Is Natural Gas a Bridge Fuel to Renewables? It’s Complicated.
Climate-Tech Investing In The Time of COVID-19 — Article 5
In July 2014, I led an activist campaign to improve the governance and operating efficiency of a public natural gas company in Canada. We met with the Board, found them amenable to our ideas, and compromised on taking two board seats and a formal observer seat that I occupied. We had done our work on the company’s reserves and infrastructure and believed by emulating industry best practices the company could achieve some of the lowest-cost production of natural gas anywhere in North America, a formidable competitive advantage.
We also took comfort, thanks to Daniel Yergin’s excellent historical analysis, that while we had a bearish long-term demand view for oil, our long-term demand view was bullish for natural gas. Oversimplifying, we believed that natural gas-fired power would increasingly replace coal-fired power. I also took comfort that the carbon footprint for natural gas was half that of coal and that natural gas would function for many decades as a bridge fuel. But was that right? Or is switching to natural gas like switching from smoking Marlboro Reds to Marlboro Lights? It’s still going to kill you, it’s just going to take longer.
In the proceeding article, I will give a basic overview of the role natural gas plays today in the energy stack, the Faustian Bargain we are striking each time we put in place another large-scale natural gas asset, the role renewable natural gas (RNG) will play, and wrap things up with investment implications. To read previous entries in this series, Climate-Tech Investing in the Time of Covid-19, see links here:
Article 1 — Whither Climate Investors’ Opportunity Set?
Article 2 — There Is No Climate Change Deus Ex Machina
Article 3 — Earth’s Climate Budget — A Primer
Article 4 — A Case for Rapidly Scaling Carbon Capture, Utilization, and Storage
Context for Natural Gas Discussion
Upon combustion, natural gas, otherwise known as methane (CH4), emits approximately half the carbon dioxide compared to coal (in addition to fewer trace pollutants like sulfur oxides and nitrogen oxides). Without a doubt, we have to thank coal-to-gas switching over the past ten years for a reduction in the US carbon dioxide emissions in the power sector.
The peak in power emissions in 2008 coincides with the peak in US natural gas prices. You can see this relationship visually if you map the upside-down V-shape of US natural gas electric power price in the chart below to the V-shape of the US power sector CO2 emissions in the chart above. Correlation does not prove causation but it passes economic muster that switching to natural gas had little to do with environmental virtue and more to do with economics. Sustained lower natural gas prices have pushed the economy toward using less carbon-intensive natural gas power.
Ever since the experience curve of hydraulic fracturing crossed into an affordable cost threshold in 2008, the US exploration and production (E&P) industry has generated an abundance of cheap natural gas which has done two things:
i) Improved natural gas’s position in the electrical generation merit order increasing the consumption of natural gas hydrocarbon molecules in lieu of coal.
ii) Tipped the scales heavily in favor of building new natural gas-fired power plants instead of new coal-fired power plants. In fact, it’s unlikely a new coal-fired plant will ever be built again in the US.
Unabated Natural Gas-Fired Power is a Faustian Bargain
In the play from the 16th century, Dr. Faustus exchanges eternal damnation for 24 years of unlimited knowledge. Sub ‘power’ for ‘knowledge’ in the previous sentence and the author of the play could not begin to understand how aptly his plot would describe the trade-off natural gas extends to society four centuries later. Said another way, unabated natural gas-fired power might slow down the cooking time by a couple of decades compared to coal-fired power, but it still cooks us in the end.
The way we currently utilize natural gas has three main drawbacks:
1. Methane is prone to leakage and is 1–2 orders of magnitude more potent as a greenhouse gas than carbon dioxide. Behind closed doors and under the promise of anonymity, the head of Environment, Health, and Safety at one of the largest oil and gas (O&G) companies in the world told me that their internal tests showed that most of the methane leakage occurs not during the transportation process, but actually near the wellhead, during and after the drilling process. This is further complicated by two facts:
a. If the well in question is meant to be an oil well, then the associated methane is often viewed as a nuisance, the trash fish of the oil patch.
b. Methane is colorless and odorless which makes leak detection and leak reduction enforcement difficult (or rather, easy to look the other way).
2. Natural gas generation and transportation assets require 30–60 years of continuous operation to justify the up-front investment. Therefore, committing to any new large-scale natural gas project locks-in decades of methane and CO2 emissions. As Professor Gary Yohe stated last year on Jason Jacobs’, My Climate Journey podcast, “I think the constraint on natural gas has to be it’s a bridge….The warning sign would be if people are investing in natural gas in long-lived infrastructure projects, that’s problematic. What do they look like? They look like big pipelines. If you build a pipeline and you expect it to last for 60 years, you’ve committed the country to 60 years of natural gas.”
