Sol y Viento
Oil prices have risen significantly over the last year but only after collapsing in the first quarter of 2020. The long-term trend is down. We might be at peak-oil. The US Energy Information Agency (here) estimates that global crude production fell in 2020 by around 6.3%. There was probably a COVID-19 impact and the same agency expects production to be higher again in 2021-2022. Yet the shift to renewable sources of energy is clear. The longer-term implications are profound and net beneficial for the climate and for the global economy.
I recall writing somewhere recently that I thought that the energy transition would be as transformative for the world economy as the digital revolution has been. It could be even more. For a long time, fossil fuels have been the predominant source of energy. Today, that is changing. According to the International Energy Agency1 , renewable primary energy is the second most important fuel in global electricity generation, ahead of oil and natural gas (but still behind coal). For OECD countries, coal’s contribution to electricity generation has been falling since 2007 while renewable energy is just behind natural gas as the dominant fuel. Renewables will become the main fuel source in the coming years. At the same time, electricity will replace carbon as the major fuel source in a number of sectors – transport and buildings for example. More of the electricity will come from renewable sources and more economic activity will be driven by electricity rather than the “burning” of fossil fuel. I have just read about a partly European Union funded hydrogen project being built on the island of Mallorca (where I am lucky enough to be spending the current lockdown). It will produce green hydrogen using solar energy which will then be used to fuel the island’s bus and rail network and rental vehicles (of which there are a lot, especially in July and August – oh, and most seem to use diesel), provide power to commercial and public buildings and allow an auxiliary power reserve to be maintained. It will transform the island’s economy, create jobs and help reduce the smog that engulfs Palma on a hot August day.
The sun shines…
Spain has historically been a net importer of energy. It has no oil and gas reserves to speak of. What it does have is lots of land and lots of sun. Solar and wind power are thus potential drivers of economic growth in the future. This is an important point. Fossil fuel reserves are not uniformly distributed around the world. The easiest to access are concentrated in a few geographical locations. That has allowed economic rent to be exploited by sovereign states that control the reserves and selected companies that are allowed to exploit them. There are all sorts of geopolitical and ethical issues associated with the history of fossil fuel excavation and trade. However, the sun shines in lots of places (even in the UK sometimes). Wind blows everywhere. Countries that have historically been fossil fuel poor can possibly look forward to a future of being renewables rich. The shift has the potential to change national economic fortunes, structurally improving long-term growth and productivity, impact on trade balances (for good and for worse) and significantly change the geopolitical balance of power. This article in the Financial Times Magazine (How the race for renewable energy is reshaping global politics | Financial Times (ft.com)) and this paper from the Bruegel Institute (The geopolitics of the European Green Deal | Bruegel) discuss at length some of the implications of the energy transition for the global outlook and for European policy makers in the wake of the Green Deal.
…and the wind blows
The FT article maps where solar and wind power potential is greatest. These areas are diverse. Solar intensity can be found in the Arabian gulf (lucking out again as a major source of energy), the south-west of the USA and Mexico, the Pacific coast of south America, much of Africa and, of course, Australia. Areas of high wind speed, and thus potential locations for wind farms, include many coastal areas in the deep south of Argentina, New Zealand, the British Isles and continental mountainous regions like the Rockies and to the north of the Himalayas. These are just the areas where wind and solar potential is greatest but other areas can also unlock the potential – the south of Europe is not that different to the northern coast of Africa in terms of sunshine resources.
As the shift towards more locally sourced renewable energy increases, demand for traditional fossil fuels will decline (in absolute terms it isn’t yet). The relative price of oil is likely to fall too. That reduces revenue for traditional oil suppliers like the Gulf states, Nigeria, Indonesia, Russia and the US. At a macro level, their balance of payments may deteriorate. The mirror of this will be an improvement in countries where energy trade is a big contributor to balance of payments deficits. They will benefit from not having to spend so much of domestic output on importing fossil fuels (oil especially). The reduced reliance on oil and the handful of large suppliers that control the market (OPEC and others) will also have other economic consequences. Energy prices should be lower and less volatile as there will be reduced “political” influence on energy supplies. The Middle East has been a geopolitical battleground for decades and part of the reason for that has been the West’s need to secure oil supplies. When the politics has turned bad, oil prices have gone up. When that has happened it hurt consumers, raised inflation and, on occasion, triggered recessions. Politics can interfere in the supply of the technology and capital needed to exploit renewable energy, but nobody can control the sun and the wind. You never know, reduced political tension around securing access to dominant energy sources might also mean lower military spending in the future. A dollar spent on health and education and not on guns and bombs would be a great outcome.
