Energy analyst Kingsmill Bond considers if peak fossil-fuel consumption has been reached and whether investors appreciate the implications.
Read this to understand:
- How Russia’s conflict with Ukraine has accelerated the rush to renewables
- How new energy technologies will drive down the cost of power generation
- Why stock and bond investors need to be mindful of exposure to legacy fossil-fuel assets
Brace for change is the message of Kingsmill Bond, energy strategist at the non-profit Rocky Mountain Institute, who suggests investors should look closely at their fossil-fuel risk. His argument is that as renewable deployment increases and costs decline, fossil fuels will no longer be able to compete.
Bond suggests the shift to renewables will accelerate, with major implications for fossil-fuel assets. He sees the transition in energy technology upending the status quo, resulting in widespread write-downs and the possibility of a Minsky moment as fossil-fuel investors rush for the exit.1 Meanwhile, all the growth to be found is in renewable technologies.
How has the need to transition away from fossil fuels changed?
The need to change is becoming more urgent. Twenty years ago, we thought the environmental risks would be high or very high when global temperatures were around 4.5 degrees Celsius higher than the pre-industrial average. We now think the risks are going to be high or very high at 1.5 degrees. The science and understanding of the system have evolved; the more we understand, the more risk we see.
Russia’s invasion of Ukraine has accelerated change. Prior to the conflict, solar and wind were getting cheaper and had begun to compete with fossil fuels. Then the marginal cost of fossil fuels suddenly went through the roof, and renewable alternatives are now obviously cheaper.
Contrary to the narrative from the fossil-fuel industry, high prices have destroyed fossil-fuel demand
That has implications in lots of areas: for electric vehicles (EVs), the production of green hydrogen, green ammonia and so on. Contrary to the narrative from the fossil-fuel industry, high prices have destroyed fossil-fuel demand. Of course, if you take out five per cent of supply, you get people scrambling around to fill the shortfall in the short term, but total fossil fuel-demand is placed under enormous stress.
In addition, there has been a dramatic policy shift in the last five years, and we have seen an S-curve of political action. In the last year alone, we have had the Inflation Reduction Act in the United States, RePowerEU in Europe and the Chinese 14th five-year plan, all of which prioritise clean energy. The private sector is catching up and most major companies now have net-zero targets.
When the world's political business, and financial leaders all try to solve the carbon problem like this, we are poised for a tsunami of innovation.
What are the geopolitical implications?
Change has major implications for the expensive fossil-fuel system which channels trillions into the pockets of oligarchs and petrostates. Renewables have the potential to liberate the poor and the Global South from energy dependency. I see the shift as equivalent to that which took us from hunting wild animals to farming crops ten thousand years ago. We will shift from hunting for ever more remote fossil-fuel deposits to farming eternal solar reserves.
Wealth will shift from petrostates to the rest of the world because everyone has renewables
Wealth will shift from petrostates to the rest of the world because everyone has renewables. This shift is not just taking place in the OECD. It’s happening everywhere: in Brazil, Vietnam, India and China for example.
Where will this leave the cost of renewables?
The cost of new energy technologies has fallen 60 to 90 per cent in the last ten years (Figure 1). By 2030, we may be able to produce solar power for $10 to $15 per megawatt hour and wind at $20 to $25 per megawatt hour with battery storage available around $50 per kilowatt hour. Green hydrogen could be $1 per kilogramme, assuming current growth and learning curves continue. These are all far below the fossil-fuel equivalents.
Figure 1: The energy technology cost revolution, $/MWh (real 2021)
Source: Aviva Investors, BloombergNEF, January 23, 20232
People then say: “How can costs fall? The cost of energy went up in 2022.” The answer of course is that prices have gone up for everything. But unlike fossil fuels, renewables have capacity to respond, and they have a track record of falling costs over many decades, punctuated by brief periods when they didn’t.
Energy production from renewables is potentially about 100 times larger than from fossil fuels
We have seen a strong build-out of polysilicon factories and, as a result, the cost of polysilicon is falling again. There have been efficiency gains, so it takes less polysilicon to produce each watt of solar power. That is the difference between a technology and a commodity – technology keeps getting better. There was some interesting analysis done by mathematicians at the Institute for New Economic Thinking in Oxford, which shows learning curves are very sticky; that simply means costs are highly likely to start falling again.
Even if you constrain where you place these technologies, energy production from renewables is potentially about 100 times larger than from fossil fuels. Of course, in parts of the Global South, the potential outstrips demand thousands of times over.
Which sectors are likely to see most change?
The electricity sector has reached a position where solar and wind generation is cheaper than fossil fuels and fossil-fuel capital expenditure and demand have peaked. That tipping point is now happening in the auto sector, for heat pumps and right across the energy spectrum.
There are counterarguments, including supposedly insoluble barriers like intermittency or lack of raw materials. Experience shows intermittency is a soluble problem and solutions are being found for each of the barriers.
