Management of the coronavirus has provided further evidence of humanity’s evolutionary bias towards the short term. From the time it took China to acknowledge there was a problem in Wuhan, to British delays to facilitating adequate testing, actions around the world almost universally came too late to stem the health crisis.
Governments have performed much better on the economy with gargantuan fiscal stimulus (spending and tax cuts), but that was when the storm was upon them and damaging lockdowns imposed. Unfortunately, if it takes rising domestic death tolls to increase urgency in democracies and for authoritarian regimes to even admit an epidemic has broken out, it does not bode well for humanity’s ability to deal with its greatest challenge.
Climate change is arguably the number one threat to our species but, although some governments were talking a good game before Covid-19, nothing like the level of spending that we have seen to combat the pandemic has been enacted.
In any case, meeting the target set in the 2016 Paris Climate Agreement – for countries to take steps to limit the rise in global temperature to two degrees celsius above pre-industrial levels – was already problematic. Unhappy at concessions given to India and China, US president Donald Trump rescinded America’s commitment to the deal.
Although other nations and blocs such as the European Union have forged ahead, there are worries the efforts governments are making against Covid-19 will leave treasuries too exhausted to fight climate change. Yet, as the world economy struggles back, a paradigm shift in our approach to energy and sustainability is imperative.
Governments struggle to make ends meet
Looking at raw figures, it is hard to see how green targets will be met. Estimates from the Department for Business, Energy and Industrial Strategy say the UK’s ambition of net zero carbon emissions by 2050, announced when Theresa May was prime minister, will cost £70bn a year.
Footing such a bill is much more difficult in the aftermath of expenditure akin to a wartime budget to keep the economy on life support through lockdown. Already, the Institute for Fiscal Studies (IFS) has more than trebled its expectations for UK government borrowing in 2020, from £55bn to £177bn.
The Financial Times reported a survey of economists suggesting that, in 2024, Britain is likely to run an annual deficit at 5 per cent of national income. That’s more pessimistic than the estimate of the Office for Budget Responsibility, the independent watchdog. Even so the budgetary challenge is extreme, and in the 2024 election year any wriggle room is likely to go on giveaways, the very essence of short-termism.
Fiscal policy fatigue isn’t just a UK problem. Worldwide, rising deficits undermine plans to cut carbon emissions. While acknowledging the risk, EDHEC-Risk Institute finance professor Riccardo Rebonato is philosophical, arguing that getting Covid-19 under control is a prerequisite for progress towards economic sustainability.
“Let’s not forget that all non-Covid-related research (including climate change research) is currently on hold. Therefore, also from the perspective of fighting climate change, the best strategy is to get back on course as quickly as possible.”
Could green initiatives be a focus in getting economies on track? Climate ministers from several EU countries (now including France and Germany) are calling for stimulus packages to emphasise the transition to clean energy. It has been stated that the European Commission's newly announced E750bn recovery fund will prioritise sustainable and digital investments.
There is also talk of a Green New Deal on the other side of the Atlantic. Veteran left-winger Bernie Sanders may have withdrawn his candidacy for the Democrat Party’s nomination to run for US president, but much of his environmentally conscious agenda may yet form part of Joe Biden’s challenge for the White House.
“In general,” says Professor Rebonato, “I am suspicious of mixing goals and trying to kill two political birds with one stone,” and he doubts whether Covid-19-related fiscal stimulus is best spent on green initiatives. But he does believe government investment is essential in financing long-term solutions to climate change:
“Capital markets will certainly play an important role, but it is important to look at the public/private split in a non-dogmatic manner. For a variety of reasons, the private sector currently seems uninterested in solutions (such as sequestration [carbon capture] and negative emission technologies) that we know will have to play a major role if the two-degree target is to be met. Subsidies must play a key role in this.”
Who pays and what are the implications for investors?
Clarity of objectives is sensible, but the central question of who pays for it all remains. One vital query that often gets ignored is: who is buying all the government debt?
