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- [00:01]
Michelle Weaver
Welcome to Thoughts on the Market. I'm Michelle Weaver, US thematic and equity strategist at Morgan Stanley.
- [00:07]
Devin McDermott
I'm Devin McDermott, head of Morgan Stanley's North America Energy team.
- [00:10]
Mike Camfield
And I'm Mike Camfield, head of the Europe's sustainability team.
- [00:14]
Michelle Weaver
This is the second episode of our special miniseries Big Debates where we cover key investment debates for 2025. Today we'll look at where we are in the energy transition and some key investment opportunities. It's Monday, January 13th at 10am in.
- [00:29]
Mike Camfield
New York and 3pm in London.
- [00:35]
Michelle Weaver
Since 2005, U.S. carbon emissions have fallen by about 15%. Nearly all of this has been tied to the power sector. Natural gas has been displacing coal. Renewable resources have seen higher penetration. When you look outside the power sector, though, progress has been a lot more limited. Let me come to you first, Devon. What is behind these trends and where are we right now in terms of the energy transition in the US over.
- [01:00]
Devin McDermott
The last 20 years? Now it's actually been a pretty steady Trend for overall U.S. emissions. There's been gradual annual declines ratcheting lower through much of this period. There was really two primary drivers. The first is the displacement of coal by natural gas, which has driven about 60% of this reduction over the period. And the remainder is higher penetration of renewable resources which which drive the remaining 40%. And this ratio between these two drivers, net gas displacing coal, renewables, adding to the power sector really hasn't changed all that much. It's been pretty consistent even in this post Covid recovery relative to the 15 years prior. Outside of power there's been almost no progress and it doesn't vary much depending on which end market you're looking at. Industrial emissions, manufacturing, pechem, all relatively stable. And then the transport sector, which for the US in particular relative to many other markets in the rest of the world is a big driver, transport, a big driver of emissions. And there it's a mix of different factors, the biggest of which though driving the slow uptick in alternatives, is the lack of viable economic options to decarbonize outside of fossil fuels and the fact that in the US specifically there is a very abundant low cost base of natural gas, which is a low carbon, the lowest carbon fossil fuel, but still does have carbon intensity tied to it.
- [02:16]
Michelle Weaver
You've also argued that the domestic natural gas market is positioned for growth. What's your outlook for this year and beyond?
- [02:23]
Devin McDermott
The Natural gas market has been a story of growth for a while now, but these last few years have had a bit of a Pause on major expansion from 2010 to 2020, that's when you saw the biggest uptick in natural gas penetration as a portion of primary energy. In the US the domestic market doubled in size over that 10 year period. And you saw growth in really every major end market. Power and decarbonization there was a big piece of it. But the US also transitioned from a major importer of lng, which stands for liquefied natural gas, to one of world's largest exporters by the end of last decade. And you had a lot of industrial and petrochemical growth which uses natural gas as a feedstock. Over the last several years globally, gas markets have faced a series of shocks, the biggest of which is the Russia, Ukraine conflict and Europe's loss of a significant portion of their gas supply, which historically had come on pipelines from Russia to replace that. Europe bought a lot more. LNG drove up global prices. And in response to higher global prices, you saw a wave of new project sanctioning activity around the world. The US is a key driver of that expansion cycle. The US over the next five years will double, roughly double, I should say, its export capacity. And that is an unprecedented amount of volume growth domestically as well as globally and will drive a significant uptick in domestic consumption. So that the additional exports is pillar number one. And pillar number two, which I'd say is more of an emerging trend, is the rise of incremental power consumption. For the last 15 years, US electricity consumption on a weather adjusted basis has not grown. But if you look out at forecasts from utilities, from various market operators in the country, you're now seeing a trend of growth for the balance of this decade and beyond tied to three key things. The first is onshore grid manufacturing. The second is power demand tied to data centers and AI. And the third is this broader trend of electrification. So a little bit from EVs, more electric appliances, which fit into this decarbonization theme more broadly, we're looking at now an outlook, this is our base case of US electricity demand growing at just shy of 2% per year over the next five years. That is a growth rate that we have not seen this century. And natural gas, which generates about 40% of US power today, will continue to be a key player in meeting this incremental demand. And that becomes then a second pillar of consumption growth for the domestic market.
