No decarbonisation, no energy security

The global energy shock has reminded policymakers, investors and the general public of the importance of safe and secure supplies – and the economic havoc wrought by shortages and price volatility. This has prompted calls for a U-turn on decarbonisation.

We believe, however, that there will be no energy security without decarbonisation. Indeed, the solution involves an even speedier energy transition, alongside an increase in investment in all forms of clean power, especially in the short term.

Cause and effect

Europe is at the epicentre of this crisis, in which the price of energy in all forms has risen dramatically. Inflationary pressures are growing, government finances are increasingly strained and consumers – especially those on the lowest incomes – fear the onset of winter.

An analysis of the underlying causes underpins our view that investors should not abandon, or deprioritise, climate goals in the interests of energy security and affordability.

First, what brought us to this situation? There are a number of plausible suspects – not least geopolitical events. But in our view, at its heart, this is a crisis of underinvestment in which the world is simply not deploying capital into renewables on the vast scale required.

This has been compounded by understandable caution from the oil and gas industry. Companies in the sector have been investing, broadly speaking, in line with an expected decline in demand for their products of around 1-2% a year. Unfortunately, demand for hydrocarbons has proven far more resilient.

Funding the energy transition is not going to be – and is not proving to be – capital neutral. When reallocating capital from oil and gas to low-carbon alternatives, significantly greater amounts of funding will be required to produce the same amount of usable energy. That’s because energy is not yet a homogenous product; for example, electricity and petrol are not yet fungible with each other for consumers who still have petrol-powered cars.

But there is a more fundamental challenge: low-carbon energy is far more capital-intensive than the carbon-intensive system. This is intuitive – with a solar panel, you spend almost all of the money upfront, then it produces electricity ‘for free’ (or nearly) thereafter. By contrast, after building a coal power plant, each year you will have to spend a significant amount of money buying the fuel to burn in it. This uplift in capital intensity is difficult to calculate – but in our view it is anywhere from two times to 10 times the original amount, depending on what and where you are measuring.

Low-cost and long-term

This is, in our view, the heart of our current energy crisis. Decarbonising our energy system is going to require an immense injection of capital – certainly at least $1 trillion extra each year – and we are just not investing enough.

Over the short term, it is likely that Europe – and probably Asia – will experience elevated energy prices for several years. While there are no easy answers, we are unconvinced by the argument that we are caught in a conflict between financing decarbonisation and financing energy security. We believe the lowest-cost, long-term solution is to do both.

In most global markets, including Europe, renewables are the energy source with the cheapest marginal cost. We agree that conventional measures of energy cost do not capture all costs of renewable electricity generation.

However, compared to current energy prices, renewables are clearly a highly attractive source of new supply, in our view.

Not only is scaling new renewable energy likely to be cheaper than many alternatives, it can also present significant benefits for costs and carbon. It reduces dependence on third-party suppliers of inputs – like oil or coal. And while renewables can increase price

fluctuations volatility over short periods of time, over longer periods, a decarbonised energy system in Europe may result in lower volatility as the impact of commodity cycles is dampened.

Finally, scaling renewable energy reduces companies’ vulnerability to the risk of holding ‘stranded assets’, which suffer from unanticipated or premature write-downs, devaluation or conversion to liabilities.

The above is an extract from our CIO autumn update, which shares LGIM research on sustainability themes ahead of the COP27 climate summit in Sharm El-Sheikh.

Read our CIO autumn update