This is Dana Perkins and you're listening to Switched on the podcast brought to you by BNF.

Back in twenty twenty three, BNAF released its inaugural report on Energy Supply Investment and Bank financing Activity.

We introduced a series of ratios to highlight the volume of bank financing to low carbon technology when compared to fossil fuels.

Is a ratio format proved to be a game changer, with multiple financial institutions either adopting or creating a ratio of their own.

Today we discuss our latest metric, the Energy Supply Fund enabled CAPEX ratio.

It's a bit of a mouthful, so we'll refer to it as the ESFR for short for the rest of the show.

Note this ratio focuses on climate alignment of investment portfolios, focusing on specific products and institutions.

In the report, the team analyzed over sixty seven thousand credit equity and multi asset funds.

They looked at the capital expenditure enabled for energy supply activities and created a ratio, which we'll talk about later in the show, and we'll also discuss where that ratio might be going.

We also looked at the regional picture, with North American funds enabling the largest amount of energy supply capex in terms of volume, but their ESFR significantly lags behind Europe and China.

We'll also get into a discussion around private markets.

We're playing an increasingly important role in capital deployment to low carbon energy assets, but with little publicly available data, how large could the ratio be for some of these funds.

To learn more about esfrs today, I'm joined by finance and Investment associate Ryan Lockhead.

He discusses the report Energy Supply Fund Enabled Capex Ratio.

BNF clients can find it alongside its accompanying interactive data set at benof Go on the Bloomberg terminal or at BNF dot com.

Okay, let's talk about the climate alignment of investment portfolios through esfrs with Ryan.

So.

I haven't been on the show in quite a number of weeks, so it's nice to be back with a friendly face.

We've done this a few times, Ryan, welcome.

Back, Thank you.

Den So.

We're here to talk about some of the ratio work that we do.

It's the Energy Supply Fund Enabled capex ratio really rolls out the tongue, so we call it ESFR for short.

Yes, But before we talk about the specific ratio, let's om out a bit and talk about some of the ratio's work that we started a couple of years back, because this was a new concept at the time.

We started with the energy supply banking ratio, then moved into the energy supply investment ratio, and now where the new Energy Supply fund enabled CAPEX ratio.

So, first of all, why did we start thinking about the investment in the energy transition in terms of ratios?

To begin with?

Yeah, it's a I think a really important place to start here, But why are we bother doing this?

Suttle because it was a big lift on our part to try and I start calculating these ratios for financial institutions.

So the concept of the investment ratio is measuring the proportion of low carbon energy supply capital investment as a proportion of the same thing for fossil fuels.

And the basis for this is that we have a theory of change a BNF that the energy transition is an industrial revolution, and the way industrial revolutions work is that you need a disruptive technology to grow and scale and expand and start displacing incumbent technologies to provide services that incumbent was previously providing.

That's exactly the same way that we see the energy transition.

So whereas the traditional energy services were provided by conventional energies and fossil fuels, so gas fired power plants are called fire power plants, our transportation system is fueled by petroleum.

Really, the other in order for us to actually get to your world where those services are still provided but the emissions are low, is that there is enough flu carbon energy supply present in the system that can actually then go ahead and displace that.

So the reason they then decided to apply that to financial institutions is because they're the arbiters of capital and the flu of cap and that investment has to be channeled somehow, coming from somewhere, and that somewhere is usually institutional investors, and then the banking system is there to help funnel that capital to its most productive places and hopefully along the way, hopefully to facilitate that capital flowing too, or we think it needs to go in order for the transition to transpire, which is blue carbon energy supply, so a renewable electricity generation or even nuclear or just anything that's generally going to help with electrification of the economy.

The other side of this is the reason we started tracking this as a sort of system wide, market level, top down piece of work in the energy supply investment ratio.

But we also wanted to apply this to the entire spectrum of financial services and starting with the banks, because to date, up until that point, the research that we'd seen going into how banks were aligned on climate was really my opic.

Almost they look at fossil fuel financing of financial institutions at research lets from engineers would look at who is financing fossil fuels and whoever is financing fossil fuels should be beaten with a stick until they stopped doing that and the world will be good.

