Investing for the Energy Transition
Never has so much financial muscle, nor religion of all stripes, or polities of all leanings been so aligned behind a single cause. Described by Francois Hollande as the ‘first universal agreement in history’, it is neither financial regulation or sanction, trade treaty or peace deal – it is an energy treaty. The culmination of the 21st United Nations Framework on Climate Change was the signing of COP21 by 195 countries. The formidable goal universally agreed was to limit the increase in temperatures to 2 degrees by the end of the century, principally by transitioning from fossil fuels to green energy.
This is as bigger ticket as there is - McKinsey & Co, a global consultancy have anticipated that it will require spending 275 trillion USD over the next 30 years to achieve– investment opportunities abound.
What is the Energy Transition?
For thousands of years, humanity’s progress was fitful – reliant on the capricious nature of earth’s fires, winds and currents; mobility, building and nutrition was elementary. Then in the eighteenth century, by virtue of the discovering of a black stone called coal, steam powered the ability to build ocean going vessels, locomotives and looms – the first industrial revolution accelerated man’s economic means. So whilst we undertake this prospective energy transition, we can draw some comfort that this is not a maiden voyage.
Let’s consider our historic miles gained. The original Industrial Revolution was facilitated by the transition from whale oil and wood to coal. Then during the 1900’s, the automobile was popularised in part due to the commercialisation of oil discoveries. However, it was the extraction of another rock oil, petroleum, that allowed us to conquer the skies and build ever more powerful internal combustion engines. The 1930’s and 40’s brought natural gas to the energy mix and the 1950’s and 60’s introduced nuclear energy to national base loads.
More recently, interest has grown in what has been stylistically termed ‘green energies’. The investment in renewables in earnest finds it roots in 1980’s Germany. But how well do we understand the nature of these new energy forms and their origins? Our ancestors of the nineteenth century had a visceral understanding of the primacy of coal; the generations that have followed have been acutely aware of the value of oil to today’s globalised economy. However, as we stand, we’re less convinced that there is widespread recognition that the indispensable underpinning of the green transition squarely resides in another rockborne substance, extracted in lilliputtian quantities, and called the ‘rare earth’ metals. In principal at least, these are the new ‘oil’ and form the backbone of the green and digital technologies, that will drive the energy transition.
Perhaps ‘transition’ is a somewhat leading descriptor, to what has gone before and lies ahead. Whilst our energy mix has transitioned many times historically, for example coal’s market share in the United States’ energy provision has fallen vertiginously over the last 30 years, in absolute terms, we use more than 3.5 times more than we did all those years ago. Each year the world requires more energy, not less, and thus we need to grow the energy base load, rather than simply replace it. Transition perhaps in practical terms will ultimately mean diversify.
The road to greener energies is fraught with potholes, previous transitions took decades and this will be no different. In order to identify the most promising of investing opportunities, we feel there is a trenchant need to understand some of the challenges that lie ahead of us. We need to be wide eyed about these, and in doing so, ensure that some of the consequences remain palatable to ensure we stay the course. Moreover, we believe that significant research capabilities in the field, can unearth investing opportunities, which do sidestep some of the more contentious issues raised as we undertake the journey to net zero.
The realities of side lining hydrocarbons
At the time of going to press, the world consumes, with demand having recovered from pre pandemic levels, approximately 100mn barrels of oil a day, as well as other liquids. Furthermore, we guzzle approximately 400BCF (barrels per cubic foot) of gas. The current market is as ‘tight’ as perhaps it has ever been, particularly given the current geo-political pressures having effectively removed 4.5mn barrels of Russian crude per day from the global market. By way of alleviating any shortages, President Joe Biden has sought to release an additional 1mn barrels per day from the US’s Strategic Petroleum Reserve in order to restrain further price appreciation. With approximately 500+ barrels held in the SPR, it is neither a ‘bottomless’ well nor enduring fix.
Chart 1: Current Global Energy Mix
Global primary energy consumption by source
Primary energy is calculated based on the 'substitution method' which takes account of the inefficiencies in fossil fuel production by converting non-fossil energy into the energy inputs required if they had the same conversion losses as fossil fuels.
