Energy Transition

by George Hatjoullis

Climate change has finally sparked some significant steps towards energy transition. Investment in green energy and nuclear is proceeding rapidly albeit not without hiccups. The more significant development is in continuing fossil fuel investment. The fossil fuel capacity is not diminishing. Governments have turned a little ambivalent on fossil fuel capacity . In large part this is because they fear finding their economies without secure energy supplies in the transition. Total investment in energy provision is thus very likely growing rapidly. The prospect is for a period of excess energy supply and collapsing energy prices. Moreover this period of excess supply is likely to materialise in the next five years or so.

The consequences of an abrupt collapse in energy prices may be quite serious. The energy complex is a large part of the global asset base. An abrupt collapse in the nominal value of this asset base could bring with it systemic risk. It rather depends on how leveraged this asset base has become. The most obvious point of weakness is the banking system that may find itself having to write down loans to energy companies. However, given the complexity of the financing and ownership of energy assets the problem may arise in a quite unexpected sector. The important point is that an abrupt collapse in energy asset values is a tail risk which is being underpriced.

There is of course an upside. A collapse in energy prices is a transfer of wealth from the energy producing sector to the energy using sector, which is pretty much everything else. The direction of travel has usually been the reverse with consequent inflationary shocks. There is a prospect of an energy price induced disinflationary shock in the not too distant future. This could provide a huge boost to real incomes and growth in production of energy intensive products. In the long run this is a desireable development so long as the energy used is green. However, the energy transition on its preset trajectory implies a potential short term economic dislocation. If it breaks the financial system then it may delay the benefits of cheap energy.

The dislocation may also have significant geo-political consequences. Fossil fuels are not equally distributed and the consequences of collapsing energy prices will affect some nations more than others. Large real income shocks on a national basis often have profound and unpredictable consequences. Even the nations without fossil fuels and having substantial green energy and nuclear capacity will experience dislocation. Much of their investment in these sectors will have been based on unrealistic energy price projections ( not inevitable but very likely). These sectors will also suffer and be part of the asset value collapse. Government intervention may be necessary.

The economic risks may be exacerbated by climate change. It is likely that global warming and its earthly consequences will become more pronounced and accelerate the urgency for transition. Government intervention to limit the use of fossil fuels will exacerbate the collapse in fossil fuel prices. This will partly protect clean energy producers but the consequences for the fossil fuel industry, and the asset owners, will be even more severe. The problem will be the greater the more the fossil fuel industry keeps investing and expanding capacity. The pressure fossil fuel companies and right wing lobby groups are putting on governments to encourage fossil fuel investment is ultimately self destructive and very risky for the global economy. A managed transition would have reduced these risks.

From an investment point of view the message is clear though implementation of a green investment programme is quite challenging. The ESG vehicles available don’t really address the risk. My own approach has been to assume that at some point in the not too distant future energy prices will collapse and with this a collapse the value of energy assets. Fossil fuel assets will be particularly hurt. The question I then ask is how does this impact my portfolio? It is at least the right question even if I cannot precisely answer it.