Levelized Cost of Energy — Part 2

Geopolitics Explained

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12 min readJul 25, 2024

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Inflation, Interest Rates, The CAPEX Cycle, and The Clean Energy Transition

Contents

Introduction
Are Interest Rates High Yet?
What’s Going On Now?
Looking Forward
The CAPEX Cycle
Concluding Remarks

Bitesize Edition

Last week, I explored how the levelized cost of energy (LCOE) was suppressed in renewables projects due to the low interest rate costs during the 2010s. The metric also contains aspects that are difficult to assume, such as maintenance and operating costs. I concluded that as an affordability metric of energy projects, it wasn’t the best.
Today, I’m going to dive deeper into the financial side of the clean energy transition and how we need to pursue productive, profitable projects. I’ll explore the 1970s when we saw high spending for the war in Vietnam, which led to demand inflation. After this, we saw the OPEC embargo, which led to supply inflation. We’ve seen examples of supply inflation in the last few years with COVID-19 supply chain issues, and the war in Ukraine.
Today, as we stand low down on the mountain that is the clean energy transition, there is potential for supply-side inflation through scarce resources pivotal to the transition where demand is set to rise, such as copper and rare earth elements. But, there is also the potential for demand inflation, if the money supply is expanded too rapidly without productivity increasing along with it. Where does this leave us?

Introduction

When we look at the financial side of the clean energy transition, how can interest rates go anywhere but down?

A big claim, right? Especially when we’ve seen inflation rear its ugly head yet again in recent years and interest rates are often a tool used to lower demand for spending and bring inflation down.

Today, I’m going to hypothetically explore the clean energy transition through the scope of interest rates and inflation.

Interest Rates High Yet?

Historically, we’re not at high interest rates. Take a chart of interest rates over hundreds of years, or when Volcker ran the United States Federal Reserve and hiked rates to 20% in June 1981.

The previous period of inflation occurred in the 1970s in the United States. Many of us weren’t alive at the time to live through this period, and so we have to study it because even if it seems like this time is different, it very often isn’t. The same trends, behaviours, excesses, and undertones cause every crisis, even if the minutiae change each time.

In the late 1960s, the United States was embroiled in a war in Vietnam. Wars cost money. This put pressure on deficits, which means the United States was spending more than it was earning in a specific period. Increased spending has inflationary pressures, and often has connections to politics. If a president has key policies that are going to cost money, they will spend spend spend if it makes their period in office a success.

In 1971, Richard Nixon ended the monetary system of the time, when gold could be traded for dollars. After World War Two, the Bretton Woods System saw many nations attach their exchange rates to the dollar. The dollar in turn could be exchanged for gold at a price of $35 per ounce. This saw dollars overvalued, and too many dollars floating around than gold to exchange them for.

Remember US inflation from the increased spending? Well, this was reducing the purchasing power of the dollar. You could buy less with the dollars you possessed as prices were rising, and so countries were demanding gold in return, known as an inflation hedge.

The United States couldn’t handle the demand for gold, and so Richard Nixon ended the monetary system of the time. The dollar was no longer exchangeable for gold.

We saw supply-side inflation enter the story when OPEC, the Organisation of the Petroleum Exporting Companies, issued an embargo on Western nations since they were supporting Israel in the Yom Kippur War of 1973, which I discussed here.

Energy prices skyrocketed, and a recession emerged. Fast forwarding a few years, Volcker inherited a situation where inflation was once again spiking in 1979 due to rising energy and food prices.

Small initial interest rate increases did little to slow rising prices. When you need access to necessities to live, it’s going to take a bigger demand hit to stop inflation in its tracks. The world ran on fossil fuels back then, and everybody needs food.

Interest rates were set at 13.7% in October 1979. By April 1980, it was 17.6%, and hit 20% in 1981.

Interest rates ensure debt costs are higher. This naturally reduces spending. This slows the economy and leads to recessions and job losses. Volcker left office in 1987, with inflation back at 3.4%, leaving two recessions and a peak of unemployment of 10.8% in 1982 in his wake. He has crushed inflation, but at what cost?

