Keeping it Cool - Air Conditioning and ESG

 

2023 has smashed through multiple global temperature records. With more than 1,500 heat-related deaths in the US in 2022 alone, air conditioning is an immediate response to making our homes, our places of work, more liveable. It’s also making the problem worse. It’s no surprise then that demand for air conditioning set to keep growing at breakneck speed.

In this special episode, Francois Kotze, Portfolio Manager at Man GLG, and Amanda Wong, Analyst at Man GLG, share their research into the ‘cooling conundrum’ and why green bonds can demonstrate a commitment to sustainability from manufacturers.

Recording date: September 2023

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Mark Chappel

Hello and welcome to a special podcast episode from Man Institute. I'm Mark Chappel and I'm joined today by Francois Kotze and Amanda Wong from Man GLG to discuss how sustainability focused investors should consider air conditioning. Francois, Amanda, welcome to the podcast.

Francois Kotze

Thank you.

Mark Chappel

So we're sitting here in London or the U.K. and I think it's often easy for us to forget how much some parts of the world truly rely on air conditioning. I think I read that air con accounts for maybe 70% of all household power consumption in Saudi Arabia, with three quarters of them running it between ten and 24 hours a day, which is, quite frankly, insane.

Mark Chappel

Can you share a sense of what this massive demand for air conditioning around the world really looks like?

Francois Kotze

Yeah, that seems about right, actually. Throughout much of northern Europe, air conditioning is mainly seen as a commercial or a product that we experience in vehicles. But in the rest of the world, the demand picture looks completely different, with both households and businesses relying heavily on air conditioning. Demand for air conditioning is also set to essentially quadruple by 2050, according to the International Energy Agency, versus a 2016 baseline because of rising populations and incomes in part of the world that rely much more heavily on air conditioning systems like China and India.

Mark Chappel

So can you put that in context? What is quadrupling mean? Did you have any numbers there?

Francois Kotze

So currently the world has around 6000 gigawatts of installed capacity of air conditioning, and by 2050, that could look a lot more like 24,000 gigawatts installed capacity.

Mark Chappel

Incredible increase there from demand.

Francois Kotze

But an important point is how energy intensive will that 24,000 gigawatts of installed capacity be, as we'll see later in a couple of numbers. The total electricity demand from that installed capacity can vary hugely depending on the actions we take.

Amanda Wong

Yeah, I think, you know, we have a classic case of a catch 22, so demand for air conditioning is going to contribute pretty significantly to global warming. One true HFC, which for our viewers who don't know, that's hydrofluorocarbons. So the most commonly used type of refrigerants and air conditioning systems, and they have a really large global one potential gwp.

Amanda Wong

And second, true, as Francois was talking about, the amount of electricity they consume. So, you know, in a nutshell, our desire to control the climate inside is basically ruling the climate outside, which is not really great.

Mark Chappel

So really, it's there's two elements there have understood that right is about what's in these air conditioners, the manufacturing, as well as the use of these air conditioners, the efficiency of electricity demand on the power grids as well. So it's kind of, as you say, this making the inside cooler can have a huge impact, not just of point of production, of how they're made and the products that go into it, but also just the running.

Mark Chappel

And as we see in Saudi Arabia, the share running over almost full time, nonstop.

Francois Kotze

And the more we run them, the more global warming gets worse, the more we have to run them.

Mark Chappel

Yeah, exactly. So it's kind of spiral spiraling case. So I think what we've what we've talked about here is kind of the demand for air conditioning being this massive part. But of course, these countries who are experiencing climate change perhaps most acutely or are in places where, frankly temperatures are unbearable for humans during the day or at certain points are quite often the developing countries.

Mark Chappel

Can you tell us a bit more how this global demand actually looks like on perhaps a more regional basis or in specific to certain countries?

Amanda Wong

Yeah, for sure. You know, if you look at a world map and, you know, if you zero in to see where the increased demand for air conditioning is coming from, it's not surprising you find countries like India and China. And that's because you know, disposable incomes have been rising. And plus the climate there is really, really hot. I was back in Malaysia, so that's my hometown.