Monetary policy (central banks’ management of the supply and cost of money) provides some of the answer. Along with slashing interest rates to keep funding sources cheap, quantitative easing (QE) programmes – central banks buying bonds from financial institutions – have been revived to lubricate the financial system with cash.
In March, the Bank of England (BoE) committed to buying £200bn of gilts (UK government bonds), but creating money at the touch of a button to pay for them may have ramifications. Debasing the value of the pound could import inflation even if the UK economy is still contracting, in other words a return of 1970s-style stagflation.
Voting against more QE in April, Bank of England governor Andrew Bailey and others on the monetary policy committee demonstrated they are mindful of this risk, especially as the bank’s commercial paper facility to help businesses raise short-term funds is effectively an uncapped form of QE direct to non-financial companies.
So, if the BoE is avoiding unlimited bond buying, the government must keep an eye on demand from other sources. Given gilts offer historically low yields already, it is possible a weak pound will put overseas investors off further and raise the damaging spectre of failed gilt auctions. The logical progression is that diminished demand for sterling-denominated assets leads to lower demand for sterling, a potential vicious circle.
Therefore, an assumption that the UK can just borrow endlessly at zero or even negative real interest rates is over-simplistic. The government must push the limits of what it can do, but those limits exist, which leaves the quandary of how to top up state funding for essential projects to help the economy come back greener and stronger.
Sovereign debt issuance cannot be the sole solution in other countries either. In the eurozone, German courts have challenged the scope and legitimate purpose of the European Central Bank (ECB) buying bonds. Even in the United States, which has the fallback of the dollar being the world's reserve currency, arguments about budgets and raising the ceiling limit on the ballooning federal debt is a source of controversy in Congress.
Other options must be seriously considered, with public and private sector co-operation in the Covid-19 crisis, such as home appliance maker Dyson and the Mercedes Formula One team helping manufacture ventilators, showing what is possible. That’s before considering the co-operation between the US government and huge companies such as Pfizer (US:PFE) in the search for a vaccine.
The social impact finance team at legal firm Reed Smith see a precedent for dealing with climate change. Senior associate Priya Taneja and associate Nathan Menon make the assertion: “Technological challenges associated with climate change (such as fast-charging batteries or the efficiency of carbon capture or hydrogen systems) are areas ripe for collaboration and engagement between private companies and public bodies. The hope is that [examples of] such partnerships don’t simply stop once the Covid-19 pandemic is over.”
Public and private partnerships have been controversial in the past, but there is no longer the luxury of leaving money on the table for ideological reasons. A framework for assessing the efficacy of investments for all stakeholders is crucial, however, to avoid commercially naïve civil servants being hood-winked by unscrupulous firms.
Investors have an important role in keeping businesses honest and at a corporate level the weight attached to environmental, social and governance (ESG) scores can provide a steer towards moral best practice. Indexing and benchmarks for ESG are still in their nascency, but once again there are lessons from Covid-19, such as how to assess social ‘S’ impact scores and integrate them with the rest of the ESG mix.
Discussing the positive role partnerships are having on the current crisis, the Reed Smith associates say: “We are witnessing the “social” limb of ESG, which is usually the hardest to quantify, in action. The same framework can be utilised to address the environmental limb and tackle the climate emergency.”
Improved transparency and cohesion of all ESG factors will greatly aid custodians, who hold the keys to the kingdom of billions of dollars of capital. The chief executive of Blackrock, Larry Fink, famously outlined the world’s largest asset manager’s commitment to sustainability at the start of this year and when capital allocation decisions are being made on this basis, it becomes material for companies.
These developments add to the advantages of companies that already have a sustainable business model. As economies build back after Covid-19, trailblazers in green energy, waste management, transport, packaging, construction and food supply will greatly enrich their investors as well as wider society.