What’s Going On Now?

We learn key lessons from history, and this period of inflation can give us some lessons about the world we live in today.

Firstly, the oil embargo by OPEC was an example of supply-side inflation. This is the same type of shock we saw during COVID-19, and when Russia started its war in Ukraine, energy and food prices skyrocketed.

This period of inflation has been difficult to categorize. Some have stated it is supply-based, due to fractured supply chains and less global trade and availability of key materials. The rise was especially helped by rising oil prices, often used as a proxy for inflation.

Photo by Kenny Eliason on Unsplash

This inflation usually fades when supply chains correct themselves through a push to increase production or seek alternative sources. It’s debated if raising interest rates to quell supply-based inflation is helpful. It will seek to lower demand, which allows supply expectations to reach a more sustainable level quickly. But, by the time rates have been raised, supply issues have often come out in the wash.

In a world of fracturing supply chains and trade wars, costs for raw materials, fuel, and freight will rise. This will especially affect the energy sector.

Demand-side inflation occurs when governments use accommodative monetary policy such as low interest rates, and fiscal stimulus such as quantitative easing or helicopter money. The aim is to increase the money supply and aim to stimulate the economy through spending. Increased money supply can increase demand for goods and services from consumers who want to spend. If demand exceeds an economy’s productivity, the strain on resources is seen in demand inflation.

Demand-side inflation is an issue that many countries are aware of with government debts rising, especially in developed and developing countries. Metrics such as debt-to-GDP monitor this, but often the rising debt is focused on in isolation. If debt is used productively, it can produce greater economic advantages through growth than the financial costs of printing and inflation doesn’t spike. In the clean energy transition, this is why profitable energy projects should be a key aim. Profitable projects generate productive economic activity, which in turn can be used to create more profitable projects, and inflation is avoided.

Fixes for demand-side include quantitative tightening which reduces liquidity but has to be carefully managed to ensure a liquidity crisis doesn’t occur. Fiscal spending can be reduced or tax increases can also be proposed strategies. There are some examples of strategies seen such as austerity seen here in the UK, or financial repression, where a government channels private sector funds to themselves as a form of debt reduction.

So, the aim of our clean energy transitions should be profitable projects and increase productivity. That way we limit demand-shock inflation risks. We have to spend in this transition, and so tax increases could also be seen, such as a carbon tax, or plastic tax, as examples.

However, thanks to geopolitics and strained supply chains in our current world order, we’re susceptible to supply-side inflation in key materials at the same time that there is potential for unproductive spending to incite demand-side inflation. Yikes.

Photo by CHUTTERSNAP on Unsplash

Looking Forward

In connection to geopolitics, we’re seeing nearshoring and friendshoring, as many developed countries export manufacturing to countries with cheaper labour, such as China and India. We’re now seeing Vietnam and Mexico stepping into those positions. This is especially important for countries in their clean transitions, as the period of inflation seen over the last few years has also seen increases in labour costs. For the superpowers, having strong relations with these manufacturing hubs, while also securing your own country with a level of self-sufficiency is a trend we’re currently seeing.

For countries who don’t have access to manufacturing hubs, then stockpiling of reserves is an alternative strategy that we’re also seeing. This is often seen through bans on exports of key materials, as we’ve seen China do with rare earths before to Japan in 2010, and the United States with Gallium and Germanium. We’ve also seen Indonesia ban exports of nickel and tin. Inventory strategies are pivoting to just-in-case, instead of just-in-time during the period when globalisation was in full swing.

Photo by Claudio Schwarz on Unsplash

The CAPEX Cycle

Are you still here? You might be wondering why I’ve gone on a long-winded barrage into inflation, debt, and geopolitics. Well, it’s because all these concepts can be seen in the energy sector and the clean energy transition. It’s these deeper issues that LCOE doesn’t see and struggles to account for. LCOE also doesn’t consider this world is susceptible to supply-side and demand-side inflation at the same time.

