Green Energy Transitions

Two influential green energy transition papers were published this week. At this point, parties on all sides agree that investments in green energy are necessary and urgent. Eventually, the sector will experience an economic tailwind that investors will want to take advantage of.

The first paper is by Michael Cembalest of JPM, a long-time author of financial markets opinion pieces. This is his 13th annual energy paper. The second is an essay by Vaclav Smil. Vaclav is excellent at cutting through the noise and emotion and getting to the heart of the engineering constraints present in the energy equation. Michael’s paper is here and Valclav’s essay is here. They are both long reads. Below are takeaways as well as stories that tie into these two papers.

Nuclear fuel (uranium) is an incredibly dense form of energy. 1kg of uranium can produce 24,000,000 kWh of heat energy vs just 12kWh from 1kg of oil. We developed most of our nuclear capacity in the 60s and not only never expanded further but have been gradually decommissioning plants since. Germany had been a leader in nuclear power but began drifting from that policy after Fukushima in 2011. Germany’s energy costs skyrocketed after the Russian invasion of Ukraine, dramatically increasing energy costs. Higher energy costs in Germany lead to demand destruction for industrial materials like chemicals, steel and aluminum and, ultimately, an overall weaker economy. Fortunately, the US has energy independence and is less exposed to global energy price shocks. For this reason, it would have been valuable for Germany to maintain its energy independence via nuclear power, and they were ultimately left exposed.

Michael estimates that had Germany not decommissioned its nuclear plants, it would have required 50% less electricity from fossil fuels and 82% less from liquid natural gas. Germany currently has no active nuclear power plants, down from 17 that provided 25% of the country’s electricity at one point.

Small Modular Reactors (nuclear fission) still exist only on paper. While people have been excited about SMRs for decades, there is not a single test unit in the West and only one in China. The hope is that they would provide flexible, scaled, distributed access to electricity, but that has not come to fruition.

At the same time, Amazon just purchased a data center next to a large nuclear reactor in Pennsylvania, presumably to power highly energy-intensive AI and machine learning systems. Big tech companies selecting nuclear power is a meaningful vote of confidence for the sector.

Inflation has hit the electrical grid hard, as the cost of transformers and power regulators is up 92% since 2018. I don’t have the supply chain details, but I assume that’s due to a mix of few providers, higher labor costs, and higher costs for raw materials like copper and steel.

Kyoto to 2050, the title of Vaclav’s paper, refers to the midway point between 2050 and the original Kyoto Protocol in 1997 when 200 countries first met and agreed to reduce greenhouse gas emissions. This meeting eventually evolved into the goal of completely decarbonizing our global energy system by 2050. Given the current economic and physics-based constraints, this paper aims to promote resetting our climate objectives to be realistic and achievable rather than aspirational.

Our deep reliance on fossil fuels presents a challenging reality. In its current form, fossil fuels cannot be rapidly eliminated without extremely expensive investments or an extreme global economic downturn. For example, we have yet to deploy large-scale, zero-carbon commercial processes to produce essential materials. We haven’t found alternative energy sources for heavy road transportation, shipping and flying. The electrification of cars is slowly underway. Fortunately, electric vehicles make a dent in the emissions calculations, with BEVs (battery electric vehicles) creating roughly 50% of the emissions over their lifetimes.

Eliminating fossil fuels immediately without a viable alternative means grinding the world to a halt and/or dramatic price increases for everything that requires energy, which is just about everything. For example, renewable jet fuel can be made from soy oil, municipal waste or even sugar cane molasses, but the cost of that fuel ranges between 2x to 8x the cost of the fossil fuel source. Forcing people to pay 2x-8x more for jet fuel is pushing an economic boulder up a hill, no matter how hard or consistently you try, it just does not want to go in that direction. The continuously increasing global energy demand compounds this issue as other nations advance and mature.

Either lower cost or higher efficiency options, or both, are needed to rapidly adopt new energy technologies. Lower costs do not drive the interest in nuclear energy, but it is orders of magnitude more efficient. The increase in efficiency is enough to create more nuclear resources regardless of costs.

Copper is critical to the energy transition. In past articles, I’ve expressed concerns that we could see a dramatic parabolic spike in copper prices due to increasing demand, increasing use cases, and underinvestment in global supply. Unfortunately, there are no green methods for mining this material. Battery electric vehicles use 5x more copper than internal combustion engines.

Overbudget projects are another challenging reality. A study of 16,000 global public works projects in 16 countries, from airports to nuclear stations, shows that 91.5% of projects worth over $1b went over budget. The mean overage was 62%. McKinsey estimates that global decarbonization would cost $440 trillion, or $15 trillion annually for three decades, or 20-25% of GDP for multiple decades. This budget has no physical limitations thanks to money printing, but it would lead to currency devaluation and inflation, perhaps equally as high at 20%-25% per year. That inflation would increase the lifetime cost of the transition. We’ll have to decide if that’s a tradeoff we want to make, but it is a choice and can be a conscious decision. The only time in modern history where a single effort grabbed a high share of GDP was the five years it took to bring World War II to an end.

The incentives at the country-specific level are also a challenge. Russia’s economy is dependent on hydrocarbons and would need to find a new source of economic power in order to get on board with decarbonization, not to mention completing that transition while in an active war with Ukraine.

Africa’s population is set to double from 1.2 billion to 2.5 billion and sees fossil fuels as a path to economic prosperity as they can use fuel to produce cement, steel, plastics and ammonia. As global living standards rise, the demand for air transportation rises as well. Airbus forecasts demand for more than 40,000 more jetliners over the next 20 years. The incentive for planes is to be in constant use because they are expensive, and an unutilized plane does not make any money. There are no alternatives to fossil fuels for air travel.

I like reading Vaclav Smil’s work because he does a great job of acknowledging our desires and fears while explaining the real constraints of physics, material sciences, economics, timelines, human nature, and politics. I would say this latest paper leans on the negative side, but that doesn’t have to be the ultimate takeaway. Often confronting problems head on is necessary to make progress.

In the past, he’s discussed how technological breakthroughs have miraculously lifted us out of depressing, insurmountable challenges. The most famous example was the near certainty we would run out of food with a growing global population, popularized by the book “The Population Bomb.” Synthetic ammonia (fertilizer) completely changed the equation and opened the door for dramatically higher food yields per acre. That change instantly diverted us from inevitable disaster to global prosperity. Similarly, there is always the possibility that breakthroughs could change the green energy, greenhouse gas, climate change equation.

This article will follow up with part II next week with a deeper look into the economic and investment opportunities related to the transition to green energy and climate change. These articles are here to help evaluate the changes and challenges in the world that drive risk, returns and opportunities and ultimately portfolio decisions. A topic this large should not be ignored when considering investment strategies.