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4D inflation podcast (part 2): The US Inflation Reduction Act

With inflation still the word on everyone’s lips, 4D Infrastructure’s latest podcast is published in two parts. Part 1 dealt with the impact of inflation on the current macro environment, and part 2 looks specifically at the US’s new Inflation Reduction Act.

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In part 2, Peter Aquilina (4D’s Head of ESG and Senior Investment Analyst) speaks with Dave Whitby (Bennelong Account Director) about how the US’ new Inflation Reduction Act is really about transitioning the US to a decarbonised, clean/renewable energy economy.

 

  • 0:34 – Why the Inflation Reduction Act isn’t actually inflation policy
  • 3:56 – How the Act is supporting decarbonisation efforts
  • 6:30 – What this means for infrastructure (and why 4D is excited)
  • 9:32 – Some of the names in 4D’s portfolio that could benefit.


The content contained in this audio represents the opinions of the speakers. The speakers may hold either long or short positions in securities of various companies discussed in the audio. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the speakers to express their personal views on investing and for the entertainment of the listener.

 

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Transcript

David Whitby:

Hello and welcome to part two of the 4D inflation podcast. My name is Dave Whitby from Bennelong Funds Management, and joining me today I have 4D's Senior Analyst and Head of ESG, Pete Aquilina. G’day Pete, how are you going mate?

Pete Aquilina:

Hey Dave, thanks very much for having me on.

David Whitby:

Always a pleasure, mate. And can I just start off today by asking you about the US Inflation Reduction Act? Pete, can you just maybe provide an outline as to what exactly this is?

Pete Aquilina:

Sure. Well, the Inflation Reduction Act, or the IRA, is not necessarily inflation-focused policy. This is essentially industrial energy policy with the express interest of transitioning the US to a decarbonised, clean/renewable energy economy. And secondly, in supporting energy security in the US, that is by establishing vertical supply chains for the manufacturing of renewable and clean energy. And I think this is especially important in the context of geopolitical uncertainty regarding China, Russia, OPEC, etc.

But I should just stress that this isn't an inflation policy. And in fact, two prominent analysts – being the Penn Wharton Business School and the Congressional Budget Office, which is a federal agency who provide economic information to Congress – they both agree that legislation is likely to have a negligible effect on inflation; that is, not increasing or decreasing. And so this is very much, despite the name, focused on energy; and it incorporates around $369 billion worth of spending over the next 10 years to sort of reinforce those two goals that I mentioned. And I should just mention that this spending package is likely to be funded through two main avenues, one being the establishment of a minimum corporate tax rate in the US of 15%, and also greater powers provided to the Internal Revenue Service, or the IRS, to pursue and minimise tax avoidance.

David Whitby:

What was the background to it, Pete? How did it actually come about?

Pete Aquilina:

Yeah, so I think rewinding to the last election, you had really a split ideology between the Democrats and the Republicans. And now President Biden, at the time, communicated a strong intention to that transition away from fossil fuels, both of energy and the US economy. And so he'd sort of spoken to not only transitioning the economy but also re-signing the US to the Paris Agreement, and that is to achieve net zero greenhouse gas emissions by 2050. So following on from that, he wins the election. Come April 2021, Biden established an interim target for the US economy, and that was to reduce greenhouse gas emissions by between 50 and 52% as compared to a reference year, being 2005, by 2030. So that's sort of seven, eight years away. So what this policy has been verified as doing is likely to move the US towards about a 40% greenhouse gas reduction by 2030.

And so it doesn't take the US all the way to that 50 to 52% that Biden is looking for, but I suppose you have to walk before you can run. And it's worth noting that without this legislation the US would likely reduce greenhouse gas emissions by 2030 by only about 26%. So it is a major driver in that decarbonisation process.

David Whitby:

I believe, Pete, is spending – what – upwards of $369 billion?

Pete Aquilina:

Billion, yeah. Big number.

David Whitby:

It's the capacity of 4D, I believe, we'll get you up to that shortly. But 369 bil, what exactly does that get you?

