There Is No Climate Change Deus Ex Machina
Climate-Tech Investing In The Time of COVID-19 — Article 2
As the climate investing lead at Inherent Group for the past four years, I was often asked: what brilliant energy breakthrough technology is around the corner that will save us from impending climate doom? Surely when the world needs to come together, on the brink of climate destruction, a coordinated set of politicians and scientists with omniscient decision making and uncanny good looks would save us. That is not how this will play out.
I apologize if right now is not a good time to get any more bad news, but there is good news. We have all the technology we need today to make substantial progress toward staying below 2 degrees Celsius (2C) of warming. According to Lazard’s annual Levelized-cost-of-electricity (LCOE) analysis, new-build wind and solar power are now cheaper than new-build coal and natural gas power in most parts of the world and experience less price volatility once built because the “fuel” is free. Utility-scale energy storage is rapidly sliding down the cost curve and small modular nuclear and carbon sequestration are far along the path toward commercial scale.
The issue preventing rapid de-carbonization, therefore, is not the need for a technological breakthrough. It is scale. And to scale, we need the ability to finance large de-carbonization projects. Capitalism will take care of the rest.
But what about nuclear fusion? Look how quickly the world adopted smartphones! Nuclear fusion and many more exciting energy technologies are in the works in labs across the globe and in various stages of commerciality. But (you knew a ‘but’ was coming)…change in the energy industry does not function like consumer technology with rapid adoption rates. To understand what challenge lays before humankind to decarbonize the economy and stay anywhere close to 2 degrees Celsius (2C) of warming, it’s important to indoctrinate into our collective brains that the energy industry does not change much year to year; rather, adoption rates of new energy technologies occur over timeframes measured in decades as the chart from BP below demonstrates.
How we decarbonize the economy is the second complex question I will address in a series of articles tackling climate investing topics. To start at the beginning, see Article 1.
What is the path to zero net emissions?
I don’t know about you, but for a long time, I used Google Maps Street View without actually knowing how the service worked. It felt very sophisticated. I imagined an algorithm splicing together satellite photographs using artificial intelligence (AI) in which Google allowed me to zoom in on any street in the world. I was later amazed to learn they actually had just hired people to drive, bike, boat, walk, snowmobile, ski, and even go underwater with cameras to physically photograph every street they possibly could. Discovering this fact felt prosaic…Herculean to be sure, but also so…non-techy. This is analogous to how we will decarbonize the energy sector.
Moving away from hydrocarbons within the timeframe outlined by the IPCC to stay under 2C comes down to one simple, non-techy, pathway: electrification powered by zero-carbon generation.
Every home, business, and plant in the developed world has the electrical infrastructure already feeding in, powering all the electrical appliances. (In certain developing countries where electrical grids are minimal, it might be possible to skip straight to distributed micro-grids, but that is a topic for another post). Electricity does not have attendant emissions at the point of consumption, but the genesis of the electricity at the plant-level has a wide-range of carbon-emission intensity (the so-called “long smokestack”, pictured below). The key term to dwell on is “zero-carbon.” Renewable energy like wind and solar produce zero emissions and have an extremely important role to play but if we are going to rapidly de-carbonize the economy, we need a comprehensive attack using all forms of zero-carbon power including nuclear, carbon sequestration, and energy efficiency.
There are three significant challenges using the electric infrastructure we have today to decarbonize the power sector:
(1) the electrical grid is often brittle and prone to disruption by weather, which is getting more volatile, and requires significant investment to harden and upgrade;
(2) finding the least cost and most equitable way to 100% zero-carbon power generation given the intermittency of renewables, the sunk investment in hydrocarbon power to date, the cost of carbon sequestration, and societies’ misgivings about nuclear power, and;
(3) putting in place the necessary market signals to speed the financing of (1) and (2).
Thankfully, many governments have been convinced by the scientific community that zero-carbon-powered electrification is the best path forward and has put in place policies to support its growth. Others need to catch up. I am going to focus the remainder of this article on (3) financing ability, as (1) and (2) are investment opportunities for savvy climate investors that we covered in Article 1.
If advancing the electrical grid to zero-carbon will take decades, where do we start and how can we speed things up?
The rapid adoption of a new power source is encumbered by the requirement of capital-intensive physical plant and equipment. It is additionally subject to a complex choreography between government, banks, equity sponsors, developers, and impacted private citizens before a single unit of energy can be sold. And unlike iPhones, there is very little consumer differentiation.
In response to an economy in COVID-19 freefall, governments around the world are looking to spend trillions of dollars to put people back to work. In addition, as Jigar Shah recently cited, Bain & Company reports that private equity funds have $2.5T in uncalled capital. The capital is available but how do we motivate investment in the broad areas outlined in Article 1 to decarbonize the economy. To spur rapid investment in de-carbonization projects, the government can build infrastructure by diktat, or better, they can put in place long-term policies that encourage the private sector to finance the development of low-carbon infrastructure.
