Decarbonisation: A doubter’s guide for conservative investors

Chris Leithner

Leithner & Company Ltd

In December of last year, Livewire “surveyed more than 4,000 investors and learned that 62% of them intend to invest in decarbonisation in 2022. That was double the level of interest of any other megatrend.” Its latest Megatrends Series, Decarbonisation 2022, “unearths the funds, ETFs, and experts leading the charge to Net-Zero.” One contributor asserts: “climate represents a significant long term investment opportunity.”

Conservative investors beware: these opinions and survey results reflect disregard of history and overconfidence about the future – and thus presage trouble. Advocates of “the world’s biggest thematic right now” will, if past is prelude, likely generate disappointment and perhaps hefty losses. As Benjamin Graham warned in The Intelligent Investor: “… on Wall Street, (enthusiasm) almost invariably leads to disaster” (see also Why you’re probably overconfident – and what you can do about it). Are crypto-currencies and FAANG stocks the latest examples? Will decarbonisation suffer a similar fate?

Education
Why you’re probably overconfident – and what you can do about it

Four Doubts

In this article, I make four sets of points:

  1. Proponents of decarbonisation are adamant that it’s a megatrend. In contrast, I show that (a) current attitudes towards decarbonisation may be a fad; (b) decarbonisation of electricity generation in Australia and elsewhere is clearly a trend; (c) decarbonisation of total consumption of energy isn’t clearly a megatrend.
  2. Decarbonisation advocates regard it as inevitable. Yet megatrends have often been “predictable” only in retrospect. Moreover, only two things in life are certain – and one (mega)trend can delay, divert or even extinguish another.
  3. Boosters strongly imply – and sometimes boldly assert – that decarbonisation will enhance investors’ returns. This, too, is doubtful. Megatrends’ results have often fallen well short of proponents’ hype – and have sometimes become megabusts. Remember the collapse of the Dot Com bubble?
  4. The world’s greatest investor, Warren Buffett, hasn’t boarded the decarbonisation bandwagon. What do its boosters purport to know that he allegedly doesn’t?

Let’s Clarify Our Terms

It’s important to distinguish a megatrend from a fad, micro- and macro-trend (Michael Haberman, “Can You Tell the Difference between Fads, Micro Trends, Macro Trends and Megatrends?” 5 February 2016).

Fads

A fad is anything whose attractiveness or prominence rises and falls quickly and often unexpectedly. Fads typically attract relatively small groups, particularly of young and impressionable people, but sometimes affect significant swathes of society. Clothing and hairstyles, foods, exercises and dances and music are particularly prone to fads. They may last as long as a couple of years, but usually leave no lasting effects. Is decarbonisation a fad? Attitudes – including those of financial market participants – are often shallow, fickle and ephemeral. In this subjective sense, today’s interest in decarbonisation (as opposed to its objective extent in the real world) may be a fad: time will tell.

Micro- and macro-trends

Trends develop more slowly than fads, but affect many (or most) people or occur on a much wider scale. A micro-trend seems to last roughly 3-5 years; a macro-trend perhaps 5-10. It takes longer to develop, but once it does its presence is generally durable. The popularity of specific social media applications (Instagram versus Snapchat, Yelp versus Zomato, etc.) may tend towards the “fad” end of the spectrum, whereas social media as a whole (IT applications that enable users to create and share content or to participate in social networking) is clearly a macro-trend. But is it a megatrend?

Megatrends

If trends develop more slowly than fads, megatrends take even longer to develop (or become noticeable). If trends and their effects last for years, megatrends’ endure for decades. And if fads are superficial, megatrends are subterranean; for this reason, although they profoundly influence entire populations, many people can long fail to notice them. As an analogy, fads come and go quickly, like thunderstorms; trends’ effects last much longer, like droughts; and megatrends, like climates, evolve most slowly but pack the most powerful punches. The Copenhagen Institute for Future Studies’ definition is oft-cited but contradictory: “megatrends are the probable future – or express what we know with great confidence about the future. Megatrends are certainties.”

That’s the crucial problem: given human beings’ abject inability to predict the future (as well as their repeatedly demonstrated talent to “mispredict” it), investors shouldn’t uncritically accept the assertion that decarbonisation is a megatrend. More generally, the greater is boosters’ and alleged experts’ confidence, the stronger should be investors’ scepticism (see also Experts can’t predict yet investors must plan: What, then, to do?).

Education
Experts can’t predict yet investors must plan: What, then, to do?