Amanda Wong

I'm Malaysian, alas, for the last few weeks. And it just hit me how hot it was. I've been here for a few years now and I forgot how hot it could get in Malaysia. If you're there in the afternoons, it's just that so no one is outside. Everyone is inside with the air conditioning. And I think it's really interesting to note that the father of Singapore, Lee Kuan Yew, he once said that the key to success for his country is what, like over a hundred fold increase in GDP per capita in the span of 50 years plus because of air conditioning.

Mark Chappel

To boil it down to that one, that yeah.

Amanda Wong

That was the one thing. So the first thing that he did as prime minister was just to install air conditioning units everywhere in his public service buildings because before the only hours you could really work was in the morning where the weather was a bit cooler. And then the afternoons you just more as those off. I can relate.

Amanda Wong

I was you just do nothing in the afternoons. So it's very clear that you have the doubling or even more of productivity once you install air conditioners.

Mark Chappel

And a contributor to economic output then is this climate intensifying unit and yet it's such a necessity.

Amanda Wong

Yeah, it's not just a luxury. Well, yeah, one, it actually helps your productivity.

Mark Chappel

Yeah.

Francois Kotze

There's a huge clear and clear social benefit of air conditioning and that definitely needs to be set against what is only a potential environmental cost. India, Indonesia, China to a lesser extent are countries that are driving the demand, but also the climate in these countries are already quite hot. Yeah, and of course. And any further increase will take a significant toll on the people living there.

Francois Kotze

I mean, studies have shown that a lot of weather, as Amanda said, impairs sleep, impairs cognitive ability. It's not great for workers productivity or long term health. And we've already mentioned that even in the US, heat waves can lead to significant deaths. We don't have great data on the amount of deaths caused in India by heatwaves in 2023, but one can estimate those numbers don't look good.

Francois Kotze

So the social good air conditioning can do is therefore immense, and the environmental challenges they present are not insurmountable. So it looks like they have to stay.

Mark Chappel

So, yeah, I was going to kind of follow up exactly on that point. So what I'm hearing from both of you is that the economic benefits, the social benefits of conditioning are so great that to say for the sake of the climate, we must go without. And in fact, that would greatly have the many developing countries economic prospects.

Mark Chappel

So air conditioning is here to say. I don't think anyone can quite rightly argue against that for these very specific countries that we've talked about. So what does a solution look like? How can the world have its air conditioning cake and eat it too?

Amanda Wong

Yeah. So I think what you're trying to say is can we have the social benefits? Would out the bad, the environmental consequences.

Mark Chappel

Exactly right.

Amanda Wong

Yeah, I think we can. I think if we want to do that, you kind of have to be quite holistic in how you approach the problem, looking at it from every conceivable angle. And, you know, for us, what we feel like the most direct way to address this is via efficiency. So if you look at air conditioning, the effective efficiency of more or less improve by about 1.7% since the nineties, you could argue that this could be a step change over time because most efficient technologies today are more bonds.

Amanda Wong

But I think a lot of it also comes from the fact that they have improved significantly through R&D. And I think that's something that we as investors can definitely help with and we'll talk about that later. And then from a separate angle, government policies for sure are really important. You know, China and India, they already have monetary performance standards for air conditioning.

Amanda Wong

So we expect then we hope that these will be tightened over time. Just a couple of examples. You know, in terms of the retail market, you can have government policies that shift the initial cost outlay for air conditioner to the energy consumption versus, you know, the initial costs of buying the air conditioner. And since air conditioners have about a 10 to 15 year lifecycle, you have about, I guess, two life cycles before 2050.

Amanda Wong

And, you know, you could also focus other things like designing buildings that require a lot less air conditioning, for example, again, kind of bringing it back to Malaysia. If you look at a lot of all three or houses, they're actually very old when you're inside and they have no air conditioners installed at all. And that's because of the natural air.

Amanda Wong

Well, that you have there. So I think, you know, it's more of a holistic solution and how we can approach it.

