Schroder International Selection Fund

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1 Schroder International Selection Fund Global Climate Change Equity Monthly Newsletter May 2018

2 Special topic Mind the (band) Gap The trend towards electrification of many industries is both well established and well supported by climate change policy trends. Efficient management of electrical power is therefore crucial, and one very interesting area is the market for power management chips, which encompasses products such as inverters, diodes and power transistors. The traditional silicon-based technology for power management is now reaching technical limits meaning that performance improvement is quite incremental. However, a new category of wide band gap (WBG) materials such as Silicon Carbide (SiC) and Gallium Nitride offer material reductions in energy loss, and are set to take considerable market share. The main drawback of these materials has been manufacturing cost, which remains significantly above silicon devices. Production costs are coming down though, and will fall further as volumes ramp up. For high power management applications, such as an electric vehicles (EV), silicon carbide is likely to be the most viable material and can reduce power losses in the inverter by 70-80%. The example below illustrates how the overall costs including power savings available to the consumer, are now beginning to make these devices viable in EVs. Comparison of silicon and silicon carbide transistors for EV power management Source: Power America, CLSA research, March 2018 Virtually all industry participants expect an eventual shift towards wide band gap materials, and are investing heavily in the research and development, or acquisitions, necessary to position themselves for the transition. As a result, fast growth is expected for silicon carbide devices, with compound growth of over 30% in the next 5 years. May newsletter Special topic Mind the (band) Gap As we approach the limit of what silicon-based technologies can deliver in power management, a new category of materials is providing exciting opportunities in energy saving. Policy developments and climate change news We assess if the impact new policies have on climate change is waning. Investment philosophy While the path to a lowcarbon economy is predictable, we do not believe it is well understood, or discounted, by the equity market representing a significant alpha generation opportunity. A broad investment universe gives us the opportunity to select only the best stock ideas across all sectors, and we believe that a portfolio consistently focused on these stocks will outperform global equities over time. Stock selection strategy and activity We believe that the structural growth trends created by climate change will remain a powerful underlying driver to performance in global equities, with the hugely compelling returns on energy efficiency investments making this the most powerful theme in the short term. Schroder ISF* Global Climate Change Equity is a product of the Global and International Equity Team Schroder International Selection Fund 2

3 Silicon Carbide device market size estimates, by application Marketing material - For professional investors and advisers only Source: Yole, CLSA Research, March 2018 Power management incumbent Infineon is relatively well positioned for this transition, as they have good SiC technology to allow them to migrate customers from silicon products. However, US-based company Cree is a very interesting relative pure play on this growth. Cree s Wolfspeed division specialises in SiC substrates and power management devices, and doesn t face the drag on growth from the eventually declining silicon market as they have no position there. Cree also supplies Infineon and others in the industry with the SiC substrates that they use to manufacture power management devices, providing them with broad exposure to penetration of the technology without facing all of the competition in device engineering. Science and Policy Developments Peak Policy are politicians running out of steam in tackling climate change? 2017 marked one of the three warmest years on record and the warmest since 1850; reached without the influence of El Niño on temperatures in the Pacific Ocean. The blame lies with relentless rises in atmospheric levels of greenhouse gases (figure 1). While the dates and headlines change, the message has been consistent for years: tougher action and more radical changes in the global energy system are needed. Figure 1. Direct measurements: 2005 present CO2 (parts per million) Year Source: Schroder International Selection Fund 3

4 Politicians and regulators have historically been seen as the key change agents. Investors and the media have focused on their willingness to introduce legislation to create meaningful penalties for carbon emissions, provide incentives for alternatives or outlaw high carbon activities. The growth of emission trading schemes is an example of that policy in action, such as implemented in the EU and China. However, despite the growing evidence for the need of change and some headline policies, in general political leaders have proven indecisive in recent years. While implemented legislation saw a steady increase from 2004 to 2012 (green line in Figure 2), recent years have shown much less legislative output. On the face of it, that weak level of action presents a challenge to companies focused on climate solutions. However, the challenge is much lower than it has been in the past. Figure 2. Policy impact is fading Policy was historically a bigger driver of profitability......but has become less so as climate technology economics have improved Laws LHS Alt Energy return on assets RHS Source: 2018, Climate Change Laws of the World, Grantham Research Institute on Climate Change and the Environment; Thomson Reuters The blue line shows the profitability (return on assets) of the global alternative energy sector. The blue and green lines profitability and policy moved in tandem until 2010/11. Since then however, that relationship has broken down; technological advances make alternative energy increasingly competitive with fossil fuels, regardless of policy support. Policy still matters without government intervention its hard to see how the global economy will come close to the two degree limit agreed in Paris but companies and investors fortunes are no longer tied to policy cycles. The trend affirms our view of the opportunity from identifying future growth markets driven by the adaption to, and mitigation of, climate change. Policymakers may find their mettle but if they do not, climate investing has matured beyond its shadow. Schroder International Selection Fund 4