We are heading for between 30 and 50 petawatt hours of solar energy by 2050
We generated about one petawatt hour (one thousand terawatt hours or one thousand million hours) of solar energy in 2022 and believe we are heading for between 30 and 50 petawatt hours by 2050. Before you say, “It cannot be done”, this is a pattern we have seen before, with canals, railways, roads and oil pipelines.
The use of fossil fuels and electricity once grew on S-curves. In 1900, we generated around about seven terawatt hours of electricity; this year we'll generate around 28,000 terawatt hours, a 4,000-fold increase. No-one sat down in 1900 and said: “There will be no electricity system unless we get it to Timbuktu.” Our network evolved. This is exactly what will happen this time.
What does it mean for financial markets?
The rise of the new pushes out the old. This is normal for investors; the pattern is common in all technological shifts. Of course, many financial market actors listen to incumbents, who do not anticipate the scale of change. Why would they?
Change is not a 2030 or 2050 story. It’s a 2022 story. This is the decade of disruption. We can demonstrate that by looking at data on the slow growth in global energy demand and contrasting it with the rapid growth of renewable supply. The lines will ultimately cross, and in the energy system they cross this decade.
At the heart of this is a simple story of the new challenging an established system. You can see the peaks across the old system: coal began to peak in 2013, and it’s plateaued for a decade. The peak in OECD fossil-fuel demand happened about 15 years ago, and in industry it happened about seven years ago. We believe the oil peak is imminent and the gas peak will follow.
Peak fossil-fuel demand occurred in 2019 and we are now just bouncing along the plateau at the top
From our analysis, peak fossil-fuel demand occurred in 2019, and we are now just bouncing along the plateau at the top. What follows is decline. This can be seen clearly in forecasts for fossil-fuel demand from others too; they are all variants on a single theme.
Five years ago, incumbent fossil-fuel forecasters suggested demand would carry on growing forever. That argument is over. Today's debate lies between “slow decline” and “fast decline”. Our view is that tomorrow's debate is between “fast decline” and “very fast decline”.
What does it mean for shareholders? Fossil-fuel stocks have been declining over time, with occasional bursts of enthusiasm driven by specific events. You could make money when Putin invaded Ukraine, but when the impact fades, you will continue losing money.
Renewable stocks, in contrast, are experiencing a typical Gartner hype cycle where they boom, collapse, then recover.
But the story is not just fossil fuels versus renewables. A changing energy system has profound implications across financial markets. All heavy fossil-fuel usage sectors need reinvention; the power sector was the first to be disrupted, and we now have obvious disruption in autos and machinery. Ultimately, we expect supply chains to reform around clean, cheap energy sources.
The risk-reward for holding fossil-fuel securities is poor
The risk-reward for holding fossil-fuel securities is poor. There is currently around $30 trillion of fossil-fuel capital employed against around $5 trillion in renewables, but all the growth is in renewables. Investors are massively exposed to the old system. Peak demand means stranded assets, but this is being obscured by Putin's war. Once the fog of war dies away, the risk will become more obvious.
From an analysis of Bloomberg data, we believe about one quarter of global equities, half of traded bonds and half of US syndicated loan portfolios are in sectors at risk from the energy transition. This is not just in coal, oil and gas, it's also in electricity, transport and machinery and the banks lending to the fossil-fuel system. Fossil-fuel exposure is far greater than many appreciate.
Figure 2: Climate-relevant sectors of US syndicated loan portfolios
Source: Ceres, 20203
The other observation is that investors tend to sell shares in incumbents towards the peak. Fossil-fuel advocates use the work of academics like Canadian Professor Emeritus Vaclav Smil to argue there is no threat to the fossil-fuel system because demand will remain relatively high for decades. But that misses the way financial markets work. You aim to sell at the top, not halfway down.
Investors in fossil fuels face a range of risks, including cheaper alternatives, taxation, declining prices, stranded assets, litigation impacting reputation and so on.
Investors with deep exposure to the old system should be reducing it as a matter of risk control
Investors with deep exposure to the old system should be reducing it as a matter of risk control. There could be a Minsky moment when investors realise they have too much exposure and all try to reduce it at the same time.
In contrast, renewables are where the opportunity lies, but investors need to be highly selective and pick stocks well. There will be many losers too.
What are the sovereign and sector implications?
This transition has profound implications across countries, sectors and markets. We believe countries with expensive energy will see a migration of energy intensive sectors to countries like Australia and Morocco with plentiful solar. Today’s petrostates will get more fragile: Venezuela has already collapsed, Russia is vulnerable – watch out for their currencies and debt. In contrast, fossil-fuel importers like Turkey, Thailand and India are going to see their balance of payments improve.
One technology getting a lot of hype and supported by fossil-fuel dollars is carbon capture and storage (CCS). Without CCS, fossil-fuel companies can burn around 30 per cent of their reserves; with it, they can burn significantly more. What are your views?
