• Steven Bowen

The Bigger Picture: Climate change big themes (Part 1 renewables & distributed energy)

An opportunity for asset owners to really make a difference

 

"Climate transitions are a $100 trillion investment opportunity" Forbes 2021

Its not just about renewables - think grid resilience and energy security.

While wind and solar are going to be the big investment opportunity in terms of $ spent over the next two to three decades, the really interesting opportunities are going to be in modernising the electricity grid, so that all of this new variable generation can be accommodated and used by consumers.


Better informed asset owners can make better sustainable investing decisions

Simple fact - better informed asset owners and investors can make better and more meaningful climate related investment decisions. And being informed has never been more important. If your objective is to help deliver the required climate related transitions, while still earnings a fair financial return, you will be very aware that there are lots of trade-offs and compromises, lots of potential dead ends and stranded assets, and lots of green wishing and green washing. Plus, there is no simple algorithm or silver bullet. It doesn't matter if you invest directly, or if you use advisors, the better you understand how the climate related transitions could play out, the better placed you are to make your investing decisions.

 

As this is the first of the Bigger Picture blogs, we start with the very big picture.

If you want to skip the introduction and go straight to the theme click here. These are, by necessity, longer blogs. The complexity of the climate transitions means we can only simplify to an extent, there are lots of interconnected moving parts. While we would love to say that this blog gives you all the answers, even in this extended length format we can only really flag the things you need to think about, and the questions you need to ask. But then in a world where everyone seems to be trying to sell you an easy solution, we think that is a really good start.

 
 

Three reasons for investors to think about sustainability and ESG

Lets start right at the very beginning. There are broadly three reasons why asset owners invest in sustainability and ESG. These are not mutually exclusive - real world investors might be motivated by a combination of all three. However, its useful to separate them out, as they imply very different priorities and approaches when we come to construct investment portfolios.

  1. They want their portfolios to be aligned with their values. The most common form of this is to use the ESG scores of the portfolio and the companies in it, and the policies that their asset managers use to select investments, as a proxy. This approach may also include active engagement to drive change. Aligning values with holdings is actually harder than it sounds, with many ESG rating systems being more focused on the impact on the company, rather than the impact the company has on the planet.

  2. They see ESG as an additional risk measure. By including this in the investment case for a company, they can avoid future value destruction (stranded assets, flooding risk etc) and, in some cases, identify ESG factors that can lead to improved long term value creation (such as board diversity). This is arguably the main reason why most asset managers use ESG data.

  3. They see a material investment opportunity. The climate related transitions (including those wider changes that will be needed to create a fairer and more stable society) will require the deployment of vast amounts of capital. Intelligently allocated investments in these activities could not only generate a fair long term financial return, but they could also reduce the risk of a disorderly climate related transition.

The massive investment opportunity

The analysis in this blog is largely focused on the third reason, the investment opportunity. There is also a nod to the second reason, with future blogs on this theme picking up on the risk of future value destruction. We also intend to expand on our view that a disorderly climate related transition over the coming decades is perhaps the biggest risk asset owners face in relation to future financial returns (plus of course to the survival of our planet - at least in its current form). Other blogs, principally in our Thinking Differently series, will pick up on the potential for ESG related factors to be a good indicator of future "unexpected" value creation.


Five big climate transition related investment opportunities

From an investment perspective, there are broadly five themes which dominate greenhouse gas (GHG) emissions and climate related mitigation and adaption. These are multi decade investment themes that will shape our society and determine the likely level of our future financial returns.

  • Distributed energy/renewables - where our energy comes from

  • Agriculture/natural capital/food - what we eat & where it comes from

  • Our built environment - our buildings and cities

  • Materials/supply chains plus circular economy and reuse

  • Transport - including shipping, aviation and freight

Fixing these challenges gets us most of the way there

If we can "fix" these five challenges, we reduce the majority of the risk we face around the climate transition impacts. On the flip side a very disorderly climate related transition could materially impact not just our planet, but also the level of our future financial returns. And its these returns that will fund our retirement, pay for our children's education, and support essential services like hospitals and the care of the elderly. Not all of the required changes can, or will, occur quickly. These are multi decade themes. In terms of solutions. some (such as EV's and renewables) are happening now. Others, such as electricity grid enhancement, are approaching scale, while a few, such as industrial carbon capture or green hydrogen, could potentially take decades to roll out.

