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Quarterly Client Letter September 2017

The EV Revolution and Implications for Materials DemandElectric vehicles (EVs) are already a reality on the streets of the world’s major urban centres and projections are that growth from here will be exponential. In an eye-catching prediction this August, Morgan Stanley said to expect over a billion EVs on the world’s roads by 2050. EVs come in different forms, using various sources of energy to drive the electric motor, including batteries (BEV), plug-in hybrids (PHEV) and hydrogen fuel cells (FCEVs). The substitution of traditional internal combustion engine (ICE) vehicles by EVs is being pushed hard by government policy, with the main objective being cleaner air, particularly lower nitrogen oxides (NOx) and particulates. Airborne pollution is a major public health issue, particularly in Asia, but also in Europe. In the UK, the Royal College of Physicians and the Royal College of Paediatrics and Child Health estimated this February that there were 29,000 premature deaths annually from inhaling particulates outdoors and a further 11,000 from NOx exposure, together representing around 8% of all UK deaths. Largely for reasons of cleaner air, the UK announced in July that all new cars must be EVs within 20 years and numerous cities are likely to ban ICE vehicles even sooner.

The implications for the world’s energy use are profound, of course, but here we will be investigating what the adoption of EVs means further up the supply chain, for metals demand and what that means for client portfolios. Two main metal producers are held. Anglo American (99 basis points at quarter end) is a diversified miner with key interests in copper, worth 15% of ebitda in 2016, and platinum group metals 9%. Anglo owns stakes in two of the biggest copper mines in the world, both in Chile and both with expansion potential, as well as large undeveloped projects in Peru and Finland. First Quantum Minerals (28 basis points) specialises in mining copper, with a portfolio of assets rich in expansion opportunity, but also owns two projects with the potential to be among the world’s largest nickel mines, if market conditions are favourable. But this is as much about what is not yet in client portfolios, but could be in future.

So far, predictions of the adoption of EVs have been overly optimistic. According to Norilsk Nickel, “the revolution has been announced, but has not materialised yet”. The 695,000 EVs sold in 2016 (according to Bloomberg New Energy Finance) amounted to less than 1% of the new car market. But the way forward is clear. For example, in August, EV sales in China rose 76% year-on-year to a market share of 3.2%, from 1.8% a year earlier. Our current base case is that 18% of new cars will be EVs by 2025, but this could be conservative. Industry and regulators have big plans to electrify the vehicle fleet. Volkswagen, the world’s largest carmaker, says it wants over 20% BEVs in its sales mix by

2025. China and India are working on timetables to end all new ICE vehicle sales, offering incentives for EV production and purchases. These policies have notable energy security advantages for both countries. The take-off point is expected when total cost of ownership (TCO, purchase plus running costs) becomes comparable with ICE, which could happen as early as 2018 in Europe, although the UK automotive consultancy Ricardo does not expect cost parity until at least 2030. Technology breakthroughs and increased scale are reducing EV TCO, while increased emission regulations are driving up ICE costs. Maruti once told us that EVs were “too fancy” for India – times have changed.

TechnologiesElectric motors have superior mobility characteristics to the ICE, such as less mechanical complexity and greater linear torque. According to Tesla, its Model S is the fastest accelerating car in the world (0 to 60 mph in 2.39 seconds). EVs of course need a source of electric power and the current standard is lithium ion (Li-ion) batteries. Huge expansion in Li-ion battery capacity is underway, from manufacturers such as Panasonic, South Korea’s LG Chemical and Samsung SDI and China’s BYD as well as the renowned Tesla/Panasonic gigafactory. The idea, familiar in electronics hardware, is to drive down unit costs by increasing scale

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aggressively. The battery of an EV has, like all batteries, two electrodes: an anode made of graphite and a metallic cathode, containing metals such as nickel. The cathode is key to the battery power and energy density, which determines the acceleration and range of an EV.

There are various Li-ion cathode chemistries. For example, Li Cobalt Oxide (LCO) has the highest energy density but safety risks make it unsuitable for vehicles. Li Ferro Phosphate (LFP) has poor energy density (so needs large scale) but is cheap and is currently used in Chinese buses. NMC (Nickel Manganese Cobalt) and NCA (Nickel Cobalt Aluminium) are lower cost, safer (than LCO) cathode materials, with varying proportions of nickel and cobalt. Tesla uses NCA chemistry. In EVs, a battery’s useful life ends when over 20% of the original capacity is lost, which is usually after seven years. Although the economics of recycling are currently unattractive as the recovery process is too expensive at current metal prices, ex-EV batteries could still be used in grid-energy storage.