We are producing about 40 gigatonnes (40 billion tonnes) of CO2 a year. Even under the most optimistic CCS scenarios, we might only be able to lock away about ten per cent of the total. So, under no circumstances can we continue with business as usual.
It’s helpful to compare the chains involved getting energy from the two sources - fracked gas with CCS versus a solar panel. You can frack gas in the US, pipe it to the coast, freeze it, put it on a boat, ship it to Japan, unfreeze it, burn it in a power plant with a CCS capture unit, which itself increases the amount of electricity required, transmit the electricity on a pylon to rural Kyoto, and turn the lights on. That's a long process. You have efficiency losses throughout and you will get only a fraction of your energy out. You have to do it every day, because you are burning the gas after all.
Alternatively, you buy a solar panel, put it on your roof and get high-quality electricity immediately and for the next 30 years. There is no competition now we have made the economics of renewables work.
What are your assumptions on demand, alternative technologies, the price of fossil fuels and efficiency gains? Where will we get plastics? What about ongoing demand for petrol from the existing passenger car fleet?
We will probably continue getting plastics from oil. That accounts for about five per cent of fossil-fuel demand, but it is too small to hold up the transition. As with many things, we tend to change the easiest elements first and the harder ones later. Hard to solve sectors do not hold back system change.
The car fleet issue is a question of timing. Once all new sales are EVs, you are only about 15 years away from having almost no cars with internal combustion engines on the roads.
We are only about 15 years away from having almost no cars with internal combustion engines
The third point is about cost. Prices fluctuate, but fossil fuels are competing with renewables, where costs are falling over time on learning curves. Ultimately, fossil fuels will simply get priced out of the market.
Efficiency gains are achieved by a combination of the deployment of superior technology and from learning by doing. When you put a wind turbine in the North Sea ten years ago, you did it with an old boat, it was complicated, took several weeks and you probably fell into the water a couple of times in the process. Now you have dedicated boats and they put them up in a single day.
We are confident these learning curves will continue. Change is not happening in a vacuum: governments and people are keen to deploy these technologies.
When will we have enough renewables to change the overall mix, not just satisfy incremental demand growth?
Our view is that solar and wind will overtake fossil fuels in the power mix comparatively soon. By 2030, solar, wind and other clean energy sources will account for 60 per cent of electricity generation and fossil fuels will have fallen to 40 per cent. We believe we have reached a peak in fossil-fuel demand; demand may plateau for another three or four years, then the decline will become increasingly obvious after 2025.
The transition is going to create a huge amount of stress within the system. There will be tensions in those petrostates that built systems based on oil at $80 to $100 a barrel and now live off the huge rents that the fossil-fuel system generates of nearly $2 trillion, a year.
What do you think about integrated assessment models (IAMs), like the one used by the Bank of England?
My first criticism is empirical. IAMs constantly underestimate the growth of new energy technologies. Go back to any forecast five or ten years ago, and you will find projections of tiny amounts of expensive solar in 2022.
Secondly, these models fail because they use conservative forward-looking assumptions and rely on peer review by fossil-fuel incumbents; by the time the process is done, they are using data two or three years out of date. People in financial markets must not be constrained by this: our job is to get the key assumptions approximately right, not precisely wrong.
IAMs implicitly assume business-as-usual is a superior answer and anything different is going to cost money
The third problem is that these models implicitly assume business-as-usual is a superior answer and anything different is going to cost money. That’s another false assumption because business-as-usual will lead us over a cliff.
IAM models always conclude the answer to the emissions problem is carbon taxes and CCS. We support a different approach: accelerating the deployment of renewable technologies, making targeted efforts to reduce costs and using the lower cost base to provide a superior solution.
Many models also hide behind extreme complexity to come up with a variant on business-as-usual which is self-evidently unrealistic. They go through all kinds of complex hoops to tell us the largest capital transition in history will cost two per cent of the value of a portfolio, about the same as it moves in a single day. Meanwhile, in the real world, we have a $30 trillion fossil-fuel system unlikely to exist in 30 years’ time and stranded assets about to cascade through the system.
Oil majors are involved in renewables. The return on capital from fossil fuels has been high, which has helped fund renewables projects, where return on capital is low. You say investment in renewables is attractive, but from a cashflow perspective some renewables companies are seen as high risk. Do you have any observations?
This is a perfect encapsulation of Clayton Christensen's famous book, The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail. It says that during technological shifts, people who stay with an old technology make money until the day before it collapses and find it hard to shift to a new approach until it's too late.
It is hard to make money in new industries but change is happening
It’s exactly the argument Barnes & Noble made about selling books online and department store operator Sears made about selling via the Internet. Why should they do things differently? It is hard to make money in new industries, particularly at the beginning. But change is happening. Farsighted management teams need to recognise the only way to succeed is to channel profits into technologies and industries with a long-term future.
Meanwhile, fossil-fuel companies are largely peripheral to the transition. They are only spending about five per cent of their capital expenditure on renewables, according to the International Energy Agency. The transition is being driven by new companies, as in any technology transition.