What to expect from this blog?

The objective of this blog series will be to share some of the thoughts of the European Long Only team with the aim of contributing to the wider public debate on a variety of topics. Through the process of articulating our own perspectives, we seek to test their internal logic, whilst also opening up a medium for feedback and greater dialogue with both our existing investors and other interested parties. The issues that investors are forced to examine today are increasingly both complex and dynamic in structure and we will use the blog to convey our current thinking and highlight pathways for potential evolution. Whether or not in total agreement, we hope the reader can extract some thought-provoking ideas from this series and we would very much welcome your thoughts not least to expand our own understanding.

Starting at the beginning: The end of the carbon era

In this first blog we lay out a framework for assessing the climate sustainability challenge before diving deeper into some of the critical issues in future articles. Addressing climate change typically gets framed around the targets set by the 2016 Paris Agreement, which in turn rest on academic research as summarized by the UN’s International Panel on Climate Change (IPCC). Global warming is thought to be a function of the amount of greenhouse gases floating in the atmosphere as they capture heat within the earth’s atmosphere. Therefore, we should focus on the stock of emissions that accumulates over time as much as the level of emissions per annum. It is thought that in order to limit average global warming to 1.5° Celsius above the level at the start of the Industrial Revolution, we need to cap cumulative global emissions to no more than c.400 Gigatonnes (Gt) of CO2. Setting the limit to 2.0° Celsius gives us a cumulative future ‘carbon budget’ of c.1,100 Gt. For context, the world emitted around 35 Gt in 2019 (excluding the impact from agriculture, fugitive industrial emissions and deforestation), so without any change in the magnitude of annual emissions we would already breach the cumulative allowable envelope between 2029 and 2050.

There are a number of prominent institutions that have attempted to model out scenarios for the emissions reduction path that keeps emissions within the limits of the carbon budgets set out by the Paris Agreement. These are often referred to as “Net Zero 2050” scenarios, even though modelled emissions may or may not reach zero by 2050. One such model is provided by oil giant BP in its 2020 Energy Outlook. Its Net Zero scenario shown below is in line with the IPCC 1.5° C scenario.

Global Carbon Emissions from Energy Use
Gt of CO2

As always, the devil is in the detail. The BP scenarios include a carbon price which reaches $250 per tonne of CO2 in developed markets and $175 per tonne of CO2 in emerging markets. Today, the region with the most developed CO2 pricing system is the European Union, which applies a price of around $60 per tonne to the emissions of power plants and industrial installations like steel and cement plants. We are very far away from a global CO2 price on all sectors, let alone a price at, or near, $200 per tonne. It would also be tremendously costly. Applying a $200 tax on 35 billion tonnes of emissions would amount to $7 trillion of annual additional costs to be borne by CO2-emitting industries, the equivalent of about 8% of global GDP. These taxes would generate significant income for governments, so the economic damage could perhaps be contained, but we think that the stakeholder conflict that it would unleash means a global CO2 tax of this magnitude is unlikely in practical terms.

We think that the climate debate overlooks the critical importance of managing the pace of the energy transition. Currently, expensive zero carbon technologies such as carbon capture systems, hydrogen fuel, and energy storage through batteries look set to become significantly cheaper over time as the scale of applications increases and R&D dollars are used to improve the technologies. At the same time, existing fossil fuel assets reach end of life after being fully depreciated, which makes the decision to replace them with zero carbon alternative technology much easier. Broadly speaking, the longer we wait, the cheaper the energy transition becomes. But we can’t wait very long, time is ticking as we come closer to exhausting the remaining carbon budget.

We need to be smart about the energy transition and focus on the lowest cost technologies first. These tend to be in industries such as power generation, through renewables like wind and solar, and mobility through electric vehicles.

We have built our own Net Zero models by looking at the major sectors that emit greenhouse gases, such as power generation, passenger vehicles, trucking, shipping, steel and cement production, refineries, etc. We have modelled out the economic costs of legacy fossil fuel technologies versus zero carbon alternatives. This allows us to understand whether and when we are likely to see an economic incentive emerging for sectors to transition to the zero carbon option. We found that in most cases, before 2050, a carbon price is required to tip the balance in favour of the zero carbon alternative. We start to model broad adoption of zero carbon technologies once the required carbon price reaches $50 per tonne, a level we think will become politically acceptable in most countries. Even then, it appears to us, that the transition is more likely to gather steam in the 2030s than in the 2020s.

CO2 Required Abatement Price: c$100/t After Mid-2020’s, $50/t ’30s
$/tonne CO2 Price at Which Cost of Low Carbon Solution = Fossil Fuels 

The graph below shows the results of our modelling. Economic and population growth, especially in emerging markets, means that the gains from the renewable energy and electric vehicles we are buying today do not have a major impact on the overall carbon emissions until the 2030s. Even where economic incentives exist for a new factory to go green, it takes decades to replace the existing stock of fixed assets. Buildings are a category of their own. Heating homes is often done with gas in developed markets. An owner is usually required to go through a stressful renovation project to de-carbonize, using electric heatpumps which do not pay themselves back until after a decade or more.

We see the world still emitting c10Gt by 2050. By that year we will have emitted nearly 1,000Gt from energy-related sources alone. Agriculture, process emissions, and deforestation could add another 300Gt, in which case we would easily breach the carbon budget for the 2° Celsius global warming option.

Global Energy-Related GHG Emissions (estimated)

So based upon the current trajectory, we are not on track but if the world is committed to limit global warming, what options does it have? The most likely outcome at this stage is a mix of solutions from the following two categories:

1. Higher imminent price of carbon / stricter legislation – We expect ratcheting regulation to increase the penalty faced by emitters via both higher carbon prices and greater breadth of coverage. In coming months for example, more details will be disclosed around the proposed European carbon border adjustment tax and expected further tightening of Europe’s carbon exchange traded system.
2. Greater embracement of offsetting technology – While a breakthrough in novel technologies such as Direct Air Carbon Capture hasn’t yet materialised, trees represent a 400m year old low-cost carbon-absorptive technology.

Our sense is that the implied price of carbon embedded in investors’ cash flow estimates and thus required cost of equity for many companies does not accurately reflect the regulatory direction of travel. Similarly, we find the discussion with respect to the likely investment implications of carbon border taxes (due in Europe in 2023), sizing of potential government subsidies (not yet disclosed) and the potentially deep knock-on ramifications of China’s own push to net zero are very nascent. So too is the debate on the contradiction between current regulation, which seemingly in reality targets gross zero (i.e. total elimination of emissions) versus the true objective of net zero (i.e. achievable via use of offsetting carbon sinks).

In a future post, we hope to articulate the surprisingly positive optionality of tree re-forestation as a potential under-analysed solution and the profoundly virtuous cycle that could develop between sovereign self-sufficiency in carbon and calories if protein substitution by alternative meats and dairy takes off.

To discuss, provide feedback or pose any questions, please click here to email the European Long Only team.