destination - the future world of energy · dramatically in the past 50 years. economic growth and...

September 2019 Destination– the Future World of Energy

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Destination - the Future World of Energy Meeting the goals of the Paris agreement what would this mean for investors?

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ENERGY MATTERS Whether it’s driving our cars to work, powering the lights in our offices, or the central heating in our homes, we use energy in every aspect of our daily lives – mostly without paying any attention to it. Every product we buy contains ‘embedded energy’, which is used to make and transport it. The global energy system is the engine room of the world’s economy, and changes to it are of first-order importance for long-term investors. The energy industry has total invested capital of over $10 trillion, corresponding to at least 10% of most major benchmarks in both equity and credit. As many as one in 10 people globally live in countries that substantially depend on their domestic fossil fuel industries.

ENERGY – A PRODUCT IN DEMAND The quantity of energy the world consumes has grown dramatically in the past 50 years. Economic growth and growth in demand for energy have gone hand in hand. Even with the large gains that are still to be had from

making the world’s energy system more efficient, it is highly likely that as long as the global economy continues to grow, so will the demand for energy.

It is not only investors in the energy industry who have benefitted. Energy consumption and human development are broadly correlated. As countries’ consumption of energy rises, infant mortality declines, literacy levels rise, and life expectancies increase. At the same time, as the consumption of energy increases, so generally does the quality of the energy products that are consumed. This is important; the World Health Organisation estimates that around four million preventable deaths a year (and around 10% of all deaths of children under five years old) are caused by air pollution indoors – primarily from the use of unsafe and unclean domestic cooking fuels (like animal dung). The provision of more, cleaner, energy to the developing world has, and will continue to have, huge benefits for the world’s poorest people.

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Destination – the Future World of Energy

Energy and Human Development

Source: LGIM Analysis, BP, Vaclav Smil, Prados de la Escosura, L. 2019.

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ENERGY – A PRODUCT WITH A PROBLEM Unfortunately, the world’s energy system has a problem. Our energy system is dominated by fossil fuels, with around 85% of all energy globally supplied by the burning of hydrocarbons. As a consequence, the growth in energy consumption has led to growth in CO2

emissions. For every 5,000 kilowatt-hours (kWh) of energy consumed, we emit around one tonne of CO2. Each day takes us one day closer to the limits of what most scientific experts tells us is our cumulative carbon limit, beyond which point we will not be able to avoid the effects of potentially catastrophic climate change.

It is not enough to slow down the rate of growth of emissions, or even to reduce them moderately. The world needs to reduce CO2 emissions to net zero, as soon as possible. The question is how fast can, or will that transformation take place? The process of making urgent changes to the energy system that are necessary to drive decarbonisation, is one in which investors are going to play an important role given the quantity of fresh capital that will be required.


Energy consumption and greenhouse gas emissions

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Source: LGIM Analysis, Lambert Energy, World Bank, BP, Oak Ridge Laboratory. 2019.

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CHALLENGE ONE: THE WORLD’S DEMAND FOR

ENERGY IS LIKELY TO GROW RAPIDLY Globally we consume vastly different amounts of energy. In the Western world we use anywhere from 10 to 20 times more energy per person each year than in the emerging world. For example, in the United States primary energy consumption per person is around

As the graph above shows, around half of the world’s population live in ‘energy poverty’, with a daily budget of less than what would be needed to drive 25 miles in a typical European car. A further two billion are middle-energy countries, using between 25 miles and 100 miles of energy. A little over one billion enjoy abundant access to energy.

The inequality is startling. Today, around one billion people globally do not even have access to electricity. It is highly likely that as long as the world continues to get richer, demand for energy is going to grow. But unless the energy mix changes dramatically, that growth in energy demand is going to make the challenge of decarbonisation even more pressing. By way of illustration, if the whole world were to emit the same quantity of CO2 per person as an average American, then the carbon budget the world has left would shorten from around 30 years to fewer than 8.