It's almost like an all or nothing with this point A and point B and kind of new perspective on what it takes to get from point A to point B.

Yeah, exactly that, exactly, exactly right.

I couldn't have put it better.

And a lot of that research basically would find that the biggest banks in the world were financing mist of the fossil field in the world.

Because obviously we did research then in the energy supply banking ratio which looked at who was financing the other side of that on top of the fossil fueld, so looking at clean energy side of things, and we find that okay, JP Morgan, Yes, they are the biggest finances the fossil fuel in the world.

They are also the biggest financiers of clean energy in the world because they are the biggest bank in the world.

So it's not an unintuitive finding.

So the way we then wanted to apply this to the banks is to say, Okay, if we were actually going to analyze how these banks are doing on climate and net ero alignment, what we need to normalize for that size.

So let's look at the ratio of clean energy to fossil fields.

And then the third thing I would say about the ratioes is that there needs to be the scale up of investment.

We know that if we track how much investment is going and classic BNF chart up into the right as time progresses, more investments going into clean energy in every aspect of the transition, be that power supply or transport or grids.

Until there is enough deployment in these solutions, we don't see a world where general populace is going to accept the fallen living standards.

And there's a direct correlation between energy consumption and living standards, particularly in the developing world, or well.

An energy consumption looks like it's going up for many of our charts anyway.

So there is the electrification of heavy polluting things like electric vehicles replacing internal combustion engines.

But then there's the energy demand associated with things that have nothing to do with a cleaner, greener future, which has to do with the use of a and data center demand overall increasing.

So energy demand is increasing, and a more resilient system, one could argue, is a more diverse system, which has some aspect that interrelates and interlocks in with the energy transition.

You're thinking about it also from a decarbonization standpoint, because those are the new technologies that are coming online.

So this concept of the transition, for whatever reason you may think that it is or is, you know that it is happening.

We're now tracking kind of what that direction of travel is for those who maybe are trying to be more actively involved in this process.

Exactly that if we look at BNFS, net eros and AR from the New Energy art or our flagship report on the Emissions Abatement to curve the chart that shows you which technologies are going to be emissions as energy system decarbonizes.

Even under the net ero SNARI by twenty fifty, there is still the presence of fossil fuels in that system right up until twenty fifty.

That's twenty five years away, So it's going to require some level of investment.

So when we calculate ratioes looking at clean investment the fossil fuel investment, it's something to one, not something to ero.

Like there's still going to be a place for investing in gas fired power, for example, in certain parts of the world, and it's obviously there's it's regionally disparate, but the overarching point is that there is still some place for fossil fuel investment over the next two and a half decades.

But what we really really need to see in order to get to this net ero world is a massive scale up of investment in the low carbon site.

So that's where financial services and the entire ecosystem comes into play.

So looking at these giant institutions who control the allocation of capital because they whether deliberately or otherwise, they will have an impact.

So as we're living in the Industrial Revolution the sequel, and as with many summers, this is a summer of sequels.

We've got Jurassic Park, so I would say the Superman wants more of a remake.

But here we are Industrial Revolution the sequel.

Why are we working specifically?

It's fund enabled cathex ratio.

So we looked at banks and now you're looking at that mix of equities and debt.

Who were you speaking to here?

Who are you expecting to read and glean insights from the painstaking work you've spent on data and charts and graphs in order to bring this to life?

Good good questions.

So we started with the banks because they were they were the headline grabbers, really and there was this sort of idea that the banks were causing climate destruction, which we didn't necessarily agree with, but it felt like the most natural place to start.

Most of what we were measuring for the banks is capital market activity, so that they're underwriting of security is onto capital markets, so bonds and listed stocks.

They were usually just responding to what their clients were doing.

For asset managers, so yeah, the energy supply fund enabled capex ratio where we're measuring the same concept.

It's an absolute mouthful, so I'm going to refer to it as the ESFR from here on o.

The asset management community is more like the client side for the banks, So the people who are actually deciding which securities they're going to put into their pulled investment products like ETFs or mutual funds, who are serving their clients as well.

Who are the institutional investors, so pensions, sovereign wealth, endowments, insurance, whoever.