For non-financial readers, I will digress quickly to explain why financing is the lifeblood of power infrastructure using a stylized example. If you are familiar with finance, skip to the next paragraph. Let’s say you are the Governor of a State and it’s time to decommission one of your coal-fired plants and replace it with a new power plant. You want to ensure a steady supply of cheap and abundant power for your citizens. Replacing the 1GW of power will cost somewhere in the neighborhood of $1B. Financing the $1B estimated cost is not easy. Most likely you will outsource this headache to a local utility. The utility, in turn, will develop the project (if they are allowed to) or outsource this to an external developer. Either way, to motivate the large up-front capital expenditure, the developer is going to want different forms of government-enforced guarantees that will give them comfort that they will earn their capital invested back plus a minimum return. These guarantees often come in some form of the power purchase agreement (PPA). A PPA will state a minimum amount of power that the utility will purchase annually at a fixed price (often with escalators to offset inflation) for a set amount of years (10–20). With a PPA in place, the project becomes financeable, meaning the developer can access cheap loans from commercial banks. Without cheap financing from major banks, large-scale infrastructure projects do not get built.
What are some ways we can scale the finance-ability of de-carbonization projects?
There are numerous ways governments have tried to incentivize the private sector to participate in de-carbonization. One effective way at the State level is renewable portfolio standards (RPS) which dictate a certain amount of power must be generated by renewable power by a certain date.
That RPS standards can work is seen clearly in the chart below in which California’s electricity sector has managed to halve its carbon emissions over the past decade while the remaining sectors’ emissions have barely budged. California first established an RPS standard in 2002, requiring the State’s utilities to obtain 20% of its non-hydro power from renewable sources by 2017. This type of government diktat comes at an enormous price but perhaps it’s worth it to advance technologies rapidly down the price curve (will save this debate for another post.)
One criticism of renewable portfolio standards is policy should not pick technologies. California heeded this criticism recently by passing SB100, a law that requires California’s utilities to use 60% renewable power by 2030 and 100% zero-carbon electricity by 2045. By allowing 40% to come from zero-carbon sources, California’s lawmakers wisely allowed for the least cost solutions to win, agnostic to whether that be nuclear, geothermal, natural gas + carbon capture, renewables + energy storage, or something else entirely.
Which brings us to the carbon-fee concept. The near-unanimous way to reduce carbon emissions is through the carbon-fee + dividend model. Conservative economists, including Greg Mankiw, and independent climate scientists, including James Hansen, believe it’s the best path forward. And liberal politicians including Joe Biden and conservative Bush/Reagan politicians including James Baker and Hank Paulson advocate for a carbon-fee + dividend. I have also met with numerous oil and gas (O&G) executives who would welcome a settled agreement on a carbon-fee which would help them better allocate capital spending.
I will let James Hansen describe a carbon-fee + dividend model, taken from Storms of My Grandchildren (2009):
In [the carbon-fee + dividend] method, a fee is collected for each fossil fuel at its first sale in the country. The fee is uniform, a single number, in dollars per ton of carbon dioxide in the fuel. The public does not directly pay any fee or tax, but the prices of the goods they buy increases in proportion to how much fossil fuel is used in the production. Fuels such as gasoline or heating oil, along with electricity made from coal, oil, or gas, are affected directly by the carbon fee, which is set to increase over time. The carbon fee will rise gradually so that the public will have time to adjust their lifestyle, choice of vehicle, home insulation, etc. so as to minimize their carbon footprint. Under fee-and-dividend, 100% of the money collected from the fossil fuel companies is distributed uniformly to the public. Those who do better than average in reducing their carbon footprint will receive more in the dividend than they will pay…Fee-and-dividend is a progressive tax…Given the current distribution of wealth and lifestyles, about 40% of people will pay more in added costs than they will get back in their dividends. For the most part, it will be those with high incomes, [large houses and lots of air travel] who pay more, but not always. [Long distance commuters will be encouraged to figure out more efficient transportation].”
Greg Mankiw can explain the economic theory to us as he explained to Leo in 2016:
“The carbon tax would be basically a tax on any kind of activity that puts carbon into the atmosphere. So when you tax something, you raise the price, people are going to tend to consume less of it. In fact, that’s sort of lesson number one of economics. The basic idea is we want to tax bad activities that have negative side effects on other people in society. So we raised the price of cigarettes by putting a tax on cigarettes…people are going to consume fewer cigarettes. Climate change involves a variety of negative side effects and costs. A carbon tax forces people to take account of those costs. I think trying to appeal to peoples’ social responsibility is really very hard. People have complicated lives, they have lots of things to worry about. They don’t want to have to think about climate change every time they make a decision, they can’t…What a carbon tax does is it nudges them in the direction of doing the right thing…One of the important things to keep in mind is if you have a carbon tax, you can turn around and cut other taxes, for example, the payroll tax.”