Mark Chappel

Yes, exactly. Because it feels like there is both improvements in the architecture, as we kind of described, kind of from countries that have been historically this hot in them. Yes, they were that prior to air conditioning. But then approaching this problem and kind of through these kind of behavioral incentives, almost like the move to electric vehicles or key pumps for the UK or kind of subsidizing solar panels, there are all these kind of public policy ideas that can really assist.

Mark Chappel

And as you say, I feel like air conditioning lifecycles are not so long that we have to make those kind of trade offs. Right now, there is a chance for manufacturing efficiencies to really make an impact quite soon. Would you agree?

Francois Kotze

Yes, I completely agree. And I want to just illustrate the point without getting too technical so earlier. Not to be confused with the gigawatts of installed capacity. I want to talk now about the electricity required to run that installed capacity. And currently we're using 2000 terawatt hours a year to run our air conditioners globally, roughly under a baseline scenario outlined by the International Energy Agency.

Francois Kotze

This could grow to 6000 by 2050, but with the aforementioned gains could also actually remain steady at around 2000 until then. So we can keep it as flat.

Mark Chappel

In a in a in a strange way.

Francois Kotze

Even as the installed capacity quadruples. Yeah, that's possible. Although some of that is accounted by efficiency gains through more efficient buildings, etc. So slightly less installed capacity, but nonetheless the efficiency potential gains are huge. And then air conditioning because of that 2000. So I was actually consumes about 10% of all electricity generation currently by 2015 that could be 15% or it could be 5% depending on how much efficiency gains we can squeeze out of the system.

Francois Kotze

Not only that, but it's then also about and this is where Amanda's holistic point comes in, how much carbon that 2000 terawatt hours electricity takes to generate because of currently, if you're in France, for instance, because of their energy policy, has led them down a path of mostly nuclear wind. Right. Which is low carbon, using that amount of energy would be significantly less than if you're in the US or China, which still rely more heavily on fossil fuels.

Francois Kotze

So that part of the policy is also key and will be part of everybody's policy globally as we move towards hopefully net zero in or before 2050.

Mark Chappel

Exactly. Electrification is such a big part of that puzzle and kind of the source of that energy mix and kind of diversification across EV renewable and let's call them green sources like nuclear as an example.

Francois Kotze

Exactly. And one last point on the solution. The demand for air conditioning also creates a problem in that the demand for power spikes during the warmest times of the day, which creates the problem of oversupply because gas and coal power plants don't like being turned on and off in a 12 hour cycle. But fortunately for us, and part of the holistic solution is solar panels have a very similar, very high correlation towards when air conditioning demand, when it's sunny and warm outside, the solar panels are producing electricity.

Francois Kotze

So that is a great way the world could potentially deal with those air conditioning power spikes. We have to look at solutions from every angle and they're all solutions to the problems.

Mark Chappel

I completely agree. Amanda, anything to add on this kind of understanding of the energy mix from a fundamental.

Amanda Wong

Oh, yeah. I mean, I think for so I did a really good job of illustrating the problem itself. And I think if you look at it in terms of the building blocks, you need efficiency gains, government policy moving to renewables, and that's kind of the blueprint that you want to reach net zero. And I don't think it's just limited to the air conditioning industry.

Amanda Wong

Like other industries, other manufacturing industries can easily take those and use it to get to their net zero path as well. So it's that free building blocks which is applicable to other sectors, I think.

Mark Chappel

I'd love to turn here to the investment problem, obviously with yourselves as part of the discretionary investment teams. What is it that you see as an opportunity here perhaps, and how can you influence these changes? Certainly from a position as a fixed income investor through cost of capital or certain fixed income products or issuances that might make a difference here?

Amanda Wong

Yeah, sure. So I think having talked about how important efficiency can be as a means of solving this problem, I think as investors, you want to approach it from that angle, encouraging companies to invest more in R&D, right? And if we're working from a baseline of banning air conditioners, socially unjust and potentially counterproductive as environmentally and socially conscious investors, I think improving the efficiency of these products, it's a win win, both from ESG and returns perspective.