Source: Our World in Data.org, BP Statistical Review of World Energy
The chart above shows how our current energy load is provided for. Hydrocarbons account for nearly 65% of our daily energy consumption. Pre-pandemic oil demand was growing at approximately 1m-1.5mn barrels per day. Simultaneously, global oil reserves deplete at approximately 8% per annum – meaning we have to find approximately 8mn barrels per day per year to maintain current reserves. The Shale Oil revolution began in earnest in 2011, which initially contributed to a significant global weakness in crude prices, averaging 40 -60USD per barrel between 2014 and 2021. In fact, few realise that now the US is the biggest producer in the world – at nearly 10mn barrels per day, dwarfing Russian and Saudi daily output. However, that was before the ESG movement catalysed a massive curtailment in financial capital available to US shale oil projects, for which we are now beginning to feel the effects. As new supply projects have been shelved, due to little appetite on behalf of banks or investors, demand continues its inexorable push higher, and the markets have tightened.
If we were to simply stop drilling now, effectively go cold turkey, then within two decades we would need to find another 7 Shale Oil discoveries, or perhaps even more starkly, another 7 Saudi Arabia’s to fill the supply void. J. P. Morgan has just released a doomsday report pricing oil at 380 USD should Russian oil be sanctioned, which entails removing entirely 4.5mn or say barrels of crude per day from the market. Anybody with an electricity bill would shudder (or more likely shiver), if faced with energy prices resulting from an effective prohibition on all hydrocarbon based fuels.
Over the next decade the world is due to add 1.1bn people according to the United Nations, all of which will require more energy, rather than less. Electrifying the world – transitioning from molecules to power, will also bring significant transmission challenges. The capacity required will mean ultra efficient energy grids – whereas in the West, our current infrastructure would be charitably described as antiquated.
Chart 2: Europe currently facing gas prices equivalent to 600 USD oil
Source: IEA.org, ARIA
Russia’s invasion of Ukraine puts Europe under acute pressure. As of June 2022, Europe currently digests a gas price that is 6-8 times that which the US pays. That in and of itself puts any energy intensive industry at a significant cost disadvantage to its global peers – Germany is a manufacturing powerhouse and we would expect it already to be in recession with such high input costs. Not to mention the profound impact that those prices have on the European consumer. It’s not surprise that Spain has announced 6bn EUR support plan in direct aid, tax breaks and fuel subsidies to cushion the blow, Italy 3bn EUR and Germany is having to nationalise Uniper one of its biggest gas uitility companies on account of the losses sustained by rising gas prices.
Oil is more fungible than gas as a commodity. Germany only imports 20% of its oil from Russia, and so it is easier to consider oil sanctions. However, Putin’s pipelines are responsible for 40% of Germany’s gas. Replacing Russian natural gas supplies is more problematic that crude. To transport gas means liquified natural gas, or LNG, which requires liquification, then freezing to minus 160 degrees centrigrade, before loading specially designed vessels before re-liquifying again at the destination port. LNG port infrastructure requires investments of between 15 to 50 billion USD and typically 4 years to complete – assuming permissioning can be achieved within 12 months.
Industrial Policies and Uneven Playing Fields
To effect a genuine energy transition requires all nations to move forwards shoulder to shoulder. Moreover, the narrative can quickly novate from energy transition to energy security, should some nations seek to exploit a competitive advantage from divergent environmental standards. For example, should the West reduce its carbon emissions from 11mn tonnes per annum to zero, only to see China’s increase from 12 to 25, the net benefit is zero.
Recent decades have seen the West outsource its heavy manufacturing base to emerging nations which have de facto lower environmental standards. In the short term, that lead to rapid industrialisation of emerging economies, and bumper profit margins with limited carbon footprints for companies of the West. One of the biggest wins in the net zero roadmap is the decarbonising of building materials industries, those producing cement, alloy metals and steel. Half a century ago, countries such as France, the UK and the US were responsible for nearly 50% of all aluminium manufacture – a number today that is less than 10%. Over two thirds of all solar panel manufacturing capacity resides in China – the costs of production and subsequent resale are so low that European manufacturers can simply not compete. However, there are concerns that these costs of production are achieved by cheap labour, which often means child labour. Strict yet laudable regulations in the US prohibit the procurement of panels which has any associated child labour rights concerns. That alone is one reason why the anticipated installation in the US will be only 6 or 7 gigawatts of solar this year, well short of the targeted 25 gigawatts.