Impact on Materials / SupplyIn a tear-down of an EV (the Chevrolet Bolt), UBS found that it contained 80% more copper and 70% more aluminium than a comparable ICE car. Based on the Bolt’s battery chemistry today, a 100% EV world would increase demand for aluminium by 12%, copper 21%, nickel 118%, graphite 260%, cobalt 1900% and lithium 2500%. In addition, demand for rare earth elements, used in the permanent magnet within the electric motor, is forecast to double.

However, the proportions of the metals used will inevitably change. Technology breakthroughs in battery chemistry are inevitable – today’s metals demand rates cannot be extrapolated far into the future. Economics plays its part too – for example, battery manufacturers are looking to thrift out cobalt because of its high price and relative scarcity in favour of nickel. The Bolt’s battery pack, supplied by LG Chemical, uses NMC cathodes with a 1:1:1 ratio between nickel, manganese and cobalt. The same chemistry is used by Samsung SDI. The next generation of NMC cells (expected for 2018) will use a 3:1:1 ratio, i.e. a higher share of cheaper nickel. By 2021, the cathode materials mix is expected to be 8:1:1. At the same time, energy density rises 20% with every new generation, improving the battery cost per unit of energy. Despite these savings, UBS concluded that the EV supply chain needs significant investment to increase output to the required levels.

LithiumEVs are likely to have the most impact on demand for lithium. The lightest metal is relatively abundant in the Earth’s crust and is found in high concentrations in the salt flats (salares) of Chile, Argentina and Bolivia, as well as in hard-rock deposits in Australia. Li-ion batteries already consume over half the world’s mined lithium and, despite a trend to NMC/NCA cathodes with lower lithium, demand should grow double digits to 2025. Four companies produced 86% of global lithium supply in 2016, but that dominance is likely to be eroded with growing supply from new players. Chile has dominated production from salares but the new government in Argentina is promoting growth in its lithium output and Bolivia is seeking to develop the Salar de Uyuni, the world’s largest salar covering over 10,000 sq. km and largest single source of lithium. Meanwhile Chile’s copper giant Codelco has its own plans to develop salar lithium in northern Chile. Along with new mines in Australia, Macquarie estimates that this supply will push the market into surplus this year for at least five years, despite the frantic demand growth.

CobaltMorgan Stanley says that the 9.4 million BEVs that could be sold in 2025 would require 55kt of cobalt, an order of magnitude more than the 5kt demand from EVs in 2016 (in a 93kt global market), despite declining cobalt use in batteries. Most cobalt is produced as a by-product of copper in central Africa, particularly in the Democratic Republic of Congo (DRC, accounting for over 50% of global reserves), so investment decisions are governed by the economics of copper production. The biggest cobalt supplier is the Tenke Fungurume mine, bought last year by state-owned China Molybdenum from Freeport and Lundin Mining, but artisanal miners are a key feature of the country’s industry.

The cobalt price has trebled over the past 18 months. Bernstein put it starkly in early September; there is simply not enough cobalt in the reserve

Salar de Uyuni

Artisanal miners in the DRC

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base for the green future we desire. We either need to find and develop a lot more cobalt, precipitated by a significant rise in the price, or develop new, cobalt-lite battery technologies.

NickelStainless steel currently accounts for 70% of global nickel demand while demand from EVs in 2016 (14kt) was less than 1%. However, in PHEVs and BEVs nickel usage is up to 25x that of a comparable ICE vehicle and the trend towards higher nickel/lower cobalt NMC batteries, as well as the NCA battery preferred by Tesla, means use of nickel in EVs should rise sharply. Morgan Stanley estimate that nickel’s use in EVs could reach 340kt by 2025, which, it says, would need the nickel price to rise to a level sufficient to incentivise new mine supply, and also require an expansion of conversion capacity to produce the nickel sulphate required for batteries.

Aluminium Although changing battery technology might mean volatile demand for nickel and cobalt, consumption of copper and aluminium should be more consistent. Like nickel, these two metals have much wider applications beyond batteries so the impact of incremental EV demand is less. Even though Tesla’s battery of choice (NCA) uses aluminium in the cathode, it accounts for a negligible proportion of the market. However, the need to increase vehicle range and offset the heavy battery is likely to further incentivise the light-weighting of EVs, increasing aluminium demand for the vehicle body. The Aluminium Association estimates demand will rise by 50kg per vehicle over the next ten years as a result.

Copper BHP Billiton has suggested incremental copper demand from EVs will be around 11Mt between now and 2035 assuming 80kg of copper per EV (compared with 20g in an average ICE vehicle), meaningful in a market of 25Mt last year. UBS suggests that by 2025, a year in which they estimate global EV sales of almost 14 million, EVs should account for 5% of annual copper demand, implying an acceleration of annual demand growth above 3%.

EVs influence copper demand not only through the vehicle battery but also in wiring in the charging infrastructure. In addition, the development of charging stations would require investment in additional grid infrastructure, meaning more copper. Looking at the whole ecosystem surrounding EVs, and in a “rapid adoption” scenario, Bernstein calculates the additional annual demand for copper by 2035 will be over 20Mt, with seemingly little risk from changes in battery technology. Bernstein goes on to estimate that the capital expenditure required for new mines to supply EV materials will be over US$500billion.

