Weekly Thematic

C-MACC Perspectives 28 – Energy Transition/Plastic Waste

A Global Industrial Revolution? Risks and Opportunities For Chemicals

• While investment in a carbon neutral world will be substantial, we have not seen a credible analysis that suggests it will be a meaningful boost or drag to global GDP, with the risk of mismanagement leading to a drag on growth, offset by the same mismanagement resulting in likely over-spending.
• Chemical companies without a decarbonization plan could get dragged into the “bad fossil fuel” bucket and see more expensive, or hard to get, funding as well as continued downward pressure on equity multiples. The same issues may arise on the plastic recycling front if positive posturing does not become more positive action – this is not a problem that polymer producers can solve alone.
• We see opportunities for those companies with a vision of what they need to look like in 10-15 years, and who start to act on it, to outperform those who hope that no-one notices them and see business as usual as the right path.

See PDF below for all charts

With China’s declaration last month that it plans to be carbon neutral by 2060 and will see carbon emissions peak by 2030, the World now heads into a coordinated surge to offset the agreed caused of global warming and improve air quality for all. It is our belief that the US will fall in line, either almost immediately or within 5 years. 

To achieve these goals on a global scale will require major investment in clean power, clean fuels and the necessary infrastructure to bring these to market.  The period of transition will take decades and will overlap with other sustainability goals such as minimizing waste (with a focus on plastics) and cleaning up the oceans – as well as meeting what will be increasing need to get clean water to parts of the world. There is significant market premium for clean energy versus fossil fuel.

Exhibit 1: Fossil fuel equities meaningfully underperformed the broader market since 2017, but the underperformance versus new energy has been dramatic

We are focusing on three subjects in this report that we believe will impact the chemicals sector, but in most cases, it is early days with respect to quantifying the impact:

• Spending – how much will need to be spent to achieve the goals, how will the money be raised and will the expense be enough to boost economic growth and create jobs, especially in the context of recovering from COVID
  • Europe appears to be trying kill two birds with one stone – implement a faster transition to clean energy while at the same time targeting recovery stimulus on jobs that fit with the clean energy goal
  • Europe is also proposing tax structures to drive higher levels of plastic recycling and there is an expectation that carbon values will rise in Europe – see FT article linked here – to help drive the transition
  • Will there be a meaningful positive impact on GDP and jobs?
• Funding – we are already seeing a bifurcation of borrowing rates – even in the US – with clean projects gaining access to very attractively priced funding and old energy getting expensive or no funding. This is in part driven by perceived risk in the old industries, but also by ESG and climate pressures at the lenders.
  • While the “bad boy” focus is on traditional energy, could it impact the chemical companies with large carbon footprints and could it also impact those providing feedstocks – both the energy companies and the distributors?
• Benefits – what chemicals and polymers benefit and what gets hurt – such as oil field chemicals potentially.

Spending

We have yet to find a comprehensive and politically neutral analysis of what it might cost to achieve the aims of the Paris Agreement, with the proponents offering lower estimate and offsets that could result in a boost to GDP, if the spending is managed correctly, and opponents suggesting higher numbers and a major economic drag. 

In effect, we are looking at a major, but timeline condensed, “Industrial Revolution”, one that will be resisted aggressively by those whose business models will be hurt and where jobs will be lost, and supported by those open minded enough to recognize that change is inevitable and necessary and that the transition will likely create (different) jobs rather than destroy them (just like all prior industrial step changes).  Unlike the migration of manufacturing to lower labor cost regions – this a change that will require each country and region to fix its own problem – if well managed (which is always a big if) jobs lost in each region can be replaced by jobs gained.  Transport infrastructure cannot be exported or imported, and neither can power (over long distances).  There are projects under discussion to make green hydrogen where power is low cost and then ship to markets where it is needed, but these may not materialize if local green hydrogen projects can be cost effective where the hydrogen demand is the greatest – this will require a further step change in already high renewable energy spending – this should be a major area of spending and job creation.