220 kWh per day. In the Philippines, it is as low as 11. That is about as much energy as would be used running an average electric heater for about seven hours, or driving a typical European car for about 13 miles.

CHALLENGE TWO: THE WORLD’S ENERGY SYSTEM

NEEDS TO CHANGE VERY RAPIDLY RELATIVE TO

HISTORY Whilst the global energy system has made tremendous progress in meeting the world’s growing demand for energy – almost halving the number of people without access to electricity over the past twenty years – we have made very little progress in lowering the carbon intensity of our energy use. The pace of change urgently needs to accelerate if we are to avoid potentially catastrophic climate change. In making these changes, the global energy system will need to be totally rebuilt. History tells us that energy systems change very slowly, with past transitions taking between 50 and 100 years. If the world takes even 50 years (i.e. between 50% and 100% faster than before) to transition away from our current energy system, we will fail to constrain climate change to anything approximating an acceptable outcome, in line with the goals set out in the 2016 Paris Climate Agreement.

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Source: LLGIM Analysis, BP Statistical review. 2019.

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CHALLENGE THREE: A DISORDERLY TRANSITION

WOULD THREATEN GLOBAL ECONOMY Whether in a data centre in California, or a steel mill in China, the cost of energy feeds directly through to almost every product we consume, and every type of economic activity. Large unexpected changes in the cost

of energy have historically been closely correlated with recessions; our research suggests almost every US recession in US post-war history has been associated with an oil price spike. The energy transition, if it proceeds in a disorderly fashion, would risk causing a significant shock to the world economy.


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Source: LGIM Analysis, BP Statistical review, Vaclav Smil. 2019.

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Source: LGIM Analysis, Bloomberg. 2019.

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THE FUTURE OF ENERGY: MAPPING OUT PLAUSIBLE

PATHWAYS Given how important the energy system is, and the magnitude of the change and disruption that likely lies ahead, understanding how the change will take effect is, we believe, of first-order importance to long-term investors. However, mapping out and modelling the energy system is very complex – principally because of how interconnected it is. For example, modelling the shift to electric cars is surprisingly complicated, as changes to the types of vehicle on the road in a country like China has the potential to have knock-on effects for markets on the other side of the world.

Trying to forecast the energy transition therefore requires making a highly complex set of interdependent choices about the role of different energy technologies and resources; not just on which technologies to use, but how much, where and crucially when to deploy them.

DESTINATION – A DYNAMIC ENERGY SYSTEM TOOL In 2018, LGIM entered into a strategic partnership with Baringa Partners, a leading global management consultancy, to construct a bespoke model that we could use to analyse scenarios depicting how the energy system is likely to evolve over the next 35 years and what the implications are for long-term investors. Using a recognised methodology, Baringa developed a framework that models the energy system by making choices in the lowest-cost way.

We have developed ‘Destination’, a dynamic tool that we can use to analyse the energy transition. Rather than making these decisions on an individual basis, using a systematic algorithmic approach can help us understand the optimal choices. Our process is to present the model with the best available data on the technology choices and to leave the model to solve the problem. We built a dataset, using around 100 different public and proprietary sources, of around two million variables and assumptions. These address issues such as how much an electric car is likely to cost in China and India relative to a petrol-powered car, and how fuel-efficient those two technology options are likely to be.

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Electric vehicles require electricity but where does this come from?

If we import more gas from the US does that increase the price consumers pay in the US?

China burns more coal to generate electricity and meet growing demand?

Using more coal in China may push up the coal price for Europe. Does Europe use more gas from North America instead?

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Two worlds of energy – today vs. the future

Source: LGIM Analysis, Baringa Partners. 2019.

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WHAT DO OUR TWO DESTINATIONS LOOK LIKE?