Why might you care ?

We assume you care about mitigating the climate transition impacts, while at the same time wanting to earn a fair financial return. This could be because you want a better alignment of your investments with your values, one that goes beyond a simple ESG score, and that is better matched to the needs of the climate change transitions. It could be that you want an exposure to the massive, multi decade investment opportunity that building the new systems we will need is creating. Or it could be that you have a real concern that a disorderly climate transition could materially damage your long term financial returns. If none of these apply, you should probably stop reading now.

Image credit Tamara Gak - unsplash

So you care - what do you do next.

There is a vast amount of published material on the climate change transitions. So why might you want to read yet another blog ? First, so much of what gets published isn't actually that useful for investing - by that we mean the processes around identifying where your capital gets allocated AND how you might use the leverage your investments create to better engage with companies, governments and wider society. These blogs build on my many years experience in the investing world, so hopefully bringing a more practical perspective. Second, we are not selling you something. We don't promote individual companies or investment funds. We want you to be better informed, full stop. In our industry this is rare.


The Bigger Picture blog series aims to give you some of the important tools and understandings you will need to make better climate transition related investment decisions. As we highlighted above, these blogs are primarily about investments that will make a real difference, principally by replacing existing environmentally and socially damaging activities, but also by avoiding investments in activities that we expect to become value destructive. They will also give you tools to allow smarter and more incisive engagement.


It is important to note that nothing in these blogs should be construed as either investment advice or marketing material (as defined by the FCA and other financial regulators).


We build on the material in these blogs in more depth in our weekly Sustainable Investing blogs. If you want to know more, contact us and we can discuss how we can help.

Image credit - Malcolm Lightbody - unsplash

Where to start.

For each of the five themes we start with the challenge to be resolved, then how big could this market become, over what time period will it grow, and potential barriers to growth. And, because this is about investing, what issues and factors do you need to be aware of and monitor, so trade-offs, risks and compromises. Then the biggest pushbacks we hear from the sceptics, and where they might be right or wrong. Finally, how will the transition impact on industry structure, so competitive advantage, barriers to entry and potential profitability. Basically, the things an asset owner or investor might need to know as they make decisions about where to invest in the climate transitions.


One final but important point - this is not just about technology. Sustainable Investing also includes considering how and why we make investment decisions, human rights, diversity, social and political factors including communication and regulation, and the big topic of engagement. We should never forget that people are at the heart of how the transitions will develop, and people are not always rational.

Transition 1: Renewables and Distributed Energy

Why are renewables and distributed energy important

This is easy to answer. From a climate perspective, electricity and heat generation together contribute around 25% of global greenhouse gas emissions, of which the vast majority is due to the use of coal (still 36.5% of electricity generation - Ember 2022). Looking forward, electricity demand will continue to rise as many countries follow the electrify everything approach, led by EV's, and building heating/cooling. So, its importance as a theme increases over time.


By and large, its a challenge that we already have the tools and technologies to fix. In this blog we focus primarily on the generation and distribution of green electricity, what you could broadly describe as the power sector. The role of electricity and distributed energy in the more complex questions around the hard to decarbonise sectors such as steel, cement, shipping, and aviation, and the associated issues relating to hydrogen (and ammonia) use, will be covered in a future blog.

How big a theme could this become

According to BNEF (Energy Transition Investment Trends 2022) in 2021 the world spent c. $487bn on the various elements of clean distributed energy and renewables, of which the majority (c. $366bn) went on renewables. The push by nearly very country to shift away from a reliance on fossil fuels means the level of investment required will grow. BNEF estimates that to achieve the Paris Agreement targets, clean energy spending would need to triple by 2025 and then double again by 2030. This would, by 2030, equate to investment levels c. 6x higher than that for oil & gas supply. We are not convinced all of this capital will be used, but even at a lower trajectory, the numbers get very big very quickly.


Looking at the transition more widely, so including all of the required investment in the energy sector, BNEF reports in their New Energy Outlook 2021 that we will need an "investment in energy supply and infrastructure of between $92 trillion and $173 trillion over the next three decades. To achieve this, annual investment will need to more than double, from around $1.7 trillion per year today, to somewhere between $3.1 trillion and $5.8 trillion per year on average over the next three decades"


Understanding the theme

Despite the massive focus by politicians and the press on wind and solar, there is a lot more to this theme. This is actually three interconnected investing questions, wrapped up in one.


