This is an excerpt from our recently published report titled “Comfortably Numb: The COP27 Discussion Is Easier Than The Need“.
The Checkbooks Being Targeted Are Not Big Enough
Navigating the funding of energy transition remains one of the greatest challenges of the next 20+ years, especially if what needs to be done is measured against what is fair. Somehow the developed world must find a way to support the decarbonization (and growth) of the developing world while pursuing its own decarbonizing priorities and at the same time not going broke. And that is the simple version! The complicated version includes politicians’ needs to stay in power and their consequent reluctance to make decisions that make them less popular. The chart below is meant to show uncertainty and lack of consistency of analysis rather than accurate estimates of costs. If you cannot measure something, it is quite hard to fix or change it. Dithering politicians and regulators are working with estimates and analysis that is so varied that you could drive a fuel cell-powered truck through it, and unfortunately, all this will do is delay activity – if we cannot agree on the data then it will be hard to agree – globally – on what to do about it.
Exhibit 1: Note that the data is not consistent by provider – the estimate producing most of the lows has the high for power, and a total close to the average
Source: LSE Grantham Institute, and C-MACC Analysis October 2022
We are reminded of the great Rowan Atkinson’s “Father of the Bride” speech – “There comes a time in every wedding reception that the man who paid for the damned thing is allowed to speak a word a two of his own”. The rest of the speech is not relevant, but the payment line comes to mind every time a broad and largely theoretical analysis of what climate change will cost and how it should be funded is published. The chart in Exhibit 1 is illustrative in that it shows some of the challenges with respect to costs and the definition of where those costs are. The chart is based on the data in Exhibit 2, which is a summary of those studies that have published estimates. Exhibit 3 shows a breakdown of the required spending annually to meet 2030 goals, but this one is more precise around categories.
Exhibit 2: A summary of the conclusions of studies used in the LSE Grantham Institute analysis
Source: LSE Grantham Institute
Part of the issue with the analysis is that there is an overlap between categories – in some cases hydrogen is included in power, industrial, or transport or spread across all. Given that hydrogen is being looked at as a natural gas substitute for industry, as a precursor to ammonia for fuel and for AFOLU (Agriculture, Forestry, and Other Land Use) as a fertilizer, and as both a direct fuel and to generate power, it is hard to categorize. Regardless, the overall sums of money involved are huge and the Grantham Institute analysis goes to great lengths to talk about possible sources – from public to private – debt, equity, grants – etc. Where the money is anticipated to come from public funds, governments will need to find ways to pay for it – taxes are unpopular at the general level, and taxing corporates through windfall taxes, carbon taxes, etc., will be equally unpopular and might drive behavior that you do not want. But the funds must come from somewhere. On the private side, it all comes down to investment attractiveness and incentives. Private money will follow risk-adjusted return opportunities, and the easier they are to identify and measure the more likely it is that money will flow. Putting a high price on carbon emissions seems to us to be the most obvious lever that governments can pull globally, with a tax perhaps more helpful than a cap-and-trade mechanism or a tax break.
The increase in the 45Q values in the US seems to have kick-started activity around CCS and other carbon abatement schemes, but it will eat into government revenues – if we sequester 1 billion tons of CO2 in the US per year this could be a loss of tax revenue of as much as $85 billion dollars – not insignificant. A tax would likely drive the same abatement behavior, but at the margin, it would generate government revenues, and this may be increasingly important in developed countries if they are on the hook to fund decarbonizing efforts in other parts of the world – see Indonesia headline below. The central issue is inflation as there is no getting away from it unless you increase personal taxes to fund energy transition, which will lower consumption, but also likely result in a revolving door of political leadership, and policy inconsistency.
Exhibit 3: Investment/spending needs for climate action per year by 2030
Source: LSE Grantham Institute, November 2022
The fundamental problem is that energy transition spending is unproductive capital – for the most part it does not drive production growth. Companies cannot justify the spending based on expanded production and the ability to sell more products – they are spending money to make the product more environmentally compliant in almost all cases – not to add capacity. So, the question of “green premium” comes back up. Will consumers (corporates or retail customers) pay more for a product with the right green attributes? If they will, projects will get funded, if they will not, progress will be slow. Not getting a higher price or some sort of margin incentive will keep pressure on governments to fund transition directly or do so through incentive schemes like 45Q and this will lower government revenues.
We have an interesting test case today with recycled plastic, especially in the US. This is a fixed-cost business for the most part as the costs of collection, sorting, and then recycling – mechanical or otherwise – do not move with the price of oil and gas or the profitability of the virgin polymer business. As we see virgin polymer pricing collapse in the US, we are also seeing recycled polymer prices come down, either because of the pricing mechanisms that have been agreed upon between buyer and seller or because polymer buyers are demanding it. Recycling is a thin-margin business in many cases, buoyed every now and then by spikes in virgin prices. In the past, virgin polymer downcycles have killed recycling businesses, but this time the stakes are much higher. There is quite a bit of private capital in recycling today, and if businesses fail, the private market will turn away and not come back – not unless deals can be struck with polymer buyers to maintain the viability of the recycling business. If recyclers fail, none of the packagers will meet their recycled content goals. This would be quite negative for the recycling industry but could possibly give new life to the waste to energy or waste to syngas sectors. As we watch US polypropylene prices fall, we question what the future looks like for PureCycle!