We have used Destination to model two important pathways for the energy system – representative of two possible ‘worlds’ of energy. The first is the destination that the energy system will reach if we fail to act to make the necessary changes – ‘Today’s World’. This is where we think the world’s energy system is heading, after incorporating the falling low-carbon technology costs that are likely to occur over the next 35 years, but without a globally co-ordinated policy response. Crucially, this first destination is a technologically optimistic view of the world, with many green and low carbon technologies becoming significantly cheaper than legacy choices over time. For example, in our ‘Today’s World’ destination, by the late 2030s, electric cars will become cheaper and more compelling than conventional cars, with one in two cars globally being electric by 2050. To calibrate our forecasts for different climate outcomes, we have relied upon external scientific studies and research providers.

Global warming levels are generally estimated at a fixed point in time – often, but not always, 2100 – and relative to average pre-industrial temperatures. Measured in this way, despite all the technology improvements we assume, our research suggests that the most likely outcome is a global average temperature increase of greater than 3.5°C, possibly as much as 4°C, warmer. The bulk of scientific and economic research has confirmed that the consequences of this are significantly negative, potentially catastrophic.

The second destination is a world where we take definitive, joined-up policy and investment actions to move the world onto a well-within 2°C pathway – this is what we call ‘Future World’. Rapid decarbonisation of the global energy system, in a co-ordinated and efficient manner, leads to a temperature increase of between 1.5°C and 2°C degrees. Whilst there are still significant negative economic consequences, they are significantly more manageable.


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The energy mix (composition of different possible types of energy in use) that our model predicts for these two outcomes looks dramatically different from each other. In our ‘Today’s World’ scenario, we forecast an energy mix that remains remarkably stable. Coal, oil and gas all hold onto roughly constant shares of the energy mix. Nuclear should see modest growth, mostly in Asian markets where it is cost-competitive – but few new reactors are forecast to be constructed elsewhere and in most of the Western world, nuclear is likely to be in rapid decline by the late 2020s. Renewables grow very rapidly in both scenarios, with solar becoming especially valuable to the system, as costs continue to decline throughout the forecasting period. Given the challenges and uncertainties that plague grid integration, we have limited the growth in solar in the modelling with integration constraints that we have adopted from the work of other forecasters. Solar is so cheap in the later periods of the forecasts that even with the penalties we apply to account for intermittency, we expect very rapid growth which is only limited by the constraints described above. The implications of this, as we discuss below, suggest that even our most aggressive forecasts may be exceeded. Finally, as technological change continues to advance very rapidly, even in our ‘Today’s World’ scenario, we see oil demand peaking in the middle of the forecast period, with the growth in demand stagnating in the early part of the next decade. As such, oil starts to see its share of the energy mix decline – moderately – from 2030 onwards.

The contrast between our ‘Today’s World’ and ‘Future World’ scenarios is stark. In the latter, the energy mix is

heavily disrupted, very rapidly. When looked at in the context of history, the energy system changes at somewhere between two and three times the pace of ‘normal’ change. Disruption is widespread; both coal and oil lose roughly 50% of their share of the mix in our forecasts in only 35 years, with much of that disruption occurring in the middle years of the forecast period rather than the later years. In our Future World scenario, the electricity system is rapidly decarbonised. Around two-thirds of all electricity is generated from low-carbon sources by 2050. The energy system of the future is disrupted, far faster than has ever happened in history. Such a change is bound to have significant implications – both positive and negative.

IS OUR ‘FUTURE WORLD’ AFFORDABLE? One frequent objection that we hear about climate change policy is that the world can’t afford it. We disagree. Whilst cost predictions from a modelling exercise like this are inevitably approximate, we estimate that the net change in costs accruing from our ’Future World’ energy system are only about $350 billion a year more (in 2015 dollar terms), than in our ‘Today’s World’ scenario. Whilst that is a large headline number, it is consistent with less than 0.5% of global GDP – and would in our view drag global GDP growth rates down by between 0.01% and 0.02% over the time period in question. It is also a very small number when considered in the context of the trillions, possibly tens of trillions, of dollars that would need to be spent to manage the global economy in a world that is 4°C warmer. However, our estimates exclude friction costs, and are an attempt to model a lowest-cost pathway. If global policy follows an inefficient pathway, the adaption costs could be significantly higher. The disruption involved in a rapid transition could have other negative effects that may be significant at a macro level – for example, writing off parts of the world’s energy-installed capital base – with the possibility of debt defaults and equity losses in parts of the energy sector.

