- Geopolitical Strategist
United States, Intermediary
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The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.
Episode notes
The war continues to exacerbate the twin crises of energy availability and affordability. We explore how the situation may take shape from here.
2:00 Availability crisis
7:30 Demand-reduction measures
9:25 Affordability crisis
11:10 Effects on domestic politics and policy
17:30 Effects on geopolitical friction
20:00 Effects on research and collaboration process
Transcript
TIM CASALETTO: I think energy security is something that the world has really taken for granted for the past several decades and it’s really been this crisis that has highlighted that we really can’t take that for granted anymore. That the world is a much more interconnected place and if you have one bad actor in the energy landscape they can cause significant disruptions.
THOMAS MUCHA:Today’s topic is the war in Ukraine and how it continues to impact markets and policy far beyond Kyiv and Moscow. I’m joined today by Tim Casaletto, a global industry analyst at Wellington, who sits on our energy and utilities team, and who specializes in Europe. Tim is our first repeat guest. He last joined us in April to discuss the impact of the war in Ukraine on global commodities markets, the acceleration of fossil-fuel interdependence, and the clean energy transition. A lot has changed since April so we’re happy to have him back here today. Tim welcome.
TIM CASALETTO:Thank you very much for having me again.
MUCHA: So, let’s start with the big picture here, and what’s changing in Ukraine. We’ve had a lot of change in recent weeks. Momentum shifts on the battlefield. Continuing successes by Ukrainian forces. We’ve had deepening military support for Ukraine from the US and its NATO partners. And now we’ve got these shifting political dynamics around the war. We’ve seen some protests in the Czech Republic and Germany. A decided move rightward for both Italian and Swedish politics. And now we’ve got a new government in the UK. So, lots going on. All of this obviously impacts energy markets. So, from your perspective, Tim, how do you summarize where we are in this European energy crisis?
CASALETTO: Yeah, absolutely, so I think it’s important to really break down this energy crisis into two different components. The first component is the availability of energy, so this availability crisis. That is will there physically be enough energy molecules for Europe to continue to operate business as usual. And we’ve had a few updates on that point. On the negative side, we’ve seen Russia continue to weaponize gas against Europe. This is best exemplified by Russia cutting off Nord Stream 1 entirely. And so, as we stand here today, Russian gas flows are only 10 percent of normal levels into Europe. So, they’ve been cut in total by 90 percent, which is a massive deal, given that Europe gets 40 percent of their natural gas from Russia pre-crisis. So, that’s the biggest negative development. Another negative development that we’ve seen is really on the climate angle, so, Europe gets quite a bit of their electricity from nuclear and also from hydro. And so on the hydro standpoint we’ve seen a terrible drought ripping through all of Europe this year, and that’s really exacerbated this availability situation where we can no longer count as much hydroelectricity as we once could, which means we need more natural gas power generation. And then on the nuclear side, France, which gets 70 percent of their electricity from nuclear power, has found some issues with the welds on their existing nuclear plants. And so, it really depends on how things go from here, but we could see France’s nuclear production being only 70 percent of what we normally would have expected. So, that’s been some bad luck, I would say, on Europe’s side. But the availability situation has gotten worse since we last spoke in April. The positives on the availability side is that Europe has done a pretty good job at filling natural gas storage. And so, I do have confidence that we should be able to get through this upcoming winter without too much issue from the availability side. Climate really depends here. If we have a very cold winter that will be much more difficult. If we have a warmer winter, it will be much easier. The one thing to keep in mind here is that even if we get through this winter unscathed, the next winter is when we’re going to have the real big issues because if we’re only operating at 10 percent of Russian natural gas flows today and that continues, it’s just going to be really difficult to refill the storage in time for the winter of 2023-2024. So that’s where it nets out on the availability side.
MUCHA: So how does Europe then solve this, Tim? I mean Europe has gas and oil alternatives, we’ve seen Norway, Algeria, Israel sort of step into this. They’re trying to build out solar, wind, hydrogen, nuclear at a faster rate. I mean how do you parse through these potential options?
