Imagining the energy transition

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This year’s election, after days of counting and prognosticating, culminated on Saturday Nov 7 with the race called for now President-elect Joe Biden and Vice President-elect Kamala Harris. In contrast with the incumbent, President Trump, the Biden-Harris ticket had laid out a plan to address climate change through policy initiatives, including targeting net-zero emissions by 2050 and investing in resilient and smart infrastructure. Crucially, and most important from my point of view, was the acknowledgement in their policy platform that “our environment and our economy are completely and totally connected” (from the campaign website).

They are right, and because the two are inextricably connected, incentive alignment with respect to addressing climate change ought to be very strong within the private sector (though companies like ExxonMobil seem to think they can overcome these particular market forces). And more importantly, I believe that it will be private sector that generates the most impactful and quickly scalable solutions to climate change, though undoubtedly policy will play a role. I think it’s important to consider the edge along which policy and private sector engage to better understand the various layers and facets of this extraordinarily complex challenge each actor can best address.

A good case study illustrating what I mean by this ‘edge of engagement’ is the current energy paradigm in the US — what our incumbent energy paradigm is, how it came to be and how it has remained the norm, as well as exploring potential other energy paradigms that could come to be in the not so distant future and what is required to bring them about.

First, understanding the current state of energy use in the US is crucial. In the US today, energy consumption is broken down into primary energy sources (petroleum, natural gas, coal, nuclear, renewables) and secondary energy sources (electricity). The primary energy sources are what really matter, because they determine what the secondary energy sources build off of. As of 2019, over a third of our primary energy came from petroleum, and another third came from natural gas. The balance came from coal, nuclear energy, and other renewables, as shown to the left (Source).

Second, understanding which sectors use these energy sources is important, because it can help us understand what challenges exist to replacing incumbent energy sources. In the US, petroleum comprises 91% of transportation energy, 34% of industrial energy, and 8% and 9% of residential and commercial energy, respectively. Natural gas does the bulk of its work outside of transportation, fulfilling 40% of industrial energy needs, 44% of residential energy and 40% of commercial energy needs. Interestingly, about 50% of renewable energy flows into secondary energy via the electric power sector, which goes on to power 49% of commercial and 41% of residential energy requirements. I find the graphic below really useful for understanding how these various systems relate to each other (Source)

Over the short to medium run, phasing out coal and petroleum ought to be priorities and replacing with renewables and nuclear, with natural gas as a transition fuel, should be the ultimate goal. This transition has begun in certain industries, specifically the automotive industry. Tesla obviously comes to mind here as a vanguard driving a shift from petroleum-powered cars to electric cars, but as the Guardian points out, electric vehicles are only as clean as the electricity used to power them. That can be seen from the graphic above, where petroleum, natural gas, and coal supply the energy underlying the electric grid uses to power residential and commercial spaces as well as transportation. As more and more automotive companies bring electric versions of popular vehicles to market (see the Mercedes G Wagon, Hummer, Bentley) moving electric power away from greenhouse gas-emitting energy sources will be crucial.

So how might we do that, and how might we transition other end uses of petroleum, coal and (eventually) natural gas to cleaner inputs like nuclear and renewables? Here are some areas of investigation I would pursue:

1. Understand the infrastructure and systems underlying extraction, processing, and selling of current energy resources and replacement energy sources. This will shed light on how challenging / easy it will be to re-tool or replace these systems in an energy transition. Key questions to ask:

• How is extracted / generated energy stored?
• Is the energy grid updated to accommodate potentially new or novel energy sources? If not, what is needed to make these upgrades?
• Are homes, businesses, manufacturing facilities, etc. equipped to utilize a new energy source?
• What happens to the jobs of people who work in incumbent industries?
• This is a preliminary list as I am sure there are many other questions worth asking

2. Understand the cost of incumbent energy sources from extraction to utilization. Alternative energy won’t be competitive if it’s not at least as cheap as incumbent sources. It’s important to note here that government incentivizes or subsidies for incumbent or alternative energy sources play a role. In a perfect world, markets would be left to surface the most competitive energy source, but in our world, government policy has distorted the market over the years, including by favoring domestic production of oil and gas. Understanding implications of policy for the deprecation of existing tech and the roll-out of new tech is extremely important to making this transition cost-effective and efficient.

3. Understand how much capital is needed to fund a transition to the new energy paradigm. This will hinge mostly on the need for technology development and infrastructure updates, both of which would be capital intensive and high-risk but extremely lucrative over the medium to long-term when the investments pay off. Not all of this capital need or must come from government, and in fact I would argue that private capital has historically played a powerful role in funding world-changing businesses, and ought to here.

4. Understand what second- and third-order consequences the energy transition will have for the market. Then, prepare accordingly by raising capital to invest in new businesses, by starting a company to seize a new opportunity, etc. I can only imagine what software and hardware companies will emerge off the back of and alongside the energy transition, just as myriad enterprise software companies emerged off the back of cloud computing. Those are likely to be great investment opportunities for capital allocators who are wary of the deep technology risk associated with large-scale systems changes.

Understanding some of these areas requires deep technical knowledge and none are likely to come about simultaneously. Neither of these things are an excuse for inaction. In the infamous words of a young Mark Zuckerberg, sometimes the best course of action is to “move fast and break things” — forging ahead in the presence of imperfect conditions or information and solving problems as you go is sometimes necessary for deep, paradigmatic shifts to occur and for the largest markets to be captured.

The current energy paradigm in the US and globally is not sustainable in a world where temperature increases stay below 2 degrees C (and ideally below 1.5 degrees C). If we want to avoid these outcomes, how we get our energy and power our society will have to change. The four big points above indicate plenty of opportunities for businesses, innovation, and capital to make a difference here — for example, by developing energy storage technology, energy grid monitoring tools, new systems for transportation of energy from extraction to use, products that can adapt existing infrastructure for use in new energy regime, and much more. And this would only be the first wave of businesses, as second and third order challenges will undoubtedly emerge that can be addressed by companies.

Are markets the only solution then? Definitely not. There are policy changes that would help even the playing field (removing incentives like the allowance for intangible drilling costs and % depletion v cost depletion that advantage oil) and ease the friction of the human labor transition from oil, natural gas and coal to renewables and nuclear. More importantly, the government could spend a larger share of the national budget on R&D, just like it did back in the 1960s and 70s, and seed a new wave of technology that can be brought to market and made economically valuable by businesses. Too often people forget the role government spending played in the invention and eventual proliferation of the internet, and in turn the billions of dollars of market capitalization and real economic value that have resulted. The return on investment of those dollars is much higher than any subsidy will ever reach and is the most efficient use of tax dollars.

If I believe in anything, it’s in the power of American innovation and the dynamism of markets, which have historically delivered exceptional outcomes for science and technology. The unique combination of intellectual capital, finance capital, manufacturing and production capacity, and consumer power position us better than almost any other country to address the challenges of climate change. Moreover, reducing our dependency on oil would be a win for national security, because it would eliminate incentives to engage in oil-related conflict in the Middle East. Once we have solutions, we can commercialize them globally. This accomplishes three important things: (1) it protects our geopolitical position as a global superpower, (2) it addresses the substantial global challenges of climate change and (3) it proves yet again that democracy and capitalism are the best way.