There are many possible policy responses that could be adopted to push the world onto an energy system pathway that is consistent with our ‘Future World’ scenario. Most commentators agree that the two most effective would be either a global carbon tax, or a cap and trade system that allows market forces to set the cost of carbon independently. Either policy would need to be adopted, in our view, at a global level, but if regional policies are adopted, border adjustment taxes are likely to be necessary. The energy system in ‘Future World’ is consistent with a global cost of carbon of between $150 and $200 a tonne, in real terms, by 2050.


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The big changes in costs between the two systems are primarily the result of two factors. Firstly, in our ’Future World’ scenario, we spend much less money on the fossil fuel sector in general. We pay coal mining companies less to dig coal out of the ground, and we pay the oil industry for fewer barrels of oil. This represents a significant saving at a global level – offsetting about 50% of the extra costs of the system in our ‘Future World’. Secondly, we have to pay a much higher cost for the capital employed in the energy system. For example, we have many more solar panels – which have a much lower ongoing operational cost than a coal power plant, but which cost more money upfront. That capital cost, which

we calculate as an average discounted cost, represents nearly $1 trillion a year, but has to be considered in the context of the costs not incurred by the fossil fuel sectors.

THE UNCERTAINTIES AHEAD ‘Destination’ does not answer all of the questions about the energy transition – in fact it highlights that there are several significant uncertainties that lie ahead, with big implications for investors. The uncertainties that we highlight in the following pages are far from an exhaustive list, but are some of the most important areas we have identified.


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UNCERTAINTY ONE: ARE NEGATIVE EMISSIONS GENERATED THROUGH CARBON CAPTURE AND STORAGE A

REALISTIC SOLUTION?

We have concluded1 that in our lowest-cost pathway, the use of carbon capture and storage (CCS) – particularly when paired with biomass – is an extremely important tool in reaching the Paris goals. CCS is a technology still in a very early stage of development, which ‘captures’ the CO2 emitted from an energy process, such as burning coal in a power station. Rather than emitting that CO2 into the atmosphere, it is captured, and then pumped into a location where it is stored permanently – like an old depleted oil-and-gas field. The use of CCS is controversial;

few projects exist today. It is uncertain if this technology can be deployed at the scale our modelling implies.

The reason CCS is so important in our scenario planning is not because we see a huge need to sequester emissions from coal power stations, but primarily because when CCS is paired with the use of bioenergy or biomass, it can create ‘negative emissions’ at a global level. This is normally referred to as bioenergy with carbon capture and storage (BECCS).

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As long as the biomass that is consumed in a BECCS process is replanted after harvesting, the initial stages of combusting it to produce energy can be considered carbon-neutral. When we then add a CCS line to the process, capturing the CO2 that is emitted at the point of combustion, the entire process is considered to be negative in terms of net CO2 emissions.

Negative emission technologies, of which BECCS is in our view the most cost-competitive, are very important in our modelling. This is because the negative emissions created this way allow sectors which are much harder to decarbonise, like air travel, to continue to be delivered in a carbon-intensive way, whilst at the same time meeting the Paris goals as modelled in our ‘Future World’ scenario. However, we are very conscious that our modelling has used the quantity of BECCS that sits at the upper end of what other analysts consider plausible. Therefore, we are uncertain as to whether or not this level of reliance on BECCS is credible. Importantly, because our modelling tool is dynamic, we can use it to produce other iterations of our ’Future World’ scenario in which there is much less reliance on negative emission technologies. In those scenarios we see significantly greater disruption to parts of the fossil fuel system. There is less room for carbon-intensive solutions to exist without negative emissions. As a consequence, we think the right way of understanding this uncertainty is to recognise that – as disruptive a change as our ’Future World’ pathway is – this is most likely a conservative set of forecasts. The risks of disruption to the coal and oil sectors are probably greater if BECCS does not become as widespread as we have assumed.