Generating green electricity

The first question is about electricity generation, how do we build enough low carbon electricity generation, fast enough, to make a difference. The challenge here is to displace coal, and then gas. In investment terms this is a "now opportunity". The world is already adding a lot more renewable generation capacity, and even without demand growth from EV's and building heating, this investment is going to carry on for decades. This is probably the best understood aspect of this theme. But we suspect that investment in this part of the theme is about to get a lot more complicated, as we build greater levels of intermittent wind and solar generation.


Getting green electricity to the consumer

The second investment question is about how we get this electricity to the end consumer in a cost efficient way, one that keeps the grid stable, and that ensures energy security. Only a decade ago it used to be thought that we could only support c. 20% of our electricity generation coming from renewables before grid stability was compromised. Now, for many grids, 70-80% looks very achievable and work is underway to potentially get us to 100%. Grid stability and transmission investment is already ramping up. using interconnectors, battery storage and new grid management tools.


This is a much harder part of the theme to understand. There is a lot of complex technology and regulation, much of which is expressed in very non investment focused terms.


The electricity grid is getting more complex

One example of this complexity is the duck curve, so called because it looks like a duck. In the old centralised electricity grid system, balancing supply and demand was "simply" a case of ramping up or ramping down a fossil fuel powered generation station. And by and large, the demand curve for the electricity these generators produced was known and fairly predictable. This model no longer exists.


Distributed generation and an increase in local renewables is changing the load shape of the grid. The traditional afternoon peak (see 2012 line below) is being replaced by an afternoon valley (see 2020 line), when solar generation is at its highest. Then there is a steep peak in the later afternoon, when solar generation supply decreases, and people return home from work and school, increasing residential demand. The old logic of matching supply and demand is ending, and this new way of operating is making the "when" of savings/storage increasingly important.


We think this part of the theme is going to be particularly challenging as it forces societies to rethink how we build, regulate, and operate our electricity grids. Despite this, from an investment perspective we think modernising how our grids operate is the growth opportunity of the next two decades.


Electricity's contribution to hard to decarbonise sectors

In addition to thinking about how we generate green electricity and get it to consumers, we also need to recognise that electrification is unlikely to be viable for all activities. This is our third question. What to do about the so called hard to decarbonise sectors, the ones where electrification is not really viable.


Here we need to look at alternatives including green hydrogen/ammonia. You can think about these are being distributed energy, often being generated and stored close to where it is consumed. Why is this (partly) an electrification question. Because many of these technologies need cheap and abundant green electricity to work in a low carbon way. These solutions are most likely to become real from an "at scale" investment perspective in the 2030's and the 2040's.


There will be some really interesting investment opportunities in this part of the theme, but the technological pathway is less certain and the economics, absent high carbon prices, currently look challenging. These are topics we will come back to in later blogs.


Investment risk varies across the theme

This is a theme where many of the solution technologies are already commercially proven and viable. Given this it can be one of the lowest risk entry points into investing in the climate transitions (not no risk). And, some of it involves investment in physical assets, which, in the right circumstances, can make good investments for those with a long term perspective. But even then, there are trade-offs, compromises and risks.


Plus, this doesn't apply to all of the theme solutions. Some, such as grid forming invertors (which could help us add more wind and solar to weak grids), are not yet proven at scale. Others, such as battery storage, are good for part of the challenge (say up to 4 or even 8 hours storage) but they have shortfalls when we look at the emerging need for long term storage. And even when the technology is commercially viable, such as solar, too much of it in one place and one time can impact pricing and hence profitability. As we said before, its complicated, and we want you to make your investing decisions in full possession of the facts.

How much electricity might we need

Our first question is "if we electrify as much as we sensibly can, roughly how much more electricity could we need ?" Its probably not as much as you think, especially when you include the potential savings from energy efficiency. The IEA Net Zero by 2050 report (p70 to 72) estimates that electricity usage would need to double by 2050 to deliver our net zero targets. In the shorter term, their Announced Pledges (AP) scenario (in the World Energy Outlook 2021 Table A.15) has electricity generation growing at c. 2.5%pa.