So THEESFR it's a slightly different concept, which I can explain further later, but it is the sort of companion piece to the EsBr.

It's a different part of the cm ecosystem.

So whereas we were looking at banks who provide primarily at their debt capital through loans and underwriting services for securities, we're now looking at asset managers who provide investment products for investors, and they do typically just respond to to client demand.

Up until quite recently, a lot of these groups had lent into the sustainability theme, having specific departments on it, starting back in the days when it was all called ESG or Environmental, Social and governance factors and then sort of becoming more and more granular as the utility of that term win bit.

So we thought this was a pretty natural next step for this ratio suite of research products that we're making.

So eroed in on the energy transition.

Okay, Ryan, so tell us how you count the beans.

Give us the detail on how you think about this and how you arrive at these ratios, because invariably there's a ton of underlying data and theory that goes behind it.

We're partially doing this because we think this is a metric that is better at measuring net ero alignment than something like financed emissions, but we're actually being pretty pretty inspired by the calculation of financed dimissions and where we've used and massaged the methodology that they Partnership for Carbon Accounting or PICA used to develop this.

So the fund enabled copex aspect of this mouthful of a term is about attributing the capital expenditures of portfolio companies and non financial companies who are in the energy sector.

So the exons or the vestass or whoever of the world they're making capital expenditures annualized bases into real tangible assets.

So wind turbines or oil directs or LNG terminals, and we're attributing that capital expenditure to funds ETFs or mutual funds and then mapping that up to the institutions that offer those products.

We do that in much the CM way that financed missions calculation is performed for portfolios by looking at how much of the portfolio company is owned by the fund.

So say say a fund owns ten percent of the entire capital structure of Exon, and Xon spent a billion dollars last year on oil and gas capital expenditure.

We would then say one hundred million dollars of oil and gas CAPEX was then attributable to that particular fund because they owned ten percent of the enterprise value of Exon.

Those are entirely made up illustrative numbers, but that's the that's the concept, that's what we're measuring.

And because something like finance missions is only looking at the high emitting assets, so the oil and gas and coal infrastructure on the fossil fuel side.

Back to the ratio concept, we then wanted to look at CAPEX because then that brings into the folder, allows us to bring into the fold the clean energy side of the things, the low carbon capex into wooden turbines and solar PV farms and battery storage, et cetera, et cetera.

So now that we know how you put it all together, there's the results element of it lay the foundation where we are now, so we can talk about where we're going and what does this ratio look like.

So I will add caveats to this afterwards, but the upfront answer to this question is that as of twenty twenty four, inaggregate, where the asset management market is at the moment, is that for every dollar of fossil fuel capital expenditure that they've enabled us of twenty twenty four, we've associated or attributed to them forty eight cents of low carbon energy supply capital expenditure that's been enabled.

So that's a ratio of ero point four eight.

On the direction of travel, is that the ratio is declining over the previous three years to that.

So we started measuring this as of the end of twenty twenty one.

That's the time series data we have, partially because of just the granularity of the data that we have that was different sources.

That's as far back as they allowed us to go.

Is that the caveat is that the catch.

There is there is a caveat there because the way, and this is one of the concerns about calculating something like financed the missions is that we're doing this as a how much of the enterprise value does a fundown?

And the enterprise value includes market capitalization, which is subject to the whims of the market, so it is in part dependent on the stock market.

So there's a specific dynamic in the energy related stock market that has occurred since December twenty twenty one has partially resulted in this.

Now it's not necessarily entirely done to this.

There are some other reasons, but we basically started at a point where if we look at any clean energy stock market index, which became very very popular up until through past the pandemic to the end of twenty twenty one, that was sort of their enith, where from December twenty twenty one the stock market for most clean energy indices was falling and has continued largely to fall to this point, while the started twenty twenty five has looked a little bit better, so maybe it's going to change.

Conversely, December twenty twenty one was only three months before Russia's inversion of Ukraine, and.

Is that the hypothesis as to why, well, it had.

An obvious impact on commodity prices in particularly in oil and gas markets.

So a lot of the listed firms that we're looking at here, their prices, their stock prices reacted to that they were heavily exposed to commodity prices which spiked, and therefore, over that timeframe, the cash for the companies increased as well and correspondingly suited their stock valuations.