Overall we would expect the investment in energy transition to more than offset the loss of investment in old energy, providing a boost to overall economic growth, especially in China, and if handled correctly it could also be a boost for the US.  There is plenty of cash on the sidelines in the US and with the right incentives, much of the needed capital could come from the private sector.  The premiums being paid today for “green” investments both in the private and public markets suggest that available capital far exceeds demand.

While we see the spending boost in energy transition to be more likely a net positive for GDP than a net negative, and while it should lead to job growth and therefore consumer spending, it is unlikely to be enough of a boost to impact our forecasts of demand for chemicals – outside those directly related to clean energy – covered later.   

Funding

Funding may be a bigger issue as we are already seeing an immature ESG initiative directly impacting lending.  Banks and other sources of borrowing are under pressure to minimize lending to low ESG rank/score companies and industries, and this is impacting both the availability of funds and the cost of funding in a black and white “barbell” manner today.  See the JP Morgan release from this week. There is so much money allocated to funding “green” projects that there is an oversupply today and borrowing rates for a group of industries that are in their infancies are extremely low and cash very available.  By contrast, if you have been placed in the bad ESG bucket, whether you deserve to be there or not, funding, where available, is expensive.

Exhibit 2: we are seeing funding rates rise for the energy space already, but this is partly an inverse correlation with oil prices relative to average oil F&D costs.  Energy companies are seeing reluctance to lend at all from some traditional sources and there is an expectation that spreads will widen materially from here.  The Chart is sourced from this linked Bloomberg article.

• The very low cost of funding for “green” industries is likely to backfire in a number of ways in our view:
  • The economics of many of the initiatives depend on incentives – oil and gas are so cheap that few of the alternatives available today make sense economically on their own – especially for bio-fuels and renewable based polymers.
    • All incentive schemes are subject to change as they are government/regulatory driven – we saw some major swings in valuation in the early days of the solar industry as incentives moved up and down.
    • Some are “market traded” incentives, such as the European Carbon Price and LCFS in California – high values for Carbon credits drive investments based on the assumption that the credit will remain high. If it falls – projects and companies can fail.
      • We have noted in prior work that the LCFS credit, shown in Exhibit 3, is high enough to encourage all to jump into renewable based fuels and the project list is growing. If you add all of the initiatives and assume that all the projects go through you will have enough bio-based transport fuel to supply 100% of the California market today – should that occur the value of the LCFS credit will likely collapse.  The hope for the emerging bio-fuel industry is that other states adopt LCFS – thereby increasing the demand.

Exhibit 3: LCFS credits remain very high and present potential low carbon fuel makers with significant incentive today.

• Many projects and ideas – especially in the areas of renewable fuels, polymers and efficient disposal of waste – involve new technologies. There are examples of new technologies that have seen significant funding prior to large scale operation that have simply not worked.  In the past, when such financing was deemed risky, and the projects were pursued by large companies with strong balance sheets, the pain fell on the company involved – the most notable being the Tees Valley municipal waste gasification project in the UK, which cost Air Product almost $1bn.  Today, because of the thirst for “green” investments, we are seeing lending to (as yet) untested technologies – or technologies that have not been tested at scale.  A few headline grabbing failures could tighten lending standards and slow down the rate of progress in areas that are critical to the energy transition story
• Equally, the high cost of funding is creating problems elsewhere. Not every old energy project is a bad one, especially if we need natural gas a bridge to get us to Carbon Neutrality.  China will need LNG as well as steel and other materials to change its energy footprint – as will every other region.  If the natural gas producers, transporters, and LNG providers loose access to capital and if other vital material producers are placed in the same bracket as coal and oil producers, it may have the effect of slowing down the transition.
  • It should certainly be difficult to get funding for any project in energy and materials today that does not come with a carbon plan – so LNG producers should have a CCS plan in their projects, for example, but if that is the case, then penalizing these initiatives with expensive debt will be counterproductive.

