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Energy, Climate & Investment

The 2020 ECI Report Peninsula Capital Management

PO Box 941 Mt Eliza

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January 2008 #1 03 97 877 455

The Heat is On Welcome to the first edition of the 2020 ECI Report. We hope it becomes a recognized guide to Sustainable Investing both for clients of Peninsula Capital Management and a wider community of interested analysts, activists and investors. The first draft was prepared on the hottest day of 2007 which one of the hottest years on record which in turn was part of the hottest decade on record. Writing and research continued through three weeks of erratic weather: heat followed by unseasonal cold days and nights, strong winds and flooding rains to the north. In Queensland one area received more than its typical annual rainfall in three days. This was a small taste of real world climate change with its skewed patterns and greater “amplitude”. Under rising greenhouse conditions more and more energy is trapped by carbon gases which intensifies and disturbs oceanic and atmospheric systems. Hardened skeptics need proceed no further, but we are persuaded by the weight of evidence and the quality of convergent data sources. The UK Royal Society, the US Navy, NASA, the CSIRO and leading science research agencies, many of the world’s biggest corporations such as GE, oil companies like Shell, numerous large banks and insurers and of course the UN’s IPCC.

Atmospheric CO2 -- from the combustion of fossil fuels in major part -- increased from around 280 parts per million in the 19thC to 380 parts per million today. About 35% of carbon dioxide emissions are absorbed by oceans, which causes rising problems for marine organisms. Dissolved in ocean water, CO2 forms carbonic acid by stripping out carbonate ions, and less is available for their shells, skeletons and exoskeletons. This is having a major impact on the life expectation of many fish and marine species

Rising Alarm Rising alarm on the emission of nearly 30 Billion tons per year of CO2 from fossil fuel burning - the world’s volcanoes and tectonic change only emit about 300 Million tons per year - has been condensed by the IPCC into a simple message we can summarize, below: The global rise of average temperatures parallels the increase in atmospheric carbon released by industrial processes over the last 150 years. one of us are exempt from this trend. Our goods, food, daily travel, heating, cooling, cooking and holidays all leave a carbon trail or ‘footprint’ behind. Globally we consume about 31 billion barrels of oil, 17 billion barrels equivalent of natural gas, and 6 billion tons of coal a year. It is simply

very unlikely that the injection into the atmosphere of this amount of carbon, previously stored over hundreds of millions of years, would have zero effect when released in such a compressed period of time. The worst case scenario for runaway climate change is unimaginably bad. It includes the accelerated and sure destruction of thousands of coastal towns and cities as sea levels rise, and the extinction of huge numbers of animal, fish and plant species, with dramatic droughts and floods inland, possible new and miniature ‘ice ages’ in some regions of the planet, social stress and ultimately, perhaps, war and chaos as food and water supplies dramatically shrink. We can hope this end game scenario does not come about, but the best outcome will need a radical and historically rapid change of our entire energy systems, ways of using resources, and our overall economy. Rising alarm simply mirrors the present implacable growth of carbon emissions, and the effects this can have within at most 25 or 35 years. We will need a great shift in corporate, political and community thinking to prevent a further 2 degreeC rise in the Earth’s average temperature by 2040 or 2050. Fortunately a an Increasing numbers of world leaders do grasp the science such as Angela Merkel, a physicist by training. Her government is mooting a 60% cut in fossil fuel burning by about 2055.

ALARM CALL FROM THE IEA The OECD’s energy watchdog agency the IEA reported in November 2007 that under its ‘trends continued’ or Reference Scenario world energy consumption would increase 55% by 2030, driven by Chinese and Indian demand growth and continued high per capita demand in the OECD countries, including Australia. This big increase in fossil fuel burning would raise world average temperatures by 3 degC, according to the IEA. The agency also set out an Alternative Policy Scenario under which urgent energy saving and renewable/alternate energy development measures were put in place. Under this Scenario, growth in fossil fuel emissions would only be 27% above current, holding the increase of world average temperatures to 2 degC

The investment and capital mobilization needed to achieve this momentous change will of course be enormous. It will dwarf all current spending in the energy sector, already running hard to stand still because of depletion, and racking up spending in 2006 to more than 450 Bn dollars (400 billion USD) per year simply for Exploration and Production (E&P) in oil and gas.