UNCERTAINTY TWO: ARE OUR RENEWABLE ESTIMATES

TOO CONSERVATIVE? In our modelling for both scenarios, we expect solar power to become widespread. The cost of solar panels should fall rapidly, and they should become a cost-effective source of electricity generation. However, renewables in general, and solar in particular, cause all sorts of problems when integrated into grids at large scale. We know, for example, that solar power is not intrinsically ‘dispatchable’ – it can’t generate electricity at will, only when the sun is shining. Many of these problems are surmountable, but there are very different opinions between forecasters on how much solar, and renewables more generally, can be incorporated into our global system. To incorporate those concerns, we have used manual adoption limits on solar power, to cap adoption rates at levels that are consistent with other major forecasters.

However, these limitations are far from certain. If we re-run our analysis with no adoption limits to solar, then far more solar capacity is built. In fact, the modelling implies that if the problems of grid integration and intermittency were fully solved, then the potential for solar generation is more than double the extraordinary growth we currently project in our ‘Future World’ scenario. Our conclusion on this uncertainty is that whilst the limits we have assumed may be reasonable, we think it is likely that solar adoption may exceed these limits. We do not want to be caught out, like other forecasters have, by underestimating the potential growth for solar power over the long run.


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number of cars on the road were to double over the period in question.

But are these assumptions realistic? We are concerned they may not be. In a number of key areas – particularly in transportation – progress is clearly lagging way behind the level of improvement we would like to have seen over even the past five years.

Energy efficiency is possibly the single biggest potential contributor in the world’s race to meet the Paris goals. We are not alone in making this assertion – most other forecasters would agree with us. As the chart above shows, when we add up all of the potential sources of energy efficiency, we think it is plausible that global consumption of energy per capita might not grow at all over the next 35 years, even if the delivery of service demand was to increase dramatically; for example, if the

Source: LGIM Analysis, Bloomberg, University of Michigan. Sept. 2017. Data series no longer published.

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Source: LGIM Analysis, Baringa Partners, IEA ETP. 2019.

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CONCLUSION: THE IMPLICATIONS FOR INVESTORS What should a long-term investor do in the face of the challenge, disruption and uncertainty that the energy transition creates?

Firstly, engage. This paper has laid out our view on what the energy transition looks like in terms of the scale of the challenge, and some of the implications and uncertainties. Whilst some of our conclusions are different to others, the primary thrust of the analysis is consistent with most other bodies who have conducted similar analyses. We think this evolving body of work should be engaged with by institutional investors. A successful transition is going to require capital markets to deploy trillions of dollars of capital – possibly as much as $30 trillion over the next 35 years. To do so will

require carbon risks to be properly priced, and capital to flow efficiently in response to pricing signals. Investors have a crucial role to play in the energy transition as part of this price-setting mechanism. Given the social imperative, the disruption posed by the transition, and the significance of the energy system to investors, we strongly believe that given all investors should engage and equip themselves with the facts to understand the issue properly.

Secondly, protect. A pathway to Paris, like our ‘Future World’ scenario, is going to disrupt large, important areas of capital markets. This creates significant uncertainty for investors in a number of areas – one of which is oil markets.

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September 2019 LGIM Future World Destination

When considered in the context of history, oil markets face one of, if not the, largest periods of uncertainty of any major commodity. Extrapolating long-run trend growth would suggests oil demand will continue to climb to upwards of 160 million barrels of oil per day by the middle of this century. By contrast, our ’Future World’ scenario suggest that oil demand could fall to around 60 million barrels per day over the same time period – in other words, creating a window of uncertainty equal to around 100 million barrels per day. That is the same size as the entire global oil market today. These outcomes are associated with radically different oil prices. In our modelling, the difference between a ’Future World’ and our ’Today’s World in terms of the price of a barrel of oil is around one-third – suggesting that a significant profit pool for an important industry is at risk.