I told you in Article 1 that I would revisit the concept that the necessary change for the really big climate resiliency must occur at the system-design level or what you might remember as “McDonough’s smokestacks.” A carbon-fee + dividend, as prosaic as it sounds, is the invisible hand that can rapidly guide the economy away from carbon-intensive activity. How fast depends on how fast we increase the carbon fee.
How does a carbon fee connect to financing zero-carbon power?
At its essence, a carbon fee rebalances the cost of capital from hydrocarbon-intensive to zero-carbon power projects. For non-financial readers, I will digress again quickly to explain the concept of “cost of capital” as typically only finance geeks have an intuitive sense for this term. Skip ahead two paragraphs if you’re a finance geek. Going back to economics 101, all production requires some mix of land, labor, and capital. A farm may be an intuitive example. In order to produce milk, you need land, farm-hands, and buildings/equipment. When traditional economic theory crystallized, buildings/equipment were called ‘capital’. In order to buy these three key inputs, you need money, or what we also often refer to as ‘capital’. It’s unnecessarily confusing, but for our purposes, we’ll differentiate and call buildings/equipment ‘physical capital’ and money ‘financial capital’ or just ‘capital’. Before you can buy land, pay wages, or buy equipment, you need money which comes from savings or banks. When you borrow money from a bank, the interest you pay on that money is the cost of that money which is commonly referred to as the “cost of capital.” Additionally, when you redirect your personal savings (often referred to as equity) to financing your farm, you are also paying for the cost of the money or the “cost of capital” because you could be doing something else productive with that money (like buying the S&P 500 index).
If a carbon fee were made permanent, suddenly the price of extracting coal, oil, and gas becomes more expensive, increasing the amount of capital (money from savings and bank borrowings) that you need to produce those hydrocarbon molecules. A higher fixed cost base in the form of a tax also makes bankers more concerned that it will be harder to pay them back which likely means they will ask for higher interest rates. On the opposing side, all carbon-free electric molecules are relatively less expensive to produce. Therefore we can say the carbon fee has increased the cost of capital for carbon-emission technology relative to zero-carbon technology which should, in theory, shift capital investment away from carbon-emission technology and toward zero-carbon technology.
If you put a fee on carbon emissions, does that mean enough zero-carbon generation will get built and on the timescale we need to avoid 2C?
The answer, unfortunately, is probably not. A carbon fee, especially one that escalates quickly, will push most, if not all, power generation away from carbon-emissions technology but it could take decades as that tax will increase the price for products that are relatively hard to see for consumers. For example, if your power bill went from $50/month to $75/month over five years, you would notice, but you might not do anything about it. Similarly, if gasoline gradually increased by $1/gallon over five years, the average person might also take notice, but not do anything about it for some time.
The final piece to developing low-carbon infrastructure is subsidies. For many investors, subsidies are a dirty word. Investors eschew regulatory risk and are wary of any product that relies on a subsidy to be competitive. Setting aside the fact that I challenge anyone to find a sector that does not have embedded government subsidies, and that all interest and depreciation expenses are tax subsidies, I still take the point that investing in an otherwise uncompetitive market is not a good long-term investment strategy. However, it depends on the subsidy and how you are investing. If you are investing on a project by project basis and the subsidy is locked in for the entire length of the project, then it certainly reduces your cost of capital and increases your financing options. The solar investment tax credit and the wind production tax credit have encouraged substantial investment into both technologies which have encouraged companies around the world to invest heavily in the sector. Now both wind and solar technologies are competitive without subsidy as the Lazard LCOE graph below shows.
But it’s not a competition between carbon solutions, we need not pick one at the expense of the other. As Dr. Julio Friedmann, one of the leading carbon policy wonks in the country recently explained on the Columbia Energy Exchange:
“I am spending all of my time thinking about policy and finance because that’s the thing we need. We don’t need more technology per se to make a lot of progress…There are certainly a lot of benefits that would come from an economy-wide carbon tax, and I think the simplest and cleanest way of doing a lot of this is internalizing an externality that way. I also can’t wait for a carbon tax. I’m on the clock. But there are many policies that are doable while we sort that other stuff out. I don’t think of these as substitutes for each other, but stuff like a procurement law, or an investment tax credit, or a green bank, or building hubs and clusters as infrastructure investments would greatly accelerate carbon management to market. And you can do that now.”
In summary, the world has the technology we need now to make substantial progress in decarbonizing the planet. We do not need to race toward a climate vaccine. What we need now are the decidedly prosaic carbon policies to inject urgency into financing large and small de-carbonization projects. The solutions have become obvious, how long it will take the US and the rest of the world to implement them is the unknown, but the clock is ticking. Those investors with the insight to understand how and when these policies will come to pass will find numerous exciting climate investments to pursue. Godspeed.
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.