Sustainable alternatives to fossil fuel investments

Energy security concerns have boosted fossil fuel investments in recent months. But the case for sustainable alternatives has strengthened even further.

Has the world’s transition to clean energy suffered a setback in 2022?

Superficially, it might appear so. The continued reopening of the global economy and Russia’s invasion of Ukraine have contributed to acute global energy shortages. Faced with potential blackouts and struggling consumers, securing national energy supplies may seem like a more pressing priority than striving for a sustainable future.

In China, daily coal production has hit record levels. The European Union – traditionally the trailblazer for green energy – has said that it too will burn more coal than previously forecast over the next decade as it seeks to wean itself off Russian oil and gas. In the US and globally, oil and gas suppliers are ramping up output while investing more in fresh exploration and extraction.¹

Nevertheless, the case for the green energy transition is more urgent than ever. Climate risks continue to mount. For the month of April 2022, average carbon dioxide levels exceeded 420 parts per million for the first time ever. Climate scientists have also warned of a significant chance that the average global temperature in any year between now and 2026 will be 1.5°C above pre-industrial levels.² A sustained breach of this threshold could have highly damaging effects upon sea levels, biodiversity and agriculture.

Clean energy portfolio

Events in 2022 have also underlined the economic imperative for the clean energy transition. Skeptics have often claimed the likes of solar and wind energy were unreliable compared to fossil fuels. Even if this was once true, the situation has now reversed. The production price of renewables is typically now known far in advance. Contrast this with the spike in natural gas input prices for German power generators, which hit a peak of 1200% in March above prior year levels.³ Reliance on weather conditions seems much less precarious than reliance on geopolitical stability.

Crucially, the cost of installing renewable energy generation facilities is now more predictable than for fossil fuel varieties. With renewables, the future costs are relatively visible. Life-cycle new plant alternative energy costs have fallen precipitously and were below the cost of coal and combined cycle power plants even before the war in the Ukraine drove up fossil fuel input costs – figure 1.

 

Figure 1. Alternatives have become the cost-efficient option

 

Chart shows the price per Source: Bloomberg, as of 20 May 2022.

 

As well as having highly volatile input costs, by contrast, new fossil fuel plants may feasibly be shut down before the end of their originally envisaged useful lifespan owing to new regulations or other environmental pressures. This means fewer years across which to spread construction prices, decreasing such projects’ potential total return. Tellingly, new oil rig deployment is far below levels during previous periods of high oil prices.⁴ This implies that oil companies view this as a risky time to add new capacity. It also makes a rapid return to lower prices less likely.

Not only has the case for the green energy transition become more compelling in 2022, there has also been progress toward it. Having reached an all-time high in 2021, global renewables generating capacity is expanding further in 2022. Some of the strongest growth is occurring in solar, where fresh records may also follow in 2023.⁵ Policy support is a key driver here. For example, Germany has responded to the conflict-driven energy squeeze by ramping up renewables production and setting a goal for 100% renewable electricity by 2030. If, as we expect, there is no return of cheap fossil fuel prices any time soon, it may spur further innovation and a ramping up of renewables capacity.

How to create a sustainable energy allocation in 2022?

After years of underperformance, many fossil fuel-related investments have strengthened in 2022. With current high energy prices and potentially high returns from fossil fuel projects in the short term, we believe this counter-trend rally may continue – see Overcoming supply shortages. That said, we caution that such investments come with outsized risks, including intensifying competition from renewables, tightening environmental regulation and eventual geopolitical stabilization. In the long term, fossil fuel projects are in danger of becoming stranded assets: subject to premature write-off or even becoming outright liabilities.

The case for greening the world via a transition to sustainable energy is more urgent than ever. We believe this unstoppable trend will accelerate over the coming years. Companies supporting the transition to renewable energy are likely to be significant winners over the medium term and bear much less long-term risk. However, still high valuations may limit short-term potential upside opportunities. The current high value of fossil fuel investments, and the high degree of volatility and indiscriminate selling may offer very attractive entry points for investors with longer time horizons and an eye on the future.