The scale of the infrastructure required can be grasped by the following. The British Government has been obliged to set plans for raising the level of the Thames barrage, Holland is raising its dykes and projecting huge scale floating cities, Japan has installed massive pumps to protect Tokyo; France is placing dykes around all low lying nuclear power plants to prevent flooding. Climate change fear has prompted Sweden to plan for a complete Zero Oil economy by 2025; China is massively building nuclear power plants and windfarms – as well as 1000 MW of new coal-fired generating plants per month. Indonesia, a major coal exporter is now contemplating a similar renewables, nuclear-and-coal future. Food, Water and Energy merge Food and water can be thought of as ‘embodied energy’, which is simple to understand for water because of its high weight and need to be pumped, stored, transported, desalinated, purified and recycled. When produced through desalination, even by the most efficient processes, around 7 – 45 kWh of energy is needed per cubic metre, enough for about 2.5 or 3 days per capita consumption in Australia. With biofuels we have an open convergence of food, water and energy in a completely new paradigm: what were previously thought of as food crops, or supplies of fibre and non energy raw materials are now potential or real sources, or ‘feedstocks’, for biofuels production.

Holland is preparing for Climate Change through developing ‘floating cities’ made up of floating houses

Many of the biofuels, as the World Bank and IMF openly admit, are intensely dependent on irrigation and almost zero ‘net energy yielders’, meaning they need as much input energy, mostly fossil, to be produced as they yield as fuel in the tank of your car, but worse still food is being diverted to fuel. The USA’s RFS (renewable fuel scheme) announced by G W Bush in his State of the Union address, January 2007, set massive and impossible targets for maize ethanol production, and handed down large subsidies for the many companies that rushed into this sector. Since then, some have simply gone into liquidation, and the low credibility of the Bush RFS is now regularly pinpointed by financial commentators and even by the Wall Street Journal, in particular their huge water needs and intense impact on food prices. The convergence of rising food crop demand as feedstock for fuel, increasing greenhouse gas levels in the atmosphere, a still expanding world population, and now admitted depletion of world oil, natural gas and coal reserves can in fact only drive food prices higher and faster. The period in which the Ags & Softs, or agrocommodities lagged behind the Energies and Metals, in the commodities sphere, is now over. Nevertheless, we can be rather sure that biofuels will continue to be developed, in part because the other main route for substituting oil for cars – batteries for storing renewable source electricity – remain costly and complex, and the focus of intense, high-cost R&D. Selecting the biofuels that yield the most energy, and demand the least water, will very surely be a winning investor strategy. Oil prices are up about 450% since 2002, and since 2006 world grain and oilseed prices have begun to move towards the same trajectory. Record highs, sometimes in absolute terms, have been attained in recent weeks for some grains, and the best correlated agro-commodity with petroleum – sugar – is beginning to move ahead. One clear reason for this is energy costs for intensive farming, especially irrigation farming, but another is simply the massive quantities of previously food-only crops used for oil substituting fuels production. In 2006-2007 about 25% of the US maize crop was used for fuel ethanol production, and over 50% of the EU-27 rapeseed crop was turned into biodiesel fuel – enough to cover about 2% of car diesel fuel used on Europe’s roads. An Australian drought is surely no surprise, but when Ukraine’s wheat yields were dramatically low, due to crop losses from huge excesses of rainfall that occurred from May 2007 onward, the market took note. Since that time, wheat prices have been climbing back near an all-time record 10 USD per bushel and the oilseeds, led by palm oil, rapeseed oil and soybean oil have followed, triggering an ‘upstream’ rise in soybean prices, now attaining a record 13 USD per bushel.

