Karl Moore: This is Karl Moore Talking Management for The Globe and Mail. Today I am delighted to speak to Russell Read who is the former chief investment officer of Calpers [California Public Employees Retirement System] North America's largest pension fund.
Russell, my students are very wound up and concerned about the environment. Is it partly because of concerns of global warming that have lead you to focus on energy?
Russell Read: The interesting part is that you can look at the energy in the world and say that there is no shortage of energy in the world, but how we harvest energy is another story. Can we pollute our world or can we change our climate? Of course we can.
Successful investing is all about capturing dynamic opportunities. You ask questions about where is capital needed in the market economy and that has shifted toward energy materials, particularly in new applications - things that can address energy and materials consumption and distribution and production in a more efficient way. So I believe that this is not only the most important and fundamental investment opportunity, but unless we get this right, then we have other problems - not only with respect to natural resources, but with respect to our impact on the natural environment.
KM: When we talked to a lot of people in this area, there is an enormous interest but it seems that there is less success in terms of investing and actually making money. What are some of the things that you have learned in terms of successfully investing in these new energy sources as well as doing better with coal.
RR: So the interesting part about successfully investing in energy materials, and what differentiates it historically and currently from what we have been used to investing in like with things from IT, biotech and other places where new capitalists have been needed.
There are essentially three big differences: one associated with capital costs. Capital cost, when it comes to energy materials, is a big deal. Often times, when I would address a room full of investors, institutional investors potentially representing a few trillion dollars worth of capital, and I talked to them about IT or biotech, the room would dwarf the opportunity. In this case it's the opposite. When we look at what's necessary to meet the world's energy needs with fuels and power over the next twenty years, the numbers are something on the order of forty to fifty trillion dollars of new capital - that's a big number. It's one where everyone in the room, all of a sudden, instead of feeling too big for the opportunity, they feel too small for it. Capital costs are a big deal. Being able to attack the capital cost that one LNG terminal, conventional LNG terminal - ten billion dollars - one single project. These are big numbers and much bigger than what we had with IT and biotech. That scale-up of Google was very different, you would hire a few extra computers - a scale-up of an energy infrastructure which could be billions of dollars, even trillions of dollars.
KM: There seems that there is an enormous potential risk when you are looking at that amount of money.
RR: Now this gets to the second factor: The second factor is how do you de-risk things when you have such great capital costs? Capital cost is such a disadvantage of energy materials. The advantages are cash flow opportunities. Cash flow opportunities, stemming from the provision,distribution and consumption of energy and materials, can be much greater than what we had with IT and biotech. When you talk about power purchase agreements, industrial supply agreements and government agreements, you have the ability to define, to secure cash flows in a way that you didn't before. Being able to anchor your cash flows with long-term contracts is a fundamental advantage associated with energy and materials. For prudent investors, you are looking at doing two things: you want to control the capital cost and you have to secure the contracts with anchor cash flows.
The third area is really a handmaiden to the first two, which is, the things that require a great deal of capital, you can't have many of your projects going belly-up. In venture capital associated with IT, you might invest in ten companies, where five may not make it, as long as five survive and one or two do really well. If you are investing five million dollars at a time, that might work, but when you are investing hundreds of millions of dollars for each project you can't acutally have failure with any of those projects. The idea is that the model for investing has to be oriented towards projects which in of themselves are low risk and have to be done in scales to make sense. We see, worldwide, a wonderful opportunity but we are having to relearn lessons about how you prudently invest in energy and materials, lesson that we haven't really had to employ for decades.
KM: When we look at this, that's true because we think maybe looking at coal, but we look at really big efficiency gains. There has got to be more risk because this is something which is untried and untested to have really big leaps in terms of efficiency.
RR: It's exactly right. One of the interesting things is that energy is not a small area of the market economy. We began to think of it that way once we had an infrastructure that wasn't changing. Now we actually have the infrastructure and technologies in flux, we actually see how large energy and materials are as an investment space and as a part of our dynamic economy. So this includes new technologies associated with venture capital. We are having to relearn some important things. We can't do the five million dollar investments that were common with venture capital associated with IT and biotech. It isn't sufficient for the deployment and development of many energy materials technologies, so we are having to adapt in the investment world. Every venture capital firm and every private equity firm is adapting to energy and materials as the new source of capital formation and it does require adapting to the new capital requirements and the de-risking opportunities associated with anchor cash flows.