Warning: Investors Are Not Prepared For the Carbon Bubble To Burst

Kingsmill Bond, an energy strategist with Carbon Tracker, shares his thoughts with Nightview Capital on the energy transition—and its ramifications on the global economy.

In our view, the biggest economic disruption of our modern era will be the transition from fossil fuels to renewable energy. This is a historic event that we believe is unfolding rapidly. The result of this disruption should have profound positive societal effects—clean energy, reducing our dependence on fossil fuels, new jobs, etc.—but there will be extreme consequences as well. Many long-term investors (including index funds, pension funds, and retirees) who are too slow to divest could suffer economic damage through poor shareholder returns. Further, over the next decade, we believe many fossil fuel-linked companies will suffer severe write-downs, layoffs, and, more than likely, outright bankruptcies.

This may sound like an extreme position to take, but there is increasing evidence that the renewable energy revolution is accelerating. Our economy is reaching peak demand for fossil fuel. The catalyst? A plummeting drop in the cost of renewables that will have cascading effects through a variety of industries. We recently wrote a case study about the impact of electric vehicles on the internal combustion engine industry. In it, we document the negative impacts of this transition on traditional auto-makers, car dealerships, and rental car firms.

The conclusion is clear: In times of rapid disruptive innovation, incumbents are almost never safe.

Recently, we had the opportunity to speak with a trailblazing researcher on the front lines of the coming energy transition. Kingsmill Bond, CFA, is an energy strategist with Carbon Tracker, a financial think-tank that has consistently publishing some of the most comprehensive, if not shocking, analysis on the effects of what they have been called the “carbon bubble” since the not-for-profit research house’s founding a decade ago. In a recent report, for instance, Carbon Tracker concluded that financial markets face a risk of $2.2 trillion of stranded fossil fuel assets—a number that should make you sit upright.

In our conversation, Kingsmill Bond noted that the incumbent fossil fuel operators are now at least talking about the energy transition; but few are making the necessary investments to pivot to a low-carbon world. In September 2019, Carbon Tracker noted that oil and gas companies have “approved $50 billion of investment since 2018 in major projects that undermine climate targets—and threaten shareholder returns.”

“I think write-downs across the fossil fuel sector are completely inevitable,” Bond tells us. “You’re talking about a sector with fixed assets of about $25 trillion, which is now being challenged for the first time in its history by a superior, cheaper, cleaner technology.”

Here is an edited transcript of our conversation.

Nightview Capital: Renewable energies have existed for decades—so what’s now changed? Why do you see this transition as accelerating?

Kingsmill Bond: The argument has evolved rapidly in the last eight years because of the collapse in the cost of renewables. It was originally a kind of moral debate about “We shouldn’t burn this stuff.” Now, because of the collapse in the cost of the technology, it has become a financial debate saying, “Actually, there are superior technologies out there, so we won’t burn this stuff.” And of course financial markets are somewhat skeptical about the first of the arguments, but they are very receptive to the second one, because they’ve seen it so many times before in many other sectors, where companies are being disrupted by superior new technologies.

But still, it’s a fraught subject. In many of the conversations we have, it seems like people are locked in the past and trying to make 10-year-old arguments about how renewables are carbon intensive or how they still require subsidies or this is socialism—but it’s not. This transition is capitalism in tooth and claw. It’s the classic Schumpeterian destruction of redundant assets.

NC: You have written extensively about the risks of “stranded assets” in the fossil fuel sector. Can you explain that?

Bond: The mechanism of stranding is simply that cheaper new energy technologies take over, so the old ones are no longer required. In the case of solar and wind and batteries and electric vehicles; all the prices are dropping at around 20% for every doubling of capacity.

So it becomes cheaper to drive electric vehicles, and cheaper to generate renewable electricity. There will be cascading effects through a multitude of industries, from coal to oil to gas. And it’s already started in the machinery sectors which are linked to them, from power plants to gas turbines to cars.

