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Energy is a big challenge for investors

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The writer is a financial journalist and author of “More: The 10,000-Year Rise of the World Economy”

If 2022 has shown anything, it’s that the abundance and price of energy is vital to the health of the global economy.

The Industrial Revolution that emerged in the 18th century had many causes, but the essential prerequisite was the replacement of human and animal power with a carbon-based fuel in the form of coal. In the 19th and 20th centuries, the global economy was transformed by the use of oil in transport and elsewhere and the use of electricity.

In modern times, the post-1945 recovery in Europe and the US was fueled by a quarter century of cheap oil. The tilt toward stagflation in the mid-1970s was associated with a quadrupling of oil prices by OPEC in 1973, and the recovery in the 1980s coincided with another drop in oil prices. Finally, there was another rise in the price of oil before the financial crisis of 2007-09.

The current climate combines a sharp rise in energy prices with supply constraints in the form of restrictions on Russian gas exports to Western Europe. If this is an echo of the 1970s, it is also the current combination of soaring inflation and sluggish economic performance.

Part of this volatility is related to the concentration of energy resources within the borders of authoritarian and occasionally hostile nations in Russia and the Middle East. It can be seen as a geopolitical joke – a variation on the “resource curse”. If a country has energy reserves, it creates the potential for a dictatorial regime to seize those reserves and stay in power.

All this means that any attempt to take a long-term view of the outlook for markets or the economy must take into account the likely development of energy prices and the nature of energy supplies. History is encouraging that in the medium term, price spikes sow the seeds of their own destruction. Either demand adjusts (for example, consumers switched to more fuel-efficient cars after the 1970s), or producers are inspired by high prices to find new sources of supply (such as shale oil and gas).

But the current crisis has struck as the world struggles to deal with another problem: climate change. And many countries have set ambitious targets to reduce their dependence on fossil fuels by mid-century. This policy will require remarkable changes in the way the world organizes its economy.

In his book How the world really works, energy expert Václav Smil points out that modern food production is heavily dependent on fossil fuels, especially through nitrogen fertilizers, which increase crop yields. As a result, the world has gone from providing adequate food for around 890 million people in 1950 to 7 billion people in 2019.

It would not be possible to support so many people with an agricultural sector dependent on recycling organic waste. Switching from a meat-based diet to a vegetarian one might help a bit. But some plants, such as tomatoes grown in heated greenhouses, have very high energy requirements.

Smil also points to the vast amount of energy used in the production of plastics (essential for the healthcare industry and many others) and the production of steel and concrete, which are essential for infrastructure. Wind turbines can offer an alternative to fossil fuels as an energy source. But their foundations are built of concrete, the towers and rotors are made of steel, and the blades are made of plastic resin.

All of this may explain why politicians are so quick to promise a reduction in fossil fuel consumption at some distant date and so slow to push for practical measures to reduce fossil fuel consumption immediately.

Even willing governments are trying to make a dent in the problem. Despite an extensive renewable energy production program, Smil writes that the share of fossil fuels in Germany’s primary energy supply has only fallen from around 84 percent in 2020 to 78 percent today. Even after all the international protocols and summits, global fossil fuel consumption increased by 45 percent in the first two decades of the 21st century, largely due to China’s economic growth.

Even if the technical challenges involved in converting to new forms of energy could be overcome, the initial capital investment would be enormous. And there is vigorous debate over whether new energy sources will be more “efficient” (in terms of energy return on energy invested) than old ones. In short, the economic impact of trying to transition to net zero carbon emissions could be huge.

Investors cannot afford to ignore this problem. But they must make a difficult calculation of whether governments will try to meet their carbon targets or back down in the face of a hostile electorate. And if governments renege on their promises, investors must then calculate the extent to which climate change damage (crop failures, flood damage, disputes over scarce water resources) will disrupt economic growth. Making the right energy call is a big long-term decision.

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