China and the free rider problem, solved

Deal puts fossil fuels on notice

China and the free rider problem, solved

Deal puts fossil fuels on notice

Jemma Green’s talk given at Melbourne University’s Carbon Bubble public lecture.

This was published in the West Australian and The Fifth Estate.

I can understand why you might be cynical about announcements around climate commitments. We have heard so many. Some which have materialised and then been retracted, like Australia’s climate laws. Some which have been pledged to but then never implemented, like Canada’s Kyoto commitments. Or carbon-neutral labelling and credits, which were later found to be entirely fabricated. But every now and then, something significant happens.

And it happened last week: The carbon-deal with the US and China. graph

President Obama and Chinese President Xi Jinping jointly announced targets to reduce carbon emissions in the post-2020 period. The United States intends to reduce net greenhouse gas emissions by 26 to 28 per cent below 2005 levels by 2025, which doubles their current rate of carbon reductions. China, for the first time, announced its will peak carbon emissions before or by 2030. That matters because over the past 15 years, China has accounted for roughly 60 per cent of the growth in carbon dioxide emissions worldwide. They also committed to increase the share of energy coming from zero emission sources to around 20 per cent by 2030.

To achieve this, China will deploy an additional 800 to 1,000 gigawatts of zero emission generation capacity by 2030. This is comparable to all the coal-fired power plants in China today, and nearly as much as the total electricity generation capacity of the United States. But this is not hard for China as they are already well down this track, with investment in fossil fuel-based power peaking in 2006 and investment in renewables now double to that of fossil fuels.

Growth in their economy is 8% per year but coal growth is now zero and will begin declining next year.

And while some may think the US may not be able to implement their commitments due to changes in the balance of power in Congress, I believe that China’s commitment signal significant commercial opportunity in clean-tech and carbon markets, to enlarge and link the US’s market with China, which the US will not want to miss out on.

But to fully appreciate the significance of this announcement, we need to understand the three main reasons for opposition to action on climate change. The first reason for not acting climate change is that the science is baseless. And while there are certainly some that believe that to be the case, for the most part, there is agreement in the science of climate change.

The second reason often cited is that acting on climate change will damage the economy and stymy growth. This theory was largely based on the coupling of economic growth and carbon emissions. But now every country in the world is decoupling growth in their economy from growth in fossil fuels. They do not need more coal or oil for their economies to grow.

The fossil fuel industry is not the stable contributor to profit and economic growth that it once was. Rio Tinto, in its most recent financial reports, wrote down $3.5 billion of losses from its coal business. Last week, Glencore took the decision to intermittently close down coal assets in the Hunter Valley due to a low coal price. And according to UBS analysts last week, in the Galilee Basin, Indian coal producer Adani’s projects were declared to be not commercially viable without a much higher coal price. Contrary to some rhetoric, these assets are hardly as safe as houses.

In fact, in January 2012, Australian coal companies were worth around $15 billion but now, these companies are a shadow of their former selves, losing over 60% of their collective worth.

This situation is not unique to Australia. The decline of Europe’s utilities surprised investors. At their peak in 2008, the top 20 energy utilities were worth roughly $1.3 trillion. Now they are worth less than half of that. In 2008, the top ten European utilities all had credit ratings of A or better. Now less than half do. To put that in perspective, that is more than European bank shares lost in value during the same period. Go to China and the United States and you’ll see the same story, with share prices commonly down 50-70% over the past couple of years.

Looking at oil, analysts at Ernst & Young estimate that the world’s energy companies are currently funding 163 upstream projects, worth a combined $1.1 trillion. The majority are over budget and behind schedule. Most big projects have been planned around the assumption that oil would stay above $100 barrel. Oil is currently trading at $78 and the International Energy Agency predicts this range to continue for some time.

Although the published profits of many of the world’s biggest oil majors have remained relatively buoyant this year, they do not reflect the recent fall in the price of crude. And many are highlighting positive cash flows rather than return on investment, which shows a different situation.

Around the world, car use has peaked whilst electric transit and electric vehicles are the largest growth area. Oil-based mobility assets are at a greater risk of becoming stranded.

The main question for industry and analysts is whether the decline seen over the last couple of years is cyclical or structural. The announcement last week, between China and the US suggests the latter. And the subsequent G20 commitments to lead the world in the 2015 Paris agreement for the post 2020 world affirm that. Governments are making these commitments because the market and community responses are enabling them to see that they are on the right side of history. And not being left behind.

