Getting from ‘Transitory’ to ‘Transition’
Benjamin M. Lavine, CFA, CAIA, RICP
This past week, investors received less than favorable news concerning the inflation outlook as the October Consumer Price Index (“CPI”) rose 6.2% from year ago levels, the “fastest gain since August 1991.” Core-CPI (CPI ex food and energy price gains) rose at an annual pace of 4.6%, also the highest year-over-year rise since August 1991. Even CPI less the ‘kitchen sink of all the bad stuff I’d like to exclude’ (Figure 1) rose by 4% (a 30-year high) suggesting that COVID-based effects related to demand recovery from 2020 shutdowns are proving to be less than transitory. The Biden Administration also acknowledges the potential contribution of higher ‘shelter’ costs to inflationary pressures that will push the ’inflation-is-transitory’ narrative beyond 2022.
Figure 1 – Inflation Less ‘Excluding Everything’ Index at a 30-Year High.
Needless to say, some alarm bells have gone off in the Biden Administration over the latest inflationary readings, as Administration / Federal Reserve officials were trotted out to the media weekend shows to re-emphasize the ‘transitory narrative’ despite acknowledging greater uncertainty over the ‘timing’ of when high inflation will normalize to more stable levels. For instance, Treasury Secretary Janet Yellen maintains that much of this timing will be dictated by the pace of COVID infection rates as well as vaccination levels. So far, the Biden Administration is holding to the supply chain bottleneck narrative that inflation pressures will be alleviated once the supply chain bottleneck issues are resolved.
And then there is a debate over the implications of ‘transitory’ inflation. Will demand destruction result from higher price pressures if wage growth is not able to keep up? Will supply chain issues ultimately resolve themselves in a timely fashion before inflation psychology takes hold? Regardless of how one views ‘transitory’ inflation risks and how those risks will manifest themselves across the broader economy, the hope is that global central bank authorities can wait out these inflationary pressures before having to resort to tightening monetary policies that could potentially derail the COVID pandemic recovery. But, if these pressures do not resolve themselves in time before inflation psychology takes hold, then central bank authorities risk losing their inflation-fighting credibility, and credibility once lost is difficult to restore (witness monetary policy during the 1970s).
Shifting from ‘Transitory’ to ‘Transition’
Apart from supply chain bottleneck shortages resulting from the pandemic shutdown, there are more structural issues at play that may likely serve as an overhang of higher costs for years to come, forcing investors and consumers to acknowledge a structural phase shift from 2019 pre-COVID pandemic to a new reality that lies ahead. One such issue is the push for achieving ‘net zero’ carbon emissions target by 2040-2050 (depending on who is making the pledge).
The challenge is how to transition to net zero when faced with the reality of 1) higher fossil fuel and coal consumption in population-dense emerging markets (notably China and India) to support their economic growth and increased consumption and 2) lower energy returned on energy invested (EROI) as well as lower energy stored (ESOI) with carbon-free alternative energy sources (hydrogen fuel cells, wind, solar) when taking into account the amount of energy needed to manufacture and produce alternative energy generation as well as increasing the reliability of availability (base loads).
With respect to #1, the world does not appear to be ‘transitioning’ away from coal consumption as global demand remains near peak levels (Figure 2) with increasing demand from Asia offsetting decreased consumption in the U.S. and Europe (Figure 3). And we will likely not see peak levels in coal consumption, as more coal-fired plant capacity is coming online over the next several years (Figure 4). Granted, air-scrubbing technologies could offset the negative environmental impact from increased coal consumption, but the cost of air scrubbers needs to drop for less wealthy countries to consider adoption (carbon offset credits could help offset some of these costs).
Figure 2 – Global Coal Consumption Remains Near Peak Levels
Figure 3 – Increased Coal Consumption Across Asia to Offset Decreases Across the Rest of the World
Figure 4 – New Coal Plant Capacity in Asia to Offset Retired Plants
With respect to #2, the EROI and ESOI on conventional fossil fuels remains far superior to that of alternative energy as documented by Goehring & Rozecwajg, where it is estimated that “as much as 25-60% of the energy generated in a renewable system is consumed internally, compared with 3% for a modern gas plant (source: G&R 2020.Q4 Market Commentary)”. For instance, when taking into account the electricity needed to manufacture, transport, and re-catalyze hydrogen gas for fuel cell energy generation, G&R estimates that 70% of the total power needed for this whole process is ultimately wasted (and that assumes electricity consumption comes from conventional fossil fuel sources rather than solar and wind). Sure, technological innovation may eventually improve the EROI of alternative energy sources, but there still exists a wide gap with conventional fuel sources, especially with a cleaner fuel source like natural gas.