Giving this some context, Our World in Data shows electricity production since 1985 has grown at a CAGR of 2.9% pa. So broadly speaking, we should expect future total electricity generation to grow at c. 2.5% to 3.0% pa.


This rate of growth is steady but not dramatic, at least when viewed from a global perspective. Thinking more regionally, the fastest growing markets will be in Asia, Africa and LatAm. In Europe and North America, we may find that total electricity demand actually stays flat or even declines.

The next question is how much of this could come from renewables ?

To answer this, we need to separate out separate out wind and solar from the other renewables/low carbon sources. The good news is that wind and solar are the fastest growing renewable generation sources, with wind up by 14% last year and solar up by a massive 23%. This has been broadly in line with the trends we have seen over the last decade. For cost reasons, they are likely to be the solutions most countries use to add the majority of their low carbon electricity at scale.


By 2050 most analysis indicates that wind and solar could make up over half of our global electricity generation. Yes, hydro, nuclear, geothermal and bioenergy will all have roles to play, but other than bioenergy, it looks unlikely that the other renewables will grow their market share materially.


More intermittent wind and solar could make grids less stable

In thinking about the growth of wind and solar, its important to remember that they are Intermittent generators, only producing electricity when the wind blows and the sun shines. So from an electricity grid perspective they are "less reliable". This can cause problems for grid stability, and in terms of balancing supply and demand. However, the problems are not as material as some critics would have you believe, although they do add complexity and cost.


A good example of a country that has made good progress fixing these issues is Denmark, which is blessed by an abundance of wind, plus good access to interconnectors that bring in, for instance, hydro electricity from their Nordic neighbours. Plus their grid operator started many decades ago to add biomass and grid flexibility to the system. For full year 2021 Denmark generated 52% of its electricity from wind and solar (nearly all wind), 25% from coal and gas (mostly coal), and 23% from other renewables including biomass. They have been a net importer of electricity since 2011, with most imports from Norway and most exports to Germany. Norwegian imports were 8.3TWh, compared with a total domestic generation of 27.9TWh. So, they score highly on their use of renewables and as a consequence, extensively use interconnectors. But, according to the European Union, they also have the highest retail electricity prices. The two outcomes are not directly connected but its something to watch for.



Current global generation mix

In 2021 renewable generation was c. 28% of total global electricity generation (Ember 2022). This is a well quoted number (often expressed as nearly a third) and it sounds great. If you also include nuclear, you get to 37%, so over a third. But wait. The majority of that 37% actually comes from hydro and nuclear (roughly 10% each). Wind and solar are currently much smaller, together 10.3%, made up of 6.6% from wind and 3.7% from solar. The rest comes from bio energy and geothermal, plus small quantities of marine etc. So wind and solar are starting from a low base, at least globally.


Future demand - wind and solar becoming more important

Looking forward, it is expected that together wind and solar could reach nearly 30% of global electricity generation by 2030 and over half by 2050. Under the IEA AP scenario we highlighted earlier, solar and wind share grows to 27%, with 15% from wind and 12% from solar. This increases to c. 26% each by 2050. When you add in hydro, nuclear and bio, you can see that by 2050 over 75% of our global electricity could easily be coming from low carbon sources. For many countries, even this high level is not enough. The IEA Net Zero scenario is based on 100% clean power by 2040. Based on current levels of investment this looks unlikely to be achieved, but this could change if governments back their words and aspirations with deeds..

For wind and solar, future forecasts imply a growth rate of c. 20% pa, which is roughly on par with what was delivered in the decade to 2020. Based on our analysis this level of growth looks achievable over the next couple of decades, although the slowing of growth in the last few years is something investors need to track. For the other low carbon solutions, growth will be much steadier, probably mid single digits (and potentially even lower for nuclear).

What will drive wind and solar growth.

Other than politics and social support, which should never be underestimated, its simple financial logic. In many countries renewables are already a cheaper source of electricity (based on the whole life cost of production) than new fossil fuel powered plants (Lazard LCOE analysis 15.0). And in some cases they are also cheaper than existing coal fired power stations (IRENA 2021). Recent supply chain related cost increases are likely to have pushed the balance back toward fossil fuels, but the longer term trend still looks to be for wind and especially solar to continue to get cheaper.