The other side of this is that this is not necessarily just the measure of how much capital expenditure is actually going towards these assets in total.

It's the capital expenditure that we can attribute to fund managers, and what we can attribute to fund managers is how much they own of securities.

So what that means is that they've got this dynamic going on where what listed firms are doing is important to this metric because that's what these mutual funds needs can actually get exposure to or debt securities.

And is there quite a bit that's not listed and you're not able to track.

Exactly right, So there are a few reasons for this.

So one, not a lot of a lot of energy expenditure capital expenditure is coming from state owned enterprises, particularly in the OPEC region and in China in particular.

So obviously anyone who pays attention to the energy transition and investment trends, generally, China is a big part of the story.

A lot of the investment coming out of China is coming through state earned enterprises as well as some securities based or listed firms.

But that means that if it's a state owned enterprise, then it can't sit in a mutual fund or an ETF that is investing in stocks, right, So that means that anything that's coming out of China in terms of leu carbon investment, it's not going to be able to be attributed to the stock market funds that are becoming more and more popular.

That's really interesting though, because one of the regional findings from this report, which I want you to talk about more, is where China lands in this ratio.

They actually come up near the top.

So you have a number of state owned enterprises which, as you mentioned, whether it's manufacturing solar panels or refining different metals for electric vehicles or batteries, actually written large.

China is a dominant player in the energy transition when it comes to technologies that are used as part of it, and much of that from being some of them state owned companies.

But yet even for the publicly listed end of it, they're coming out on top.

So what's China's ratio compared to other parts of the world.

Zi, Yeah, ero point nine er, that's what we're talking for these particular these particular companies.

A lot of these companies like solar mudile manufacturers as well.

And the other thing with this with China though, if anyone is actually to look at our regional split of charts, their ratio is second highest by region, only behind Europe.

The data, the actual volume of copecks that these funds are enabling is very very small in China, even though that's where most of the energy transition investment is coming from.

So your data set is just as smaller it is.

And that's partially just because we can't capture necessarily even for the securities that are issued by Chinese firms, we can't capture the ownership for them because the disclosure requirements on holdings isn't a stringent there as it is in perhaps Western markets.

They have, for example, two different types of shared classes, one called the H class, which is usually listed on the Hong Kong Stock Exchange, which are typically bought by the international investment community.

Or they have something called A class shares which are listed in mainland China whatever stock exchange they choose to, which are typically the reserve of domestic investors as well.

Those shares, we don't get a view on the ownership to the same level that we would for for example, US or New York Stock Exchange listed companies.

So there is there's definitely a data reason behind the results that we're seeing, and that data issue is also probably what partially contributes to the fact that the fund enabled capex ratio of ero point four it to one is lower than the real economy ratio which is actually over one to one at the moment.

So by rail economy, what I mean is the project level investment that we are tracking, either at PNF or we look at other organizations like the IA, are showing that actually there on a year to year basis in physical assets, the actual the things that are really important.

There's more blue carbon investment than there is fossil fuel investment, but what we are tracking here for fund managers, specifically, we're seeing less than half of the amount of fossil fuel investment going into lu carbon.

So there's lots of different dynamics at play driving this divergence.

Regional dynamics are going to come down to your point, what is and is not public, what natural resources you have, and then of course policy and how governments are able to really tip the scales one way or another, and some well, perhaps a good two regions to juxtapose on this would be Europe, which you have coming out as the leader, followed by China, and then you've got Latin America.

Then you've got North America, so natural gas exporter.

North America also part of the world where certain states in the US specifically have really turned away from any sort of clean energy mandate, and that as a fund manager you actually are not able to use other factors other than just what's happening in the market in some of your investments.

So the point is really clear that there is a lot of different factors which may influence these numbers, everything from how many companies are actually publicly listed, to what natural resources a region may have, all the way through to policy as that has a really handy way of tipping the scales for or against something in various parts of the world, which then leads me to another question.

And so, if you are a fund manager and you're looking at this, how much agency do you really have to make decisions?

I like this question a lot because it depends on who you ask.

So ultimately, an investor, so the person who owns the capital in theory, should have complete agency over what they do with their money.

