Governments around the world have emphasised the need for green investment as part of the recovery from the pandemic and transition to a net zero world. But does the supply crunch threaten the necessary clean energy transition? Not necessarily, says Dimitri Zenghelis.
No sooner had the ink dried on The International Energy Agency (IEA)’s prediction of the demise of fossil fuels in 2021 than the prospects for a green transition were turned upside down by the global energy crunch. A strong revival in global demand has met with restrictions to supply, dramatically pushing up the wholesale price of oil and natural gas. This came on the back of years of higher energy bills in many countries to fund the roll-out of renewable technologies. Some countries, in particular China, turned back to coal generation to keep the lights on. This has led to concerns that the energy crunch may limit ambitious plans to decarbonise the global economy.
But just how big a threat is the present energy crisis to the pace and scope of the required clean transition? In the short-run, the risks to progress on decarbonising energy are very real and already apparent in the return to burning more fossil fuels. However, in the long run its impact is likely to be relatively limited. Indeed it could hasten the transition to a low-cost low carbon future.
Within weeks of the IEA’s 2021 World Energy Outlook, it warned that an unexpected rise in coal generation was threatening goals to decarbonise the global economy. With energy bills driving the cost of living higher and causing difficulties for energy suppliers, the appetite to pay for new renewable generation has correspondingly waned.
Although low windspeeds through 2021 left many northern European countries more dependent on gas to generate electricity than in previous years, the recent steep rise in the cost of global energy has been driven primarily by increases in the wholesale price of oil and natural gas, as strong demand met with post-Covid supply restrictions.
These painful price spikes are being passed on to consumers, turning policy attention away from the switch to renewables and toward getting prices down. In the UK, for instance, politicians, consumer bodies and energy firms have called for green levies to be scrapped to soften the impact on consumers, especially in low income households.
The current economic climate is also unfavourable for investment in new energy sectors. After two decades of near-zero real interest rates, rates are starting to rise as central banks turn to tackling inflation. Clean energy sectors stand out as particularly vulnerable to the potential end of the so-called “everything bubble” in financial markets. This refers to the recent rise in asset prices induced, at least in part, by sustained and deliberate attempts by the monetary authorities to pump liquidity into the pandemic afflicted global economy.
The reason is that renewable technologies tend to be relatively capital intensive, so that upfront costs of financing them are sensitive to nominal interest rates. Many of the less established green technologies, afford scope for future cost reductions and the creation of new markets, but have yet to generate revenues and profits.
Should green investment await better times?
A structural transition to zero carbon energy generation requires more investment in physical, human, intangible and natural capital. It requires retiring or even abandoning the assets underpinning the carbon economy of the past century. These include mines, oil rigs, refineries, transport networks, power stations, petrol forecourts as well as a host of skills and ideas. It means building a new infrastructure based on renewable energy, battery and hydrogen storage, grid connectivity, demand response management and Electric Vehicles (EVs). With such large investment needs, does the inflationary and higher interest rate environment mean the green transition should be paused?
Isabel Schnabel, a European Central Bank Executive Board member recently noted that “the need to step up the fight against climate change may imply that fossil fuel prices will now not only have to stay elevated, but even have to keep rising if we are to meet the goals of the Paris climate agreement.” Yet with several trillion dollars in annual capital necessary to deploy and create these assets, the appetite for clean technology has started to wane.
A longer-term worry is that higher prices for coal and gas will encourage the ramping up of production in old or mothballed coal plants. Investment in mines and oilfields has dropped sharply over the last five years, but global power generation from coal, after falling in 2019 and 2020, jumped by around 9% to an all-time high in 2021. This demand risks further undermining the chances of meeting future decarbonisation.
On the other hand the rise in energy costs and the desire to reduce reliance on foreign energy imports is likely to have a positive effect on renewable investment. Renewables, storage and energy efficiency offer the only reliable route to energy security and the avoidance of similar crises in the future. Indeed, experience tells us that such investment is likely to prove cost effective faster than we expect. So current conditions might not only fail to slow the transition, but could instead give it a new lease of life.