Other renewables/low carbon generation

Hydro, perhaps surprisingly, is the most widely used renewable source, with 20 countries dependent on it for more than 2/3 of their electricity generation. The other technologies are less widely used. Nuclear is important to France (69%), a number of countries in Central and Eastern Europe (37% to 55%) and to Belgium (50%). And bioenergy is important in Denmark (c. 23% of electricity generation), Finland (19%) and Guatemala (16%).


Something to watch when we use global data - China

In reviewing the data on both historic and future growth rates for the other renewable technologies, its important to remember the importance of China. Since 2000, China has provided two-thirds of the global growth in hydro generation, all the net growth of nuclear, and a third of the growth in bioenergy. And its a key source of growth for solar and wind.

Slower future growth rates for other renewables/clean electricity

Looking forward, the investment cases for other renewables is more complex and nuanced than the case for wind and solar. Hydro (run of river) has high build costs and issues regarding its social and environmental impacts, and while pumped storage reduces this, the up front cost is still high. Nuclear has issues around cost to build and waste disposal, and as France is showing, generation is not as reliable as you might think. Bioenergy is facing questions about just how low carbon is it really, plus there are questions about just how much land it uses. Finally, Geothermal is still seen as an emerging technology, despite its use for many years in countries such as Iceland and New Zealand. Net net these factors mean that while all of the other renewables will see a degree of growth, it will be much slower than we expect to see for wind and solar.


The big challenges and potential roadblocks


Ramping up renewables and distributed energy is not going to be straightforward, despite the political/social pressure and the increasing cost advantage experienced by wind and solar. Some of the challenges are about making wind and solar yet more cost competitive as against fossil fuel based generation. But many other challenges are driven by the need to rethink how our electricity grids operate. How wind and solar fit into an electricity grid system is very different from the old centralised, fossil fuel based grid. Future grids will need to be smarter, decentralised and at the same time better linked and with greater levels of storage.


This is not a complete list, but it picks up many of the key potential roadblocks to the roll out of more renewables.

  • Raw material access and cost. We also pick this up in the Materials and Supply Chain theme, but briefly, we need to watch where all the inputs we will need come from, how they are processed and what might happen to their cost. We have become very used to the costs of renewable technology, especially solar, falling fast. There are good reasons to believe this trend should continue in the long term, but its not going to be a straight line and the rate of decline has clearly slowed (Lazard LCOE 15.0). Periods such as we are experiencing now, where input costs are rising, will be frequent, with supply struggling to keep up with demand. Plus, we should not rule out politically motivated shortages being created on occasions, remembering for instance that China dominates the supply of the critical rare earth minerals. Innovation will be a big driver of the longer term cost reduction, as companies design out the more expensive or hard to source raw materials. We should not assume that the technologies we have now will be the ones we use in the future. For investors, this is both a risk and an opportunity.

  • Grid stability. This is a technically complex topic, but in simple terms this is about "too much" intermittent renewable generation (wind and solar) making the grid unstable. This is a challenge, but its increasingly looking to be a solvable one. Some of the solutions are focused on smart grids, grid strengthening, alternate forms of inertia such as rotating stabilisers, and what are known as grid forming invertors. Other solutions are the same as for complementary of supply (see below), so storage, demand management, interconnectors etc. There are good reasons to believe that getting many national electricity grids to 70-80% renewable generation is very possible over the next decade or so, with up to 40-50% coming from wind and solar. This is a really interesting investment opportunity for the next couple of decades.

  • Carbon capture and storage. One solution that has a lot of appeal for companies that operate fossil fuel powered electricity generation, is the use of carbon capture. The pitch here is simple. Its could take many decades to get low carbon solutions to the scale where electricity generation is decarbonised. and even when we get to high levels of wind and solar, we are still going to need some form of stable "base load" electricity generation. So why not continue to use fossil fuels and instead capture the CO2 and put it into long term storage. Our short answer is that the technology doesn't seem to scale well, and its very expensive, but its a debate that needs to be tracked, especially in a world where energy security is becoming more important.

  • Access to the grid. This might seem a strange one but in many countries/regions getting new utility scale renewables, battery storage etc connected to the grid is a big challenge (Queued Up - Berkeley Lab April 2022). Sometimes its about a practical problem, caused by a "weak" grid, but in many other cases its political/regulatory. An associated emerging battle to watch is around the conditions imposed to connect (mainly residential) rooftop solar to the grid. A lack of grid access could become a material constraint on the ability of some countries to scale up renewable generation at the pace they hope.