Take copper, for example. Demand is expected to double by 2035. Have you heard of any newly opened copper mines recently? I’ve heard of Panama shutting one of the biggest in the world in the Cobre Panama project. Prices are so low that there is no incentive to mine for copper.

With rising demand and falling supply, the struggle in these key commodities will one day be reflected in prices. Supply-side inflation will grab these commodities that are vital to the energy transition and prices will reflect the scarcity. This raises the costs of the energy transition. All this is occurring at a time when discount rates are higher than the unnaturally low period we experienced after 2008.

What we need for the clean energy transition to occur is huge amounts of spending, when high debt-to-GDP and supply-chain inflation are key issues. Countries around the world are now in a race to access key materials needed for the energy transition which we don’t have enough of.

For years, low commodity prices haven’t incentivized miners to pull the materials out of the ground. So, if we need more materials we don’t have, but we know they’re in the ground, what happens? Well as more and more stakeholders seek to buy these key materials to hold as reserves or to use for cleaning up their energy sectors, we see prices rise due to increased demand. When prices rise enough, miners are incentivized to mine once again. This takes years to occur, especially in regard to establishing new mines, which can take between 5 and 10 years. So prices continue to rise. Supply inflation as I discussed earlier is solved by seeking alternative sources or increasing production. If there are no alternative sources for a set period while mines get themselves back online, and increasing production from mining takes years, we’re set for a period of rising commodity prices. This is known as the CAPEX cycle, and for key commodities in the clean energy transition that are low in supply, it’s a fundamental argument for why these commodities are set to rise.

Photo by Janine Joles on Unsplash

The definition of a CAPEX cycle specifically is that capital expenditure increases at a faster rate than gross domestic product. If GDP is increasing at a lower rate than CAPEX, we have less productive economic growth alongside higher commodity prices. If the little growth countries can achieve is unproductive growth through unprofitable energy projects, demand inflation has the potential to come back because governments are going to keep financing these projects to give the illusion they’re working towards the transition’s goals. Increase interest rates to counter this inflation, and economic growth slows even more.

It’s this unfortunate situation that is why interest rates have to stay low to speed up the energy transition, or the terms of the clean energy transition have to be changed. I’ve said it before, and I’ll say it again. If we wanted to fulfil our clean energy dreams by 2050, we should have started decades ago.

I’m aware you could read this and think it’s rather unrealistic. I’d agree slightly. If we take a curve that plots all potential scenarios for our clean energy transition, I’d agree that this scenario would sit on the far-left-hand side of the curve. Unlikely and negative in consequence.

There are scenarios on the far-right-hand side of the curve that are equally unlikely, but positive in consequence. The middle-ground scenario is the most likely, and neutral in consequence.

I consider as many scenarios as I can imagine on this curve in any situation I analyse, and the fact that this scenario is so frequently discussed doesn’t place it as far to the left on the curve as I’d like. Over time, if we don’t pursue the transition productively, this scenario has the potential to reveal that it doesn’t sit at the far-left-hand side of the curve at all, but it’s the middle-ground, and it certainly isn’t neutral in consequence.

Concluding Remarks

There are a range of key takeaways with LCOE, but the metric is littered with drawbacks. For a metric studied so frequently in the energy sector, I’d argue due to its ability to mislead through flawed assumptions, it’s a metric that should be avoided. If we do choose to avoid LCOE, what other metrics can we use to assess affordability More on this in the following weeks.

If you have any comments about what I’ve written today, whether in agreement or disagreement, I’d love to hear them.

Thanks for reading! I’d greatly appreciate it if you were to like or share this post with others! If you want more then subscribe on Substack for these posts directly to your email inbox. I research history, geopolitics, and financial markets to understand the world and the people around us. If any of my work helps you be more prepared and ease your mind, that’s great. If you like what you read please share with others.

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Levelized Cost of Energy — Part 2

Written by Geopolitics Explained