In a few hundred years, humans have transformed the planet from an agricultural globe to an industrialized powerhouse. This transformation was, and is still, driven by electricity powered by cheap and easy-to-access fossil fuels. Currently, more than 80 percent of the world’s power is generated through oil, coal and natural gas.
This presents two problems.
For one, fossil fuels take a long time to replenish, as in billions of years. A BP study estimated we have roughly 50 years of oil and natural gas left, and 110 years of coal. There is an imbalance when we compare the decades left of fossil fuels versus the billions of years it took to create them. Even if BP is off by a factor of 100, humans will deplete fossil fuels from Earth much faster than they can be replenished. This leads to the need to replace the energy stack with fuels that are either renewable or plentiful.
Secondly, the use of fossil fuels to generate power emits carbon dioxide. Carbon dioxide is a greenhouse gas that acts to warm the planet. While there are bound to be positive effects and negative effects to more carbon dioxide in our atmosphere, it is impossible to weigh the effects this will have on the planet. The truth is we are creating change with unknown consequences. Power production using coal is especially harmful. In addition to carbon dioxide, using coal for electricity emits sulfur dioxide and nitrogen oxides, which contribute to acid rain, respiratory illnesses and smog.
THE DILEMMA
The use of fossil fuels is not sustainable. Regardless of the environmental impact increased carbon dioxide has on the planet, the fact that we are using fossil fuels faster than they are being generated puts a shot clock on the adoption of non-fossil-fuel energy sources. This dilemma, however, creates an opportunity. The commercial opportunity to invest in repositioning our energy stack is long term and massive.
While we have known this for quite some time, what makes this an interesting investment opportunity now is that companies and countries are taking action. Recently, 408 businesses wrote an open letter to President Biden, urging him to lead a reduction of greenhouse gases of 50 percent by 2030. Some 196 countries signed the Paris Agreement, which is a goal to limit global warming below 2 degrees Celsius as compared to pre-industrial temperature levels.
The Intergovernmental Panel on Climate Change combined a number of studies from the Organization for Economic Co-operation and Development, the International Energy Agency, and other agencies that estimated the need for $2.4 trillion of investment each year until 2035 to limit warming to 1.5 degrees Celsius.
THE OPPORTUNITY
The scale of the transition from fossil fuels to renewable energy sources and the pledges from countries and companies to complete this transition creates an investment opportunity. While there are many ways to participate in this investment opportunity, we believe it is best done in the private markets.
The reason behind this is the idea of “additionality.” Additionality refers to the concept that because this money is being invested, change, in this case carbon reduction, will take place. Without this money going to work, this change wouldn’t occur.
An example of additionality is solar farm construction. Private real assets managers take investors’ capital and build a solar field. The power generated by the solar field is electricity that does not have to be generated by fossil fuel power plants, thus generating less carbon. Without this capital, the solar project would not have been completed.
Contrast this with environmentally conscious investing in the public markets. An ESG manager is most likely going to run a screen for high carbon-producing companies and not buy Exxon, Chevron or Halliburton. While that may reflect an investor’s desire to not own oil companies, it does nothing to take carbon out of the system, like building a solar field.
For example, a solar farm built by a private investment fund might deliver 12 megawatts of electricity to the grid, taking 116 tons of carbon dioxide out of the air each year.
AN INTERGENERATIONAL THEME
Decarbonization is an intergenerational investment theme that will provide meaningful return to investors who participate. To capture this theme, it makes sense to focus on investments that provide “additionality” because it increases the chance for meaningful excess returns while affecting change along the way.
The size of this energy transition requires a multifaceted approach, using large scale funds that are sized appropriately for the opportunity, as well as small niche funds that can be nimble. This opportunity spans across multiple asset classes, requiring proven technologies to be implemented as well as new technologies to be discovered.
Ben Webb is director of manager selection and implementation at Balentine.