5 Strategy and outlook Momentum behind the transition to a low carbon economy is picking up. Global policy makers, leaving the Federal US Government in the dust, continue to offer support and incentives for low emission infrastructure and technology investments. However the most crucial driver of acceleration has been the dramatic improvement in competitiveness of clean technology economics to the point where they require little or no subsidy to compete head to head with fossil fuel technologies. This means that the opportunity for growth is vast, as investments are made to displace combustion engine vehicles and fossil fuel power generation, and we expect the next 5 years to be a critical inflection point in that transition. Current allocation (%) Investment theme % of fund Sustainable Transport 22.6 Energy Efficiency 21.6 Clean Energy 18.0 Environmental Resources 17.9 Low-Carbon Leader 12.7 Other 4.0 Cash 3.2 Total 100 Source: Schroders, as at 31 May 2018 We continue to believe the automotive sector is set for very rapid and fundamental change, with an accelerated adoption of electric vehicles (EV), taking EV penetration up towards 25% of global new car sales in 10 years time. We have good and diversified exposure to this space through car makers, battery manufacturers, materials and component suppliers. We also expect rapid adoption of renewable energy practices worldwide, particularly in solar but also in wind, where technological gains are helping make installation more affordable. We have selective exposure to higher quality investments in these areas, mindful of inherent industry volatility, but have raised position sizes in wind stocks in recent months as buying opportunities presented themselves. The returns on energy efficiency investments continue to be financially compelling, though we have been using some of our long standing holdings exposed to this theme as funding sources for our increased holdings in sustainable transportation and clean energy related stocks. This theme includes lightweight materials, insulation, efficient housing, or more efficient use of energy by businesses. Finally, we are turning more positive towards environmental resources via agriculture-related stocks in particular. After years of excess inventories and declining crop prices, we expect that farm incomes have found a floor and that investment in yield-enhancing technologies such as drip irrigation, precision application, and farm machinery will recover over the coming years. In May we bought Danish power firm Orsted, which is investing heavily in clean energy as part of a strategic shift towards renewables. Orsted is converting combined heat and power (CHP) plants to biomass and has disposed of fossil fuel production assets. It plans to phase out coal use entirely by 2023 and is investing to reach installed wind capacity of 11-12GW by That strategy puts it in a strong position to be among Europe s leading clean energy generators and its generation fleet is already substantially less carbon-intensive than the European average. In 2017, carbon emissions from its heat and power generation were 151g CO2e/ kwh against 224g CO2e/kWh in That generation base and strategy put it in a strong position to benefit from higher European carbon pricing, helped by the connection of northern European power markets. We sold our positions in Jain Irrigation and Sealed Air. Schroder International Selection Fund 5

6 Investment philosophy Marketing material - For professional investors and advisers only Tackling climate change will have a powerful impact on the global economy. Long-term policy goals to cut greenhouse gas emissions require nothing less than an industrial revolution to engineer a low-carbon economy. Adapting to some climate change that is already inevitable and mitigating further climate change through the transition to a low-carbon economy will therefore affect all industries over time. What is distinctive about our philosophy is our appreciation that the effects of climate change will be far-reaching and affect a great many more companies than those purely involved in renewable energy, energy efficiency and environmental resources. As such, we believe that a dynamic and evolving universe across all sectors is the best way to capture the investment opportunity. Schroders Global Climate Change Team has undertaken a fundamental analysis of every major sector of the economy in constructing our investment universe. We have created a comprehensive investment universe comprising approximately 600 stocks from developed and developing markets from which to select our best ideas. This broad investment universe also gives us the opportunity always to focus on great investment ideas, not just the stocks of the moment. Only the very best stock ideas make it into the portfolio, and we are not afraid to exclude whole sectors if they become overvalued. While the path to a low-carbon economy is predictable, we do not believe it is well understood, or discounted, by the equity market. As a result, the fast-changing growth and relative valuation opportunity that climate change presents to investors represents a significant opportunity for alpha generation. We believe that companies that recognise the threats and embrace the challenges early, or that form part of the solution to the problems linked to climate change, will ultimately outperform the broader global equities market. Risk Considerations: The capital is not guaranteed. Investments denominated in a currency other than that of the share-class may not be hedged. The market movements between those currencies will impact the share-class. The Fund will not hedge its market risk in a down cycle. The value of the fund will move similarly to the markets. Changes in China's political, legal, economic or tax policies could cause losses or higher costs for the fund. Important Information: This document does not constitute an offer to anyone, or a solicitation by anyone, to subscribe for shares of Schroder International Selection Fund (the Company ). Nothing in this document should be construed as advice and is therefore not a recommendation to buy or sell shares. Subscriptions for shares of the Company can only be made on the basis of its latest Key Investor Information Document and prospectus, together with the latest audited annual report (and subsequent unaudited semi-annual report, if published), copies of which can be obtained, free of charge, from Schroder Investment Management (Luxembourg) S.A. An investment in the Company entails risks, which are fully described in the prospectus. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get the amount originally invested. Schroders has expressed its own views and opinions in this document and these may change. This document is issued by Schroder Investment Management Ltd., 31, Gresham Street, EC2V 7QA, who is authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. Schroder International Selection Fund 6