Pathways to decarbonisation: episode 5: the energy transition dilemma.

Having a common goal of limiting global warming to well-below 2°C - and ideally 1.5°C - by the end of the century as set out in the Paris Agreement does not mean there is a common or accepted path for how to get there. There are as many 'pathways to Paris' as there are climate scenario models. In the more than 100 Paris-aligned scenarios that we have looked at, there is a lot of variety. Yet there are some points on which most models seem to agree:

1. Radical change to the world's energy and land use systems is required.
2. The battle will be won or lost in populous emerging markets, where energy supply must grow to meet increasing demand while these markets simultaneously transition to low-carbon sources.
3. Action must be taken as soon as possible, as it will be significantly less costly in monetary and socio-environmental terms than delayed action.
4. Policy must address all fundamental elements of the transition to allow the demand and supply sides of the system to adjust as required.
5. Carbon pricing is a core ingredient of any effective policy framework.

And 6. None of the above will be feasible if the supply of metals does not keep pace with the spectacular demands expected to be created by the needs of the energy transition.

And herein lies the dilemma for investors: metals are essential inputs for the hardware of decarbonisation - there will be no energy transition without a very large increase in the production of critical minerals. Yet the production of minerals can itself be a greenhouse gas (GHG) emission-intensive process. How should investors engage?

We have conducted a deep dive into this dilemma alongside Legal & General Investment Management (LGIM), Risk's Investment House of the Year 2022, a key thought leader on this absolutely critical theme.¹

You can read the full report here.

Our conclusion was that there are two clear roles for investors in respect of this dilemma:

• Engage constructively with the resources industry to help drive down operational GHG emissions.
• Mobilise the capital that will be required to ensure metal supply does not become an obstacle in the race to Paris.

We believe investors must be a part of the transition through engagement, focusing efforts on creating an environment where companies, governments and allocators of capital work together to build the ecosystem where clean energy alternatives compete with and beat the incumbent GHG-emitting technologies.

Successful transition will require a vast capital reallocation and will generate material risks and opportunities, placing investors and global capital markets at the very centre of the challenge. Annual average energy capital investments would rise from around US$2tn today (2.5% of GDP) to around US$5tn for the period from 2021-50 (4.5% of GDP in 2030, falling to 2.5% of GDP by 2050) in the IEA's Net Zero 2050 scenario.² Total investment requirements in energy supply and infrastructure over the next 30 years could range from US$92-173tn according to Bloomberg New Energy Finance.³

Rising standards of living and population growth point to increasing resource consumption based on traditional drivers. Modern life is fundamentally dependent on the metals, energy and chemicals that the natural resources sector provides, which need to be supplied sustainably, affordably and at scale.

Yet the resources industry must not only continue to service demand based on traditional drivers in order to support sustainable development goals: it must also provide the material building blocks of the hardware required to radically reconstitute how we produce energy and use land. Whether the nickel used in electric batteries; the uranium needed to power zero operational⁴ carbon emissions nuclear reactors; the steel used in wind turbines; the potash required to boost agricultural yield for biofuels and conserve land for afforestation; the silver and silicon used in solar panels; or the copper that will enable the electrification megatrend at large, the products produced by this industry will only grow in importance to the world. It follows that the size of the prize for reducing and ultimately eliminating the sector's operational carbon footprint is large. That is why a number of major resources companies, like BHP, have established ambitious and transparent objectives for operational GHG emissions reduction.

The role of critical minerals

Given the essential role that metals play in furnishing the hardware of decarbonisation, it is no exaggeration to say that there will be no energy transition without a very large increase in the production of critical minerals.

If the world takes the actions required for decarbonisation in the coming years, cumulative demand for metals is expected to grow substantially. In the 1.5°C scenario that BHP described in its Climate Change Report 2020 (available at bhp.com/climate), cumulative demand for primary copper may double in the next 30 years, and for primary nickel it may almost quadruple, in each case compared with the prior 30 years. Steelmaking raw materials do a little better than one might think in the scenario - with an uplift over traditional crude steel ranges due to additional demand from extra wind turbines and carbon distribution pipelines assumed, which should be more than enough in that scenario to offset a loss of steel demand from the fossil fuel industries as their output falls in the long run.⁵

The vital role for natural resources implied by our research is also supported by striking projections of the world's critical minerals needs under the energy transition from The International Energy Agency⁶, the US Department of Energy⁷, and the World Bank⁸, among others. The debate is not about whether metals are essential or not, but whether the resources industry is investing fast enough to keep pace with the demand projections derived from incontrovertible themes such as the EV 'S-curve', and the double-digit trillions of dollars required to be deployed on renewable energy capacity and the future proofing of the energy grid.

Wood Mackenzie argues that the base metals capex bill to achieve a 1.5°C outcome is US$2tn⁹ - noting that the global market copper, the bellwether for the complex, is currently about US$140bn at 2019 prices.

So we need to see a step-wise increase in the supply of metals: but we should not be indifferent to where it comes from and how it is produced.

It is important to recognise that the GHG operational emissions of mining assets can vary considerably, and an industry average may tell you little about any particular producer. Differences in emissions intensity from assets producing the same commodity are due to a number of factors, only some of which are controllable. Some of the most important are the power source for the project; the geological characteristics of the deposit; the distance to port; and the economies of scale at play, for instance the size of the mobile equipment and non-production infrastructure in place. Additionally, one needs to consider the different technological routes to the chosen saleable product. For example, there are a wide variety of types of nickel ranging from ~8% Ni content nickel pig iron, 40-50% Ni content ferro-nickels, 70-75% Ni content mattes, up to 99.8% London Metal Exchange (LME) grade and then nickel sulphate, the battery precursor feedstock that trades at a premium to LME. Management actions can impact upon many of these items and we would expect the best in class to take action to reduce the GHG emissions from production, as BHP has done with renewable power agreements at operated assets in Chile, Queensland, South Australia and Western Australia.