CASALETTO: Unfortunately, there’s really no short-term solution. So, Europe has really tapped out the additional sources of natural gas. Trying to import as much LNG as possible into Europe. Trying to increase flows from northern Africa, from Norway, etc. But a lot of the low-hanging fruit has already been picked, so I’m not very optimistic that we can get additional sources of natural gas quick enough in the next few years. On the renewable side, you’re absolutely right, Thomas, that that is a big source of diversification. Because if you have a wind farm or a solar farm in Europe, it is a source of domestic energy that’s not reliant on imports. And so, Europe is trying to build out renewables as fast as possible. But unfortunately, we just can’t do that quick enough over the next few years to really make a dent to the problem.
MUCHA: Why not, Tim?
CASALETTO: You know, funny enough, it actually comes down to permitting. This not-in-my-backyard syndrome that Europe really can’t seem to shed, where everybody wants more renewables, but nobody wants the wind farm built two blocks from their home because it’s ugly and it makes noise. And so, permitting has been by far the biggest bottleneck to building renewables. The EU is trying to solve that. There is the REPower EU document that was released back in March and permitting was a big part of trying to accelerate renewables. But we haven’t seen it play out yet. It’s there but it’s not actually physically making a difference quite yet.
MUCHA: I was in Brussels a few months ago talking to EU policymakers on this very point. They kept bringing up permitting, permitting, permitting. “Something we can do,” they kept saying, to speed up the process.
CASALETTO: Recently, Wellington Management hosted a sustainability summit, and I had the pleasure of hosting the CEO of one of the largest utilities in Europe; it’s a Spanish utility. And this question was asked to him directly in our discussion: What is the biggest bottleneck? And I thought he was going to say something about sourcing solar panels or supply chain. And he had the exact answer, quote, permitting, permitting, permitting, end quote.
MUCHA: But that implies that that’s a solvable problem. Right? It’s simpler than a supply-chain bottleneck issue. It’s simpler than geopolitical competition with China or other places. Right?
CASALETTO: Yeah, that’s right, and so I do think that this will be solved, but in the short term I’m less optimistic. I do think over the next two-plus years I think we can get there, but politics moves slowly. So, I don’t think renewables is the ultimate savior. Really, the big savior to this crisis is new LNG coming online from places like the US and some of the emerging markets. When we talk to our natural gas experts internally, they say that 2025 and beyond is when we get all of these new LNG export facilities online, and that is the ultimate savior to Europe’s availability crisis.
MUCHA: Yeah, we’re sitting in 2022 so what happens between now and then?
CASALETTO: Yeah, that’s where things will get really interesting. And so, I do think that Europe will need to implement some type of demand-reduction measures and we’ve seen some legislation on that last week out of the European Commission talking about reducing electricity demand by 10 percent, which will help solve; partially solve this. But really, I think Europe is going to need to do much more of reducing natural gas demand and this could come from telling certain industries that are big users of natural gas that they just can’t turn on their factories, that they need to save that natural gas for higher and better uses. And so there would be this merit order of sorts where, you know, households will, of course, get to heat their homes to some temperature, schools, hospitals, etc. But once you continue down that line, I think there are some industries that will just be told by governments, “You can’t operate your facility.” They may receive some form of compensation for not running their factories, but it’s going to get very messy I think on these forced demand-reduction measures.
MUCHA: Ten percent is a lot, particularly from a business perspective, a GDP perspective, a macro perspective. What can you tell us about the companies that are likely to be forced to cut their usage?
CASALETTO: Yeah, I think it’s not going to be easy. I don’t think anybody’s going to raise their hand and say, “Oh, we’ll shut down our factory.” I think Europe will need to be really smart of compensating these factories, such that they’re not actually losing money by not running. But how that all gets worked out is going to be very messy. And just to put that 10 percent in perspective, Thomas, so I was looking back at other periods where we saw big declines in electricity demand, and in the global financial crisis of 2008, 2009, we actually only saw electricity demand decline by about 5 percent. So 10 percent is a very big number. And how that all gets worked out will be very interesting to see. That 10 percent number, that did come out in the European Commission’s document, but there were no details on exactly how that will manifest itself.
