Green shift: Costs and opportunities

The tectonic changes underway in the energy ecosystem present the chance of a lifetime for investors

Decarbonising world energy is by far the single biggest long-term challenge facing the world today. We are already at an atmospheric CO2 level of 420 ppm (parts per million), and we are adding about 2 ppm every year. This needs to be contained at 450 ppm if we wish to give ourselves at least a 50 per cent chance of keeping global warming to within 2 degrees centigrade.

Carbon emissions will have to fall by 50 per cent by 2030. The decarbonisation pathway needed is a huge technological, logistical and financial challenge. It is also the single biggest thematic investment opportunity available to investors. Decarbonisation will impact every single company and industry, and determine winners and losers, both sectorally and regionally.

First the scale of the challenge. The energy transition models showing the path to net-zero carbon by 2050 make three key assumptions.

First, they assume that energy demand will peak around 2030, and then flatline with no further growth. Given that energy demand has increased 60 times from the pre-industrial levels, this is a massive assumption. From 1820 (the start of the Industrial Revolution) till today, the world population has gone from less than 1 billion to over 8 billion, and energy use/capita has increased more than four times. Today, the global gross domestic product (GDP) is about $100 trillion and GDP/capita is about $11,500. By 2050, despite a global population of 10 billion and GDP/capita expected to be over $23,000, can energy demand remain near current levels? This is a huge bet on energy efficiency. We have to assume that the energy intensity of GDP drops by more than 50 per cent, and energy demand per capita actually declines!

The second major assumption of all models is the change in the energy mix. We have to assume that fossil fuels will decline from the current levels of over 80 per cent to less than 25 per cent by 2050. Coal consumption has to drop from 25 per cent of the energy mix to less than 3 per cent, while oil from 30 per cent to about 8 per cent. Only gas will hold on, as its consumption will drop from 25 per cent to 12 per cent of the energy mix. Most models have solar and wind at near 50 per cent (it is 5 per cent today) of the energy mix by 2050, with hydrogen also at double-digit levels. The assumption remains of a limited increase in nuclear and hydro. Most models have their combined share at about 15 per cent even by 2050. The joker in the pack is, of course, nuclear fusion. If commercially scalable, it will be a game changer.

As fossil fuel consumption does not go to zero, there will still be greenhouse gas (GHG) emissions even in 2050. The third major assumption of all models is the belief that more than 50 per cent of these residual GHG emissions will be absorbed by carbon capture and storage, a technology that has not yet been commercially proven at scale.

Illustration: Binay Sinha

As to how much this energy transition will cost, I have seen numerous figures from $50 trillion to over $200 trillion. The dispersion is due to how one defines its scope. Will the entire electric vehicle (EV), for example, be included in the cost of the transition or just the battery cell? Another related issue is costs. Over the last decade, the costs of solar, wind and lithium-ion batteries have declined dramatically. As an example, the costs of solar have declined by 80 per cent and batteries by 85 per cent. Going forward, given that raw materials now account for almost 70 per cent of the costs, cost declines will be far more muted. The costs of all these technologies have actually risen in 2022, given the surge in commodity prices. Cost estimates of the energy transition can differ widely depending on the cost declines you assume for these technologies.

An approximation, to my mind, is that we will need to invest $100-125 trillion cumulatively till 2050 to get to carbon net-zero. That implies an annual investment of $3.5-4 trillion in clean energy. For context, at the moment we are spending in total about $1.5 trillion annually for the energy ecosystem, a trillion dollars in clean energy and $500 billion for fossil fuels. We will need to almost triple our annual investment.

A related issue is where will all this money go? Given the change in energy mix assumed in most of the models, the biggest investment areas will be EV batteries, solar, wind and hydrogen. One should expect a cumulative investment till 2050 of $16-17 trillion for batteries, $13-14 trillion for solar and $11-12 trillion for wind. Hydrogen will need about $10 trillion for fuel cells and electrolysers. These are massive numbers and will obviously throw up huge investment opportunities for everyone involved, from the banks funding the green transition to the companies putting up the plants to the technology providers.

Investors will need to decide how to play this tectonic shift in the energy ecosystem. While huge and visible growth obviously attracts investors, it does not always lead to shareholder value creation. The critical link between growth and value creation is the return on incremental capital. Where in the battery, solar, wind and hydrogen value chains are the returns on capital the highest? Where is the industry structure the best? Should one just buy a commodity producer heavily indexed to copper, nickel, cobalt and lithium rather than focus on the cell manufacturers to play the battery value chain? Which part of these respective value chains will not be commoditised and driven by the size of balance sheet as the determinant of success? Given their strategic importance, will we see all major countries put up national champions in each of these areas creating an industry structure similar to what we had for the auto industry or for airlines? Needless to say, both autos and airlines have been a graveyard for investors over the years.

As Indian companies pivot to address the energy transition, they must decide where they want to play. India is lagging behind in core technology, but with the government serious about Make in India, we can catch up. India will provide scale as it is one of the major investment destinations for green energy. Most parts of the various value chains look to be quickly commoditised and very capital intensive. You can succeed here with government support. The large Indian groups may focus here and fulfil the national agenda. For most other Indian companies, it makes sense to focus on selected niches where returns are higher and engineering capabilities matter. An example being the pivot towards electrification taken by most of the larger Indian auto ancillaries, wherein they see electrification as an opportunity to level the playing field and increase their content per car rather than worry about cannibalisation.

It is an exciting time to be involved with the energy ecosystem. Energy transition is going to be the largest thematic investment opportunity of our lifetime. The best companies will find a smart way to engage, pick their spots and play the value chain. This transition will enable both huge market-capitalisation creation and destruction. We must find companies on the right side of this tectonic shift.

The writer is with Amansa Capital