  • Complementarity of supply. This is the catch all term for too much intermittent renewable electricity (ie wind and solar) being generated at the time time and in the same geographic area. This can push prices to very low levels, impacting the profitability of merchant generation. Part of the solution to this is having the right mix of renewables, part will be storage, and part will be demand management and interconnectors (taking electricity from regions where its abundant and cheap, to the centres of demand). This is likely to lead to a large proportion of future wind and solar generation also including an element of adjacent storage, adding to the cost but making the revenue streams more diversified.

  • Social and political factors. This should not be underestimated, especially in a post Ukraine invasion world, where security of supply has moved rapidly up the agenda. In many countries opposition to on-shore wind is leading to the greater use of more expensive off-shore wind. This in turn pushes up the cost of electricity to the consumer. Similar issues are being faced around interconnectors ("we like renewables but not when the cables come across my part of the country"). Plus, we are increasingly seeing the re-emergence of the argument that renewables are just too unreliable and too expensive to replace gas or even coal. We don't buy this argument (see below), but it has political appeal, especially at a time of rising utility bills. This is as much a psychology and communication issue as it is an investment one, which is why we have started working with experts in this field. In some countries, this could become the most important determinant of which technologies get scaled up.

  • Cost to the consumer Following on from the political/social factors, one related issue that needs to continue to be watched is the cost to the consumer. To accommodate more wind and solar on our grids we will need to invest in more interconnectors, more storage, and more grid stability and strengthening. So, its not clear that the most meaningful cost comparator is just the cost of producing the electricity, we also need think about the total cost to the consumer, which will include taxes. This is a powerful social/political factor, as countries that fail to convince consumers of the benefits of low carbon electricity are likely to find the transition tougher to execute.

  • Priorities for use of clean electricity. Looking forward, many of the hard to decarbonise sectors are going to need cheap and abundant green electricity to generate fossil fuel alternatives such as green hydrogen and ammonia. It is estimated for instance that the biggest driver of making green hydrogen cheaper (its is currently materially more expensive than fossil fuel generated dirty hydrogen) is not the technology of the electrolysers but the availability of very cheap renewable electricity. Societies will need to choose, at least in the short and mid term, where their priorities lie, cheap electricity for our homes and cars, or its use in powering industry.

The big push backs


First big pushback: renewables are too unreliable

Credit - Eugene Triguba unsplash

We frequently read that we cannot rely on renewables because "what happens when the sun doesn't shine and the wind doesn't blow". This is a big topic but the short answer is that this is actually less of a problem than the critics claim. Its clearly still something we need to think about, but until variable renewables get to very high levels, its a solvable problem using existing technologies. Much of the work we have read suggests many electricity grids can operate effectively at levels of intermittent renewables (wind and solar) as high as 70-80% of generation. But for weaker grids, or regions with poor interconnection, the tipping point might be down as low as 30% .


The grid stability challenge is approaching

To give this some context, the IEA AP scenario we highlighted earlier, has global wind and solar at just under 30% by 2030 and just over 50% by 2050. So from a technical perspective this should not be a problem for many countries in this decade.


But, its important to remember that many countries will get there much sooner, with the Ember 2022 report highlighting that three counties (Luxembourg, Denmark and Uruguay) are already generating over 40% of their electricity generation from wind and solar, and many more getting close. With 50 countries at over 10%, the importance of this question will only increase.

Getting electricity grids to over 50% wind and solar is a really interesting mid term investing opportunity. Some of the solutions to this will come from "new" technological improvements, such as long duration battery (or battery type) storage becoming cheaper. Other solutions already exist, such as pumped storage hydro and demand management, but we have yet to get them to the scale we need.


Our electricity grids are going to need a lot more investment

Its important to be clear though. Even at low levels of wind and solar generation, electricity grids are going to need more investment, in some cases materially more investment. A well regarded 2021 Princeton study estimates that to get to net zero by 2050, just in the US, will need the deployment of more than US$ 2.6 trillion of capital by 2030 and more than US$10 trillion by 2050.

 

Second big pushback: China - a big user of coal

The other big pushback we frequently see is "why bother, as unless China does something what we do is a waste of time". This one has a greater degree of factual support and so its a point that investors with a focus on climate change impact need to bear in mind and factor into their decision making.


