Beyond Carbon: Taking Stock of Energy Transformation Opportunities
Now that the pomp and circumstance that accompanies Climate Week 2024 in New York is behind us (although we still have COP-29 in November), climate operators and investors can get back to work on issues most material to the energy system.
The Energy Systems Opportunity
While there is still uncertainty around the direction and long term viability of climate-linked investing, it is clear that decarbonization will continue to be the primary driver of the Net Zero discussion for the foreseeable future, and cost-effective carbon emission reductions will remain front and center for operators, suppliers, end-users and distributors (and others) across the entire energy value chain.
Investors have called the energy transition the largest investment opportunity of our lifetime. This may be true. However, many of the thematic sessions that dominated Climate Week 2024, and other similar events, continue to highlight the same recycled themes that have guided past meetings. It is time to expand the definition of who owns the burden, as well as the opportunities, with respect to energy exposures and the ensuing global market transformation.
As I have written before, every atom of material which contributes to the products, goods and services that we consume, transform and interact with carries an energy burden. The current Scope 1 through 3 (and now 4 for avoided emissions) accounting methodologies and standards are a start, but there is a long way to go before we can accurately and defensibly estimate the material flows, consumption, transfer and attribution quantities — all associated with greenhouse gas emissions. As quantification methods evolve with the help of Artificial Intelligence, the framework through which we view and assess economic and environmental opportunities which will dictate investment over the coming decades will also need to expand. Essentially, economic growth and environmental stewardship start with energy, and every company therefore should then be viewed through the lens of spatially-referenced energy systems science and engineering.
The transition to Net Zero will also undoubtedly touch all sectors of the economy and there are different versions of what this new energy future will look like. How all of this unfolds remains to be seen, but given that oil and gas will surely be a cornerstone in the new energy systems infrastructure of the future, I suspect it will be more of an evolution than a revolution. As such, the ways in which externalities are viewed and accounted for will also need to evolve. Emissions indicators alone are insufficient as a foundation for identifying which sectors will drive high potential investment and deployment strategies that result in cleaner air and a sustainable energy infrastructure.
Conventional ESG orthodoxy suggests that assets associated with higher sustainability scores (i.e., lower emissions) should be better performers as measured by absolute or relative returns (i.e., share price, EBITDA or earnings). This logic underpins industry indices upon which many climate-themed financial products are built. The MSCI Global Low Carbon Target Index, for example, weights stocks based on two dimensions of carbon exposures: carbon emissions and fossil fuel reserves. This is not necessarily misguided, just incomplete.
The identification and quantification of energy and decarbonization pathways and related exposures at the asset level using non-traditional data, is one way that allows for early signal detection towards long term alpha generation. Companies that operate in the energy and manufacturing sectors have physical and financial exposures to a unique set of risks and opportunities; early identification of mispriced assets and deeper attribution and understanding of the emissions drivers can allow us to take advantage of the catalysts that impact future performance, many of which are not captured by traditional research and engineering accounting methodologies. Material environmental risk and raw material/commodity costs are both the starting AND ending points of the attribution exercise. Think Life Cycle Analysis rather than upstream/downstream accounting estimations.
We then move from material flows to capital flows, which have already served as a catalyst for this transition. There is no need to look any further than the earmarked and deployed capital following the passage of the Inflation Reduction Act for support. In addition to the environmental and security benefits, real money is already being made as a precursor to the decades-long transition in front of us.
So how can investors and operators begin to evaluate potential in an all-encompassing thematic story that is still being written? There are surely as many approaches as there are analysts — one way is to start with externalities.
Energy Networks
The global energy ecosystem operates as a system of systems, and relationships across this tangled web have become increasingly complicated, interconnected, and in some cases thin. The importance of understanding human, commercial, environmental and technological relationships as a series of networks is the foundation of any meaningful analysis if we are to attempt to apply our learnings towards making more informed decisions that lead to more favorable outcomes for the largest number of people.
In addition, examining energy exposures and opportunities through the lens of geographic complexity and network sciences can help to better understand the web of relationships which underlie the socioeconomic and technological foundation which is the driver of today’s interconnected global economy. However, this does not mean that viewing the world this way leads to better forecasts. Foresight is more useful than a forecast, as the latter is almost always incorrect. We should also not be so presumptuous as to believe that more analysis or better models will always lead to a more enlightened answer; instead, we should get comfortable with ambiguity and the premise that the more we understand, the more we have to learn. And to prepare, and adapt, accordingly.
The pathway to transition to anything even close to a ‘Net Zero economy’ will involve all sectors of the global economy — but the current state of emissions indicators alone are insufficient as a foundation for successful investment and capital deployment strategies. Now is the time to articulate an attempt at a new spatially and intensity referenced framework which incorporates decarbonization, emissions and other sustainability metrics, and translates to signals that serve as precursors to long term environmental and capital appreciation.
