Chancellor: Investors unprepared for carbon crunch

The sun sets behind a pump-jack outside Saint-Fiacre
The sun sets behind an oil pump outside Saint-Fiacre, near Paris, France, March 28, 2019. REUTERS/Christian Hartmann

LONDON, Nov 18 (Reuters Breakingviews) - Over the past 250 years, the abundant use of coal, and later oil and natural gas, has spurred industrialisation, lifted living standards, and increased the size of the global population. Last week’s COP26 conference in Glasgow focused on the contribution of fossil fuels to global warming. Even if climate change wasn’t a pressing concern, the world would still need to adjust to running out of cheap oil and gas. The transition to alternative energy may be inevitable, but it’s bound to be disruptive. One thing is certain: transition risk is not being properly priced in the markets.

The use of fossil fuels to generate power is constrained by certain laws of physics. As the late Kenneth Boulding pointed out in his 1973 essay “The Economics of Energy”, the second law of thermodynamics states that energy becomes increasingly less available as it is used. The law of conservation of energy states that it can neither be created nor destroyed. Thus, in a closed system such as Earth, the supply of energy from fossil fuels must be gradually exhausted. There’s only a limited amount of what Boulding called “bottled sunshine” to draw upon.

A recent study by French government scientists warns that global oil production could collapse in just 13 years. Louis Delannoy and colleagues point out that as oil becomes less readily available, more energy must be used to extract it. Prior to the 1970s oil crisis, it took the energy equivalent of two barrels of oil to extract 100 barrels. That figure has now risen to more than 15 barrels and will climb to 25 by 2024, according to Delannoy. In other words, a quarter of the world’s oil supply will be spent on production. This process of “energy cannibalism” means less energy is left over for other purposes. Given the world’s continued dependence on oil, the global economy faces a potential “carbon crunch”.

Delannoy argues that mankind needs to speed up its transition to alternative energy. The costs of generating electricity from solar and wind have collapsed over the past decade, dipping below those of natural gas and coal in 2018. But, as Britain’s recent mini energy crisis shows, these sources of renewable energy are intermittent, and the electricity supply becomes unstable as their share rises beyond a certain level. The trouble is that there is currently no economical way to store renewable energy. Furthermore, while the sun and wind are potentially limitless sources of energy, geography and climate are limiting factors. Solar power is most reliable and abundant in places like Africa and the Middle East, far from the large European end markets.

Even if it were possible to generate enough alternative energy, a stupendous supply of raw materials would be required to transition to a low-carbon economy. The Manhattan Institute calculates that a single electric vehicle battery requires around half a million pounds of raw materials – including lithium, cobalt, nickel, graphite and copper ores read more . There are currently more than 1 billion cars on the road, of which only a tiny fraction run on electricity. To power the world’s car fleet with electric batteries would consume nearly half the world’s proven nickel and lithium reserves, according to recent calculations from the Geological Survey of Finland. What’s more, those batteries would have to be replaced every few years.

The Finnish geologists conclude that expectations for replacing existing hydrocarbon-fuelled industrial and transport systems are unrealistic. “The current system was built with the support of the highest calorifically dense source of energy the world has ever known (oil), in cheap abundant quantities, with easily available credit, and seemingly unlimited mineral resources. The replacement needs to be done at a time when there is comparatively very expensive energy, a fragile finance system saturated in debt, not enough minerals, and an unprecedented world population, embedded in a deteriorating natural environment. Most challenging of all, this has to be done within a few decades.”

So far, the discussion about “stranded assets” left high and dry by the transition to renewable energy has centred around oil and mining investments. But this approach is too limited in scope, says Will Thomson of Massif Capital. “A focus on the extractive industries alone, when considering stranded asset potential, gives a misleading picture of the total value of real assets at risk in a transition to a low carbon economy.” Long-lived assets at risk include chemicals and chemical derivatives, non-metallic products and the construction industry. Many financial assets, including corporate debt, are also at risk.

What are investors to do? Investing in companies with high environmental scores won’t save the world. MSCI environmental, social and governance indexes, as currently constituted, are weighted towards businesses, such as Apple (AAPL.O) and Microsoft (MSFT.O), which have low emissions but don’t do much to assist the transition, Thomson told a Grant’s Conference in New York last month. Besides, the ESG scores are backward-looking. Investors should look out for industrial companies that are changing their processes even if they have low ESG scores. Thomson cites as examples the Swedish steel company SSAB (SSABa.ST), which focuses on producing carbon-free steel, and HeidelbergCement (HEIG.DE), which employs carbon-capture technology.

Joseph Schumpeter believed that depressions are caused by the advent of new technologies that disturb existing lines of profitability. The transition to green technology is more ambitious and more disruptive than anything attempted in the history of capitalism. As the economy transitions away from fossil fuels, the financial markets are bound to become extraordinarily volatile. U.S. stocks trading at sky-high valuations and carrying record amounts of debt look particularly vulnerable.

To kick the addiction to fossil fuels, as mankind must, and at the same time maintain high standards of living, new technologies are desperately needed – less resource-intensive batteries with greater storage capacity and more efficient low-emission energy sources. But the next generation of small-scale nuclear plants won’t be up and running for years. And despite recent advances, nuclear fusion won’t be ready for at least a decade. In the meantime, investors should prepare for a rough ride.

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Editing by Rob Cox and Oliver Taslic

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