Hydrogen’s part in the energy transition

The need to decarbonise is a systemic issue as we still rely heavily on the hydrocarbon industry to provide us with the energy we need to drive, fly and heat our homes.

In fact, only 13%ⁱ of global energy consumption is currently generated by renewable sources such as solar, wind, or hydropower and this needs to be closer to 80%ⁱⁱ if we are going to reach the Net Zero Emissions plan as set out by the International Energy Association (IEA). One of the key sticking points still to be ironed out in the energy transition is what we do with the sectors that are difficult to electrify, the so-called ‘hard-to-abate’ sectors. It’s estimated that 30%ⁱⁱⁱ of global emissions lie in this category which receives the hard-to-abate tag due to complex industrial processes. For example, temperatures above 1,500°C are required in manufacturing iron and steel which is hard to achieve in an efficient manner using electricity. Likewise, long-haul transportation and aviation are considered hard-to-abate due to the weight disadvantage of large batteries, and in some industries such as chemical manufacturing, fossil fuels are used as the feedstocks as is the case for natural gas and ammonia.

A not-so-new technology that is likely to aid in the transition is hydrogen, which the IEA expects to provide around 10% of energy consumption in 2050 to achieve net zero^iv. The advantage of hydrogen is that it has 3x the energy per unit of mass when compared to gasoline, which is helpful for industries requiring a large amount of energy at one time. It is the most abundant element in the universe but on earth it’s readily found in a bonded form in water. Much like electricity, hydrogen is an energy carrier rather than an energy source, meaning it is used as a vector to transfer the energy from point A - for example where there is ample sunlight - to point B - where there is less. However, the crucial difference is that it is a chemical energy carrier that is more easily stored and transported over long distances in a stable way. This highlights an additional advantage of hydrogen in that it can add a stock element to the energy grid to help relieve differences in supply and demand throughout the day.

The use of hydrogen has been around for centuries with the first demonstration of water electrolysis in the 1800s to fuel the first internal combustion engine. Nowadays, we use a small amount of hydrogen mostly for oil refining and fertilizer production, but it is created by releasing fossil fuels into the atmosphere. Hydrogen has quite an extensive colour scheme attached to it which relates to how it is produced. We would call it grey or brown/black hydrogen when it is created using steam methane reforming (using natural gas) or the gasification of coal. But for the purpose of net zero the aim is to create green or at the very least blue hydrogen. The former uses renewable electricity to split water molecules into H2 and Oxygen (electrolysis) and the latter incorporates carbon capture utilisation and storage (CCUS) facilities to the traditional plants in order to limit the CO2 released. Today, less than 1% of the hydrogen produced is green or blue.

Unfortunately, hydrogen is not without its faults, and it doesn’t appear to be a straight substitute for the current oil and gas infrastructure. For starters it is very light and diffusible, making its volumetric energy density low, and hence higher volumes of hydrogen would be needed to be transported to meet the equivalent energy demand from say, natural gas. It contains small molecules which can permeate metals, causing embrittlement and the potential for hazardous leaks, and if it were to leak it is highly flammable, odourless, colourless, and has a flame that is not visible to the naked eye, meaning leak detection is that much harder. Another consideration is the current cost of renewable hydrogen. We still have a way to go in making hydrogen cost-efficient against current fossil fuels although there is unprecedented political support. For example, the 2022 Inflation Reduction Act announced in the US, included up to $3 in tax credits per kilogram of hydrogen produced in a low-carbon way. Bernstein estimate that currently on average green hydrogen costs around $6/kg (varying from region to region due to renewable energy costs) which would need to fall to between $1 - $2/kg to be competitive with crude oil on an energy equivalent basis^v. However, with political support, the economies of scale should aid technical developments in renewable power and electrolysers with the IEA expecting the cost of clean hydrogen to fall 30% by 2030^vi.

Despite 2050 being just a few decades away, green and low-carbon hydrogen is still a nascent industry with various barriers to overcome before widespread adoption. The risk that investors face is determining how exactly the energy transition is going to play out. At Evenlode, our investment process is focused on finding high-quality companies with an enduring competitive advantage. We consider ten key risks to evaluate a company’s quality, assessed using both qualitative and quantitative measures. These risks, often referred to as the risk factors by the Evenlode team, are graded on an A-E basis where A is the top score, E is the inverse, and C is what we would expect an average listed company to achieve.