For the transition to net zero energy is already happening fast, increasingly driven by commercial opportunity. Some technologies already pay for themselves, such as solar and wind power and EVs. Investment in green hydrogen makes it a potentially viable alternative to oil and gas and fill in for when the wind isn’t blowing and the sun isn’t shining. Hydrogen and synthetic fuels will increasingly power heavy industry, haulage, shipping and aviation.
The energy landscape is changing at breakneck speed. When the UK Parliament passed the Climate Change Act 2008, solar power cost between five and ten times as much as coal and gas electricity and offshore wind power was still very expensive. Since then the cost of wind has fallen by more than half while solar PV costs have declined more than 90%. Today, both are cost competitive even when accounting for the need to cover for intermittency.
Far from adding to costs, investment in renewables has created new resources. Whether you care about the climate or not, the world is now set to have extremely cheap electricity (Figure 1) and cheaper better performing cars where LED lights are now mainstream technologies. Batteries and heat pumps are at an earlier point on the learning and innovation cost curve, but they are heading in the same direction.
Figure 1: The deployment and cost of renewables.
Source: Grubb et al. 2021.
Adopting clean technologies induces creativity and innovation across the whole economy and generates new learning and experience along the way. It unleashes economies of scale in discovery and production, as businesses fabricate and distribute things more efficiently and dramatically lowering costs. This in turn makes deploying new technologies even more attractive – generating a virtuous cycle of innovation, investment and falling costs. Since 2010 annual investment in solar has grown by a factor of 20 and for wind by a factor of 4. The cost of lithium-ion batteries has also fallen eight-fold over this period.
Because of these reinforcing feedbacks and network effects, such transitions happen much more quickly than decision-makers and analysts expect, catching most by surprise. Like most analysts, the IEA has long underestimated the scale of deployment in renewables and, correspondingly, overestimated falling costs. Yet it now notes that solar power offers the “cheapest electricity in history”. It predicts that “renewables will overtake coal to become the largest source of electricity generation worldwide in 2025”.
Once the clean innovation machine is switched on and is running, it has the potential to become more innovative and productive than the conventional alternative. By driving prices for disruptive technologies extremely low, growth in new sectors will have a positive impact on productivity growth.
Profitable ideas are hard to contain
Far from being fundamental to human wellbeing, fossil fuels and our over-reliance on them may now be holding the economy back. Even after the advent of innovative technologies such as fracking, the underlying cost of extracting fossil fuels from ever more remote locations has limited potential to fall sharply.
With time, even the capital costs of renewables are set to outcompete fossil fuels. Ultimately, a solar panel has fewer bulky components than a coal plant per unit of energy generated. An EV eliminates half of the components needed in a conventional vehicle. Motorists in most parts of the world will soon benefit not only from lower running costs but also from cheaper EVs.
Regardless of the latest energy spike, the fact is, fossil fuels will mostly be consigned to the technology history books within a few decades. In those cases where the marginal costs of extraction are so low that they continue to be economically viable to extract, some form of compensation will be required to prevent further emissions.
The transition will be disruptive
Not everyone will benefit from the inevitable change. Job security will diminish in declining fossil fuel related sectors. The real challenge for policymakers is not whether renewables are affordable but how to anticipate and manage the disruption. The new jobs are unlikely to be in the same places as old ones. Many financial assets are at risk of devaluation
Profitable investment in new sectors does continue to require a financial commitment at a time when energy consumers are hard pressed. Energy for heating and electricity makes up a higher proportion of the income of poorer households and so there are genuine concerns about the distributional consequences. But other policies can tackle the distributional issues, for example by shifting the burden of investment in green from energy consumers to taxpayers.
The new energy economy will be cheaper, more innovative, cleaner, fairer, safer and more secure than the fossil fuel economy. That’s why the transition is happening everywhere, and fast. The challenge for policymakers will be to manage change. The latest energy crisis does not mark a reversal of fortunes for fossil fuels; more likely it signals the last gasp of a dying sector.
The views and opinions expressed in this post are those of the author(s).