Coal, oil and natural gas have been the dominant energy sources powering the global economy for the last 100 years. But the energy landscape is changing quickly–and not only because of government policies designed to curb climate change. Rather, technological advances over the last decade have helped make the cost of renewables competitive with fossil fuels, accelerating the deployment of clean energy technology and battery storage faster than most industry insiders predicted. In addition, the development of distributed ledger technology (DLT), Internet of Things (IoT), and Artificial Intelligence (AI) and the emerging work to incorporate these into the grid has the potential to dramatically increase renewable capacity throughout the world.
Businesses are increasingly adopting sustainable business practices for both social and economic reasons. As these practices become the norm, consumer demand for sustainable products will further increase the pace of the energy transition.
With any disruptive change, there is a tipping point where innovation reaches economies of scale and causes a noticeable, sustained decline in the industry it is replacing. There have already been some downward pressures on stock prices and debt ratings in the fossil fuel industry. Coal’s share of global electricity generation has decreased and the oil and gas sector is facing questions about when demand for their products will peak.
This energy transition presents both risks and opportunities for investors and requires an investment approach that limits reliance on traditional decision-making factors. Specifically, the structural nature of energy transition has two significant implications for investors:
- Technology disruptions and their impact on markets almost always happen faster than the “experts” predict;
- the reliance on past performance to guide future investment decisions carries significant risk.
History has many examples of technology disruptions occurring faster than originally predicted. Sectors such as transportation, communications, entertainment, and even financial markets have seen new product innovations phasing out obsolete technologies. Some companies were agile enough to adapt and reinvent themselves, but these were the exceptions. More often than not, new companies emerged to take their place.
The energy sector has also underestimated the pace of disruptive innovation. This fact is reflected in an analysis of the accuracy of past International Energy Agency (IEA) projections of renewable energy capacity and market share, and the IEA’s World Energy Output (WEO), one of the most relied upon scenarios of future energy demand and usage. WEO forecasts, since their inception in 2000, have consistently and materially underestimated the capacity of renewable generation, particularly solar.,
The projections made by fossil fuel companies, particularly by the oil and gas majors, have indicated increasing demand for fossil fuels well into the 2040s. And while many companies have acknowledged the societal threats to climate change, most companies in the sector have taken a “business as usual” approach to exploration and production, all but ignoring the risks that technology disruption will cause demand for fossil fuels to peak far earlier than they anticipate.
We acknowledge that it may be difficult for investors to move away from traditional investment decision inputs such as historical risk and returns, manager track record, etc. After all, over long time frames, fossil fuel companies have proven to be relatively stable, return-generating investments. But more recently (e.g., the last five years) the sector has underperformed the broad market and clean energy companies in general. Some believe that the shift we are beginning to see is only cyclical, and that fossil fuels will remain the dominant source of energy in the future pointing to long term historical performance of the sector. For the reasons outlined above, we believe that the current and forthcoming changes are structural, and therefore investors with the same belief should consider placing considerably less weight on long-term past performance.
Can we infer anything from performance over a more recent period? Perhaps. It should be noted that the recent underperformance of fossil fuel companies occurred during a period marked by a global rise in populist and nationalistic sentiments — a political environment not conducive to establishing coordinated global climate action. It also includes the last two plus years of a US presidential administration skeptical of climate science and predisposed to supporting the coal, oil and gas industries. Yet in a time when world governments have not made the commitments necessary to mitigate the risks of climate change, clean energy still outperformed fossil fuels. To us, this short-term relative performance difference signals the strength of consumer demand and a clean energy industry working to meet that demand. Fundamentally, it is our view that the last five years are more reflective of the energy future than the past 50, and that being structurally positioned for the transition NOW, instead of trying to time it in the future, is an approach worth considering.