Pete Aquilina:

So essentially the Act looks to support through the use of tax credits, grants, subsidies, a number of clean and renewable technologies, being the traditional ones of wind and solar generation as well as batteries. But also things like carbon capture, green and clean hydrogen, biofuels. There is support for nuclear in there.

So yeah, a broad range, a smorgasbord of different technologies, and that is done purposefully because the legislation doesn't look to bias any type of technology, because frankly we just don't know which will be the prominent technologies which transition the world to net zero by 2050. And so as these technologies develop and enhance technologically, we want to be able to, or the US has suggested that they'll support all of them to see which one sort of comes to the top of the stack over time. But essentially, it's all focused on improving the economic case for these different technologies and therefore increasing their utilisation in the economy.

David Whitby:

As you know, I sometimes do watch a little bit of Sky After Dark. Isn't this likely to cost the end consumer more money though?

Pete Aquilina:

I know you're a big fan, Dave, but as all things the devil's in the detail. But what we can say is that per unit measure of energy, renewables supported by batteries are the lowest cost source of generation. Now there's specific caveats you can apply to that, but essentially on a levelised cost of energy basis, which is the usual measure in the finance industry that we look at to assess the cost of a different source of energy generation, renewables are the cheapest. And LCOE, or the levelised cost of energy, incorporates ongoing operational costs – the cost of fuel, the upfront capital cost, and the return allowed on that capital cost. So on this basis, renewables are the cheapest – predominantly because one, there's no fuel cost associated with them, and secondly, because the ongoing maintenance of renewables is far cheaper than gas, coal, nuclear, because you don't have roughly 300 people in a coal-fired generation facility employed to operate them.

David Whitby:

Some decent points there, Pete, I'll give you that, but let's get into the 4Ds and the fun. Why really are yourself and Sarah and the rest of the team excited about this policy?

Pete Aquilina:

Yeah, look, we're really excited about this policy. I mean, for one, as signatories of UN Principles for Responsible Investment, we support the intent behind the policy and that is, moving the US economy to a more sustainable future. But that aside, at 4D, we're also all about the dollars and cents for our investors. And frankly, we see multiple areas where this policy will support infrastructure investment and specifically names in our investment universe in the US. And it's doing this through a number of factors. One, there's the potential to earn increased returns on investments. So return on invested capital on some projects is likely to improve and so is ongoing margins. But in some areas that will be competed away, or regulation will remove that and maybe pass it to customers. Secondly, the breadth of investment opportunities for investment names, whether it be utilities, midstream names, or contracted generation companies, has been far broadened because these subsidies support the economic case for some technologies which prior to this legislation just weren't economic.

And then thirdly, and this is split into two, but for regulated utilities, which are required to pass on the benefits of this legislation to customers, it does two things. One, it could improve affordability for the customer. So improving the relationship that regulated utilities have with their customer base, which inherently improves the regulatory relationship, and therefore reduces regulatory risk. And secondly, where there is bill headroom, some utilities will be able to incorporate other types of spend into their investment plans, and that might be in supporting asset replacement and we know that infrastructure in the US is ageing. Secondly, it might be through hardening, supporting against things like wildfires and hurricanes that we've experienced in the southeast of the US. And for modernising; so that is, facilitating electric vehicles, etc. But this last component is likely to increase overall investment growth.

So altogether the Inflation Reduction Act has the potential to improve margins or returns in invested capital, increased growth rates of utilities in contracted generation companies, extend the investment pipelines of utilities – and I'm talking about for decades, because net zero is a 2050 target – and it provides for technologies such as hydrogen and carbon capture, which facilitates for some currently fossil-exposed pipeline companies to pivot their business model to make it more sustainable and therefore be rewarded hopefully by the market in increasing their terminal values post sort of 2040, 2050, where they currently are.

David Whitby:

Looking more specifically at the 4D portfolio, Pete, what are some names in the portfolio that you might be able to share with us that will be able to benefit from the policy?