Megatrends in the 20th century and beyond

A megatrend is a development (or cluster or series of events) that over years and decades change countries and the world fundamentally and irreversibly. During the 20th century in Australia, my list includes (in no particular order of importance):

  • The eclipse (in economic and military terms) of Britain and the ascent of the U.S.;
  • The rise of the welfare-warfare state (and the associated rise of central banks and fiat currencies, demonetisation of gold and explosion of debt);
  • Mass immigration from non-English-speaking countries;
  • (Sub)urbanisation;
  • The revolution of personal transport (from horse to motor car and aeroplane) and communications (from local newspapers to national radio and television to the global Internet) and
  • The decline of manual labour and advent of leisure.

Buttressing these megatrends were others, such as the rise of mass affluence (see, however, America’s permanent recession: Is it coming to Australia?). Underwriting greatly rising standards of living, which spread to many parts of the world by the last quarter of the 20th century, were revolutions in agriculture, public hygiene and personal health (which reduced morbidity and extended lifespan, and thus created ageing populations). And underpinning all of these and more was the unceasing advance of technology – in recent decades, particularly of digitisation.

Megatrends are predictable, or become clear, mostly in retrospect. They can take years to germinate from trends into megatrends, but only a few trends become megatrends. And the boundary between trends and megatrends isn’t hard and fast: was the secular decline of CPI and rates of interest (and related rise of asset values) from the late-1970s until very recently a megatrend? Has it concluded, and are we now witnessing the birth of a trend (or perhaps even megatrend) towards higher CPI and rates – and lower asset prices? If so, how will these developments affect decarbonisation?

It’s important to emphasise that one megatrend can blunt another. Decades ago, some people identified China’s rise as a megatrend. Today, however, it’s hardly obvious that it will continue – at least along the same path as hitherto. It’s widely accepted, not least by the Chinese, that China soon faces a demographic crisis. As a result, it’s increasingly likely that the country as a whole will grow old before it gets rich. If so, then the Communist Party must resort to increasingly authoritarian rule to protect anointed insiders against benighted outsiders – and perhaps take a leaf out of America’s book by using foreign policy adventures as distractions from domestic difficulties.

In China and elsewhere, it seems likely that one megatrend (ageing population) will to some extent counter another (economic expansion). Might decarbonsation – assuming that it’s a megatrend – experience the same fate?

In the West as well as China, will the explosive rise of debt slow or halt the megatrend towards mass affluence? Similarly, the globalisation of trade has been closely related to China’s rise. But in the wake of COVID-19 and the Russo-Ukrainian war, it’s reasonable to wonder whether it, too, will abate or alter its course. If so, and if rising CPI and interest rates, “partial deglobalisation” and demand for energy security become trends, will they delay, retard or even reverse decarbonisation? 

Surfing megatrends doesn’t guarantee great returns

Few people would disagree: China’s rise, first in economic-financial and subsequently in diplomatic-military respects, qualifies as a megatrend. Its ascent has clearly been multi-faceted. Hence the crucial question: might the risks to investors arising from China’s growing use of its diplomatic and military clout alter, hinder or even extinguish other megatrends (such as globalisation and decarbonisation)? Apart from sheer speculation, these questions are currently unanswerable. Moreover, answers won’t be evident for years. However, what’s presently known are the long-term returns from investments in China’s major market indexes.

Figure 1 plots that country’s two main stock market indexes from their starting dates in 1997 until April of this year. It compares them to the S&P 500, and to facilitate the comparison it gives to each index a common base (August 1997=100). Consider the investor who in that month purchased a portfolio of securities that perfectly reflected a Chinese index, rebalanced every month and ignored the costs of these transactions. She did extremely well for a time: the investments of $100 in August 1997 peaked at $497 (Shenzhen) and $499 (Shanghai) in October 2007. Those are clearly excellent long-term results.  

Figure 1: Three Indexes (Shanghai, Shenzhen and S&P 500), August 1997=100

Yet it’s unlikely that many investors received such returns. Over their first nine years of existence, the Shanghai index rose just 1.2% per year and the Shenzhen index 4.7% – and from 2000 to 2005 generated compounded losses of almost 9% per year.

How many would have held throughout the nine dry years in order to reap the spectacular harvest in the tenth? Probably just a few – but many, goaded by “experts” and the specialist managed funds that grew like mushrooms in 2006-2008, enthusiastically boarded the China bandwagon. Alas, those who did so suffered gut-wrenching losses of 70% from the peak in October 2007 to the trough in October 2008.

Those who bought at the nadir and held until May 2015 did very well; but those who bought at that time lost ca. 50% of their investment during the next three years. Those who bought at the pre-GFC peak lost over 40% over the next 13 years.

Over selected long intervals, a few “outside” investors in China funds have no doubt reaped huge rewards – and many more, egged by “experts” and buying at the peak, have suffered large losses. The key point, however, is that over the past quarter-century investors in the Shenzhen index have generated a compound rate of return of 3.9% per year; those in the Shanghai index received 4.8% per year. Investors in index funds that perfectly mimicked the S&P 500, on the other hand, would have comfortably outpaced them (6.6% per year).