This is all to underline that as the West has decarbonised, the world hasn’t, and the gains of offshoring manfucaturing are not without consequences.
Divestment and risks of energy supply shortages
We all rely on energy in such fundamental ways it is often difficult to perceive them at close quarters. Perhaps the most conscious experience we will each have first hand of our energy thirst, is the 2.6MGWh of energy and 500kg of Co2 emissions from the intercontinental flight we habitually undertake for our summer holidays. However, this only accounts for 3% of global yearly emissions – over half of those emissions are caused by what we consume and the buildings in which we consume them.
To be more specific, agriculture accounts for 13% of global CO2 emissions, steel is c8%, concrete is c8%, plastics are 2%, fertilisers are 1%. Notably these are all input materials, which are then ‘transformed’ into products, (drawing another 10% of global co2), which in turn is then transported to homes across the world – which speaks to another 5% of emissions. When considered in this light, energy has such a profound impact on all of our quotidian existences, shortages and price spikes will have immediate and far reaching impacts. Consider the Gambian hospital that doesn’t have sufficient electricity to power basic incubators on maternal wards which leads to unforgiveable child mortality rates, the Tunisian fruit seller that set himself alight, (and the Arab spring with it), on account on elevated food prices or the current Sri Lankan unrest which has driven the government to resign.
Higher energy prices lead to industrial products cuts, unemployment and economic downturns. So in managing this transition, we need to recognise that we need more energy not less, and massive divestment plans from traditional oil and gas, may lead to complications that endanger the success of the very transition itself.
The Rise of the Chinese Dragon
Measuring the carbon and financial cost of renewables perhaps is to tell some of the story – it doesn’t necessary account for the full lifecycle of the technologies. In some respects, it is the ‘inconvenient truth’ of green technologies – namely that their construction is highly reliant on minerals and metals – which means energy intensive mining and extractive resources once more.
The new sustainable world is largely dependent on metals found in minute quantities, bursting with remarkable properties, which are referred to as ‘rare earth’ metals. Wind turbines, solar panels and electric cars and their decarbonised energy, require significant quantities of metals, which form a family of seventeen elements, all with exotic names such as antimony, germanium, indium, tungsten and gallium. These rare earths all possess supreme electromagnetic, catalytic and chemical properties. Transitioning our energy model will mean doubling rare metal production every fifteen years. In fact, it is anticipated over the next thirty years we will need to mine more mineral ores than humans have extracted over the last 70,000 years.
As with any mining activity, the process of extraction requires staggering quantities of water, which then are often polluted by heavy metal concentrates and chemicals in the leaching process, moreover, often then entering the water table feeding local communities. China is the major producer for nearly 28 rare earths that have been deemed fundamental to our digital and sustainable futures – often accounting for more than 50% of exported volumes. Rare earths are concentrates, and very resource intensive – it takes 8.5 tonnes of rock to be purified to produce a kilogram of vanadium; sixteen tonnes for a kilo of cerium, fifteen tonnes for the equivalent in gallium.
Great Britain’s dominance in the nineteenth century is often attributed to its pre-eminence in coal production, the more recent hegemony of the United States could be viewed through its relationship with Saudi to safeguard oil supplies before achieving energy independence in its own right. Controlling the means of energy production, access to and its cost goes a long way to economic sovereignty. As we stand there is one state better positioned than any to do so in rare earths: the Middle Kingdom. That’s not to understate the importance of perhaps Rwanda to tantalum, and the Democratic Republic of Congo to cobalt, but again, typically they are produced from Chinese mines.
We expect that in the years to come, particularly if the current geopolitical tensions continue to redraw the map of ‘friends and foes’, that there will be ever greater scrutiny of supply chains and their provenance. Moreover, to date the success of recycling rare earth metals has been very underwhelming. Therefore, when the reliance on oil changes to an addiction to rare earth metals, and the potential for national security issues to result, we feel that there will be pause for thought along the way.
