reduction initiatives.
• ACCUs issued by the Government will be capped at $A75/tonne: This cap does not apply to ACCUs bought and sold in the broader market or to SMCs traded between facilities. For context, at the time of writing, ACCUs cost about half that amount, and their equivalents were trading at ~€85 ($A130) in Europe and ~$US80 ($A110) in California. It is envisaged that these credits would be purchased by Safeguard Facility companies that exceed their baselines and need credits (ACCUs or SMCs) to meet their compliance requirements. This cap will be reviewed in 2026-27. There has been no comment on the pricing structure for SMCs. There has also been no commitment from the Government that it will ensure there will be sufficient ACCUs to service all the facilities which need them. This means it is possible there will be a third pricing structure consideration for companies that buy ACCUs from the wider market, rather than from the Government.

Stock implications

Most companies under this scheme will be impacted in some way. However, we expect that companies with concentrated assets in Australia that are also considered 'hard to abate' will be most negatively impacted. For example, the following potential impacts for Bluescope (BSL), Adelaide Brighton (ABC) and Woodside (WDS) have been estimated by Credit Suisse:

• BSL would need to reduce its emissions at its Port Kembla steel-making facility by 42% to meet the new 2030 baseline. The potential cumulative cost for carbon credits is $712 million (assuming the company meets its existing climate targets and the price of credits is $75/tCO2e). At 2025, assuming production stays the same, the potential EBITDA impact could be 9.5%.
• ABC would need to reduce its emissions at its Cockburn and Birkenhead cement-making facilities by 28% to meet the new 2030 baselines (Dongara is excluded from this assessment). Assuming a $75/tCO2e carbon price, the potential cumulative cost could be $109 million. At 2025, assuming production stays the same, the potential EBITDA impact could be 10%. The potential cumulative cost to buy carbon credits between now and 2030 is $89m
• WDS would need to reduce its emissions at two facilities by 68% to meet the new 2030 baselines, and there is a potential cumulative cost of $384 million assuming the company meets its existing climate targets and the price of credits is $75/tCO2e. The EBITDA impact in 2025 however is only expected to be 0.3%.
• These companies could all be eligible for the IETE funding/baseline adjustment, however most modelling that we have seen estimates the cost impact would be less than 3% of revenue.

The changes to the ACCU rules could also have potential implications for Santos (STO) and its Carbon Capture and Storage development at Moomba. As far as we are aware, Santos was not able to secure a contract to sell ACCUs to the Government last year which means that under this new rule, it will not be able to sell ACCUs at all. It may be able to generate and sell SMCs instead, however this has not been confirmed.

Companies with ambitious emissions reduction targets and programs in place may benefit from the scheme changes. For example, Credit Suisse has estimated that Fortescue Metals Group (FMG) may be able to generate and sell SMCs between now to 2030 for $129 million (assuming a $75/tonne price consistent with ACCUs) if they meet their stated decarbonisation targets.

Summary

The changes support the Australian Government's commitment to reduce national emissions by 43% by 2030 however we expect that there will need to be further broad regulatory efforts to reduce Australia's emissions. A number of elements in the scheme will be reviewed again in 2026/27, including the ACCU price cap and baseline reduction rates.

At a company level, we expect that the cost impact will be most material for companies whose revenue-generating assets are primarily in Australia. Companies with global operations will have a smaller overall impact because the cost to purchase ACCUs or SMCs will be diluted at the group level.

Some companies may also generate SMCs if emissions are below the facility baseline. These companies can then either bank them for later years, use for compliance at other facilities, or sell these SMCs to other companies that need them for compliance.

Although the $75/tonne cap gives some certainty on pricing for Government-held ACCUs, there are still many questions about the price for non-Government held ACCUs and SMCs, and the trading mechanism for SMCs.

At this stage, all of the above changes are proposed and yet to be confirmed. However, given the amount of consultation that has taken place to date, we expect that the reform won't change materially between now and when it goes live on 1 July 2023.

Author: Jessica Cairns, Head of ESG & Sustainability

This information is for advisers & wholesale investors only.

Strange Bedfellows - Super cycle in renewables and oil & gas

The super cycle in renewables is in full flow and, perversely, oil and natural gas will remain a beneficiary until sufficient new renewable capacity is created.

The current renewable energy solutions of solar and wind are estimated to be some 10 times more metals intensive then the fossil fuel plants they are replacing. The life cycle of the current renewable solutions are substantially less than a typical coal or nuclear power station which last 30-50 years. The critical minerals required for global decarbonisation include rare earths, lithium, cobalt, copper and nickel. The world currently does not have sufficient reserves to fulfill the net-zero aspiration. Therefore, we expect prices will remain elevated, with Australia in a pivotal position given our resources inventory to help deliver on the energy transition (refer Tyndall's ESG Insights: The value in securing critical minerals).

Oil development is down substantially, with cashflow from the major integrated oil and gas companies spent on buybacks, natural gas and renewable projects like solar, wind and hydrogen. Shareholder activism and government pressure have contributed to oil producers reducing capex and development spend. Traditionally, there has been a tight relationship between oil prices and drilling/development. This relationship appears to be broken, and even in the short cycle unconventional prospects onshore in the USA, companies are drilling less despite the attractive economics.

Given oil reservoir production typically depletes by 10-15% p.a., there appears to be a substantial supply gap going forward, despite demand decreasing. Norwegian oil and gas consultant - Rystad, estimate that 61m barrels of oil per day need to be developed by 2030 when using the 1.7-degree scenario (refer Figure 1).