End of the petrodollar?
There may be implications for the dollar as well over the long-term. Trade in oil and natural gas has been conducted in US dollars. The more dispersed (and more local) nature of renewable energy production will mean less reliance on a single currency. The “petrodollar” is a thing of the past and the need for certain currencies to be pegged against the dollar will disappear. At the same time, China will play a more important role in global energy production given its existing position in the development of renewables and associated technology and supply chains. Higher rates of economic growth and a shift in the structure of the global energy balance are reasons to be long-term bullish on the renminbi over the dollar.
Less energy inflation?
I don’t know how secure the supply of electricity from renewables will be in the future but I expect that it will be more stable than from oil given the plethora of new sources of renewable energy (and we need to consider nuclear, hydro, geothermal and biofuels as well as wind and solar). This should mean more stable energy prices and less volatile headline inflation rates over time. The cost of electricity from renewables has fallen for years now and for the most part is cheaper over the life of a project than electricity sourced from coal or oil. As technology improves further, energy prices could fall even more. Cheaper technology will allow the conversion of solar and wind into electricity at the local level, radically changing the economics for businesses and countries reliant on non-local primary energy sources.
It is in the development of the technology that has attracted a lot of investment capital in recent years. Share prices of companies in the clean energy space have risen very strongly. A clean energy ETF managed by one of the biggest ETF platforms delivered a total return of 141% over the last year (iShares Global Clean Energy ETF, data sourced from Bloomberg). One of the companies involved in the Mallorca project referenced above has delivered a 46.4% increase in its share price since the end of October. While there continues to be lots of focus on the FAANGS, the clean energy sector is roaring. I suspect it will continue. There is loads more investment to do in expanding renewable energy capacity, building out networks for delivering electric vehicle charging and hydrogen transportation, and in adapting existing industrial processes to new energy sources. The revolution has strong tailwinds. Huge public funding will be made available through the likes of the European Green Deal and President Biden’s green infrastructure plans. Investors are increasingly allocating more funds to green activities – green bond issuance has been $28bn so far in 2021 compared to $220bn for the whole of last year. Bond investors aren’t getting much return in terms of coupon, but they can secure meeting their non-financial objectives through green and sustainable bonds (the current yield to maturity on the ICE/Bank of America Global Green Bond Index is 0.48%). If you can’t get much return at least do some good! The intensification of ESG policies amongst the investment community will ultimately reward companies involved in delivering a zero carbon future relative to those that are still emitting greenhouse gases. I am bullish on the sector to be a consistent long-term outperformer.
Up the UK
Finally a word on the UK. Vaccinations have now reached over 10 million and infection rates are steadily falling. The British government is being cautious about re-opening the economy, especially given the concerns about the danger of importing new strains of the virus. However, it is likely that the UK be able to open its economy – domestically at least – before many others. The Bank of England was reasonably optimistic about growth in the second half of the year and the gilt curve has steepened in response. Just like elsewhere there is a lot of pent up demand waiting to be unleashed. I would raise exposure to UK equities in this environment and would expect sterling to at least hold on to recent gains against both the dollar and the euro. Indeed, £0.85 against the euro looks a reasonable near-term target even if it is just based on sentiment about the relative vaccination programmes.
I couldn’t let a 9-0 victory go without a mention. A record equalling score line is one thing but to get back to winning ways after Manchester United inexplicably lost to Sheffield United and then had a boring 0-0 tie with Arsenal was encouraging. Liverpool against Manchester City this weekend is a key game. If Liverpool win – and they need to bounce back – then City won’t look like they are running away with the league. Chelsea are having a revival under Thomas Tuchel but they look to be too far off the mark to take the trophy to London this year. Northern dominance looks set to prevail.
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