Chart 3: Minerals used in electric cars compared to conventional combustion engine
Source: ARIA, IEA.org
The Ultimate Energy Mix
If we treble the annual capacity of wind and solar by 2050, a momentous feat in its own right, then renewables can account for approximately 40% of base loads at that point.
There has been growing ‘murmurings’ in recent times, that gas could be considered ‘green’. It is substantiated by being clear burning and abundant. Compared to coal, it emits less than a third of the carbon for 1 megawatt of energy. Moreover, there are new imminent technologies that can generate even more energy per molecule. In that respect, we feel it is possible that another 10% of the ultimate energy mix could be accounted for by shifting reliance from fossil fuels to gas. Inevitably there will be efficiency gains elsewhere. However, that still leaves approximately half of a decarbonised energy mix to be achieved by 2050 to come through newer technologies. It is these that we are seeking to direct investing attentions towards.
For reasons we’ve highlighted above, we also anticipate that nuclear will be a significant part of the energy mix, being a significantly denser form of energy than coal, and natural gas, and also without emissions. If we consider the entire lifecycle, then it potentially can claim to have a lower carbon footprint than wind and solar too. Nuclear is not something that we have exposure to, but we would be hardpressed to bet against, in the decades to come, with new smaller, technologically advanced reactors meaning nuclear playing a more important role than it does currently.
Reforestation is to our mind, an oft overlooked participant. It does not in itself produce energy, (biomass aside), but it can provide an offset to emissions. Trees are a huge part of the carbon cycle. As extracting hydrocarbons from the earth emits carbon, plants, trees, grasses photosynthesize those emissions and return to the soil. Globally we have deforested over 6bn acres which has contributed approximately a third of all man made emissions. Moreover, not just trees, but grasses such as elephant grasses are a fast growing, very ‘carbon hungry’ vegetation.
So this year, at ARIA, we calculated all of our global footprint collectively as a business, identified certain planting projects that we were comfortable with, and invested into them. By taking an acre of degraded agricultural land, before planting, we are contributing to a real incremental, enduring, measurable and biodiverse forest. Depending on the project, the costs are circa 15 to 50USD per ton of carbon sequestered – we expect to cover our entire footprint 5x over.
How to build a ‘truly’ green portfolio then, with so many conflicting considerations and entrenched obstacles?
We are committed investors to renewables. We are significant investors in Carbon Resilience, a Singapore domiciled renewables platform that could well be the largest developer in APAC already, with a prospective 12Gigawatt renewables portfolio in Australia, Indonesia and New Zealand.
Deflation (up to 90%) in the cost of renewables production costs, has reduced the cost of electricity to some of the cheapest in the world – approximately 6 cents per KW/h in some projects. In 2021, wind and solar produced 1,830TerraWatt hours of energy, which equates to 3% of the world’s 63.000 TWH global energy consumption. However, the returns from investing in solar and wind are single digits – and often that having benefitted from leverage and government subsidy, without which it would be difficult to achieve the hurdle rates of institutional pension funds and their own liability driven mandates. Moreover, wind and solar are already absorbing over 300bn USD of capital per annum, but their roll out will not be sufficient to meet our ever growing population. Moreover, as touched on above renewables work very well when supplying a grid, (subject to the wind blowing and sun shining), but do not sit well in powering transportation. Furthermore, providing the steady, non intermittent requirements of perhaps northern hemisphere heating requirements, when solar intensity can be half that of summer, (as we have already experienced in Europe), does not play to the strengths of wind and solar.
Therefore, given our experiences and investments, we’re well versed in understanding the full life cycle of green technologies. We’re well placed to target opportunities that we feel will have a significant, measurable and positive impact on the energy transition and those that perhaps will be required to deliver approximately 50% of the decarbonisation required, not accounted for by renewables and ‘low carbon’ gas supplies.