We have the same issue with our run of river power project in Mississippi. If we take the power through to green ammonia or methanol, for example, our initial estimates suggest that we can be competitive in a “normal” market for either product, but historic cyclical lows for either product would be a problem. This will be a fixed-cost business also for the most part as all the power will come from the river. The temptation today is to look at pricing formulas that reflect the current market price, but this could be a mistake, as it is proving to be for some recyclers today. Our discussions with potential offtake partners center around their willingness to take a largely fixed price which would make the project fundable – those too focused on the current ammonia price, for example, seem quite interested, which is not a surprise, but how they would behave in a cyclical downturn paying more than the general market price is uncertain. Those looking to make renewable fuels – hydrogen users for hydrogenation or ammonia users for shipping fuel, where they can get value for the lower carbon intensity, are more amenable to the fixed price idea. This would apply to fertilizer buyers growing corn, soy, or canola for renewable fuel projects also.
Regardless of all this debate and theorizing around who pays for what, there is no getting away from the inflationary or economically depressing inevitability of energy transition spending. This is mostly unproductive capital, and while it could create very many well-paid jobs and in that sense be a boost to economies globally, there is an inevitable price inflation component – some of which we are already seeing in the wind and solar sectors. The lofty goals of COP27 will be very hard to achieve unless there is an acceptance that either taxes have to rise or prices have to rise or both, and politicians trying to pretend that they can protect consumers from either, while also finding 3-4 trillion dollars globally each year for transition spending, will either have to break their promises to their constituents – and likely lose power – or break their promises to bodies like the UN around climate investment.
The need to help developing nations is well illustrated in the chart below, although many of the developing nations are missing. The argument from India, for example, is that its per-capita emissions are low and why should the country be denied opportunities to grow economically, just because it is late to the party. The same is true for Indonesia and others who would be spending scarce capital unproductively when there is a compelling need to invest for economic advancement. The climate problem is an absolute emissions problem, but the per capita analysis shows that outside the US (and Europe) there is an unevenness in the size of the emission challenge and the economic strength to address it. From a corporate perspective, the focus will be on competitive landscapes and how they might change with climate funding and support. Could we create some unexpected trade flows as manufacturers exploit low abatement cost geographies to get a cost advantage?
When you combine the expense challenges – taxes or rising prices or both – and the need to manage regional competitiveness it is easy to see why there are plenty of skeptics around the likelihood of real progress on emission abatement. Our view is that you need to tackle each problem as you see it and that one solution will not fit all
- CCS will make great sense in some parts of the world and no sense in others.
- Nuclear needs to be on the table – especially in Europe.
- Trade flows will need to change, but strong political alliances will be needed – i.e., Europe will be reluctant to increase its reliance on hydrocarbon-based exports from the US if there is a risk that a future populist government in the US could unilaterally cut supplies.
- The rise of populism in governments globally is a risk to collaborative longer-term trade agreements and climate agreements in our opinion.
Exhibit 4: There is a big difference between emissions and emissions per capita
Company Conclusions
The investment opportunities are hard to find as we think about the financial challenges outlined above. The unproductive nature of the capital spending creates the risk that companies chase pricing to cover costs, but likely lag, hurting margins. There is also the risk that the overall cost implications cause either enough inflation to slow economic growth or just slow economic growth because of redirected capital. That would be a negative for commodity chemical producers as it would prolong the current period of surplus. We still think, however, that the lack of capital spending on growth will cause many commodity shortages this decade, and much higher pricing and margins for incumbent producers while adding to the inflationary cycle.
Other areas where we see demand outpacing supply include RNG – see below – and key equipment and components for transition, such as electrolyzers (eventually) and EV components. Oddly, the most sought-after material today, lithium, is the one that we see having the least interesting future as the high price today is attracting many new entrants into a market with few barriers to entry except cost – which most are ignoring given current pricing. High prices are also driving advances in different battery designs and different choices around batteries. Lithium may have a bright couple of years, but after that, in our view, all bets are off.
Despite what are likely to be some very poor year-end results for many of the commodity companies, which will drive cautious outlooks, we would be tempted to invest in a basket of broad commodity-exposed names early in the new year with the expectation that we might have to hold them for a while. Many stocks and sectors look quite cheap today, but the risk of jumping in now is a further wave of surprises, versus what is already priced in, and the wave of tax loss selling that the market is likely to see as the year comes to a close.
For more see “Comfortably Numb: The COP27 Discussion Is Easier Than The Need“.