Energy Transition Very soon in fact, we will hear talk of a world energy transition plan, probably linked to whatever supercedes the present Kyoto Treaty after the current 2008-2012 phase. Under almost any scenario we will see wider carbon-limiting measures with a direct impact on the economy and investing, due to an accelerating need to move away from the fossil fuel. The Garnaut Commission will provide the Australian blue-print for our own response which may be prove more radical than the European concept of “20 20” - ie 20% renewables in each country’s 2020 electrical generation energy mix. This will be just the first stage before “40 40” which will require an even more massive investment in renewable, carbon capture and changed public behavior. One thing is clear: outside wartime there has never been an economic, financial and business trend which will have such longevity and economy-wide influence, depth and power. Winning the Carbon Game That may be the broad picture but investors still need income need growth. How will this be achieved in a carbon constrained economy? One local company offers some insights. CO2 had made a series of announcements during 2006 and 2007 as AGL, Origin and Qantas bought carbon permits based on the company’s ability to lock up carbon via the almost indestructible mallee gum. This business was all voluntary and few noticed. Matters changed when Woodside was required to offset carbon before it could proceed with a key project, the development of the Pluto gas field. Suddenly CO2 was an essential part of the Woodside business as the EPA said its large Pluto gas field depended on off-setting at least part of the project’s carbon emissions over an extended period. The deal involved 50 years of sequestration at a total price of $100m. Minemaker was another obscure company until investors noticed in mid January that it held a large rock phosphate lease near Tennant Creek. On a day when the rest of the market was falling it rose 30%. The reason was simple. Investors had discovered that world phosphate prices had tripled. Not only were fertilizers in hot demand as US farmers planted more grain for fuel supply, reserves were depleting rapidly. Major deposits like Nauru and Christmas Island were exhausted leaving the market sensitive to even small increases in demand. Like those above Eden Energy may play a small part in the investment mix, but it points the way. In January it won a tender for the first hydrogen fuel dispensing depot in India. Eden’s hydrogen production and fuel blending could play an important part in India’s long term response to both climate and energy policy. The plan is to use a blend of gas and hydrogen (“hythane”) to fuel India’s public transport fleet. This will require infrastructure and much co-ordinated effort but the rewards may be ultimately huge. Eden is not the only hydrogen player. Rio has teamed up with BP to provide the world’s first hydrogen powered electricity plant. Hydrogen will be stripped from the Abu Dhabi’s gas and the CO2 sequestered. This

may be more about PR than physics, but it will be widely noted that two of the world’s largest energy companies are combing to provide a greener fuel for the emirate. Minerals also will be part of the response. Suppliers of rare metals which provide better batteries, lighter aircraft, faster communications etc are being targeted by metal processors. Lithium will be in strong demand now that all the large auto companies are switching their focus to hybrid vehicles or fully electric models. If even one tenth of US vehicles used lithium ion batteries, supply would be difficult. GM says that 50% of its models will be “alternative” by 2010. Galaxy Resources is one of the few able to offer exposure to lithium, a critical metal of coming decades. More conventional ways to de-carbon portfolios are available. Energy farms managed by Babcock & Brown Wind, Viridis Clean Energy, Transfield Infrastructure and others offer regulated and mandated income mixed. Viridis combines wind and land-fill methane while Transfield manages conventional gas fired power stations and wind farms, but they each offer relatively high and low risk yields. Transfield’s low gearing and paired relationship with Transfield Services has particular appeal. Many are also aware of the Silex Systems story. As GE prepares the Silex developed uranium enrichment process for world markets, this Australian based company can conserve its cash to focus on high performance solar cells. These “multi-junction” cells are a departure from conventional photovoltaic and capture the full spectrum of the sun’s energy. The aim is double current solar efficiencies. Demonstration cells will soon be available. Equally interesting is the twist on this technology which uses the same silicon technology to convert heat to electricity. If successful much wasted heat from boilers, power stations trucks and cars could be captured as surplus energy. Revenues could eventually equal income from uranium enrichment, ultra efficient solar cells and its other major project, super fast optic silicon chips. High technology will only form part of the carbon response. Much of the transition will be based on simpler technologies, improved systems, faster communication and relatively inexpensive conservation measures. Specialty funds will appear and offer highly focused plays in the emerging carbon finance market, as well as its offshoots and derivatives. This may include fixed income securities twinned with municipal or State bonds and based on physical resources linked to, or produced from alternate energy production and water saving activities. Investors will still have to be wary because of the scale, novelty and innovativeness of these massive but entirely new investment and economic development shifts. And yet the shift is inevitable. This is nondiscretionary investment in the fullest sense. In short we see our role as two-fold: researching and selecting the better carbon solutions while avoiding the at-risk carbon heavy industries. In the middle a large group of carbon neutral activities which need to be assessed on their merits. Disclaimer: The above report has been prepared as general advice and is not to be relied upon in the absence of specific advice related to each individual’s risk profile and investment objectives. While every effort has been made to ensure the accuracy of the above information, no warranties, express or implied are entered into. Prepared by Richard Campbell with the assistance of Andrew McMKillop

Peninsula Capital Management is a an authorized representative of RM Capital (AFSL221938) PO Box 941 Mt Eliza, Vic 3930 03 97877455 Fax 0397877655