MUCHA: So, it’s a wait and see.
CASALETTO: That’s right. More to come.
MUCHA: Now, there’s also hope across the EU that they want to put a cap on power prices.
CASALETTO: Right. So that brings us to the other aspect of the crisis, which is affordability. The European Commission said that they are going to cap the power price of all forms of generation except for natural gas at 180 euros a megawatt-hour. When I run that number through my models, I think that what you ultimately have will be a power price of 250 to 300 euros a megawatt-hour when you include the price of natural gas generation. So, call it 250 to 300. To put that in perspective the power price before this crisis started was about 50 euros a megawatt-hour across Europe. So even with this power price cap you’re still going to have a 6x increase in the power price. How that manifests itself in customer bills, it really depends by the country. But when I look at the numbers, I see an increase in customer bills by anywhere between 50 percent and 200 percent. So, I think the affordability crisis is not solved by this power price cap. And I think that was actually by design by the European Commission, because they don’t want to set power prices so low that consumers and businesses use the same amount of electricity. They actually want some demand reduction, some price signal where customers say, “Well, our utility bills actually are increasing, and we should probably turn the heat down a little bit. We should probably make sure we’re turning the lights off when we’re leaving the room.” And so I do think that was the fine balance of having the price high enough such that you do have natural, organic demand reduction but having the price slightly lower than it was before implementing this price cap to prevent a complete affordability crisis.
MUCHA: That’s a real tricky situation for policymakers to be in. Inflation in general is a very sensitive topic in electorates across Europe and elsewhere. How do you think this will impact Europe’s domestic political backdrop?
CASALETTO: I think the one thing that Europe agrees on is that Europe needs as much renewable energy as possible. And there are two separate but related issues behind that. The first is that the more renewables you have, the better the decarbonization will be of Europe, which is a perennial goal of Europe is to decarbonize.
MUCHA: Well, you also get away from dictators around the world, right? There’s a positive externality there.
CASALETTO: That’s exactly right, and that tees it up perfectly for the second benefit, is that when you have domestic energy infrastructure, you’re no longer reliant on any other countries for importing fossil fuels. That’s how you really gain energy independence. And so that’s actually, I think, even more important in the short term than the decarbonization, is just creating your own destiny of really having your own energy. And renewables really solves for that. So that’s the one thing that across the European Union I think there’s unanimous agreement on, is that we need as many renewables as possible.
MUCHA: That’s at the policymaker level, though. Is that true at the consumption level? I mean we’ve seen rising protests, like I said, in Czech Republic, Germany, elsewhere. Are you confident that the policymakers can take their citizens through this?
CASALETTO: I don’t think there’s another alternative. So, I’m very hopeful on that. The one place where I’m a little bit more uneasy is just having agreement on other aspects of this energy crisis across Europe. So, every country is in a different situation. For example, you have Germany and Italy that are very dependent on Russian natural gas. You contrast that to a country like Spain or Portugal that has very little, virtually no reliance on Russian natural gas. And so how will the European Union spread the pain across all 27 member states? Can you tell Spain, “Hey, Spain, you need to export more of your natural gas to the rest of Europe in order to help alleviate their issues”? Will the Spanish government say, “Okay, we understand, we’re in this together, and we’ll do that”? Or will you have situations where Spain says, “No, we need to take care of our own people before we can help the rest of the EU”? And so, I do worry that the solidarity of the European Union will be tested by this energy crisis.
MUCHA: Has echoes of previous dynamics in Europe, when the Germans were complaining that they had to take care of the of the Spanish or the Portuguese, right? These things come back in new and interesting ways, don’t they?
CASALETTO: That’s right. And one could easily make the case that part of Germany’s success has really been on the fact that they’ve had this very, very cheap source of natural gas coming from Russia that hasn’t been an issue for decades, but now all of a sudden, just like that, it becomes an issue.
