Energy, Climate change, and long-term investing

A really thought-provoking guest post

Today’s guest post is by a reader who got in touch and offered to explain a few things about the implications of climate change. I found the conversation so interesting that I asked him to write about it for the blog, and he came through in spades. Take it away, Nicolas!

A popular long term investment strategy when preparing for retirement is to regularly buy and hold low-cost world equity funds. The rationale behind the strategy being that because most people wake up in the morning trying to create value, the long-term global market average will go up. And this has been true historically. But what if we were at the edge of a paradigm shift? A physical and social change that would bring a long-term global recession.

The probability of such an event happening in our lifetime is high, and it could come from future climate change mitigation policies and resources scarcity. This would have a material impact on the above investment strategy and would call for new approaches to retirement planning.

The importance and urgency of reducing our green-house gas emissions, and in particular CO2 emissions, to avoid the catastrophic consequences of global warming is on everyone’s mind. An increasing number of countries have pledged to reach net carbon neutrality by 2050 with often some intermediary reduction target of ~50% by 2030 (compared to ~2010s levels).

But most publications focus on the technological bets that are supposed to bring us “green growth”, and not on the real efforts that, more realistically, are necessary to reach carbon neutrality in the next 30 years.

Our civilization is built on fossil fuels

It is important to realize that economic growth, with GDP growth as a proxy, is a measure of how much physical goods are being produced and that this production is a directly proportional to the number and size of machines that we run. In today’s industrial civilization, machines account for ~200 times more production than humans. Stop the machines and the global economy comes to a halt.

Now if we consider that energy is what we feed our machines with, it is not a surprise that the world GDP is almost perfectly correlated with global primary energy consumption.

Our industrial civilization was built in the past ~150 years and exists because of the availability of cheap and concentrated energy in the form of fossil fuels. ~85% of global primary energy comes from fossil fuels that emit CO2 when they burn, and this is why the world GDP is also almost perfectly correlated to global CO2 emissions.

The end of fossil fuels?

Two forces are working to reduce the availability of fossil fuels for our economy.

It is impossible today to dispute the necessity of reducing global CO2 emissions to soften the catastrophic consequences that will come with global warming. The corollary is that governments, corporations, and individuals must do their best to drastically reduce their consumption of fossil fuels, and to reduce it fast enough so that accumulated CO2 emissions stay below the thresholds leading to high global warming.

Looking at past CO2 emissions, IPCC thresholds and the remaining carbon budget one can see that to have an 83% chance to stay below 2-degree Celsius global warming the world must reduce its CO2 emissions by 4% to 5% a year, every year. This is similar to the reduction caused by the COVID crisis in 2020.

The second force is simply that fossil fuels are a finite resource and that their rate of extraction cannot keep increasing forever, which would be a necessary condition to keep an ever-positive GDP growth.

It is oil that is of the most concern. Oil, with its high energy density and its liquid phase at ambient temperature, is the energy of transportation. Without oil globalization would not be possible. The International Energy Agency published in their 2018 “World Energy Outlook” an analysis reporting that conventional oil peak production was reached in 2008. Since then, it is the production of US shale oil that has maintained global volumes at a stable level. The IEA was also predicting “the risk of sharp market tightening in the 2020s”. A different analysis conducted for the French military reported that “The aggregate crude oil production outlook for the sixteen major supplying countries, excluding US LTO, suggests a decline of approximately 12% in 2030, as compared to its 2019 level […]”

A constraint on the availability of fossil fuels is something that we will see in the coming decades.

The fallacy of green growth

There are therefore two levers to cope with the above constraints. The first one is simply to accept and plan for a long-term decrease of energy consumption, and therefore of goods and services production. In other words, a long-term economic recession. This is a particularly difficult solution to put in place as it would require a paradigm shift in the values our societies consider important and drastic changes in our socio-economic fabric. Likely a political deathwish for anyone trying to get elected in a democracy.

It is therefore not a surprise that we mainly hear about the second lever, usually called “green growth”, which is about decoupling GDP growth from the use of fossil fuels. The goal being, through a large and fast enough deployment of new technologies, to not only replace all our energy needs by low-carbon ones but to also sustain infinite GDP growth in a fully decarbonized society.

The realization of “green growth” usually relies on 3 major concepts: the electrification of everything that can be electrified (cars, heating, industrial processes…), the deployment of low-carbon power generation (renewable energies and nuclear), and the reliance on new technologies for everything else (green hydrogen, biofuels, Carbon Capture Usage and Storage…).

Green growth however has two major physical limits.

The first one being the availability of resources to deploy the necessary technologies at scale. The IEA casts some serious shadows here and  wrote in a recent report that there is a“[…] mismatch between the world’s strengthened climate ambitions and the availability of critical minerals[…]”. This also applies for the availability of land. Land cannot be used to feed a growing global population, and to produce biofuels, and for the deployment of solar PV at the same time.

The second is the speed at which new technologies can be deployed compared to the rate at which CO2 emissions must be curbed. It would be reasonable to question if the production of green hydrogen, CCUS technologies or nuclear fusion can be deployed at scale in the next 3 decades.

Reducing our consumption is inevitable

To have an 83% chance to stay below a 2-degree Celsius global warming the world must reduce its CO2 emissions by a factor ~4 by 2050. Looking at past data and Kaya’s identity offers a way to understand the impact of meeting this goal on our economy.

If CO2 emissions must be divided by 4 in the next 3 decades, the right part of the equation must also be divided by 4. A closer look at each term shows that this will very likely require a global reduction in GDP per Capita:

• World population is expected to grow by ~30% by 2050 (UN)
• The Energy intensity of GDP has been reduced by ~35% in the past 30 years (data) and we could reasonably expect a similar outcome in the coming 30 years. Energy efficiency is an engineering problem and given its impact on companies bottom lines it is usually a priority in the corporate world. We can therefore expect sustained efforts on this topic in the coming years.
• It means that the GDP per Capita X Carbon Content of Energy must be divided by ~3.4 by 2050 and that any effort that is not done on one must be done on the other

If we want to keep the same GDP per capita for the next 30 years (no economic growth), the Carbon Content of Energy must therefore be divided by 3.4 in the same period, or a reduction of 70% vs current levels. In the past 30 years it was only reduced by 6%, despite the “new renewable boom” of the last decade and the development of nuclear capacity.

Another way to look at it is that relying on technology to “save us all” from climate change and the decline of available fossil resources is an extremely risky bet. More likely than not we will have to reduce our consumption and we can therefore reasonably expect global economy to enter a durable recession in the coming decades. The question is to which extend we will plan for it and collectively arbitrage between the services and goods we want to do without. For what we do not plan for will be imposed on us.

Back to investing

We should therefore prepare for a world in a long-term recession. Long term average global equity market growth is likely to come to an end. The standard investment strategy of buying low-cost world market trackers might not be a safe one anymore and new investment strategies might be necessary.

The remaining questions are about timing; how long do we have in front of us before the repeated shocks or controlled de-growth bring a long-term recession? And which industries are likely to bring the most value in a low carbon world?

Or maybe it would be safer to prepare for retirement through other means, for example owning a property that requires little energy in a place that will be less impacted by the increasing cost of energy. Or even better, developing one’s sense of frugality is the easiest and most impactful strategy of all.

About the author

Nicolas has been in Japan for 15 years and is an avid reader of RetireJapan. He started Carbon50, a Tokyo based consulting company specialized in the Japan Power Industry and the access to and monetization of renewable energy. He also teaches about energy and climate change.