Our exposure to the energy transition and the hydrogen market is confined to suppliers to Oil and Gas (O&G) industry rather than O&G companies themselves, which we don’t hold largely due to the capital-intensive nature of the industry; the cyclicality of cashflows and inherent link to commodity prices; and environmental considerations. The risk of a company’s end markets seeing medium to long-term impairment is captured in our Long-Term Industry Outlook (LTIO) risk factor, which assesses the threat of disruption and the growth rate of the industries in which that company operates. Our largest exposure at an individual company level is Rotork, a long-term holding in the Evenlode Income fund, which derives 40% of its operating profit from actuators sold to the O&G end markets. An actuator is responsible for creating movement in a system by converting different types of energy into motion, for example, Rotork’s products will be controlling the opening and closing of valves in a downstream pipeline to regulate the pressure and modulation of the liquids and gases. We grade Rotork a C on LTIO, as we balance the risks of lower O&G demand in the future with the opportunities of renewable infrastructure being even more actuator intensive. To illustrate this point, here is a quote from the LTIO section of our proprietary research on Rotork:

“The industry is set to benefit from a period of ‘double’ spend over the next 5-10 years as the existing O&G infrastructure undergoes investment to reduce reliance on Russian gas, reduce methane leaks, invest in Asia infrastructure growth and Liquid Natural Gas opportunities which act as a bridge to the renewable future. This will be alongside further investment into the hydrogen economy and new technologies where the actuator intensity of the infrastructure is higher due to there being more steps in the value chain (liquification and regasification, carbon capture and storage, and conversion to and from ammonia). The long-term threat is around Rotork’s exposure to the current O&G infrastructure which may experience low growth over time as the assets aren’t used in the energy transition.”

We consider the LTIO risk in combination with the nine other risk factors, to produce our maximum position, which is a self-imposed limit on how much of the portfolio we will hold in that company, regardless of the valuation attraction. It, therefore, is an amalgamation of the risks we see for a company and is a key tool used to ensure we don’t overexpose the portfolio to the risks we have identified.

As the need for rapid decarbonisation evolves, there is also a role for significant innovation to aid the bridge from the old energy world to the new. Some of the difficulties discussed earlier are already starting to be solved with innovations in development. For example, Victrex - a holding in our Evenlode Income fund - is a world-leading manufacturer of high-performance PEEK (polyetheretherketone) polymer, which is known for its high resistance to thermal, chemical, and mechanical erosion. PEEK’s molecular structure is tightly packed, creating low permeability (even for hydrogen) meaning it could be used to seal, or as a lining in transporting and storing the extremely buoyant H2 particles. Another example is Halma, a recent addition to the Evenlode Income fund which is a group of global companies that specialise in targeting niche markets across safety, environmental, and medical end markets. They are engaged in the production of sensing and detection equipment specifically for identifying a hydrogen gas leak and addressing the pitfalls of traditional sensor technologies for flammable gas detection.

To conclude, hydrogen-based technology is still in its early stages, but research shows that there certainly are applications for it where it appears to be the optimal energy solution in a decarbonised world. On balance, we view hydrogen as potentially disruptive but largely limited in our portfolio to companies with O&G end market exposure, though it also presents certain opportunities for these same companies, and others, given the new infrastructure build-out and operational challenges faced for dealing with such a difficult molecule. We continue to monitor longer-term trends such as the energy transition and hydrogen development as part of our risk factor framework and analyse the potential disruptive impacts on our portfolio companies on an ongoing basis.

Charlotte Lamb, Investment Analyst
2022

Please note, these views represent the opinions of the Evenlode Team as of 2022 and do not constitute investment advice. Where opinions are expressed, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This document is not intended as a recommendation to invest in any particular asset class, security or strategy. The information provided is for illustrative purposes only and should not be relied upon as a recommendation to buy or sell securities. Every effort is taken to ensure the accuracy of the data in this document, but no warranties are given.