MUCHA: So, lots going on obviously. Given all this, what are you doing on the investment side, with the European utility and renewable stocks?
CASALETTO: Yeah, so I’m actually quite positive longer term on these businesses.
MUCHA: Longer term. What does that mean?
CASALETTO: Longer term means three plus years.
MUCHA: Okay.
CASALETTO: Because as I said, I think the energy crisis is going to last until 2025, and that will really depend on the weather, how quickly we can build LNG. There’s so many factors at play. The war arguably is the biggest question mark here. But I say three plus years because I think that’s when Europe will be out of the dire aspect of the energy crisis and will be able to see this path of the new normal. And I think what that new normal means is, as I said, as much renewable energy as we possibly can build but not just renewable energy. We’re also going to have a record amount of electric transmission and distribution networks being built. We’re even going to have a lot of gas networks being built, because the flows of natural gas in Europe will be different than they were before. We won’t be getting 40 percent from Russia. We’ll need new natural gas networks to interconnect the continent. And so, that paints a very bullish backdrop for the European utilities. We’re going to need more domestic energy infrastructure in Europe.
MUCHA: More nuts and bolts.
CASALETTO: Exactly. And who’s going to build that? It’s going to be the European utilities that are earning regulated or long-term contracted return on that investment. So, I’m very positive on the longer term. Shorter term, there’s a bigger question mark. Everything I said is still true, where you’re going to need as much of this domestic energy infrastructure, but now politics become more tricky. Windfall taxes, power price caps, etc. How does that impact the profitability of the European utilities? So far, the approach that we’ve taken as a firm is to try to avoid the companies where we think are more vulnerable to these windfall taxes and power price caps. That is, we’ve been trying to avoid the companies where this is too good to be true. Instead, we’ve been trying to own the more stable, more predictable European utilities and renewable developers through this; the ones that might not be printing record profits, but that means that they’re less at risk, in my view, of those profits being taken away. So shorter term, it’s much more tricky navigating the politics, but longer term, which I think for Wellington and our clients, is really the more important question, I’m very bullish on the sector.
MUCHA: So you’re bullish on the sector, once we get through these three years. But there’s risks obviously out there so what are you looking at most carefully to change your view here?
CASALETTO: It really, again, comes down to the politics and the regulation of these utilities. And so, we’re having new headlines come out every week on this, and it’s really just trying to stay in front of that. I’m also really trying to focus on customer affordability. The countries that are going to experience the bigger bill increases may be the ones that we want to avoid from an investment standpoint. It’s difficult because things are happening so fast and then as we talked about before, the war in Ukraine is such a massive component of this crisis, that if the war was solved tomorrow, that would have significant implications for the utilities. Power prices and gas prices would presumably come down quite a bit, and that would have impacts on the utilities. So, there’s really a lot at play that I’m watching, but really, I’m just trying to find the more stable, defensive, predictable utilities that I still think have long-term upside to this renewable power growth. So far, that’s been a pretty good strategy, but I do recognize that things can change on a whim and it’s why I’ve been never closer to European politics than I am today.
MUCHA: Now on the geopolitics, we’ve talked about how important it is to the decarbonization effort and the motivations to get out from under dependency on Russia. But how do you think about geopolitical friction moving forward, as a subset of decarbonization? We’re going to have more competition for energy-related materials, minerals, how does that play into the risk picture here?
CASALETTO: So, I[WDE1] think energy security is something that the world has really taken for granted for the past several decades and it’s really been this crisis that has highlighted that we really can’t take that for granted anymore. That the world is a much more interconnected place, and if you have one bad actor in the energy landscape, they can cause significant disruptions.
