Clean electricity: a vital first step towards net zero

In today’s low spread environment, there is less room than ever for stranded assets.² Yet, in the global shift towards clean energy, some companies are being left behind. The International Energy Agency (IEA) argues that clean electricity is the first step towards net zero. In light of this, should investment grade portfolios focus their attention on this sector?

The IEA’s special report, Net Zero by 2050: A Roadmap for the Global Energy Sector, sets out the need for electricity generators to eliminate emissions and envisages a dramatic shift towards renewables.³

Like the IEA, we see clean electricity as a key enabler of net zero by 2050. We also believe that investors can reduce transition risk in their portfolios by investing in electricity generators with low carbon intensity, or with plans approved by the Science Based Targets initiative (SBTi).⁴

Figure 1 suggests that a reduction in heat and electricity emissions this decade will act as an important first step in allowing industry and transport to decarbonise. Intuitively, this makes sense.

There is no point moving from gas-burning vehicles to electric vehicles if consumers are burning fossil fuels to charge car batteries. 

It is also worth noting that, over time, more companies are issuing sustainability-linked bonds. To meet the key performance indicators associated with these, issuers are having to source increased amounts of clean energy.

In our view, this confirms the pivotal role that electricity generation (a material emitting sector under the Net Zero Investment Framework) will play in starting the transition toward net zero, and explains why this sector requires investor focus.

The pace of change

Although the electric utility sector has traditionally been slow to change, we believe the pace of transition going forwards could surprise investors.

The IEA’s roadmap to 2050 envisages radical growth in the proportion of energy generated by renewables. As shown in Figure 2, renewables will need to increase from 12% of global energy production in 2020 to 31% in 2030, effectively at the cost of oil- and coal-powered generation.

The IEA also predicts that advanced economies will decarbonise the electricity sector by 2035, in line with strong commitments from governments (including President Biden’s target to decarbonise power in the US). Developing economies will follow by 2040, the IEA suggests.

We believe this rate of change will allow a meaningful reduction in the level of carbon intensity within the utility sector – a pre-requisite to the decarbonisation of other industrial sectors.

As clients align their investment grade credit portfolios with net zero, decreasing the carbon intensity of their allocation to the electricity sector will become increasingly important. The Towards Sustainability initiative has created a glide path for emissions reduction (Figure 3), proposing a maximum of 393gCO2/kWh in 2021.⁵ It tapers this maximum over time, arriving at 315gCO2/kWh by 2025.

Separately, we note that the European Union Taxonomy is proposing a much stricter target of 100gCO2/kWh, tapering down every five years to reach zero by 2050.⁶

Given the rapid shift towards renewables, we believe the carbon intensity of all electricity producers should be falling. As such, it makes sense to screen heavy emitters along these lines. As well as aligning with net zero, low emitters are less likely to face the capital expenditures associated with modernising their generation capabilities. They are also less likely to suffer the losses associated with stranded assets.

Assessing progress

As net zero commitments are long-term in nature, they are easy for management teams to promise, but much harder to deliver.

Tools like the Transition Pathway Initiative (TPI) can help us understand how issuers plan to decarbonise over time. Likewise, setting a science-based emissions reduction target can be an important first step.⁷ If the SBTi approves an issuer, confirming its compliance with a 1.5°C framework, we believe the issuer merits inclusion in net zero-aligned portfolios.⁸

Clearly, such a stringent approach will reduce the investible universe within the electricity sector. However, we believe this approach is appropriate for two main reasons. Firstly, the most radical reductions in emissions will likely be achieved in this sector over the next decade. Secondly, a greener electricity sector will facilitate the decarbonisation of other industrial sectors in the decades that follow.

Our approach

Numerous factors are incorporated into a decision to invest in a fixed income portfolio: fundamental credit quality; ESG credentials; net zero alignment; and climate change exposure. Investors cannot adopt a one size fits all approach.

IFI closely monitors ESG risks across its portfolios, particularly in the rapidly evolving net zero alignment space. Our well-resourced, experienced credit team is important in assessing the issues raised here and informs our investment decisions.

We seek to ensure that credit spreads adequately reflect downside risks, including ESG factors. Where this is not the case, at-risk names are avoided.