So most fund managers aren't that, though they are fishes.

They look after their clients money and they allocate it as their clients ask them to.

Essentially, that said, most of their clients aren't security selectors, so they're not stock picking or picking individual bonds.

They're allocating so they're looking for exposure to equities or US large cop equities to be specifically, or high yield credit mandates, or infrastructure and private equity and private credit.

So that then leaves fund managers with a degree of agency about what securities they're going to put in their investment products.

Now there's a dynamic going on which we've seen in this research as well, but it's kind of well known within the investment community.

That increasingly, passive investment has become a much more popular investment strategy.

Or what passive investment is is investing in securities so that they track an index or the broader market, which is usually represented by a stock index or a bond index.

Like an ETF would be an examples an exchange traded fund.

Exchange treated funds tend to be possibly managed, their exclusively passively managed.

You can get active dfs, and they're actually becoming a little bit more popular.

But yes, the growth in ETFs coincided with the growth in passive management and we've picked that trend up as well here.

So even actually as recently as twenty twenty one.

So our first data point that we were looking at, the total volume of enabled cap X was higher for actively managed funds than it was for passively managed funds.

That has since switched.

So now passively managed mandates are bigger, they're a bigger part of the story than actively managed funds.

And what that does is it makes it a lot more important for this ratio as to whether or not firms sit inside major stock in disease.

So, for example, the most popular stock index in the world is the one that tracks the US large cap market the S and P five hundred, and within the S and P five hundred, the ratio of anyone who invests in that is ero point four eight to one, which is the same as the total market.

And the reason for that is because some of their major constituents include Exomobile or Chefron or oxy and they do have some element of clean energy exposure in there.

I think it's next era energy is its biggest contributor to the carbon copex within that index, but it's something that is probably going to continue this sort of downald trend, particularly inequities anyway, listed equities on the fund ratio side, unless there is a big shift in listed renewable energy companies getting access to some of these major industries.

Obviously, the S and P five hundred is one index.

There are lots of different ones that are tracked, but they tend to be pretty well diversified across region indices which are dominated usually by large US companies.

So even things like the MSc AQUI, the Old Cup World Index, the top companies, they are the same as the top companies in the S and P five hundred, the big Magnificent seven stock industries, so a lot of capital is moving into these these mandates, primarily driven by the lower fees and the fact that active managers are struggling to outperform the markets.

And there is this dynamics well within energy, where oil and gas companies, oil and gas majors, these big listed firms which sit inside these industries, and therefore, as more compital goes into, the more copex is enabled by the fund monitors who are running these passive mandates, whereas the renewable firms typically sit outside of those big industries, and therefore they've got this sort of tool dynamic of you know, it's a vicious bit of a vicious cycle.

So let's talk about another trend.

But on the investment side, we've already discussed how there are non listed companies and how that can skew some of the data.

But how about this move towards or a rise of probably is a better way to put it private markets.

And you know, big companies like Exxon, like you'd mentioned, the big listed companies like the oil majors, they're a huge part of this.

Is there a trend, how are you seeing it emerge and how are you tracking it?

When it comes to the involvement of private markets and money in that direction.

Yeah, this is this is a good question.

And I think actually the last time you and I have spoken the podcast.

This was the theme refresh my memory, Ryan.

We spoke you and I with Pietro Rool about the emergence of private markets and renewable energy and that part beautiful relationship that was emerging at the time.

But there is actually there's definitely something to be said, and you're right, there's a there were.

If I could talk about two big trends in investment writ large over the last two decades, one of them would have been the shift from active to passive in terms of popularity.

The other is the growth and popularity of private markets in a globally investable portfolio.

So the start of the century year two thousand alternative assets as they are so called, which are pretty much anything other than listed debt and equity securities or maybe even under five percent of global market portfolio.

Today they are probably north of twenty five percent, so they've grown in absolute terms, but they've grown in relative terms as well quite quickly.

Private markets can refer to a whole range of different subasset classes, so that can be buyout or growth or venture capital strategies that sit in private equity, or they can be private credit, which is essentially non bank lending for masset managers, which is a very hot topic at the moment.

