September 2017 Long-term Thinking - Energy For Investment Professionals Follow us @LGIM #Fundamentals FUNDAMENTALS

Peak : in terminal decline? Our forecast of a long-term structural shift away from coal could have dramatic implications for investors.

Once the bedrock of the global than the already dire predictions up almost a third of all primary energy system, coal’s position looks of some forecasters. We think coal energy consumption and a ever more threatened by the energy will be displaced from the current substantially greater share of revolution. Earlier this year, the UK at an accelerating pace. electricity generation markets.1 was able to meet its total electricity More worryingly for coal investors, demand for twelve hours without we estimate that the independently- In emerging markets, coal has an needing to switch on a single coal traded coal market, also known as even greater share of the energy generator, something not seen since the ‘seaborne’ market, is going to mix, accounting for nearly 40% of 1882. Just 50 years ago, over 1000 be disproportionately affected as consumption. Setting aside the mines were operating. Now only ten key consumers increase their self- environmental costs, coal is an remain and face yet further closures. sufficiency. Crucially, we believe this extremely abundant resource with a With the British government aiming outcome is likely even if policy makers quoted reserve life of 150 years, or to completely eliminate coal use in are unsuccessful in implementing three times more than that of oil or just eight years’ time, we look at an effective global carbon price gas, and an extremely high ratio of whether the drastic decline of coal in mechanism, although the introduction energy return on energy invested. the UK is a window into coal’s future of one would accelerate this process. Compared to alternative sources of around the world. fuel, it has also generally been cheap WHERE IS COAL TODAY? to procure as many of the major coal Our view is that the outlook for Thermal coal remains a dominant consumers have large domestic coal may actually be even worse source of energy globally, making reserves. With this in mind, it is easy to see why coal has been such a Figure 1: Coal is still a major source of global energy use popular source of energy. It is also

3% easy to understand why countries, 7% 5% particularly in the emerging world, Oil 33% have been so reluctant to take the hard (and often expensive) decision Coal to move away from coal. Nuclear energy 28% Hydro electric Renewables

24%

Source: LGIM Analysis, BP

1. For the purposes of this outlook, when we are using the term ‘coal’ we are referring to thermal coal which is used to warm homes and generate electricity. Metallurgical coal, which is used in the steel making process, looks a lot better in fundamental terms but is much smaller by volume. September 2017 Long-term Thinking - Energy

ASIA DETERMINES COAL’S Figure 2: dominates coal consumption FUTURE

Coal is a global commodity, albeit 11% with many regional and isolated 23% local markets. To understand the 12% Americas future of coal we have to focus Europe on the world’s largest consumer, 3% Africa and Middle East China. China Asia Ex-China India is also a significant import 51% market, overtaking China in 2014 (Figure 3). However, this is because

China’s domestic coal production Source: LGIM Analysis, BP is far larger, with India’s total coal consumption equal to just 20% of China’s. Figure 3: Chinese and Indian imports remain high BURNING COAL COMES WITH SUBSTANTIAL NON-FINANCIAL 2 COSTS Coal may be cheap to burn but the 15 consequences are costly. Not only does coal contribute more than oil and gas to through 1 CO2 emissions, it also creates substantial air quality and pollution issues. No country has had to deal 5 Coal mports million tonnes more with these problems than China. 21

Any frequent visitor to China 211 21 17 2 213 214 215 21 23 24 25 2 27 2 28 212 22 1 18 cannot help but notice how poor China ndia the air quality has become. If you travel into the industrial north Source: LGIM Analysis, Credit Suisse or the developing west, it can be very unpleasant. In January this year, the Chinese Ministry of Environmental Protection from significant air pollution in late March, Beijing closed its last published data conceding that over issues. This problem might once coal plant situated within city limits 60% of Chinese cities were suffering have been ignored, but no longer: following constant public pressure.

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THE GOOD NEWS – REDUCING Figure 4: Forecasters hold very different views CHINA’S DEPENDENCE ON COAL of future Chinese coal demand IS PROVING RELATIVELY EASY Predicting how fast Chinese 35 3 coal consumption will decline in 25 absolute terms is difficult to do with 2 any confidence. Three independent 15 forecasters have dramatically 1 different views, as can be seen in 5 Figure 4. That said, all agree that we have either passed, or are close to, 214 21 12 212 218 1 14 1 22 224 22 23 234 24 2 2 18 21 222 228 232 the peak of Chinese demand. 22 28 Actual Hard onnes Euialent orecaster 1 China stands apart from the rest orecaster 2 mplied of the world in that, according Source: LGIM Analysis to our estimates, almost 50% of Figure 5: The rapidly decreasing cost in solar its demand for coal is for power and the remaining half for heat, 3 burned in small-scale industrial and 25 residential boilers. Contrast this to the US, where about 93% of all coal 2 consumed is for power generation. 15 We see both sources of Chinese demand being displaced over time 1 and on multiple fronts. rice in mmbtu Real 5