The other funding complication/uncertainty is taxes.  This is a potential revenue problem for some state and national governments.  If you currently tax gasoline/petrol and other transport fuels but offer tax incentives to those making and buying electric vehicles, then tax revenues could fall meaningfully because of this structure.  This will hit states like California hard and most European countries.  In Europe, there are grand spending plans to create hydrogen infrastructure, something that needs to be paid for while one major source of taxes is falling.  Taxing carbon would make more sense than giving tax rebates for carbon reduction on this basis.  But even a carbon tax is going to be a declining annuity for governments as the intended consequence should be to drive down CO2 level, and therefore the tax base.  A high carbon tax now would provide funds for transitional infrastructure as well as discouraging carbon emissions. As the tax income declines, the spend should also decline as infrastructure is developed. 

The European Carbon Price – Exhibit 4 below – has had an interesting year as the underlying direction is meaningfully higher, but the pandemic has slowed the momentum dramatically because of lower industrial production, and lower emissions.  The step change in pricing above 20 Euros prompted further efficiency movements, but the expectation heading into 2020 was that the low hanging fruit had been plucked and that prices had to rise to get the next round of reductions – there is a consensus that prices need to increase close to $100 per ton (around 85 Euros) – to get widespread investment to capture, remove and store carbon dioxide and that this is still likely a cheaper option that trying to avoid CO2 production with new technologies. With the reopening of European economies in May and June, prices started a steep recovery but the re-emergence of COVID and concerns about further slowdowns have held the price in check in recent weeks.  This system works for progressive improvement as the carbon emission allowances (before they have to buy credits) for the large industrial polluters falls each year.  This system does not add to the tax revenues of the EU but it does not cost the EU either.  Some credit relief is given to carbon emitters in countries that are behind on the path towards cleaner energy for historical reasons, such as Poland.  To date this program has focused on the large CO2 emitters – power generation in particular.  The industries covered do include large scale “bulk” organic chemicals and the list of industries is shown below.

• power and heat generation
• energy-intensive industry sectors including oil refineries, steel works and production of iron, aluminum, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals
• commercial aviation

Smaller chemical companies are so far not in the CO2 cap program – this does not prevent companies from buying credits to offset their carbon footprint, but they are not able to gain credits by reducing their CO2 production.   

Exhibit 4: EU Carbon values in Euros per Metric Ton – The rise in the second half of 2020 suggest underlying strength in the value of carbon as emissions are still down in Europe year-on-year because of the COVID related slowdowns

Switching To The Other Major Topic for Chemicals – Taxes (Penalties) and Recycling

Given that recycling is a complex problem – see the ACC piece linked here – national and local governments need an incentive (penalty) to encourage better collection and separation of recyclable materials – and it is worth noting that Europe, on average, is well ahead of the US, on average.  It is municipalities and ultimately consumers who need to (be encouraged to) change in order to increase the pool of available plastics and other materials to recycle.  The best current systems exist in places like Germany, where households can be fined as much as $2,800 for non-compliance with strict separation and collection rules.   Despite this, only a fraction of the plastic is recycled today, and the rest is either exported or burned.  LyondellBasell/Suez has a significant recycled polyethylene and polypropylene facility in the Netherlands (also a strong recycler) on the German border.  This recycling facility is restricted to 20,000 tons a year of polyethylene and 10,000 tons a year of polypropylene because that is as much clean and segregated polymer that the facility can get within a workable radius of the location.  This is a fraction of the polyethylene and polypropylene consumed within that same radius – and this is the best system there is.  

Recycling needs only one thing to become more effective – a strong and consistent economic incentive.  Either consumers of polymer need to be willing to pay a lot more for the recycled material or incentives/taxes need to change to create enough economic pressure.  While we stand to lose a few clients with this comment, a direct levy of virgin polymer production and polymer imports would help create the cost gap between virgin and recycled polymer assuming the levy was passed directly on to consumers.  Maybe the tax should be on the consumers of polymer rather than the producers as long as it does not drive the consumers towards materials that have a higher lifecycle carbon footprint. 