And then there is real assets see infrastructure type funds and assets like renewable energy, renewable electricity specifically.

Actually really those infrastructure funds doing to a tea.

So we're seeing these private market funds when we try to measure them on the same basis, on the ratio basis, most of these asset classes and most of the funds themselves, we're seeing a ratio of over one.

So there's more renewable exposure than there is fossil fuel exposure.

And that's not just dedicated sustainable funds or renewable energy specific funds, although they're present as well, but even the suit called core infrastructure, which would traditionally include things like airports or water utilities or hospitals anything like that, there's a lot of increasing renewable energy exposure to them as well.

That's because there'sn't really a regular definition of what constitutes infrastructure as an asset class, but the kind of rules of thumb you would look for are high barriers to entry, which means big physical copex intensive assets, and usually a risk could turn profile that is characterized by a regular, steady stream of cash flow rather than sort of valuation fluctuations, so pretty non volatile.

So renewable energy typically hits those markers because most of the sort of wind farms of solar panels that come on at like utility scale will be subject to contractual cash lows through things like feed entires or PPAs or CfDS if they're their government supported.

So they've found their way into these portfolios and they hit the similar kind of ir R targets that these funds are looking for, which is usually just touching the ten percent market, and that is seemingly a major source of capital for these types of asset.

I would caveat here though, that these funds that we are tracking, and we're looking at maybe a thousand different funds from Bloomberg's own database, this is probably the area where we're least confident in the data because by the nature of these markets, they don't have to disclose the specific holdings that sit inside of their portfolios.

So if you are listening and you're from one of these funds behind you.

Care about this, Ryan, want's your data?

Yeah, get in touch.

But I think given that even with the limited data that we do have, we're still relatively confident that the sort of direction of travel is one where clean energy can definitely get a foothold.

I mean we are seeing and this is a separate piece of work in a separate podcast, but a focus on these new energy producing assets that are in some circumstances not connected to the grid, that are addressing data centers.

These are big projects.

So the hyperscalers have a role to play in this and we'll see how this actually changes your numbers in the years to come.

Because we have predictions, other people have got predictions, and they do diverge.

I mean, this is a future that people are not really certain of.

Yeah, what is the phrase?

All models are wrong, but some are useful.

Yeah, we don't know exactly how this is going to go.

We do know that there are large players in that infrastructure space who are working with some of the big tech companies in order to start investing in low carbon assets that can then connect to data centers.

And to be honest, even that might even just be the most economically sensible thing to do at the stage.

I think if you do, go and listen to the most recent Trumponomics podcast with our own Ethan Zindler on it.

Everybody is struggling to get connected or get a gas turbine to produce electricity.

For these there's the order books too long, and now in a lot of markets around the US, things like solar combined with storage are actually cost competitive options that can provide an element of dispatchability as well.

Which creates a different tipping point for some of this.

So you know your ratios may change for reasons that are beyond decarbonization, which then goes back to energy security, security of supply.

Yeah.

Yeah, the energy, I mean, the energy trilemma is always a core fixture of the way we think about this.

It's affordability, sustainability and security, and thy low carbon energy solutions and particularly renewables are kind of heading all three at the same time.

I mean, there's not a cabal of countries who can switch off the tops of a solar panels.

We're still seeing solar and batteries in particular riding the experience curve.

They have experience rights of walk around twenty percent or so or between twelve and twenty percent.

So as they continue to scale, they're going to continue to get more and more economically competitive.

And then I guess the sustainability element doesn't really even need to be talked about.

And one one is producing carbon emissions at the point of use and one one's not, so they're hitting the big three.

Well, Ryan, thank you very much for doing the painstaking work of tracking what's actually happening between point A and point B, or in some circumstances, between point A and point Z and the energy transition, but really what's happening in this investment space and what fund managers and investors are doing, and how that's then reflected in an overall portfolio basis.

It's also nice to have a reunion with you, so thanks for joining me in the pod studio for you know, my first episode in a while.

So it's been really nice.

It's it's been wonderful.

It's been very nostalgic.

Thanks thanks for having me, don It's been great.

Today's episode of Switched On was produced by Cam Gray with production assistance from Kamala Shelling.

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