NC: Given this rapid transition, do you believe there is a crisis brewing among long-term investors who are linked to slow-to-change index funds?

Bond: There is this megatrend that is currently working its way through the system.

But the risk depends to a large degree when demand peaks for a particular product. And it varies by country. One of the calculations that Carbon Tracker has done is to calculate peak demand for fossil fuels. We calculated it to be in the mid-2020s. And the demand for each sector and industry will peak before and after that overall peak.

We think we’ve already seen peak demand for coal, peak demand for ICE cars, even peak demand for fossil fuels per capita—and that, in turn, is what’s driving some of these markets to react.

So you see what’s happened in the coal sector, where two to three years after the peak of global coal demand, you have half the US coal producers go under. And you saw it with General Electric a couple of years ago as gas turbine demand peaked and started falling quite rapidly.

And now more recently in the automotive sector, the next shoe to drop, despite the fact that electric vehicles are only two-to-three percent of sales, the incumbents are being severely damaged by the speed of the transition. And the big development in the last 18 months has been the degree to which the oil sector has been underperforming the oil price and the market. There is a lot of talk about whether that’s a cyclical issue or, as we would suggest, the market starting to worry about the structural shift that’s happening.

NC: Many oil executives talk about the transition to natural gas as being “cleaner.” What’s your take on that?

Bond: Natural gas is a fantastic example of sector group-think. Every single oil company tells us the future is gas, and gas is less dirty, and that gas demand is going to carry on rising. And as a result of that, they’re building lots of gas plants and planning to expand gas production massively. Now, the problem with this whole argument is that gas volumes may well increase but the issue for a company is not the global volume, it’s the price. And the risk for all these companies and this whole thesis about them reinventing themselves as gas companies is that 40% of gas is being used for electricity generation—and electricity generation is competing directly with solar and wind in an increasing number of countries around the world.

In about 80% of the world today, it’s cheaper to deploy solar and wind than it is to generate electricity from gas and coal. And within a couple of years, it’s basically going to be every major country in the world. And then, increasingly people will be putting up new solar panels and wind turbines, which will be driving out existing capacity.

For me, the ultimate solution to this is clearly that prices of gas will be capped by renewable prices and since renewable prices are on learning curves and they’re falling over time, that means that logically the price of gas has got to fall over time. The only thing that’s sustaining it is a kind of short-term market mismatch issue that there’s not enough renewables being built to meet demand—and you’ve got some intermittency issues. But that will not last. In Europe, we’re already starting to see the price of gas being capped by the renewables coming into the system.

NC: So you’ve suggested fossil fuel operators will likely have to suffer write-downs—once a full accounting of their assets reveals a not-so-rosy future.

Bond: Exactly. I think write-downs across the fossil fuel sector are completely inevitable. You’re talking about a sector with a fixed asset value of about $25 trillion dollars which is now being challenged for the first time in its history by a superior, cheaper, cleaner technology.

And there will be write-downs across the sectors. We’ve already started to see it: The old companies are starting to sell out some of their high cost assets. Other companies are already seeing some of their higher cost assets lose value. Coal ports, gas pipelines, oil refineries—eventually, all will no longer be required. There’s a lot of areas where companies are vulnerable. It’s a little bit like the electricity sector 10 years ago. They think that they’re fine, and they think they’re completely protected, in the way that GE argued three years ago because they had a wind turbine division. But having new businesses doesn’t protect you from write-downs in the old ones. The market moves a lot faster than you can transfer your old assets.

NC: In your experience, how are you seeing the CEOs and management of fossil fuel companies react to this transition?

Bond: I think someone has done an analysis comparing companies’ reaction to this energy transition to human beings and how they deal with bereavement. The initial stage is denial, “There is no global warming, there is no energy transition, we don’t need to do anything.” That remains the case for a certain number of companies.

There’s a second stage, which is resistance, with companies actively funding lobby groups which seek to fight back by talking about a green depression and green socialism.