Platinum Group Metals (PGMs) The trend to EVs is negative for PGMs demand, because the main source of demand for PGMs, a group of closely-related metals led by platinum and palladium, is as catalysts in various chemical processes used to reduce emissions from ICEs. In 2016, this source accounted for 40% of platinum demand and 80% of palladium demand. Thus the rise of EVs, with no emissions that need scrubbing out, is a clear threat. However, non-EV vehicle sales are still forecast to rise in the medium term. Even in Europe, along with China the fastest adopters of EVs, Johnson Matthey (JM) expects small (<1%) growth in ICE plus hybrid cars over the next 10 years, with a trend to smaller engines offset by bigger and better catalysts with higher PGM loadings. Consequently, JM see no decline in PGM demand for the next 10 years. Driving this is tighter emissions legislation globally. JM notes that future Chinese legislation is still half of European current standards, but is moving faster. Norilsk Nickel estimates that these stricter regulations, particularly in emerging markets, should boost palladium consumption 34% by 2025, while platinum demand from the vehicle industry will remain flat, reflecting the shift from diesel to gasoline within ICEs.

Investment ImplicationsThere is a wide range of views out there, often passionately expressed, and our crystal ball is particularly cloudy with such a likelihood of technological change. Yet as long-term investors we want to take a view on trends. The global EV fleet will grow, although maybe not at the rates some investment banks (with a lithium mining IPO to sell) are predicting. Battery technology will take an unpredictable path but demand for lithium will surely increase, good news for miners in South America, Western Australia and even Cornwall in the UK. However, there are major environmental sensitivities with lithium extraction. For example, the Salar de Uyuni is a fragile environment and an

Copper at FQM’s Kansanshi mine in Zambia

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Important Regulatory and Risk Information

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important breeding ground for flamingoes. Cobalt has even more supply risk. In the DRC, UNICEF reported that 40,000 children work in cobalt mines. Apple said in March that it wanted to stop the purchase of cobalt that had been mined by hand in the DRC. Nickel is a safer prospect from a supply perspective, with well-established mines in Russia, Brazil and South Africa, although there are serious environmental problems with nickel laterite mining in Indonesia and the Philippines. Copper is lower risk with the prospect of a solid demand kicker ahead. Meanwhile, the price of palladium is near a 16-year high. It is premature to write the obituary for ICEs (and PGMs demand).

Emerging market resources will be key to the production of the metals the world will need to make transportation more environmentally friendly. Specifically, Anglo American has large, long-life copper assets with opportunities to expand in Chile and Peru. Anglo is also a significant nickel producer in Brazil and through AngloPlatinum in South Africa. And while the long-term future for PGM demand might be murky, as the lowest-cost producer, Anglo should be the last man standing. First Quantum Minerals is growing copper production via development of the giant Cobre Panama project and also has two large nickel projects it could bring onstream if the price justified it.

Two words of caution. Much of the electricity that drives EVs is produced from dirty coal. For EVs to help reduce CO2 emissions, there needs to be a decarbonisation of electricity generation, which is happening in Europe with the increase of renewable energy sources in the supply mix, but more slowly elsewhere. In Indonesia, for example, coal is forecast still to be 30% of the national energy mix in 2025, with renewables 23%, a target even the government admits is optimistic. The other point is whether use of passenger vehicles could change more radically. In China, annual vehicle sales are expected to lag GDP growth, due to increased urbanisation and improvements in public transport, coupled with usage restrictions in cities. Similar trends are seen elsewhere. As the Mayor of London points out, the simplest way to cleaner air is fewer cars on the road. The shift to EVs may be inevitable, but perhaps we are close to Peak Car.

Preparations for MiFID IIWe also wanted to touch on the regulatory reforms of the Markets in Financial Instruments Directive II (MiFID II) which is scheduled to come into effect on 3rd January 2018. MiFID II is a wide-ranging piece of legislation which impacts many aspects of asset management operations and reporting. Increased investor protection is one of the key aims of the legislation, focusing on greater transparency and the strengthening of governance, organisational requirements and conduct of business rules. Genesis has a MiFID II working group in place; we are confident that as a firm we will be ready to meet the expansive MiFID II requirements by the start of 2018.

One key area of the legislation covers payment for investment research. Genesis has made the decision to pay for investment research out of the firm’s resources, without passing the cost on to client accounts. This will involve a transition from the current use of commission sharing agreements (CSAs) which are funded through client commissions: it is our intention that all funds which remain in CSAs at the start of MiFID II will continue to be used to purchase investment research, but that thereafter Genesis itself will absorb such research costs.