- [04:50]
Michelle Weaver
And we're coming up on the inauguration here and I think one really important question for investors is what's going to happen to the energy sector and to renewables when Trump takes office. What are you thinking here?
- [05:03]
Devin McDermott
Yes, well, the policy that supports renewable development in the U.S. wind and solar specifically, has survived many different administrations, both Republican and Democratic. And there's actually several examples over the last 10 to 15 years of Republican controlled Congress extending both the production tax credit and investment credit for wind and solar. So our base case is no major change on deployments, but also unlikely to see any incremental supportive policy for these technologies. Instead, I think the focus will be on some of the other major themes that we've been talking about here. One, there's currently a pause on new LNG export permits under the Biden administration that should be lifted shortly post Trump's inauguration. Second, there are greenhouse gas intensity limits on new power plant and existing power plant construction in the US that will likely be lifted under the incoming Trump administration. So gas takes a larger share of incremental power needs under Trump than it would have under the prior status quo. And then lastly, consistently over the last few years, penetration of electric vehicles and low carbon vehicles in general in the United States have fallen short of expectations. And interestingly, if you look at just the composition of new vehicles sold in the US over the past years, nearly 2/3 were SUVs or heavier light duty vehicles. That offsets some of the other underlying trends of some uptick in EV penetration. Under the prior Trump administration there was a rollback of initiatives to improve the fuel economy, both light duty and heavy duty transport. I would not be surprised if we see that same thing happen again, which means you have more longevity to gasoline, diesel, other fossil based transport fuels which kind of put this all together. Significant growth for natural gas that could accelerate under Trump. More longevity to legacy businesses like gasoline and diesel for these incumbent energy companies is not a bad backdrop. Trade still at double its historical discount versus the broader market. So not a bad setup when you put it all together.
- [07:01]
Michelle Weaver
Great. Thank you Devin. Mike, New policies under the second Trump administration will likely have an impact far beyond the US and with a potential withdrawal of the US from the Paris Agreement and increased green hushing, many investors are starting to question whether companies may walk back or delay their sustainability ambitions. Will decarbonization still be a corporate priority or will the pace of the energy transition in Europe slow in 2025?
- [07:32]
Mike Camfield
Yeah, that's the big question. The core issues for EU policymakers at the moment include things like competitiveness, climate change, security, digitalization, migration and the cost of living. At the same time, Mario Draghi highlighted in his report entitled the Future of European Competitiveness and that there are three Transformations Europe has to contend with to become more innovative and competitive to complete its energy transition and to adapt to a backdrop of less stable geopolitics where dependencies are becoming vulnerabilities, to use his phrase. We do still expect that EU's direction of travel on things like the fit for 55 goals, its targets to address critical mineral suppliers and the overall net zero transition to remain consistent. And the UK's Labour Party has advocated for Clean Power 2030 goals of 95% clean generation sources. At the same time, it's fair to say some commentators have pointed to the higher regulatory burden on EU corporates as a potentially damaging factor in competitiveness, suggesting that regulations are costly and can be overcomplicated, particularly for smaller companies. While we've already had a delay in the implementation of the EU's deforestation regulation, some questions do remain over other rules, including things like the Corporate Sustainability Due Diligence Directive and the design of the Carbon Border Adjustment Mechanism, or cbam. We're closely watching corporates themselves to see whether they'll reevaluate their investment plans or targets. One example we've actually already seen is in the metals and mining space where decarbonisation investment plans were adjusted because of inadequate green hydrogen infrastructure and policy concerns such as the effectiveness of the cbam. It does remain committed to its long term and net zero goals, but the company has acknowledged that practical hurdles may delay achievement of its 2030 climate ambitions. We wouldn't be surprised to see other companies take an arguably more pragmatic and inverted commas approach to their goals, accepting that technology, infrastructure and policy might not really be ready in time to reach 2030 targets.