MUCHA: Yeah, I think we’ve moved away from that in the rush towards globalization and I think the Russia conflict is certainly a reminder for politicians and policymakers that war is a real thing. And it’s significantly changing the policy backdrop. And the way I view this, Tim, is we’ve got this emerging great-power-competition framework. China is a part of this, Russia is a part of this, obviously this is a global phenomenon. But what it’s done, is it’s put a lot more emphasis on national security and strategic sectors, and I think what the Russia conflict is showing us is that oh yeah, energy, it is a strategic sector. It’s central to economic growth, to domestic political stability, to decarbonization and what this planet is going to look like in the future. And so, I think this focus on strategic sectors is the right way to view it in the great-power context.
CASALETTO: I think that’s a great point, Thomas, and I think that really highlights the importance of social stability. I mean when you have an energy crisis like this, it’s pretty crazy how different Europe is operating their energy landscape now than they were two years ago. Now Europe is burning as much coal as physically possible in order to make sure that we have enough gas to get through the winter. That’s something that was thought unimaginable just two years ago. And so, I think you’re right. I think it really just highlights how strategic energy supply is.
MUCHA: So the E, the S, and the G are out of whack.
CASALETTO: That’s right. I think what this is showing me is that the S is more important than the E in the short term. That is Europe’s decarbonization goals are being put on the side of the table for now, just to make sure that we have enough energy in order to satisfy the S.
MUCHA: So I think this social stability point is really important, Tim. And I’m curious. How has this terrible war and what it’s done to people’s lives, let alone to energy markets, utility companies, the vagaries of policy, how has all of this altered your research process?
CASALETTO: So, there have been many tragic implications of this war. In my area of focus specifically, which is European utilities, there have really been a range of implications. For example, in certain countries, customers have felt the pain much more than others. And so, in places like Italy and Germany — I keep going back to these two countries. But they’ve seen their utility bills go up massively by upwards of 100 percent in some cases. And I actually think that’s going to continue as prices continue to go up in the energy markets. In other places like Spain, Portugal, they haven’t experienced the same level of increase in their customer bills, and it’s hard to generalize because every customer is different, but I think these generalizations hold true. So, in my research process what I’ve really been trying to do is, again, avoid those countries that I think are more vulnerable, because when you have customers that are really facing these higher utility bills, they’re putting pressure on politicians, they’re putting pressure on regulators. And it’s these politicians and regulators that come up with the new policy that directly impacts the European utilities. So I think country selection is more important now than it has been in the past as it relates to trying to get the stocks right.
MUCHA: That’s interesting. You know, one of the key takeaways for me about this war is just how complex it is. And how many different research specialties it impacts at Wellington. So, I find myself talking to people all over the firm about the war. From a variety of different perspectives. But I’m curious. How has this impacted your collaboration within Wellington? I mean who’s out there working with you? Who’s challenging your views? I mean how do you think about it from that perspective?
CASALETTO: Absolutely. So, I think you’re right, Thomas, that the level of collaboration in my eight years at Wellington has never been greater. I am in consistent dialogue with members of the macro team. So, this is people like Gillian Edgeworth, John Butler, Eoin O’Callaghan. These are people that I would speak to before on maybe a quarterly or a semiannual basis, but now I’m in constant dialogue because our worlds have really merged more so than ever, given how interconnected all of this is. And then beyond the macro team, I mean we’re very lucky to have an integrated energy team here where the energy and the utilities team sit as one team. Because I have natural gas experts like Jordan McNiven, Eugene Khmelnik, George Burshteyn. I also have the commodities team. People like David Chang, who was on the podcast with me back in April. I feel really fortunate to have these other members of the team, because my expertise on the utility side, it only expands so far. But having this vast resources of others is really important. I would even say, too, the ESG team. Having the integrated ESG team here at Wellington is paramount in trying to navigate this energy crisis. So, I will say I’m very thankful to be working at a large collaborative firm more so now than ever.
MUCHA: Yeah, me too. And a lot of us sit on the twenty-sixth floor in Boston together and so there’s a lot of collaboration that happens accidentally or intentionally because of that. So I completely agree there’s much more integration on this one issue. Once again Tim Casaletto, global industry analyst at Wellington who specializes in Europe’s utility sector. Thanks for being on the show.
CASALETTO: Thank you very much, Thomas.
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Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced September 2022.
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