3. Carbon capture is problematic for natural gas plants because subsidy schemes (45Q) and carbon-to-value technology are maximized based on the tonnage of CO2 captured. Therefore, the reduction in carbon dioxide waste density during methane combustion actually makes it more energy-intensive and less economic to capture, reducing the incentive to retrofit natural gas plants with carbon capture technology.
But Natural Gas Isn’t All Bad, It Can be Renewable Too
Renewable natural gas (RNG) encompasses an industry that captures “naturally-occurring” methane that is off-gassed from waste. Herein lies the opportunity for a tip-of-the-spear circular economy investment opportunity.
Waste-to-methane conversion may occur either through thermal gasification (a waste-cooker), anaerobic digesters (a waste-fermenter), or Power-to-gas (P2G) (a waste-electricity converter).
Many anaerobic digesting businesses are one-off dairy farms where livestock waste is used to generate methane. Generate Capital has been a leader in providing project finance to this sector.
RNG can also be produced at the residential level. A great example of a residential anaerobic digester company is HomeBiogas backed by Closed Loop Ventures.
Power-to-gas, an exciting sub-sector within RNG converts excess renewable electricity to a gaseous fuel by splitting water into hydrogen and oxygen and then combining the hydrogen with carbon dioxide to produce methane. According to an industry report by the American Gas Association, “The potential for power-to-gas systems as a contributor to RNG production could be significant.” To date, most of these projects have been built by large public corporations in pilot scale.
Renewable Natural Gas is not going to replace all-natural gas production
Unfortunately, renewable natural gas is highly unlikely to scale to the level needed to replace the current hydrocarbon fed natural gas system. As the American Gas Associate report (cited above), outlines, even in a high resource potential scenario, by 2040, the US would only be producing enough RNG to replace the residential component of natural gas, which makes up approximately 20% of total natural gas demand in the US.
But the prospects of renewable natural gas globally, especially in areas with limited natural gas infrastructure, are promising. This can take the form of a farm that utilizes its waste to produce RNG in an anaerobic digester to power a natural gas generator that provides all the electricity the farm needs. Not only would this be carbon emission equivalent neutral but it would be inherently more resilient as a secondary source of power (assuming electricity is the primary).
What Role Will Natural Gas Play Going Forward?
To the extent that natural gas is a bridge fuel to renewables, the bridge is already built and need not be extended any further. Said directly, it’s time to sprint across the bridge to zero-carbon technology. We may elect to delay the transition but the warmer the planet gets and the more disruptive the weather patterns become, the more urgently we are likely to move away from carbon-intensive energy. What is unimaginable could easily become the new normal very quickly (I assume given the current lock-down conditions in which I write these words, that horse need not be beaten further). What follows are my views of the investment implications, in order of near-term to medium-term impacts.
Natural gas peaker plant days are numbered
Natural gas peakers are frequently only run for a few hours on the hottest and coldest days of the year. Natural gas peakers are not efficient, cheap, or emission friendly, but they are used because they are simple fast-start turbines (similar to a jet-engine) that can be fired up in a matter of minutes.
Energy storage and effective demand response companies already have natural gas peakers on the ropes. Case and point, last year Southern California Edison elected to replace a retiring natural gas peaker plants with 195MW of energy storage. Additionally, exciting demand response companies like Enbala and AutoGrid are able to aggregate load across the grid and intelligently shave the peak energy demand hours further decreasing the need for natural-gas-peaker back-up power.
New combined-cycle gas turbines (CCGT) should be stalled and potentially not built at all
Probably most controversial right now are the decisions to build new base-load combined cycle gas turbines (CCGT). Given how fast the cost of renewables plus storage is falling (covered in Article 4 — A Case for Rapidly Scaling Carbon Capture, Utilization, and Storage) connected to the limited carbon budget we have remaining before we surpass 2C of global warming (covered in Article 3 — Earth’s Climate Budget — A Primer), it seems imprudent to lock-in any more long-lived carbon emission generating assets. And increasingly, the economics favor clean energy portfolios (CEP), a mixture of renewables, energy storage, energy efficiency, and demand response. This economic reality is beginning to bear out across the US, as a recent RMI report states:
“There is $70 billion worth of planned natural gas plants in the pipeline through the mid-2020s…and clean energy portfolios (which include a combination of demand response, energy efficiency, storage, and renewables) are lower cost than 90% of proposed gas-fired generation at the proposed plant’s in-service date….creating stranded asset risk for investors. Investment in clean energy portfolios instead of new gas capacity would save customers $29 billion and reduce CO2 emissions by 100 million tons per year (equivalent to 5% of current annual emissions by the power sector.”