- [09:29]
Michelle Weaver
Do you believe there are still areas where the end markets will grow significantly and where companies still offer compelling opportunities?
- [09:37]
Mike Camfield
Yeah, absolutely. We think sustainable investing continues to evolve and that as with last year, stock selection will be key to generating alpha from the energy transition. We do see really attractive opportunities in enabling technologies across decarbonization, whether that's segments like grid Transmission and distribution or in things like Industry 4.0. We recommend focusing on companies with clear competitive moats and avoiding the relatively commoditized areas, as well as looking for strong pricing power and those entities offering mission critical products or services for the transition. We do anticipate a continued investment focus on data center power dynamics in 2025. With cooling technology increasingly a topic of investor interest beyond the power generation component, the urgent need for investment in everything from electrical equipment to grid technologies, smart grid software and hardware solutions and even cables is now increasingly apparent. We expect secular growth in these markets to continue apace in 2025. Within Industry 4.0, we do think adoption of automation, robotics, machine learning and the industrial Internet of things is set to grow strongly this year as well. We also see further growth potential in other areas like energetic modernization in buildings, climate resilience and the circular economy.
- [10:47]
Michelle Weaver
And with the current level of policy uncertainty, has enthusiasm for green investing or the E environmental pillar of ESG declined?
- [10:57]
Mike Camfield
I think evolved might be a fairer expression to use than declined. Certainly reasonable to say that performance in some of the segments of the E pillar has been very challenging in the last 12 to 24 months with the headwinds from geopolitics, from the higher interest rate backdrop and inflation. At the same time, we have seen a transition towards improver investment strategies and they're continuing to gain in popularity around the world as investors recognize that often the most attractive alpha opportunities are in the momentum or direction of travel rather than simple so called positive screening for existing leaders in various spaces. To this end, the investors that we speak to are often focused on things like capex trends for businesses as a way to determine how companies might actually be investing to deliver on their sustainability ambitions beyond those traditional E areas like renewables or electric vehicles. We have therefore seen investors try to diversify exposures, so broadening out to include things like the transition enablers, the grid technologies, H Vac, that's heating, ventilation and cooling products, supporting energy efficiency in buildings, green construction and emerging technologies, even like small modular nuclear reactors alongside things like industrial automation.
- [12:06]
Michelle Weaver
And given this evolution of the E pillar, do you think that creates an opportunity for the S or G the social or governance components of esg?
- [12:15]
Mike Camfield
We do think the backdrop for socially focused investing is very strong. We see compelling opportunities in longevity across a lot of elements, things like advanced diagnostics, healthier food, as well as digitalization, responsible AI, personal mobility and even parts of social infrastructure. So things as basic as access to water, sanitation and hygiene. One topic we as a team have written extensively on in the last few months is preventative healthcare, for example. So while current health systems are typically built to focus on acute conditions and react to complications with pharmaceuticals or clinical care, a focus on preventative care would at its most fundamental, address the underlying causes of illnesses to avoid problems from arising in the first place. We argue that the economic benefits of a more effective health system are self evident, whether that's in terms of reducing the overall burden on the system, boosting the workforce or increasing productivity. Within preventative healthcare, we point to fascinating investment opportunities across innovative biopharma things like smart chemotherapy, for example, alongside solutions like integrated diagnostics, effective use of AI, and sophisticated telemedicine advances, all of which are emerging to support healthy longevity and a much more personalized targeted health system.
- [13:28]
Michelle Weaver
Devin and Mike, thank you for taking the time to talk and to our listeners, thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen to the show and share the podcast with a friend or colleague today. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.