This week we explore the last of our 5 D’s; de-carbonisation. How the Politicisation of energy markets in recent years affects markets and why individual investors should be aware of the consequences.
This week we explore the last of our 5 D’s, namely de-carbonisation. We begin with a disclaimer, neither are we experts in the field of climate science nor do we postulate a normative stance on the issue given the sheer politicisation of the energy markets in recent years, a scenario we find rather baffling. Rather our lens here will be to explore what the facts on the ground are from a policy perspective and the implications for markets.
First some background and the policy context to date.
The story of energy and its transformation is the story of humanity, from our pre-modern ancestors utilising fire to expand caloric intake, which eventually led to our expanded brain, to the fossil fuels that catalysed the industrial revolution. Energy is what makes modern society run. From the food we eat to the economic growth that allows us to avoid the Malthusian trap. In fact, the great biologist (Charles Darwin) stated that the two most significant achievements of humanity are the use of fire and language. For further context, see the below graph showing the correlation between output and total energy consumption.
We begin with the following statement. De-Carbonisation is arguably the first time in human history that we are actively trying to curtail energy output and are in fact, transitioning from a higher-efficiency source to a lower-efficiency source. Now we are by no means discounting the substantial advances in renewables technology nor the efficiency gains in recent years in say, solar, which is arguably cheaper (contingent on time) than traditional coal. We are stating that there is now active and targeted intervention to change the energy mix irrespective of traditional cost-benefit or commercial rationale.
Most governments across the planet today have at least some blueprint for a carbon strategy predicated on reducing emissions. Broadly speaking, this takes two forms. The first category is direct intervention, and the second is market-based intervention. Let's explore each in a little more depth.
Government Direct intervention
In saying direct intervention, we refer to the more traditional methods that investors may be familiar with, from infrastructure investments to subsidies. Prime examples that have hogged the limelight down under could be the infamous direct action policies undertaken by the Abbott government to Turnbulls' Snowy Hydro 2.0. Other examples could be expanded appropriation for green R&D and infrastructure in the inflation reduction act or the recently proposed tax cuts for EVs stateside.
To give some context about the sheer scale of what is in play here, consider the IEA's Sustainable Recovery Tracker, which measures global recovery plans from Covid-19 concerning clean energy measures in particular with the following in mind:
The index suggests that spending commitments across the planet have jumped 40% above the levels after the GFC or to USD 710 Billion. But within this, however, there is significant divergence, with advanced economies accounting for the bulk of the effort with over USD 370 Billion in advanced economies while standouts in emerging markets include those such as India and China.
This brings us to the second category.
Closely related to direct intervention, market-based interventions require a little more nuance in understanding. Let's first understand what the rationale for intervening in the market is. To put it in simple terms, a market-based intervention is grounded upon the notion that there is a market failure typically in the form of mispricing as a result of a negative externality. To explain this even further, consider a public good such as defence spending or law & order, which benefits all stakeholders in a jurisdiction equally, irrespective of the amount of taxes paid or even whether an individual citizen pays taxes. This could be said to be a case of a positive externality. But what happens in the event of, say, a coal-powered station which results in pollution or acid rain (i.e. the related higher expenditure)? The latter is a form of a negative externality, government intervention in this event is typically targeted with punitive measures trying to price in said externality into the market price.
Here is where things get rather hairy and the political debate gets rather heated, that is, in answering the question of what the calculus should be in pricing said externality. So if one assumes climate change to be true, it follows that the extent to which various pollutants cause it must be quantified and inculcated within the market equilibria. How do you then go about placing that price? Especially given the tragedy of the commons that allow for uneven distributions in outcomes. Take, for example, the impact of rising sea levels on third-party island nations in the pacific or changing conditions for agricultural production in China. It is this particular aspect that often requires global cohesion and consensus.
And the implications may not be so obvious.
Implications for Energy Markets
We recently encountered a litigation in the Higher Regional Court of Hamm brought against RWE, a large German utility company. The plaintiff? Saul Luciano Lluya, a Peruvian farmer from Huaraz whose 120,000 inhabitants sit close to the shores of Lake Palcacocha, which has swelled up in recent years by 34 times (since 1970) due to melting ice from glaciers above. Mr Lluya wishes for RWE to pay its share of the costs associated with building the dam that prevents flooding. Interestingly, the monetary value itself is not the issue at hand (arguably negligible) but the implications for utility companies in terms of financial risk (i.e. it could set a precedent that sees Utilities and energy providers having to pay damages for climate risks). It fits well with other cases in recent years, including the actions by ClientEarth in 2018 that effectively prevented Poland-based Enea from building its one-gigawatt power station 120 KM outside of Warsaw. In this case, ClientEarth, after having bought ten shares of the company for a grand total of $23, got its lawyers to use climate risk to substantiate the argument that it was not in the best interests of shareholders.
The cases are just some of the trends impacting investors going forward. We foresee the broader increase in the cost and risks associated with traditional assets while simultaneously catalysing lucrative opportunities. This is not necessarily just limited to simply renewables assets but also existing fossil fuels producers. On the latter point, we still contend that we will likely see a case of peak oil and energy as the transition and de-carbonisation takes place. Think for a moment about the implications for the price of outstripping demand without the requisite ability to bring on additional supply - this is a potentially lucrative proposition for incumbents with already existing production. For this reason, we continue to invest in both LNG and Oil & Gas pipeline companies taking into account some of the jurisdictional and political risks. Companies such as OKE, KMI, LNG, ENB, WMB and SLB.
In fact, assuming current trends stay on course and should demand for Oil & Gas stabilise and decline over the next two decades, the differential will continue to mean higher prices for longer.
Combine the above with further headwinds (for the broader economy) in the form of monetary policy and fiscal policy-led distortions. Our base case sees substantial risks to the downside in production with a continued upward trajectory in electricity prices. The reason? Think for a moment about the implications of the higher cost of capital (in terms of interest rates or taxes) on new or incremental production (hint - oil wells are long payoff and high CAPEX projects). As for renewables, we see both short-term and longer-term upsides. The figure below shows the sheer scale of what is required in terms of additional investments in Solar PV and Wind Capacity to meet net-0 targets over the coming decade.
Assuming, however, the tailwinds for renewables are compounded by assuming the above base case of higher unit prices in energy due to shifting demand. That is, with the assumption that input costs stay stable, the higher-end prices are effectively an increase in margin. Take, for example, the case of a solar or wind farm; a higher electricity price for the end consumer does not translate into any additional marginal cost and simply adds to the top line. Thus, we could potentially see a longer-term secular growth story in the case of renewables as the cost of capital declines due to policy along with increased margins as the price of energy and substitutes (i.e. fossil fuels) increase.
To Sum Up
We see a secular bull market for energy due to policy intervention. This is across both renewables and traditional sources. The latter is a cash flow story for incumbents, while the former offers a dual proposition for earnings and longer-term growth. The caveat, however, is a less dynamic economy given at least medium-term increases in the price and efficiency of energy generation.
Markets & Commentary
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