The first is replacing coal-fired 27 2 211 213 215 boilers with electric-powered energy sources. Even if coal power Henry Hub itumous Coal rent N olar plants generated this electricity, we Source: LGIM Analysis, Bernstein estimate that coal savings would still be about 15% because of how On the power generation side, reducing coal demand. Plant inefficient small-sized boilers are. huge falls in the cost of renewables efficiency is judged on a scale from (Figure 5), scale advantages of the ‘sub-critical’, the least efficient, to The second is to replace coal-fired domestic nuclear industry and the ‘super-critical’ and the imaginative boilers with gas boilers. There is cheapening of imported gas have superlative ‘ultra-supercritical’. an increased cost associated with encouraged the replacement of coal- Over 50% of Chinese coal plants displacing coal with gas. However, powered generation. We believe that still remain sub-critical. However, as we learned from recent meetings many investors are underestimating while it is unrealistic to assume with a leading Chinese city gas how fast the Chinese power this improves dramatically in a distributor, government subsidies generation sector is going to shift very short period of time, the on- to encourage such switching are away from coal to alternative energy going gradual modernisation of the increasing. For example, a new and sources such as solar. Chinese fleet can potentially reduce very generous policy to encourage coal consumption materially. That even non-urban consumers to Finally, we believe that coal power said, the domestic availability of switch fuel is now in place in parts plants’ technical improvements are sufficiently high grade coal may be of northern China. increasing efficiency and therefore a limiting factor.

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SEABORNE COAL – A BALANCING Figure 6: Seaborne coal price has largely tracked ITEM FOR ASIAN CONSUMPTION the Chinese domestic price While a decline in total coal consumption in China is good 12 news for the environment, the implications for investors’ 1 portfolios is less rosy.

8 The bulk of coal exposure in typical portfolios is to the internationally- traded market (seaborne), as opposed to the Chinese domestic market. The seaborne market is essentially 4 a ‘balancing item’ for Chinese and ul 1 ul 15 ul 13 ul 14 Oct 1 Oct 15 Oct 13 Oct 14 Apr 17 Apr 1 Apr 15 Apr 13 Apr 14 an 17 an 1 an 15 eb 13 other Asian power generation un 17 markets. As a consequence, prices eaborne Coal Chinese Coal for the seaborne market very closely Source: LGIM Analysis, Bloomberg, rebased to 100 as at 1 January 2013 track the Chinese domestic price (Figure 6). meet domestic demand (especially tonnes of seaborne coal? Indeed, The difficulty for investors is that premium ) but this dynamic as Figure 7 shows, China has been as China’s demand for coal has begs an important question: a net exporter of coal in the past. If declined in recent years, it has when coal demand starts rapidly China ceases to be an importer of opened up significant domestic declining and the spare capacity in thermal coal, then this could swing spare capacity. China currently China grows, will China continue the seaborne supply/demand imports a large amount of coal to to import more than 100 million balances by about 15%.

Figure 7: Peak coal demand (consumption) leaves significant ‘spare capacity’

1 25

5 2

15 -5

-1 1

-15

5 -2

-25 21 181 11 27 22 28 183 187 17 212 182 21 211 213 214 23 24 25 2 2 185 15 1 2 184 18 13 14 1 188 12 18 215 18 1

China Coal alance Hard onnes Million Euialent Coal consumption RH

Source: LGIM Analysis, BP, Jefferies Research

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WHERE COULD WE BE WRONG - Figure 8: Coal leverage has moderated, in contrast to independent THE PROBLEM OF DEBT AND THE power producers (IPP) CHINESE POLICY RESPONSE 2016 was a year that made structural 325% coal bears like us look a bit foolish. 3% After five years of price declines, 275% coal prices more than doubled in 25% the middle of the year and the share 225% price of coal companies (some of 2% which were extremely indebted) 175% rose by even more. The reason for 15% this dramatic reversal in fortunes 125% was due to Chinese government 1% policy. an 11 an an 7 an 8 an an 1 an 12 an 13 an 14 an 15 an 1 an 17

Since opening a coal mine in Coal Combined

China had previously been such a Source: LGIM analysis, Jefferies Research fantastically profitable business, many smaller mines opened in the period between 2009 and 2011. it seems unsustainable to allow and has probably seen peak As prices started to collapse these importers to gain market share demand. Companies engaged mines became large borrowers and profits at the expense of highly in the business of mining coal from what is colloquially called indebted domestic coal producers. to sell into the seaborne market the ‘shadow banking sector’ in are at risk of having substantial China. But expanding capacity and It is clear that the demise of coal is stranded reserves that will never lower prices meant that such heavy not going to be a linear journey, and be economically mined. Investors borrowing became unsustainable, is going to be extremely sensitive should therefore carefully consider and in late 2015 the solvency of to government policy response. their investments in companies China’s sector was a that extract, ship and trade potential threat to the country’s BOTTOM LINE thermal coal. financial stability. Coal mining and trading is a substantial economic activity, For coal companies this is a In response, in early 2016 the accounting for $81 billion of revenue miserable prediction, not just for Chinese government limited the in 2016 according to PWC. Our their shareholders, but also their number of days a domestic mine forecast of a long-term structural workforces and local communities could operate to roughly 260. shift away from coal could have who will require much in the way The consequence was a dramatic dramatic implications for investors. of transition assistance. However, increase in prices, leading to coal is one of the most polluting a natural deleveraging in the Over the next 10–20 years, we and carbon-intensive fuel sources. domestic coal sector (Figure 8). believe that the largest coal If we are right, then this is But this policy has come at a cost, consumer, China, will increase tremendously positive for global forcing higher leverage within its self-sufficiency. At best, coal climate change objectives, the domestic power producers as will form an ever decreasing alongside encouraging implications coal prices increased. Moreover, share in a growing energy mix for pollution and air quality.

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