“Avoiding climate breakdown will require cathedral thinking. We must lay the foundation while we may not know exactly how to build the ceiling.” That’s what environmental activist Greta Thunberg told the UK parliament last year in a call for more urgent and ambitious action. Despite politicians dragging their feet, there are reasons to be hopeful. Some private companies have been creating and investing in innovative solutions to address the climate crisis, particularly in those sectors most responsible for producing greenhouse gas emissions (see chart). From new fuels to new food, businesses have spotted an opportunity to both do good and do well. More progressive government policies would certainly turbocharge their momentum. But even without that helping hand, we can already see some players that are likely to play a key role in ‘the new future’.
Rising global demand for energy, food and travel has contributed heavily to carbon emissions since 1990:
A new energy landscape
As the technology improves and costs come down, Bloomberg New Energy Finance (BNEF) estimates that solar and onshore wind are now the cheapest sources of electricity to build for at least two-thirds of the world’s population. A decade ago, the ‘levelized cost of energy’ – the total expense of producing one megawatt-hour (MWh) of electricity – for onshore wind projects exceeded $100 (£81). That has fallen to $44 per MWh and less than $30/MWh for the world’s best projects. Onshore wind is set to get a boost in the UK now that it can once again participate in the government’s scheme to support low-carbon electricity generation – the so-called ‘contracts for difference’ auction. Encouraged by this policy change, Scottish Power, which is owned by Iberdrola (ES:IBE), plans to develop over 1,000 megawatts (MW) of onshore wind capacity.
Out at sea, Denmark was an early mover in offshore wind, building the world’s first farm in 1991. It is the home of developer Orsted (DK:ORSTED) and turbine maker Vestas (DK:VWS), both of which recently featured on our list of the world’s best shares. There is an ongoing battle in the industry to create the biggest offshore wind turbine. More than a vanity project, longer blades improve aerodynamic efficiency and increase the amount of wind that can be captured to generate electricity. General Electric (US:GE) introduced a 12MW model in 2018 with a 220-metre rotor diameter. Not to be outdone, Siemens Gamesa (ES:SGRE) is set to launch a 14MW turbine with a 222m rotor diameter that will be commercially available from 2024. Given the long lead time on projects, orders from developers are likely to flow in soon.
Floating turbines could be the next stage of offshore wind, able to be sited in deeper waters where it is more difficult and costly to pile foundations into the seabed. This would open the industry up to large swathes of, as yet, untouched ocean and more powerful winds. The oil and gas industry has more expertise than most in floating platforms, meaning this could be a key entry point for them to accelerate their participation in the clean energy transition. Analysis from energy consultancy Rystad Energy indicates that Equinor (US:EQNR) is heading up the charge. It calculates that out of the $17.5bn expected to be spent on solar and wind projects by oil and gas majors over the next five years, $10bn of that investment will come from Equinor. The Norwegian giant is the leading floating offshore wind developer and owns a 75 per cent stake in the Hywind array off the coast of Scotland.
As the shift towards renewable power continues, the ability to store excess electricity and discharge it when needed will become increasingly important. The burgeoning battery storage sector is likely to send demand for the required minerals soaring. Tesla (US:TSLA) owns the world’s largest lithium ion battery installation in Australia with a 100MW capacity, and the site’s operator, Neoen (FR:NEOEN), is set to expand this to 150MW. Beyond such fixed sites, electric vehicles (EVs) are seen as a means of managing oversupply from the grid through ‘smart charging’.
The rise of EVs contrasts with the fortunes of internal combustion engine cars, sales of which BNEF estimates peaked in 2017. The Covid-19 pandemic is likely to disrupt the EV revolution in the near term. China is the largest EV market and slower economic growth will weigh on demand. But BNEF believes the future of EVs remains “undimmed” as the electrification of transport is likely to accelerate in the long term. It forecasts that electric models will comprise 58 per cent of new passenger car sales by 2040 and almost a third of the global car fleet.