Even in West Australia, where I am from, today, Liberal Party Premier Colin Barnett has come out in support of Obama’s speech and has urged Australia to do more.

On the opportunities side, renewables are contributing an increasing part of economic growth. These disruptive innovations are changing global energy markets and contributing to economic growth. Renewable energy has transformed established business models for the energy sector, with lower gross margins and smaller target markets. Despite the 70% drop in renewables investments this year, largely due to political uncertainty, Australia has had stunning growth in renewables in the past decade. 15% of Australia’s electricity now comes from renewables. 1.3 million households now have rooftop solar, including 10% of households in my hometown of Perth. This is growing at 20 per cent per annum despite a low or no feed-in tariff.

Battery costs have come down dramatically and from next year, they will have a big future in Australia as they approach price parity with the grid. The disruptive innovation of distributed energy and storage represents an existential threat to the energy system as we know it.

A new structure is emerging, one that is slowly piecing together a system in which there will be more low-carbon energy sources, more energy suppliers, energy storage and more energy trading across borders. Many will be off grid and others held together by smart grids, which tell consumers how much power they are using, shut off appliances when not needed, and manage demand more efficiently. And it is not so far away.The technology is already here.

There is government legislation in some places that has meant the shift is much further along. On Tuesday 30th September, South Australia had a whole working day in which 100 per cent of the power was sourced from renewables. What is currently happening in South Australia, to the coal and oil industries and the utilities is just a taste of what is to come.

Mainstream financial institutions such as BNEF, UBS and Citigroup are publishing research concurring that divestment is happening and making an impact in shaping outlook and confidence in the market. HSBC research calculated that removing proven and probable fossil fuel reserves from the balance sheets of fossil fuel companies would halve their share market value.

For some, divesting their investments based on sustainability grounds is sparking backlash. We have seen evidence of this recently. Australian National University’s recent decision to sell $16m of stock from a $2 billion fund on sustainability grounds had dozens of negative articles written about them and government criticising their decision.

While there may be opposition, if the economics don’t stack up, it is asset manager’s fiduciary responsibility to act in the interests of investors.

I believe that what we are seeing in energy markets has only just begun. Shareholders will need to ask hard questions of companies who would risk their balance sheet and shareholder capital to new, speculative ventures in fossil fuel projects and infrastructure.

Make no mistake, fossil fuels will be around for some time, but the risk and opportunity landscape has changed. But its not just investments that will be impacted by the transition to a low carbon economy.

There will be less jobs in some areas and more in others. For many this change will not be easy, and we need to be pragmatic about what’s needed in re-skilling our workforce. If Australia does not acknowledge what is going on, we will not properly deal with the changes taking place. The transition is inevitable, but the suffering is optional.

Deloitte Access Economics published research last week, which shows the carbon intensity of the G20 countries GDP. The research was commissioned by the pro-fossil-fuel-lobby, trying to show Australia’s emissions in a more positive light – as being in the lowest quartile of the G20. But it’s poor evidence on that front as it actually highlights, that amongst the G20 developed nations, Australia is the second most intensive emitter of carbon per unit of GDP, after Canada. And it doesn’t factor in that the developing country’s emissions are in large part because of goods the developed world imports and consumes. But what this analysis does show succinctly is a global-mega-trend of decoupling GDP growth and carbon emissions. Economies can and are growing, without a commensurate rise in emissions. So the argument that addressing climate change will harm the economy is also not borne out when you look at the numbers.

Which brings us to the third and last reason for not acting on climate change: other countries aren’t so why should we? It’s the free rider problem. Opponents of action on climate change have always been safe quoting inaction from China and the US as a justification for doing nothing themselves. But now China has declared to the world that it intends to limit its carbon emissions. Yes the targets are open to interpretation and its not as soon as some might like. But it is a massive and significant signal. China is willing to deal and has laid some cards on the table. And the US is doing more.

Which means that the third reason for inaction: That no one else is doing anything so why should we, doesn’t hold true anymore. As Paul Krugman said in the NY Times this week, don’t expect the anti climate change movement to be conceding that a major part of its argument has evaporated. But it has. Last week was a good week for the sectors of the new economy, and a far less certain one for investments tied to fossil fuels.