Figure 1: Demand for oil outstrips supply

Source: Rystad

The three horseman of the apocalypse — energy, interest rates and labour cost

Increasing energy, interest rates and labour costs are substantial headwinds for many companies and as margins continue to come under pressure, we expect downgrades throughout 2023. Labour pressures are being felt in both wages and from the global impact of apparent labour shortages. Given this is felt across various sectors, it is difficult to envisage a short-term fix outside of a substantial economic downturn.

The impact of monetary policy tends to lag by 12-18 months, meaning the Australian economy is yet to feel the full impact of tightening monetary policy. Full employment and an above-average savings rates have softened the impact. The wealth impact of housing weakening further in 2023 will eventually put the brakes on consumption. The canary in the coal mine during slowdowns driven by interest rates is normally a discretionary consumer pullback. Consumer discretionary sales currently remain high with little evidence of pain felt by retailers. We expect commentary in the February 2023 reporting season may provide some early signs of both margin and top line growth pressures.

The combined impact of the materially higher cost inputs of energy, interest rates and labour should become clear over 1Q 2023. Margins are currently at high levels, and we expect pressure, particularly in companies and industries that have little pricing power to fight the inflationary forces. We see little respite in energy and labour outside of government intervention, whereas interest rates may roll over when Central Banks consider they have the inflation under control.

Be prepared for the profit downgrades.

China — exiting COVID Zero

The changes observed over the past 20 years of visiting China have been incredible given the combination of a growing middle class and high annual GDP growth. The Chinese Communist Party (CCP) is cautious to not upset the mass population. This is in contrast to an outsider's view which tends to believe China's people are frightened of the CCP. The catalyst for the recent COVID pivot from the CCP over COVID restrictions were the large demonstrations, often violent across China, from citizens frustrated by the restrictions. Interestingly, western governments ignored and, at times, violently pushed back on similar demonstrations. The CCP has now relented and recently announced 10 optimisation measures that mark the tipping point of the country's economy reopening.

Therefore, in 2023 we are likely to see China go through a typical reopening phase similar to what we have observed across most western countries, resulting in consumption and GDP increasing. Australia may be a beneficiary of China reopening as consumption and demand increase. Both services and materials demand will rise, with oil and natural gas being a notable beneficiary.

Recession risk rears its ugly head

The aggressive tightening of global monetary policy aimed at slowing the economy is likely to move many countries into recession territory. It appears to be a fait accompli that Europe and the UK will dive into recession, and the debate is still ongoing on whether the USA will dip into negative GDP growth. Australia has the benefit of the world desiring its resources and agricultural products, and thus the probability of a recession appears lower, albeit in many ways this is just semantics given a slowdown is coming.

Inflation and interest rates — the return of the "old normal"

Inflation will reduce as COVID supply chain issues and the Ukraine war impacts alleviate. However, inflation will remain stubbornly higher compared to the past 10 years given obvious structural changes including labour shortages, persistent supply chain disruption and constrained supply of some goods. Technology innovation and productivity will need to accelerate to offset these pressures. Demographics, meanwhile, are negative for many countries, with a slowing population, particularly within advanced countries including China. Australia benefited prior to COVID with strong immigration but, overall, the combination of increasing demand (consumers) and decreasing supply (workers) is not great arithmetic. Global demand for labour currently is high.

We hope central bankers have learnt their lesson, given they kept monetary policy too low for too long and entered COVID with very low interest rates. It is difficult to envisage interest rates being that low outside of an emergency, meaning higher interest rates are here to stay.

The net result is that higher interest rates and inflation imply that long duration assets should further derate.

Getting deglobalisation right

Globalisation, together with China essentially selling deflation to the world over the past 20 years, will pause and perhaps even retreat. Companies and countries have recognised that relying on single supply chains or countries is risky. COVID and the Ukraine War have illustrated these risks, and we are starting to see governments develop plans to mitigate these risks.

In one example, new chip manufacturing plants are being built in the US and governments are helping to fund the critical minerals required for the pathway to net zero. Additionally, the Australian Government provided an AU$1.2b non-recourse debt facility to Iluka Resources to help fund their rare earths processing facility in West Australia. This was unprecedented for the Federal Government and illustrates how countries are viewing the access to reliable and secure supplies of critical minerals.

Most recently, the US passed the Inflation Reduction Act of 2022 (IRA), which directs nearly US$400b in federal funding to clean energy, with the goal of lowering carbon emissions by the end of the decade. There are strings attached, with many of the IRA tax incentives requiring domestic production, domestic procurement requirements or from a country with a free-trade agreement. Australia could be a beneficiary of this given our relationship with the US, which includes a Free Trade Agreement.

The bottom line is that deglobalisation is inflationary and will continue placing pressure on inflation for many years to come.

Value investing makes a big comeback

Tyndall has always viewed value investing as a philosophy rather than a factor. Our process has always aligned with the approach from Benjamin Graham, the father of value investing. Tyndall values companies based on their sustainable earnings capacity. We determine the intrinsic value by capitalising the sustainable or mid-cycle earnings of every stock under coverage. At its core, value investing is buying companies that are trading below their assessed net worth, maintaining a disciplined and patient approach.

The valuation gap between growth and value remains at extraordinarily high levels despite a recent narrowing (refer Figure 2 & 3). The tailwinds for growth post the GFC are unlikely to return anytime soon. Higher inflation and interest rates are here to stay, and thus we expect the elevated valuations still being priced for growth will derate further. A disciplined and bottom-up valuation approach will deliver alpha during these times.

Figure 2: High PE firms trade at a 75% premium to the market - well above historical averages. US LNG capacity forecasts

Source: Goldman Sachs

Figure 3: Value on track to outperform over the next few years

Source: MSCI

Author: Brad Potter, Head of Australian Equities