Chinese companies made an early start in electric transport, buoyed by supportive government policy. BYD (CN:002594) – which is backed by Warren Buffett – was the world’s largest EV manufacturer before being surpassed by Tesla last year. It remains the leading provider of electric buses to Europe.
Tesla has been dogged by accusations of overpromising and underdelivering. But the naysayers have had to watch its shares rocket upwards since the end of last year, recovering almost all ground lost from the ‘Corona crunch’. The recent success of SpaceX’s ‘Dragon’ mission may also make people think twice about doubting eccentric chief executive Elon Musk. One of Tesla’s key advantages is its cheaper and more sophisticated battery technology. Manufacturing batteries at scale in partnership with Panasonic (JP:6752), it has driven down the cost per kilowatt hour. According to Reuters, the company has also developed a lower-cost and longer life “million mile” battery with Chinese battery giant Contemporary Amperex Technology (CN:300750). Planning to introduce it to China later this year, it could bring the cost of its Model 3 car in line with or cheaper than internal combustion vehicles. While Tesla’s structural growth drivers are undeniable, it’s worth noting that famed short seller David Einhorn has raised issues over how the company treats it receivables.
As Tesla races ahead, the competition isn’t sitting idle, particularly as the European Union (EU) mandates that auto manufacturers reduce their fleet-wide carbon footprint to an average of 95 grams per kilometre by 2021. Volkswagen (DE:VOW3) is the world’s biggest carmaker and has ambitions to become the global leader in EVs, too. It plans to spend €33bn (£30bn) on developing and building EVs by 2024 and recently announced a further €2bn investment in China to expand production. Chief executive Herbert Diess believes the VW ID.3 will “take the electric car from being a niche product to the mainstream”.
The bold new world
Hopefully, as ESG scoring becomes more sophisticated and the taxonomy becomes more transparent, investors should be able to direct their money away from harmful businesses and towards doing good. Although that’s not to say private capital markets and the private sector can ever pick up all the slack from government.
For example, subsidies were an important part of helping the wind power industry, when the private sector was disinterested. Without help the cost in pounds per mega-watt hour of onshore and offshore wind wouldn’t have fallen to the economically viable levels it is at now. The same is still true of carbon capture and positive emissions technologies, which the private sector is apparently ignoring.
For Professor Rebonato, who also has a background (and another PhD) in nuclear physics, a stark example of underinvestment in fighting climate change is research into nuclear fusion technology. Currently, our nuclear power stations rely on fission – splitting the atom – and the energy that releases. Enormous, reliable and low-carbon electricity is generated, but there is radioactive byproduct, and the risk of catastrophic episodes like Chernobyl and Fukushima cannot be ruled out.
Fusion, by contrast, is when atomic nuclei merge. It’s the reaction that occurs in the sun where hydrogen nuclei fuse into helium. The binding energy is a source of virtually limitless power that is cleaner and safer than fission.
Although cracking fusion would be transformative, Professor Rebonato notes that less money is spent on research annually than Americans spend on pet-grooming, artificial Christmas trees or on beer each 4th of July.
Clearly, some projects lack the timeframe, control over budgeting and visibility of payback that private financiers seek before investing. Like the mission to the moon in the 1960s, ventures such as nuclear fusion must be led by government (although help from super philanthropists like Bill Gates would not go amiss either).
Private sector finance in other parts of the economy can free up governments to lead the charge where internal rate of return (IRR) payback models fear to tread. It is therefore essential frameworks exist to allay concerns about profits being prioritised at any cost if private finance is used to supplement sensitive areas like health or education.
It may not be a popular suggestion in some quarters, but a better blend of public and private sector could lead to improved outcomes for citizens. After all, the state can't pay for everything and prioritise efforts needed to transition to a greener future. Efficient and pragmatic co-operation across the spectrum of funding sources may be our best chance of averting a climate disaster and building a better world.