Old versus new world economics in transitioning energy markets
Attending an energy conference a few months back, I found myself listening to a presentation by some European presenters outlining the capital work underway in converting the ports of Rotterdam and Bruges to facilitate hydrogen receivals. I was surprised on a couple of fronts. Firstly, that investment was underway now in hydrogen port infrastructure – well before meaningful volumes of hydrogen are being either commercially produced or shipped anywhere in the world. Secondly, that investment was backed largely by commercial capital. This surprise was reinforced over subsequent weeks in discussions with a range of other sophisticated capital providers and industrial asset managers who were investing equally in energy related technology projects where the investment case was difficult to construct when viewed through the lens of old-world economic principles. These interactions got me thinking whether we were amidst a shift from old to new-world economics in transitioning energy markets.
Old world economics driven by the rules of Net Present Value
In old-world economics, an investment would require a well-constructed business case where the return on the invested capital provides a payback more than the up-front investment over a reasonable period of time – frequently represented by an investments Net Present Value (NPV). Assumptions around addressable market size, sales price realisation, and costs of production and distribution are core building blocks for this investment case. Rarely do investments happen in a cocoon, and so these key valuation assumptions are built around assessment of viable next best alternatives for consumers of the proposed investment.
The role of government to support investment for the public good
If investment returns are not attractive to a commercial investor, but the proposed investment is deemed valuable for the common public good, then public money managed by governments is required to supplement commercial investors if the investment is to proceed. In Australia, key government agencies providing this public funding support into the transitioning energy markets include; (amongst others) the Northern Australian Infrastructure Fund (NAIF), Clean Energy Finance Corporation (CEFC), and Australian Renewable Energy Agency (ARENA).
Motivators for investing in higher cost alternatives to the current state
The transition to lower carbon energy alternatives is often only achieved at higher costs than existing energy solutions. In some cases, this higher cost differential relative to the current state will be reduced over time through increased economies of scale and continuous technology learning benefits. Commercial investors may be willing to invest in otherwise unattractive investments understanding the benefits of scale and technology learning will improve investment outcomes over time. Alternatively, investment may proceed with support from public funding when the scale and technology learning effects progress for the benefits of many other producers and consumers. Finally, a shift in government regulation (such as a regulated carbon tax, or legislating against the sale of internal combustion energy (ICE) for transportation) may remove the viability or cost of the current energy solution, thereby supporting the higher cost of the new energy alternatives.
Science will influence aspirations and end-use applications for hydrogen
Having been bred on the principles of old-world economics throughout my career, I have been puzzled by how and why sophisticated commercial capital is committing to transitional energy projects where traditional investment cases appear challenged. This brings me back to the hydrogen investment underway in locations such as the Rotterdam and Bruges ports.
Current ‘green’ hydrogen technology delivers full lifecycle energy production costs well in excess of existing carbon energy alternatives. Scale and technology learning will play their role in reducing this ‘green’ premium. However, hydrogen thermodynamics remain part of the field of science and related energy losses during phase changes and/or in combining/stripping hydrogen in ‘carrier’ chemicals (such as ammonia) and places scientific limits on how far scale and learning curves will play a role. Science will influence future cost aspirations and end-use application suitability for hydrogen.
Self-regulation versus legislated regulation underpins new energy economics
Is the current investment in hydrogen projects heralding the emergence of new energy economics? On closer analysis, I don’t think so – albeit underlying drivers of self-regulation supporting investment are somewhat different from traditional economic drivers of legislated regulation. Regulation plays an important role in adjusting and shaping the rules of an otherwise free market game. The most common example of this at play is import tariffs and trade barriers impacting international trade and providing economic support to in-country supply options relative to offshore competitors. The consequence of regulation impacts final price to consumers as they are almost always higher than the free market alternatives.
New world energy economics is heavily dependent on a looser form of community or societal self-regulation dressed up in publicly committed carbon reduction targets by specific timeframes. Rather than legislating, Governments are playing a supportive role of reinforcing broader community expectations of carbon reduction targets increasingly expressed in Environmental, Social and Governance (ESG) policy.
High compliance to self-regulation is key to maintaining viable and vibrant capital markets in new energy
So what are the implications of community/society led self-regulation versus government legislated regulation? High compliance to a common approach to self-regulation can imitate the impacts of government legislated regulation and create new viable commercial markets that would otherwise not exist without (self) regulation. As an example, self-regulation of carbon reduction targets is creating new markets and enabling sophisticated commercial capital to participate in new low carbon energy investments. Albeit there is a big caveat! It is crucial that there is a high degree of compliance with self-regulation otherwise those who choose not to self-regulate are likely to enjoy a competitive advantage (on a like-for-like basis) relative to self-regulators through lower costs. Over time, non-compliance to self-regulation increases pressure on existing self-regulators to defect to recover their lost competitive advantage and defection can risk unravelling the self-regulated market. Therefore, the risks to commercial capital in a self-regulated market are higher than in a government legislated regulated market.
The dual motives for transitioning energy
The reality is that transitioning energy markets are now being driven by dual motives. The first motive of reducing the impact of carbon on human induced climate change is shared. However, sophisticated capital is strongly motivated by ensuring a high community compliance to self-regulation of carbon reduction targets to support vibrant investment markets in new energy that may otherwise not exist. Regardless of motives, the predictable outcome of ‘energy embedded’ inflation is well underway.
Role of government in transitioning energy market could change
In this self-regulated market that is attracting commercial capital at scale, what role should governments play to continue the transition of energy markets? At a very minimum, governments should support strong compliance to self-regulation and signal their willingness to step in with hard regulation, in part or whole, if needed to underpin commercial investment. This should continue to support vibrant commercial capital investment in new energy solutions. The role of government as a (joint) financier for the common public good could subside. The focus for government could shift to how to provide the insurance policy should the timing of retirement of old and investment in new energy not be matched as planned and hoped.