Europe is experimenting with a tax on non-recycled plastic (see Politico Piece linked here), but at the moment this is a proposed tax on EU member states based on the volume of plastic in each state that is not recycled and ends up in landfill – how that might impact each country is summarized in the Exhibit 5.  The tax has come in for a fair amount of criticism as while it can raise significant revenue for the EU it looks like the individual countries need to work out how to pay it. Offering incentive schemes to encourage recycling will add to each country’s costs unless there is a quick reduction in land filled plastic – enough to offset any incentive programs with a lower tax burden. 

Because of the multiple steps required to create efficient recycling, incentives and or penalties need to apply at each point in the chain – for example, the EU governments need to push the taxes down onto municipalities, which have local control over recycling collection and sorting – either through municipality funded trash collection or contracts with the majors.  They are also best placed to encourage individuals/families to recycle (and to police behavior – as in Germany).  Local governments should be able to offset their tax burden to the national government either through taxes or penalties on trash collectors who do not commit to recycling programs or from fines on individuals for not providing recyclable material for collection correctly.  This all sounds good in theory. but there remain too many steps and too many different parties in the chain to hope for a complete solution.

We believe that the public will to reduce plastic waste and increase the use of alternatives or recycled material is as high as it has ever been on a global scale and will only get move higher.  It will be interesting to see whether consumer or corporate behavior changes as costs rise (although we think the consumer impact will be incremental).

Exhibit 5: European plastic landfill taxed – estimated by county for 2021 based on existing volumes of landfilled plastics – Source: Politico article listed above.

We have maintained for some time that there is a critical role for packagers themselves to play in helping the process by standardizing their use of polymers and choosing recyclable function over style.  This is especially true in household products. 

Some very strong collaboration is needed between packaging polymer producers and their food and consumer products end users.  A lack of collaboration may result in a faster migration to paper which today is much easier to recycle and comes from a renewable resource – despite its packaging shortcomings – more below,

Specific Chemicals Implications

Funding: For now, the chemical industry has not been dragged into the “bad actor” group for funding and it is restricted to the fossil fuel producers and to some extent to the logistics companies serving fossil fuels.  However, it is not a stretch to see the base commodity chemicals companies getting sucked in as they all have large carbon footprints and, in some cases, much larger than some of the smaller refiners and smaller E&P companies.  It will be interesting to see how easy/cheap it was for LyondellBasell to raise the debt needed for the Sasol transaction (we would assume that was all agree before the deal was announced).

If you are a chemical company, we believe that you should be factoring more expensive debt into future plans, while at the same time working on concrete plans to lower your environmental footprint in an attempt to remain in favor with lenders and investors

• All things being equal, it would be interesting to see whether Air Products would be treated any different by lenders – given its definitive goal of lowering its carbon footprint by 30% by 2030 – versus one of the other industrial gas companies. It would also be interesting to see whether investors are willing to pay more for a detailed plan rather than for some vague targets.
  • Any change in lender sentiment or investor sentiment with respect to firm ESG improvement goals, as opposed to a static ESG rating, might start to justify the spending necessary to achieve those goals – whether it be environmental (mainly carbon) or the circular economy around plastics.

In the table below we show a summary of where we believe the major chemicals and polymers sit from both a carbon footprint perspective and sustainability perspective. 

• Carbon footprints are high where you need a lot of heat – so any cracking (bond breaking) process especially – ethylene, propylene (PDH), styrene, VCM, hydrogen.
• Ethylene oxide and propylene oxide are also difficult reactions, requiring a lot of heat.
• Chlorine requires electricity and has a high carbon footprint associated with the power source unless it is a renewable source
• For the products below it is the monomer that is the major problem – the polymers also require heat but much less on a per pound basis.

