Fossil fuel energy dependence is not only fueling climate change but also threatens the economy and national security. We believe this strengthens the case for the transition to clean energy and for positioning portfolios accordingly.
Energy security is vital: Energy investment opportunities and trends 2023
The world is in the grip of an energy crisis. Consumers and businesses across multiple regions are already suffering heavier costs for electricity and gas – Figure 1. The epicenter of the crisis is in Europe, where Russia’s near-halting of its natural gas exports has sent prices dramatically higher. Among the consequences are lower economic growth, higher inflation and greater human deprivation. What does this mean for the still early-stage transition from fossil fuels to clean energy sources?
On one level, it might appear as if the energy crisis is unhelpful to the transition. After all, public and government are focused on immediate imperatives such as keeping businesses powered and homes heated. This has seen a resurgence in fossil fuel usage, including of coal, the dirtiest of all. The crisis has also emboldened some – including certain fossil fuel executives and skeptical populist politicians – to claim that the transition will need to happen much more slowly than previously envisaged.
The case for an accelerated transition
At Citi Global Wealth Investments, we take the opposite view. Today’s difficulties call not for slowing but for accelerating the transition toward renewable energy sources such as solar and wind. Indeed, we believe that failing to do so would create even greater risks.
Above all, the objective is to limit greenhouse gas emissions to avert a climate catastrophe. In 2022, summer heat records in multiple regions, Arctic wildfires and disastrous floods in Nigeria and Pakistan were the latest reminders of the intensifying threat to people and planet. However, it has become even clearer that other forms of our security also depend on the transition.
Fossil fuel reliance, economic vulnerability
The economic damage of Europe’s reliance on Russian natural gas is mounting. With energy prices more than 40% higher than a year earlier, inflation in the eurozone hit an all-time high of almost 11% in October 2022. Amid the uncertainty, households and businesses are retrenching.1
Both the eurozone and the UK look set to suffer recession, despite government initiatives to subsidize energy bills amounting to many hundreds of billions of euros – see Europe: Bracing for winter recession. Globally, the cost of such initiatives has already breached $500bn.2 Deprivation is nonetheless on the increase.
Seeking high prices for their output, liquid natural gas suppliers have diverted cargoes away from other destinations and toward Europe. Shortages in certain developing countries are already a reality.
As a result, the number of people with access to electricity worldwide has seen a decline for the first time ever. The longer the crisis persists, the greater the risk of social unrest and political instability, as in 2011 when soaring food prices stoked the “Arab spring” uprisings and revolutions.
Fossil fuel dependence can threaten national security as well as economic well-being. Russia’s attempt to use its gas supplies as leverage has at times complicated Europe’s response to the war in Ukraine.
Over time, some fossil fuel–importing nations have found themselves having to adapt their foreign policy in ways they would rather not have. By striking compromises with authoritarian regimes or engaging in overseas military ventures, for example, they have suffered reputational consequences on the world stage.
Shifting toward renewable energy can help mitigate such issues. By generating cost-efficient, clean energy locally, countries can strengthen their economic resilience and their national security.
This is not to say that renewable energy is fail-safe, however.
At times, for example, the UK’s still-growing windfarm network can already supply over half of the nation’s electricity needs. But unusually calm and cloudy conditions in 2021 saw a dip in its renewables’ consumption, with the shortfall made up by coal burning. For now, greater energy security thus means having diverse sources of supply, of which more comes from renewables.
We believe that diversity of supply will be essential to longer term energy security too. Today, much of that diversity comes from fossil fuels. However, this must change radically if the world is to have a chance of limiting climate change.
Massively increasing renewables’ share within power production is clearly critical to the drive toward energy security. And yet it is still only part of what is needed. Electrification and improving energy efficiency are also essential.
Switching from fossil fuel burning to electricity from renewable sources in heating and cooling buildings, transport and industry has great potential to lower emissions. The same goes for increased efficiency – using less energy to do more. The less energy intensive we become, the more our energy security increases.
As in in the 1970s oil shocks, the drive for efficiency is increasing because of the current crisis. In Germany, for example, households are rapidly replacing gas heating with heat pumps. These electrical devices – which take in air from outside a building and raise its temperature to heat the building inside – are already 300% efficient. This means it takes one-third of the energy to heat a home compared to one with a completely efficient combustion-based heater. Experimental designs may boost this to one fifth before long.
The potential here is substantial. A complete transition to next-generation heat pumps would reduce total energy use 40%, all else equal.3 Admittedly, this would take a very long time, as it would require replacing heating systems in every building globally. However, with governments subsidizing adoption of these devices, uptake could increase rapidly.
Despite such encouraging progress, there is a very long way to go indeed in the quest for cleaner and more secure energy. Over the next thirty years, $125 trillion may be required to achieve net zero emissions. To get on track, Citi GPS estimates that $2.6 trillion a year annually needs to be mobilized between 2021 and 2025, $1.7 trillion a year more than of late – Figure 2.
Aside from the amount of capital required, there are many risks along the way. Trade wars and other supply chain disruptions, technological disappointments and policy reversals driven by populist skeptics represent just some of the potential challenges. But if these or other factors were to frustrate the transition, the resulting insecurities would be far worse than anything we have so far seen.
GPS: Global Perspectives & Solutions – Climate Finance, November 2022. Chart shows the required climate finance by global region for periods out to 2050. Note: Current annual climate flows are estimated on average at between $600 billion and $900 billion depending on the data source used. CPI estimates climate finance flows in 2020 amounted to $640 billion, including both mitigation and adaptation. BNEF estimates total investment in Energy Transition was $611 billion in 2020 and increased to $798 billion in 2021. Vivid Economics estimates total investment averaged $900 billion annually between
2016 and 2020.
with both series rebased to 100 at the start.
Energy transition investment trends
Since 2021, the publicly traded green infrastructure sector has sold off, underperforming infrastructure investments more generally – Figure 3. However, this does not reflect any change in the fundamental case for the clean energy transition. Instead, we think it reflects the high valuations reached in the sharp rally in 2020 and the subsequent rise in interest rates that have hurt all growth-oriented assets. The selloff may present a potential long-term entry point. But we cannot rule out further downside, especially if we are wrong about a peak in interest rates in 2023.
Accelerating the transition will involve a wide variety of companies. These include specialists in renewable energy technology, energy storage, electric vehicles and heat pumps, sustainable materials and carbon capture. In aggregate, we believe such companies are likely to be significant winners over the medium term and bear much less long-term risk than fossil fuel assets. In the meantime, we recognize that liquid natural gas can serve as a transition fuel. New and existing supplies of this fossil fuel will be key to helping meet European energy needs – representing another kind of opportunity for investors.
In the long term, clean energy can be more secure energy. We believe that related technologies can help generate portfolio returns as well as sustainable power.
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