The next stage, and the narrative we see quite a lot in Europe, is companies paying lip service to the transition. A lot of money is being spent on advertisements by the oil sector about how they’re shifting their business model and they’re changing, etc. If you ever go to these companies, the buildings are festooned with pictures of people servicing wind turbines and biofuels. And they tell a good story!

But when you look at the details, the facts, you see they’re still spending 90 or 95% of capex on oil and gas and a tiny amount of capex on renewables. In fact, many of these companies are planning on growing oil supply over the next five to six years by about 3% a year. So I would suggest the next stage has been one of paying lip service but not actually doing very much.

The next stage is acceptance, at least on the surface. Companies get a lot of pressure from their investors who are a bit more far-sighted. And their investors go, “Well actually guys, you do have to take this seriously”. So companies build up major new energy divisions.

And the final stage is a strategic transition, such as what Orsted has done. You will note, there are not many companies in this bracket.

NC: Are you confident that this can happen within the next couple of years?

Bond: I’m absolutely confident that it will not happen. And I’m extremely confident that most of the incumbents will fail to move beyond greenwashing. And I’m equally confident that in 10 years’ time, half of those won’t be here at all. And that’s tough. Unfortunately that’s what creative destruction is—those who fail to adapt are overtaken and replaced by those who do. And in the process, society as a whole gets richer.

NC: What has been the reaction to the reports you’re putting out?

Bond: I think there’s a bifurcation right now between financial markets and fossil fuel companies. And fossil fuel companies in their public research and their public statements are assuming that business as usual will continue. That gas, coal, and oil demand will carry on rising for the next 20-30 years and there’s really no risk to their core business model. And that’s still what most of these companies think in their heart of hearts.

However, investors ae not so wedded to the status quo. They want to make sure that they don’t lose a lot of money, and they can sell quickly. And they have also seen technology transitions in other sectors—and therefore investors are clearly ahead of corporations, and much more aware of the risks of the energy transition.

And within investors, I’d say there is a split. You have the more cautious end of the scale, with people thinking of all the reasons why the status quo will remain. And the more visionary, who look ahead and assume the transition will roll on. It’s funds such as yourselves that are really on the cutting-edge of recognizing, and thinking through, and taking action.

So we still see a huge gap between reality and perception, and therefore very significant financial opportunity.

NC: Well thank you. Thinking about the future–what do you think will make people wake up to the realities of the energy market?

Bond: There are three interesting catalysts that are going to make this transition come alive for people. The first is low low prices. The kind of prices for solar and wind and EV that you just can’t ignore any more. And they are coming every week in different countries.

The second is the emerging market energy leapfrog. China, India and Vietnam and the like. It’s a no brainer to embrace renewable energy and electric-based transport systems. Because they don’t have fossil fuels, they’ve got a big pollution problem, and they import most of their energy, which gives them energy dependency. They’re desperate for a cheaper solution, and now suddenly a cheaper solution has materialized. China, as you know, is leading the world in the energy transition; India has gotten incredibly aggressive goals to make the shift. And between the two of them, that’s half the anticipated growth in energy demand over the next 25 years. So we think the increasing emerging market evidence will be a very important factor.

The third factor is the policy shift. Policymakers realize that actually the game has changed. Five or 10 years ago, there were lots of reasons not to embrace renewables because these technologies were expensive and difficult to integrate so there was a lot of resistance and inertia from incumbents. Now, you have a very different framework. You have a cheaper technology, you have a lot of the intermittency issues already solved, and of course in the last 12 months there’s been a huge groundswell in global public opinion which is driving policy makers to act. So we think increasingly you’re going to see higher levels of taxation, bans, and different ways of making fossil fuels pay for the externalities—because policymakers can now do this.

The other side of the coin is that it creates an incredible number of opportunities. Jobs to build out the infrastructure, new software innovations, etc. I think there’s going to be a huge flowering of new and innovative technologies. It’s going to be a very exciting time to invest in many different areas—but quite scary if you don’t get with the program.

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