Continuing with the example of nickel, which is the key metal in the battery cathode chemistry that we expect to enable the long term decarbonisation of transport. There is an enormous gap between the GHG emissions intensity of an integrated nickel sulphide operation utilising renewable power and, say, a nickel laterite operation fed with power from a plant burning lower calorific value coal, and producing an intermediate variety of nickel through high pressure acid leaching. And that is before additional sustainability questions of land clearing, tailings disposal and broader biodiversity impact are considered.

The energy transition obviously requires a lot more nickel to be produced, promptly, but the world should be demanding as to how it is produced. Auto original equipment manufacturers (OEMs) are increasingly conscious of the differentiation within the industry and are acting to secure the sustainable supply that their customers demand. BHP's recent agreements with Tesla and the Toyota-Panasonic battery joint venture (Prime Planet Energy & Solutions and Toyota Tsusho Corporation) are indicative of this. Other OEMs, like Renault and Rivian, have indicated they will back a moratorium on sea bed mining, which is a controversial new supply frontier.¹⁰

A final consideration is that capital needs to be mobilised today to ensure metals remain the affordable backbone of the energy transition. The discovery, appraisal and development of new metal deposits is a time and capital-intensive process, where a decade from start to first production would be regarded as incredibly swift. Exploration success has been only modest over the last decade, and in the case of copper, the bellwether for both the base metal complex and the electrification mega-trend, grade decline is expected to become a material headwind for primary supply over the course of this decade. The industry does not currently have an abundance of high-quality development opportunities ready to go, and scrap supply is insufficient to fill the gap.¹¹

Summing up the key message on minerals demand and supply:

• The energy transition will not happen without a massive increase in the supply of metals.
• Yet the extraction of minerals can itself be a GHG emission-intensive process in general, albeit there is considerable diversity across commodities and across operators as to emissions intensities.

We believe there are two clear roles for investors here: (i) engage constructively with the sector to help drive down operational emissions; and (ii) help mobilise the capital that will be required to ensure affordable metal supply does not impede the race to Paris.

Appendix. The many, many paths to Paris

Source: BHP and LGIM analysis, as at 31 December 2021.

Note to table: (1) Refer to the BHP Climate Change Report 2020 available at bhp.com/climate for information about the assumptions, outputs and limitations of BHP's 1.5°C scenario.

Important notice: There are inherent limitations with scenario analysis and it is difficult to predict which, if any, of the scenarios might eventuate. Scenarios do not constitute definitive outcomes for us. Scenario analysis relies on assumptions that may or may not be, or prove to be, correct and may or may not eventuate, and scenarios may be impacted by additional factors to the assumptions disclosed.

Footnotes

¹ Investment house of the year: Legal & General Investment Management - Risk.net
² Sources: https://www.iea.org/reports/net-zero-by-2050
³ Source: https://about.bnef.com/new-energy-outlook/

⁴ Here we distinguish between "operational" emissions from the generation process itself and "cradle to grave" emissions, which draws the boundary more widely, and are more correctly assessed as "low" rather than "zero" carbon.
⁵ Potash, a future facing portfolio commodity for BHP, receives an additional demand fillip on top of its already compelling demand fundamentals under deep decarbonisation due to biofuel crops and the need for even greater intensification of agriculture as competition for land from afforestation and renewables ramps up. BHP's 1.5 degree scenario did not simulate an abrupt change in diet. A standalone scenario on what a global move towards veganism would do to potash demand has however been conducted. Its output indicated that there are many moving parts, and potash demand finishes roughly square. The dynamics are that livestock feed demand declines, reducing crop demand, but this is offset by two forces: (1) plant based calories replace meat calories, partially offsetting the loss of feed demand; and (2) the manure provided by livestock, which is a competing source of nutrients for crops (20% of potassium supply), is lost and is replaced by higher potash intensity of use. For more details see BHP's potash briefing at https://www.bhp.com/investors/presentations-events
⁶ https://www.iea.org/reports/the-role-of-critical-minerals-in-clean-energy-transitions
⁷ https://www.nrel.gov/transportation/assets/pdfs/battery-critical-materials-presentation.pdf
⁸ Hund, Kirsten, Daniele La Porta, Thao P. Fabregas, Tim Laing, John Drexhage (2020) 'Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition', World Bank: Washington DC, available from https://pubdocs.worldbank.org/en/961711588875536384/Minerals-for-Climate-Action-The-Mineral-Intensity-of-the-Clean-Energy-Transition.pdf

⁹Kettle, Julian "Can metals and mining keep the 1.5 degree dream alive", December 2021.

¹⁰ https://www.reuters.com/business/autos-transportation/exclusive-frances-renault-says-it-backs-moratorium-deep-sea-mining-2022-02-09/
¹¹ BHP analysis indicates that scrap currently provides around 31% of copper units globally, 33% of steel and 30% of nickel, with end-of-life collection rates of around 55-60%, 80-90% and 65-75% respectively. These proportions are expected to rise, but in BHP's view are unlikely to pass 50% of total metal units in any of the three before mid-century.