And if this economic comparison favors clean energy portfolios over new natural gas-fired power in the US, where we have a well-established natural gas infrastructure, clean energy portfolios almost by definition must be more economical in parts of the world like China, India, and all of Africa, that have much less well established natural gas infrastructure.
Liquefied natural gas (LNG) assets have questionable terminal value and long-term contracts should be viewed warily
To obtain financing and justify the enormous up-front capital investment, LNG companies require 10–20-year-long take-or-pay offtake contracts with other countries. Often, these contracts are enough to make equity returns pencil to something in the mid-single digits. The upside to the equity investors comes in the form of excess available capacity that can be sold into the merchant markets in addition to the presumed terminal value of the LNG trains. It may well be that LNG trains have terminal value (no one can predict the future 10–20 years from now), but I contend that to invest capital under the assumption that the world will still demand LNG in 10–20 years is an enormous leap of faith. Faith is somewhat an ironic term to use in that assuming LNG assets will have terminal value 10–20 years hence presumes a lack of faith that humanity will seek to address our reliance on hydrocarbons.
In addition, given the vulnerability of oil markets that has been exposed over the past month, I cannot resist pointing out that LNG requires a Rube Goldberg-esque series of steps to generate power. First natural gas must be pumped out of the earth, then transported by pipeline to a natural gas pre-treatment plant to remove the longer carbon chain liquids, then transported by pipeline again to the LNG train to be liquefied. Then the LNG must be loaded onto a specialized LNG carrier, kept at constant pressure as it sails across the ocean, and once docked, pumped into a pipeline, or trucked to a regasification facility. Once turned back into gas, it must again be transported by pipeline to the final destination, a natural gas power plant, where it is finally combusted to spin a turbine. Setting aside the fact that the environmental benefits are substantially diminished by the time you process all these steps, do you want to rely on that supply chain for your power? Said differently, if you don’t like relying on oil to drive, you are going to hate relying on LNG to power your home. And if the bottom falls out of the LNG market, the way it just did for oil, who thinks take-or-pay contracts will be honored? If one believes that, I have a Natural Gas Bridge to sell to them.
Liquefied Natural Gas Production Process:
Natural gas utilities are on notice
Natural gas utilities still trade at high valuations in the United States (less so in Europe) but equity and debt holders should be concerned. Currently natural gas provides critical power to residential furnaces and stoves and industrial processes but it’s only a matter of time –granted it could be many years — until natural gas begins to be viewed as purely a back-up energy supply or not used at all. Case and point, California recently allowed several municipalities to put in place bans on new natural gas appliance installations. Could a residential gas ban be the next plastic bag ban?
What about all that natural gas pipeline Infrastructure?
For the next several years we will still need to use the natural gas infrastructure as constructed but it’s reasonable to think that if we do begin to replace natural gas generation with zero-carbon power, that some of the pipeline infrastructure will no longer be needed. However, those pipelines are still likely to be valuable molecule highways. In some cases they could be repurposed to transport: carbon dioxide to be injected and stored deep within the earth, hydrogen if we can scale green hydrogen (a topic for another time), and potentially water if rain patterns shift in a manner that climate scientists predict they will.
Our view on natural gas as a bridge fuel back in July 2014, which supported the investment thesis behind the activist campaign turned out to be mostly right. Domestic demand for oil has plateaued while demand for natural gas has increased and LNG exports have taken off. But there are new facts now and I would not make that same bet today. The rapid decline in renewable power costs, coupled with energy storage cost declines changes the entire paradigm for grid operators, policymakers, and investors around the world. Unless the natural gas is produced and utilized in a net zero-carbon manner as described in the renewable natural gas section above, investors would be wise to evaluate current natural gas holdings and steer clear of backing new natural gas assets that depend on long-term utilization.
About the Author:
Benjamin M. Hogan, CFA
At Inherent Group, Ben led investments into companies enabling the transition to a lower-carbon economy, with a particular focus on the energy sector. In addition, Ben engaged with management teams to improve their ESG practices. Prior to Inherent Group, Ben led energy investing at Orange Capital, a $1.5B AUM special situations and activist hedge fund. Prior to Orange Capital, Ben worked in private equity at AMF, a subsidiary of Credit Suisse, which successfully invested $1B into 21 asset managers. Ben started as an M&A Analyst at Berkshire Global Advisors, a boutique M&A advisory firm focused on the asset management industry. Ben holds a B.Sc. in Economics from Duke University as well as the Chartered Financial Analyst (CFA) designation. In addition, Ben is pursuing a part-time M.Sc. in Sustainability Science at Columbia University with a focus on climate science.