And unfortunately, the EROI outlook for fossil fuel energy production, which is still a ‘necessary evil’ as we transition to net zero, has deteriorated due to a combination of 1) lower capital investments from energy producers (as investors balk at capital allocation for production, whether due to lower return on investment or ESG considerations) and 2) tougher-to-drill sources following the pullback in North American shale production. In an August 2021 paper published by energies/MDPI (“Assessing Global Long-Term EROI of Gas: A Net-Energy Perspective on the Energy Transition”), the ratio of energy required to energy produced (gas) is projected to rise to approximately 25% by 2050 from around 5% in 2010, right around the time of peak North American shale production (Figure 5). Unless there is a renewed push for fracking across known oil/gas reserves and/or easily accessible reserves are discovered (and in a politically stable region), we have likely seen peak EROI for conventional energy production.
Figure 5 – Energy Required for Conventional Gas Production Expected to Exponentially Rise Through 2050
Source: “Assessing Global Long-Term EROI of Gas: A Net-Energy Perspective on the Energy Transition,” energies/MDPI, August 2021
In our quest for net zero, it seems we’re taking two steps back for every step forward.
Looking Ahead – Perhaps We Need to Expand Our Focus When Assessing Energy Transition
But rather than fixating on the present challenges, it is better to look for positive developments that will help us make this energy transition that will not cost us much in the way of long-term productivity or a material decline in living standards. The invention of the catalytic converter for fuel emitting cars – “an exhaust emission control device that converts toxic gases and pollutants in exhaust gas from an internal combustion engine into less-toxic pollutants by catalyzing a redox reaction” is a good example. The give-up in fuel efficiency is negligible considering the positive environmental externalities.
To that end, we encourage readers to keep an eye out for technological developments that will improve the EROI/ESOI of an energy solution, whether
- Increasing the energy efficiency of conventional fuel sources;
- Decreasing the environmental impact of fossil fuel production and usage;
- Increasing the energy efficiency of non-fossil fuel sources;
- Revisiting previously environmental taboo energy technology solutions such as nuclear power.
Tyler Cowen wrote a Bloomberg Opinion article (“Nuclear Fusion is Close Enough to Start Dreaming”) that provides an optimistic angle on the energy outlook. Nuclear fusion might still be a pipe dream for a safer nuclear energy solution, but real investor capital is flowing to innovators trying to engineer safer nuclear power generation (whether through lower uranium enrichment, sodium-cooled fission, or achieving actual fusion). Cowen also lists some potential second-order effects for granting access to high EROI energy sources such as:
- Scaling up and increasing the geographical scope of water desalinization;
- Higher labor wages commensurate with productivity gains as a result of greater energy efficiency;
- Expanding the limits of supercomputing (see this article on how we’ve hit feasible energy constraints on deep learning)
Yes, Cowen throws in the obligatory Malthusian warnings on the unintended consequences of technological innovations leading to unchecked population growth (i.e. cheaper energy translates into greater meat production that can buttress higher population), but then Malthusians aren’t exactly known for their optimism. The technologies look promising such that philosophical handwringing over unintended consequences seems like a decent trade-off for the benefits as we strive for net zero transition.
The science of economics ultimately boils down to modeling human rational behavior in the face of scarcity (food, energy, luxuries) and uncertainty (risk). However, as long as positive incentives exist for innovation, then we can continue to solve the scarcity problem while efficiently addressing the risk problem (that’s the premium investors are compensated for the uncertainty). But it seems the world is trying to rush the energy transition using a top-down hammer (regulatory, ESG mandates, shareholder activism) rather than through bottom-up incentives.
Sustainability Investing should not just be about minimizing carbon emissions, a common ESG screening criteria for environmentally friendly companies. Rather, the Sustainability Concept should also consider metrics to incentivize greater productivity and shareholder returns, such as EROI/ESOI, in addition to improving externalities, such as reducing the environmental impact from burning coal. With the right incentives, the future does look brighter and actually achievable as we look to transition from transitory.
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By: Benjamin Lavine