The chemical industry can make several moves to dramatically improve its environmental and sustainability profiles, but none is cheap and historically the chemists in the industry would rather spend a lot of R&D money on trying to find the most elegant solution rather than the more practical.  It is also worth noting that for many of the products listed above, the substitute also has a carbon footprint.  It is probably cheaper to build a carbon capture process into an original design than it is to retrofit an existing facility, especially with the additional power needs and how to ensure that the power is also carbon free. However, subsidizing or providing incentives for a new product, that likely does not have the versatility or the supply chain efficiencies of polyethylene (for example) appears to make less sense than finding ways to reduce the carbon footprint of the known and preferred polymer.  

• Electric furnaces seem like a “holy grail” for parts of the industry, but the return on investment may be much higher on carbon capture and where possible the eventual conversion to hydrogen as a furnace fuel.
• There is lots of money being spent on researching how to make polymers from renewable feeds as well as how to make polymers biodegradable – this made a lot more sense when the base costs of polymers were supported by $100 crude oil, but less sense today without major subsidies
  • Again, the better option might be to clean up the process to make polymers in wide use today – low carbon fuel – hydrogen – and carbon capture elsewhere.
  • And increase the focus on standardization to enable higher levels of recycling while at the same time increasing the incentives to recycle
  • The link takes you to a Wall Street Journal Article this week that discusses how much of the European plastic packaging market could be taken by paper – as much as 11% by 2031. This would knock around 1% per year out of what is already anemic polymer growth in Europe, and that is before we factor in higher levels of plastic recycling – the goal of the new taxes – and single use bans.  It is not hard to see a scenario in Europe where virgin plastic packaging demand falls over the next 10 years.  This would be especially bad for polyethylene.
• There is a tendency in the chemical industry to try and find a solution to something that looks difficult or expensive, only to come up with an alternative that is either more difficult of more expensive – it is one of the reasons why chemical industry R&D productivity is so low. Elegant solutions are only valuable is someone is willing to pay for them in full.

The gains for the industry are in the more obvious product areas that are focused on clean energy:

• Silicon for solar panels – but this is now very much a commodity market – as are the other components of panel, although there is still significant development in this technology and there may be niche opportunities as the efficiencies evolve. Silicon producers include Wacker and Tokuyama, and EVA is a key component part [see LINK] – Celanese, Dow and Lotte Chemical are notable EVA producers.
• Carbon fiber for wind turbine blades – whether the wind business can be enough to offset the expected lost in commercial aviation over the next 4-5 years is unclear – Hexcel and Solvay are the main carbon fiber producers – Huntsman and Olin supply epoxies to the carbon fiber industry.
• Infrastructure related chemicals and polymers to support the underlying infrastructure needed behind the clean energy projects – PVC pipe (Westlake, Shintech, Formosa, OxyChem, Ineos), High Density Polyethylene pipe (LyondellBasell, SABIC, CP Chem, Borealis) – roadbed modifiers (Kraton) – wire and cable polymers (DuPont, Celanese, Lanxess).
• Hydrogen – unclear whether the industrial gas companies fill this role as they do not have a lock on the electrolysis technology. They can certainly be early to market with blue hydrogen, but it makes more sense for the power companies to make green hydrogen – maybe in local partnership with the gas companies, who do have the expertise in moving it around. 
• Batteries for EVs – Lithium mainly. The primary lithium producers are Albemarle, SQM, Livent, Tianqi and Ganfeng.
• E&C – Carbon Capture systems, furnace refits – already seeing Shell doing this in Europe to make a traditional furnace on an ethylene plant more efficient and consequently emit less CO2 per unit of ethylene. Conversion to hydrogen would have no CO2 emissions – but we would need a lot of hydrogen – which would involve a step change in renewable energy availability and significant infrastructure to store and transport hydrogen.
  • Given the massive investment that would be needed to make hydrogen a cost-effective heating source for an ethylene unit, for example, the more straightforward option is likely CCS.

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