Pete Aquilina:

Yeah, look, I've got some pearlers for you, Dave. The obvious one is NextEra Energy. So these guys are best in the industry, utility based in Florida, but they are also the biggest developer of renewable generation, and that is unregulated renewable generation, across the US. They have about 40 gigawatts of operational renewables, which incorporates a small amount of batteries and also incorporating their investment pipeline. So that's 40 gigawatts either operational or in the pipeline. They've proven to have a competitive advantage in the development and operation of renewables and batteries, and that is through procurement advantages that they might have, extensive partnerships and relationships that they have with various utility names and corporates across the US, greater data around solar and wind resource, and also permitting expertise. So we believe that these competitive advantages should at least allow them to maintain their market share in this growing market. And when I talk about growing market, NextEra have actually identified that in the road to 2040, 2050, they believe that the US power sector will need to have investment of $2 trillion in order to achieve targets that have been communicated under the Paris Agreement, and another $2 trillion across other parts of the US economy, that predominantly being industry and transport. So with their competitive advantages and strong market share and these massive potential markets that have been opened up with the help of this legislation, we just think that the growth associated that could come for NextEra is exponential. They've talked about a 10% dividend growth out to 2024, which is fairly solid in the current environment, and we think the IRA supports this level of growth for much longer.

So another one that we do have in our top 10 is Williams Company. This is a midstream, predominantly natural gas company which looks to connect the best, most economic gas resource basins in the US to demand centres; and that is both domestically, on the east coast, but also internationally. And that is predominantly through liquified natural gas, which there are facilities predominantly in the south, in Texas and Louisiana. So some concerns that the market have raised to date around Williams is associated with the life cycle of natural gas, and with support provided by this legislation for things like hydrogen and carbon capture, we believe that the usage of natural gas in supporting these technologies will push the life cycle much further than sort of 2040, 2050.

For example, the International Energy Agency, even under their most aggressive decarbonisation scenarios that they've modelled, believe that natural gas in unison with carbon capture will mean that we'll still be using about half the level of natural gas that we're using today in 2050. So because of Williams' competitive advantages and linking the lowest, most economic cost of natural gas, we believe there's a strong case now for their business model into the extended future. In addition, they've also just recently communicated intention to work with partners on establishing hydrogen hubs around the US, specifically near to their operations in Wyoming and also feeding into the states of New York and New Jersey. These are all sort of pilot projects at the time, but looking to get a foothold in these various sectors, which we believe as we've sort of explained, the investment potential is exponential.

And then a final name which I'll leave you with, and this is probably more of a pure play regulated utility, and it's called American Electric Power. They're one of the larger ones in the US, serving about five and a half million customers across 11 states. So following the signing of the Inflation Reduction Act, American Electric updated their net zero decarbonisation goal to 2045, which was five years earlier than their previous goal. And they already have the quite ambitious greenhouse gas reduction target of 80% by 2030. So that's only sort of eight years away. And so when you sort of think that that 80% reduction being 2030, in their current five year capital plan they're talking about spending $8.6 billion on renewable generation – and then when they look out to the 2040 target, they think there's about 17 gigawatts of renewable capacity that they could actually own and operate.

And just as an idea, that represents about half the level of renewable generation across Australia as of the year 2020. They've spoken to their intention to grow EPS 6 to 7% over the next five years. But with this investment pipeline and the opportunities coming through this legislation, we think that 6 to 7% extends for at least a decade, if not longer. And when you think about this, 6 to 7% growth is paired with its current dividend of sort of 3 to 4%, a total return in the current environment for a safe regulated utility of midpoint 11% is pretty attractive.

David Whitby:

Pete, thank you very much for that. That was very insightful and especially going through some of those stock names there. I'll be keeping an eye on my 4D portfolio and my super, and I'll be expecting some of those returns to be coming through there. But no, thank you very much for your time today. Very much appreciated and thank you also to our listeners for your continued support of 4D. Should you have any queries or require anything from us, please either let myself know or your designated account director know as well. So thank you very much.

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