Those are slim pickings from a megatrend! Similarly, will investors in decarbonisation – assuming that it’s a megatrend – will receive returns that fall far short of their current expectations?

Decarbonisation: Fad, trend or megatrend?

“Decarbonisation,” says TWI Global, a British consultancy firm, “is the reduction of carbon dioxide emissions through the use of low-carbon power sources.” It “involves increasing the prominence of low-carbon power generation, and a corresponding reduction in the use of fossil fuels. This involves in particular a use of renewable energy sources like wind power, solar power, and biomass. The use of [CO2] can also be reduced through large-scale use of electric vehicles alongside ‘cleaner’ technologies. Decreasing carbon intensity in the power and transport sectors will allow for net zero emission targets to be met sooner and in line with government standards.”

By this conception, which exaggerates the importance of renewables (see below), since the early-2000s the generation of electricity in Australia has been decarbonising. Moreover, it’s occurring at an accelerating pace.

Figure 2: Generation of Electricity in Australia, by Source as a Percentage of Total, 1980-2020

Using data compiled by the Energy Information Administration, an agency of the U.S. Department of Energy, Figure 2 disaggregates the production of electricity in Australia into two categories: fossil fuels (i.e., coal and gas), hydro and non-hydro intermittent (i.e., solar and wind). The percentage of total output generated by burning fossil fuels rose from 85% of the total in 1980 to 92% in 2002. This percentage rose because hydro power’s share halved from 15% in 1980 to 7% in 2002 (in that year, non-hydro intermittent output was just 1% of the total). Since the early-2000s, in contrast, fossil fuels’ share of power production has dropped steadily – to 75% in 2020. In that year, hydro produced 6% and solar-wind 18%; collectively, then, these renewables’ share of total output of electricity rose from 8% in 2002 to 25% in 2020.

How does this definition of decarbonisation overstate renewables’ importance? “Electricity” and “energy” aren’t synonyms. All electricity is energy, but not all energy is electricity; electrical power, in other words is or subset of – and but one form of – energy. 

In 2020, intermittent sources provided one-quarter of Australia’s electricity but much less of the country’s total consumption of energy. That’s because coal, gas and oil enable transport via air, rail, road and sea; they also heat homes and offices, and are essential inputs for agricultural and mining production and the manufacture of countless things. Many and various activities, which are essential to modern life, consume vast quantities of energy – of which intermittent sources supply little.

Solar panels and wind turbines currently generate a growing, significant but still minor percentage of Australia’s electricity, but little of its total supply of energy. During the next decade or more, that’s likely to remain the case – and thus significant decarbonisation in this broader and more fundamental sense is hardly certain to occur. If so, can it qualify as a megatrend?

Figure 3a: Australia’s Total Consumption of Energy, by Source as a Percentage of Total, 1965-2020

Figure 3a quantifies this critical reality. In 2020, renewables supplied just 10% of Australia’s total consumption of energy – and fossil fuels 90%. Fossil fuels provided nine times more than intermittent sources of this country’s total energy needs. Figure 3b disaggregates these sources. Coal’s and oil’s shares have fallen from 48% each to 30-35% each; gas’s has zoomed from nothing to almost 30%; and more recently, solar and wind’s has risen from nothing to ca. 7% (hydro comprises another 3%).

Figure 3b: Australia’s Total Consumption of Energy, by Components, 1965-2020

Many of decarbonisation’s boosters disparage Australia as a laggard and laud Germany as a leader. Over the past half-century, fossil fuels have comprised a steadily-falling and renewables (importantly, including nuclear) a steadily-rising percentage of Germany’s total consumption of energy (Figure 4a).

Figure 4a: Germany’s Total Consumption of Energy, by Source as a Percentage of Total, 1965-2020

Yet in 2020 fossil fuels provided a large majority of its energy. Indeed, they supplied three times as much (75%) as renewables (25%). “Green leadership,” it seems, includes nuclear power and necessitates continued heavy reliance upon fossil fuels.

Figure 4b disaggregates 4a’s data. Coal’s share has collapsed from more than 60% in 1965 to less than 20% in 2020. The bulk of this decrease occurred before 2000; since then, its pace has greatly abated. Oil’s share, in contrast, has fluctuated but not budged: it was 35% in both 1965 and 2020. And gas’s share has risen from virtually nothing in 1965 to more than 25% in 2020. Nuclear’s share rose from 0% in 1965 to more than 10% by the early-2000s; since then, however, it’s halved. Finally, solar’s and wind’s combined share has increased from virtually nothing in 2000 to 13% in 2020.

Figure 4b: Germany’s Total Consumption of Energy, by Components, 1965-2020