Having reviewed over 150 technologies, an ongoing task, we have identified a dozen or so themes we believe will see significant acceleration during the energy transition and attractive investment candidates. Opportunities such as carbon capture, glass fibre, photovoltaic glass, biofuels, carbon capture systems and energy efficiency technologies such as heat pumps. That’s not to ignore the exciting areas that are new developments in materials. Carbon fibre may yet be considered a miracle breakthrough. It is three times stronger than steel yet, 70/80% lighter. It can be used to make wind turbine blades, hydrogen tanks light and more fuel efficient planes.
The following table highlights some of the opportunities that resides within the universe we continue to research and build.
||PerkinElmer makes an elemental analyser to test soil carbon, which dries c25mg of soil at 105C, then combusts off the carbon at 925C. The company also makes spectrometers, specialized measurement devices and medical diagnostic instruments. Out of $2.9bn in 2019 revenues, $1.2bn was from medical diagnostics, $0.9bn was life sciences and $0.5bn was applied sciences and $0.3bn was food. But will elemental analysers be displaced by infrared devices?
||Green Plains is a pure-play ethanol MLP, producing around 1bn gallons of ethanol per year. On our numbers, bioethanol production still emits net CO2, whereas devoting the same land to reforestation and burning fossil fuels instead (or burying the biomass) could lower net emissions, for a net economic benefit at $20-50/ton.
||Conservation agriculture cuts fertilizer use 50-98%, can sequester 3-15bn tons of CO2, transforming crop-farming economics and will increasingly be accelerated by energy transition policies. Fertilizer is also 1% of global emissions.
||c2-3% of global gas production ends up leaked. The largest upstream component is from pneumatic controllers and actuators. There are 750k around the US, leaking an average of 1.5T/methane/year. Rotork is the leading manufacturer of electric actuator alternatives. They are more expensive, but as the industry concentrates in the hands of larger, more ESG-conscious companies (particularly shale), we expect increasing retrofits.
||Plastic pyrolysis is on the cusp of commercialisation. This nascent opportunity can turn waste plastic back -- of which only 15% is currently recyclable -- into oil, generating >30% IRRs on investment, and potentially displacing 15Mbpd of future oil demand. OMV started its ‘ReOil’ programme in 2010, to turn plastic back into oil, opening a test facility at the Schwechat refinery in 2018, which can process 100kg/hour (c700Tpa).
|ITM Fuel Cells
||ITM is aiming to generate power from green and blue hydrogen. We have visited a wind-to-hydrogen filling station demonstration plant outside Sheffield. We estimate 50% higher costs per mile under UK fuel conditions and 85% higher in the US; plus 24c/kWh realized power pricing to earn a 10% return at 50% utilization from blue hydrogen and c50c/kWh for green hydrogen. Hydrogen is a 'bad battery'.
The ecological transition of our economic activities is fundamental to our survival as a species. The challenges of meeting the ambitious COP 21 targets should not in any way soften our resolve to meet them. We have tried to highlight some of the considerations which need to be carefully managed to ensure that we do stay the course. Successful conclusion of this transition will require difficult conversations to be had, potentially compromises to be struck and scientific breakthroughs to be made. It also requires significant investment in the technologies that will enable us to meet our marks.
From tea to crude oil, nutmeg to tulips, saltpetre to coal, the demand for and the supply of commodities has shaped history. The technologies of the future, those sectors of the economy deemed to be the leading lights of a greener, more sustainable future such as artificial intelligence, digital healthcare, nano-electronics and autonomous cars, all rely on extractive industries and the supply of the rare earth materials which will cornerstone such progress. The demand for and the supply of these earth encrusted metals, will not be any less germane in penning the chapters of times to come.
At ARIA, we believe we have strong ‘environmental credentials’. From our investments and holdings in certified avocado production, with zero fertiliser production and farmer education programs, through to our recycled lead battery plants in Tanzania, our renewable investing platform and our corporate program of natural carbon offsets, we have mapped a number of ways to reduce our carbon footprint to zero in the coming years. A true net zero where possible. Moreover, we believe we can positively steer capital towards ensuring the energy transition to a greener future. We’re pragmatic about what that energy mix looks like, but also fervent believers in newer or proven technologies which will make a significant contribution to achieving these noble goals.