Amanda Wong

And I think that green bonds is the perfect tool for us to achieve that. And I feel like, you know, with the recent news and a lot of the criticisms that you have with ESG, I feel that far from saddling a company with additional costs, which is how ESG is often viewed, I think with this air conditioning thing, companies that are the most environmentally friendly with the most efficient air conditioners, they will have the most competitive advantage.

Amanda Wong

And I think that if you invest in the R&D, they come up with the more efficient air conditioners. It will feed through to the bottom line of the P.A. because you have to think about how, you know, governments are moving towards regulating this space. It's the companies that have the dirtier, less efficient units that are going to take that regulatory penalty and that will translate to your bottom out.

Amanda Wong

So, yeah, like I said, it's a win win both from an ESG and a returns perspective. It's not an either or. You're not giving up anything as an ESG investor.

Mark Chappel

That's really interesting to understand Green bonds here as a tool for demonstrating sustainability. Francois, why particularly green bonds here and what are you looking out for in this way?

Francois Kotze

So we're going to use Johnson Controls as an example here because they've recently issued a green bond and they are a manufacturer of their conditioning units. So green bonds are a great way for investor to channel funds towards a specific project because the point of a green bond, without getting too geeky about this, is to have a limited use of the proceeds of that bond.

Francois Kotze

And the main use of proceeds for the JCS Green Bond was developing components and systems with a minimum of 15% efficiency gains for systems used in buildings and residential development, and in total, that could reduce their scope three emissions by 16% by 2030. So a very short term goal and the pretty significant haircut scope three emissions essentially means all the company's emissions and all the emissions from other people using that company's products.

Francois Kotze

So it's a pretty holistic definition of the total emissions from air conditioners that JCI produces. Companies also benefit from issuing green bonds.

Mark Chappel

So it's interesting kind of this is the real benefits, obviously, from your perspective as a portfolio manager. Amanda, tell us, what does the company understand or get really from issuing bonds? What's the incentive perhaps on that point?

Amanda Wong

Yeah, from a investor perspective, green bonds, as we were talking about, is a great way for investors to channel our money towards sustainable projects because the proceeds are specifically set for sustainable projects. So I think for companies there's also a benefit in issuing green bonds because one, they get a slightly lower cost of capital versus non green bonds.

Amanda Wong

So if you compare a regular bond that's being issued by a company versus a green bond, you'll see that the costs for issuing the green bond is lower. So it's kind of premium. But the other thing is also the companies can access this readily pool of willing couple of investors that want to invest in green projects and want to see the companies succeed from ESG perspective.

Mark Chappel

To wrap this up, are there any final thoughts you'd like to leave us or our listeners with on air conditioning in green bonds and perhaps thinking about green bonds in the context of this kind of manufacturing opportunity and demand opportunity for fixed income investors.

Francois Kotze

So air conditioning demand is going to grow and that will have enormous social benefits. In a warming world. There are potential environmental costs, however, but they're much less certain. Efficiency gains, building design, government policy and renewable energy can all play a part in effectively mitigating a great deal of those environmental costs and companies that lead the way in efficiency gains will have a competitive edge over those that don't.

Francois Kotze

And one way and a great way to get a competitive edge is through increased R&D spending, through more green bond issuance with their restricted use of proceeds. Investors that are environmentally and sustainably minded also get to invest their fixed income products directly into projects that finance R&D that is required to realize both these environmental and social benefits.

Mark Chappel

So there's a kind of direct result that you can see as a fixed income manager to be saying, This is why we really want to direct our capital in order to achieve their sell. Amanda, any final thoughts?

Amanda Wong

No, I think for as far put it in a really beautiful way. I think at the end of the day, if we were to be honest with ourselves, if we really want an equitable solution, that means moving forward to those environmental goals without neglecting the US. All right. And I think that's something that as an ESG investor that you have to pay attention to.

Mark Chappel

Well, thank you so much, Francois Amanda, for coming on the podcast. Thank you for joining us.

Francois Kotze

Thank you.

Amanda Wong

All right. Thank you.

Mark Chappel

Thank you for joining us. And be sure to catch all of our podcast episodes on Man DotCom Forward slash Man Institute Forward slash podcast. Thank you.