A few days ago, Bloomberg ran an article entitled “Global Energy Crisis Is the First of Many in the Clean-Power Era”. The newspaper argued that “the next several decades could see more periods of energy-driven inflation, fuel shortages and lost economic growth as electricity supplies are left vulnerable to shocks.”
Indeed, the current energy crisis is the first (and surely not the last) of the clean-power transition era. However, the mainstream focus on why the world has been seeing an increase in energy prices has been on the supply and demand forces, rather than on the type and productivity of the energy sources that are being changed in this transition process.
The supply and demand argument can be summarised as such: as the global economy re-opens and recovery is speeding up, demand for energy is increasing to sustain the upwards momentum. “Electricity demand is heading for its fastest growth in more than 10 years” wrote IEA in its 2021 Global Energy Review.
However, as Goldman Sachs’ Global Head of Commodities has explained in a recent interview, “[…] supply chains are so severely depleted, the system cannot accommodate any type of disruption.”
As a result, the world’s energy markets are imploding: “British gasoline stations running dry, surging power costs in the European Union ahead of winter, forced restrictions on energy use in China and rising oil, natural gas and coal prices”, wrote Reuters in early October.
Note that this disruption is not confined to energy markets only. Indeed, different types of supply chains around the world are under substantial strain. From consumer goods to food and energy, supply is failing to keep up with recovering demand in many places around the world, including in key economies like the United States, Europe and China.
Although looking at the economy and its sectors through the lens of supply-demand analysis can yield great insights, when it comes to the energy market there is a factor which is often overlooked when assessing the causes of disruption.
This factor is called exergy.
I became familiar with the notion of exergy during my years at Woodford Investment Management, through the work of MacroStrategy LLP. Exergy is a complex concept from the world of physics but, when we apply it to economics, it is the capacity of energy to do physical work.
As Niels Jensen from Absolute Return Partners LLP wrote in his book, “The End of Indexing”, “think of exergy as productivity.”
More specifically, exergy can be viewed as how productive a type of energy is. In other words, how much economic output can you generate per joules produced from a certain type of energy source?
I explained in more detail how investors can implement exergy in their assessment of whether energy is used productively or not in my research report, “Debt, Energy and Productivity”. However, here is sufficient to highlight that if the production of energy is not productive (i.e. it does not pay for itself by generating a greater economic output than the costs needed to extract, transform and transport the energy), then that is not a process which can be sustain for the foreseeable future through economic growth alone and an ever increasing debt level is required.
Importantly, not all energy sources are equal in terms of their exergy (productivity). Fossil fuels are typically more efficient than greener alternatives, like wind, solar and hydro. However, the exergy of fossil fuels diminishes as we dig deeper in order to extract them as it requires more energy to extract the same amount of fuels.
Nevertheless, as the [developed] world continues to transition towards green energy and ditch fossil fuels, the economic output per joules produced is likely to go down.
A recent analysis from Nordea also highlights this. It takes the case for Germany, a country which has been a European leader in the transition towards greener energy sources.
Its policymakers “decided to end the nuclear capacity as soon as possible with a potential end-date during 2022. Capacity in nuclear production has since gone from >10% of German energy consumption to levels below 5% currently, with wind energy and natural gas as the replacements,” writes Nordea.
However, this increasing reliance on wind and natural gas came with risks which surfaced in recent weeks. The most obvious one being a disruption to economic activity which may likely translate in lower GDP figures.
“We have seen similar developments in countries such as Sweden and France, which has left the European electricity grid vulnerable should the wind not blow. Windfarms have produced 30-40% less electricity Y-T-D compared to a normal year, which paired with a structurally distressed supply chain has chased energy input prices up into the stratosphere with continued bizarre daily price increases in both natural gas, coal and oil at the moment.”
To contextualise the above analysis, take a look at the insights provided by Niels Jensen in July 2019:
“In Europe (I do not have corresponding numbers from the US), every 1% increase of wind and solar in the energy mix has raised electricity prices by more than 3%”
“This is (in economic terms) an absurd misallocation of capital and is one of the key reasons why GDP growth continues to decelerate. According to BP World Energy Statistics, between 2000 and 2016, about $3 trillion was invested in renewables and a further $1 trillion in network upgrades to support the switch to renewables.
Furthermore, according to Bloomberg, between now and 2040, no less than $7.4 trillion will be invested in renewables worldwide. In other words, the vast investments over the last couple of decades is only the beginning.
In the highly leveraged world we all live in, we need GDP to grow robustly. Otherwise, we won’t be able to service the debt we are saddled with.”
This link between energy, debt and productivity is an important piece of the macroeconomic puzzle which not many investors are aware of.
If energy is not productive, i.e. the cost of producing it outweighs the economic benefits from consuming it, then growth will suffer and the cash flows needed to sustain the increasing levels of debt around the world will stagnate, leading to stress in credit markets (unless central banks step in, but the power of central banks’ policies is limited by inflation which has been picking up recently).
Exergy is the key to understanding this dynamic between energy, debt and productivity which will become far more important in the years ahead, as the transition away from fossil fuels and towards greener alternatives continues.
Thank you for reading.