The risks don’t stop with oil markets. The geopolitical order today has been built upon the energy endowment, or lack thereof, of many of the largest and most important countries in the world. Many fast-growing Asian emerging markets, like India and China, have experienced equally fast-growing demand for oil and other fossil fuels, whilst at the same time having relatively little natural endowment of those resources. They have become increasingly dependent on international markets – and energy exporters – to supply their needs. This leaves many emerging markets very vulnerable to big changes in energy costs, which can have disproportionate effects on their own economies. By contrast, most economies in the Middle East have become very wealthy by exporting energy to the rest of the world. For investors, one of the most interesting, and often underappreciated implications of the energy transition, is that this geopolitical order becomes unstable.

Relative to our forecasts in ‘Today’s World’, in our ‘Future World’ destination, the Middle East as an ‘energy exporting block’ is significantly worse off – both versus today and versus how they would otherwise have been. This threatens not just investors in Gulf Cooperation Council country bonds, but risks upsetting the whole geopolitical order. By contrast, whilst the capital investment required to free their economies from dependence on international energy markets will be high, both China and India will be importing significantly less oil in 2050 than they would otherwise have been. This benefits both their balance of payments and the sensitivity of their domestic economies to big changes in the oil price.

We do not believe the right answer to this dynamic is simply to divest from the oil industry, or to sell out of whole markets or regions. But, given the size of the uncertainty, we think there is a strong argument to consider taking steps to de-risk portfolios in simple, low cost ways, to protect return profiles from the worst implications of a rapid transition.

The opportunities - just as the energy transition creates risks and disruption to certain market participants, there are also significant beneficiaries. A rapid transition is likely to see many end markets growing incredibly rapidly.

We think there are some areas where companies and industries that are positioned appropriately could benefit. Excitingly, we think that in many areas the opportunities look highly asymmetrical. One such example is to consider the electrification of the global car fleet.

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In our analysis, the number of electric cars grows rapidly. By 2050, even in our ‘Today’s World’ scenario, electric cars are cost-competitive with petrol and diesel cars in many end markets. We see roughly one in two cars globally as being electric by 2050. However, in our ‘Future World’ scenario, the pace of disruption accelerates dramatically. The rapid change that is facilitated by a transition to our ‘Future World’ scenario is strongly suggestive that investors who position themselves appropriately for disruption on this scale can benefit materially from it. Importantly, investors positioned for global car-fleet electrification are likely to find themselves on the right side of the trend, regardless of which energy pathway the world takes. We think that the opportunities to invest constructively are often skewed asymmetrically in favour of presuming an outcome similar to our ‘Future World’ scenario.

CONCLUSION We believe the energy transition is likely to be extremely disruptive for investors, but with meaningful opportunities for those who position themselves appropriately. Capital markets are likely to play a big role in financing the transition – with tens of trillions of dollars of investment opportunities created by all plausible pathways to the Paris goals that we can foresee. There are significant uncertainties still ahead – not least which of our two scenarios more accurately describes the energy system of the future. Either outcome has huge implications for long term investors – and implications that are likely to be seen, we think, sooner rather than later.

1. The extent to which we use negative emissions technologies is consistent with some, but not all, of academic and professional research studies addressing the same topic.

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The fund-specific data presented in this document is supplemental information to its relevant GIPS composite report, an example of which can be found in the Attachment. All GIPS composite reports are available on request.

For the purpose of GIPS compliance, the ‘firm’ is defined as Legal & General Investment Management Limited and does not include assets managed by the SEC registered company, Legal & General Investment Management America.

As required under applicable laws Legal & General will record all telephone and electronic communications and conversations with you that result or may result in the undertaking of transactions in financial instruments on your behalf. Such records will be kept for a period of five years (or up to seven years upon request from the Financial Conduct Authority (or such successor from time to time)) and will be provided to you upon request.

© 2019 Legal & General Investment Management Limited. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, without the written permission of the publishers.

Legal & General Investment Management Ltd, One Coleman Street, London, EC2R 5AA

Authorised and regulated by the Financial Conduct Authority.

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