Coal is a big GHG emitter

The IEA World Energy Outlook 2021 estimated that 72% of CO2 emissions from the electricity and heat sectors came from coal. And its also true that China is the world's biggest user of coal for electricity generation (well above the USA, India and Japan in tonnes). Unsurprisingly then Ember estimated China generates c. 38% of global electricity related CO2 emissions, while consuming "only" 31% of the world's electricity.


Why is China using so much coal

China's electricity consumption increased dramatically in 2021, with the China Energy Portal estimating the growth rate at 10.3%. As a result, even with the surge in renewable electricity generation ( wind generation grew 32%, solar 27%, bioenergy 8% and nuclear 11%), they needed coal to fill the gap. Despite the massive historic spending in China on renewables, they have only just passed a 10% share for wind and solar. So, even at these high growth rates, the sector is not yet big enough to move the dial.


Not just a China issue

Plus, its worth noting that this is not a specifically Chinese issue.


According to Ember "despite a record rise in wind and solar generation, only 29% of the global rise in electricity demand in 2021 was met with wind and solar. Other clean electricity provided no growth, with nuclear and hydro levels unchanged for two years. The remaining demand increase was therefore met by fossil fuels. 59% of the electricity demand rise in 2021 was met by coal generation alone"


What happens going forward.

China now has an electricity demand per capita above the UK and Italy and nearly in line with the EU. But its a long way behind Canada, the US and heavily industrialised economies such as South Korea and Japan.

This suggests demand growth could continue to rise, possibly trending toward the mid term average growth of c. 6.4% pa CAGR. This is likely to mean that even with the strong growth expected in renewables, increasing amounts of coal will still be consumed. On renewable growth, its worth remembering that the IEA forecasts that 43% of global growth in renewable capacity out to 2026 will be built in China. But this will only start to bring down their CO2 emissions well out into the future. Until then, China, and specifically Chinese coal, is going to remain a big contributor to global GHG emissions.


Future Industry structure - competitive advantage

It tough to do this part of the analysis the credit it deserves in just a few paragraphs, but here goes. Things we think we need to really watch around competitive advantage and industry structure, that we didn't really cover in the barriers to development include:

  • Commoditisation - we don't really like this word, but its the best we have for now. As the equipment needed for renewable generation and grid stability becomes more standardised (perhaps more strictly - modularised), we expect innovation to become rapidly diffused globally. This means that there is a real risk that some equipment supply becomes a "lowest cost producer" battle. Solar panels are largely there already, on shore wind is close and some hydrogen electrolysers are not far behind. This could become a material factor in future company profitability.

  • Over supply of finance - the rush to renewables', especially wind and solar, have not unsurprisingly attracted new entrants, excited by the growth prospects. This has included new specialist utilities, as well as oil & gas companies, seeking to diversify (after all - its what many investors asked them to do). This rush of new capital has predictably pushed down financial returns. Concrete evidence for this is tough to find, but investors we have spoken to confirm that financial returns are now materially lower than say only five years ago. In terms of long term value creation, the lower returns on capital invested could become a major drag.

  • Decentralisation - the old utility industry model, dating back to when I started analysing the sector, was fairly simple. Large centralised providers of electricity built generation and distribution/transmission assets largely on what was then known as the Regulatory Asset Base (RAB) model . Put simply, you built things and you got a set rate of return. This encouraged conservativism and caution among the companies. As we move to an increasingly decentralised and renewables led electricity grid, the business model changes dramatically, potentially allowing new, more nimble companies, to take market share. Rooftop solar, local electricity storage and microgrids are obvious examples of this trend.

  • Governments picking winners - this is not a plea to "let the market decide" but it is a warning about going too far the other way. This has always been an industry where governments and regulators materially impacted company profitability. Think windfall taxes, green subsidies, and oil & gas exploration and production incentives. Sometimes this has been a good thing, getting green solutions to scale much more quickly. Our worry is when it becomes a tool to protect jobs, allowing old technologies and approaches to carry on well past the date when the company and/or industry could have survived on its own. Coal, nuclear, and some green hydrogen applications spring to mind, but there will be others. Investing in an industry that relies on government protection and financial support carries hidden risks.