Confluence: What happens at the intersection of the Energy Trilemma, Capital & Politics?.. Part II: Capital
Financial Capital’s Context in Energy Investment
In Part I of the Confluence series, the aim was to establish a grounding first pillar in the energy trilemma confluence . To re-iterate, the energy trilemma is the conundrum that society has to put its collective power in coordinating and establishing an energy system that is secure, affordable and low emission. This discussion meant appealing to energy’s physical properties which have the outcome of core practicality to how the energy system works and the constraints limiting the options available based on current technology. We therefore now proceed to join this up with the next dose of reality which is capital. Capital here is being defined around the financial capital that enables activation of the two broad factors of production i.e. labour and land.
Capital is an inherent reality but in a different way to the energy physicality and provision side because there is a wider degree of “engineering” possible which is not constrained by physical boundaries the same way the energy value chain is. A wider spectrum of inputs and outcomes are available to engineer how capital flows to energy related projects. Some of the reasons capital now has this degree of increased flexibility among others is the aggressive globalization of the world economy and the modern era monetary system that is fiat and no longer tied to gold as backing for cash capital value as it was in the Bretton Woods era from 1944 to 1971 . Furthermore, the overlaying of internet technology today has allowed capital flows to occur virtually instantly particularly between centers of the world plugged into the capital machine . However, it must be noted that this same internet connectivity has added a degree of intensified virality to how news and therefore financial impacts can spread.
The combination of these backdrop characteristics has allowed capital to be deployable towards virtually any cause or area where the prospect of returns on investment is considered favorable. However, they have also set up a situation where financial capital in the global economic system can more readily and easily disconnect from physical fundamentals via speculation on said returns which unlike previous moments in history, is markedly more convenient to indulge.
This context is matters in terms of what it means for capital’s movements and how or whether the way capital moves indeed addresses the trilemma as opposed to simply generates return - normally or speculatively. Energy investment requires large amounts of capital for which return is a long-haul matter both directly for private capital and indirectly in the case of capital deployed by the state in creating foundations for economic prosperity. These two areas of privately deployed capital in the energy value chain versus the state deployed capital bring two broad lenses regarding the way capital then practically manifests in the energy financing landscape and how this relates to actually addressing the trilemma.
Financial Capital in Energy & Returns
Private capital, as widely known, looks for return. Of late this return has absorbed a wider mandate of what is classified as return as ESG mandated capital deployment has continually gained momentum. But ultimately, this still boils down to returns because in order to justify investment, the capital must reward the investor(s) for the opportunity cost forgone of not having deployed their funds elsewhere. Therefore, even the altruistically intended approach of giving more priority to the ESG theme will still boil down to whether this will yield returns. Furthermore, particularly for stock exchange listed capital deployed , the performance pressures are high in the short term which means other mandates beyond direct financial returns can easily take a back seat.
The other important consideration in the capital landscape is that theoretically, the action of attracting capital to be deployed and what happens in valuations effectively acts as a method of rewarding entities working on projects and business models that the investment landscape believe to warrant future return. This means that one of the benefits that ends up accruing to society as a whole, when actively managed for governance and exploitation that is, is that access to capital is directed towards societal solutions which end up getting cheaper to deliver as critical mass builds up. This is emphasized for overarching technological solutions that truly and broadly progress human living conditions such as those relating to or adjacent to electricity, water management, medicine, transport, food and agriculture provision. 2022 global energy investment is estimated to have been approximately $2.5tn with approx $1.4tn of this being in what is classified as clean energy investment. These figures are comparable to approx 3% and 1.5% of total global GDP respectively. While this seems relatively small compared to other areas where investment and venture capital is pouring at a larger scale such as software, this investment for better or worse, facilitates the consumption oriented global economy we experience today.
Financial vs On-The-Ground Returns Decoupling Risk
With all this backdrop in mind, the concept itself of “yielding return” brings its own complexity in the case of listed companies because there is the aspect of “on the ground” returns in terms of the actual earnings and profitability of participating in the energy value chain compared to the stock market returns which are a combination of share price changes and dividends earned (if there is indeed cash for dividends). This dynamic of how returns maybe earned muddies the waters as to whether capital deployed in the energy value chain during this transition period achieves the on the ground capital return goals it aims to achieve as the two natures of return can easily decouple i.e. returns earned with observed actual cashflows vs returns earned by share prices which would be effectively building-in future prospects of cashflows. One useful way that this shows up can be by looking at relative variations of Price-Earnings (P/E) Ratios where at the most basic level, Price per Share is divided by Earnings per share to give a reflection of the amount of time over which the company would need to sustain its current earnings in order to make enough money to pay back the current share price. This tends to be quoted in the context of being in the toolset of measures to determine if a share is over or undervalued but in this context, we are saying that seeing relative PEs allows us to peak into the extent of potential disconnect between how the share is valued compared what it’s on the ground earnings are.
A key question to ask when trying to relate to and assess the decoupling that tends to occur in our capitalism system as it expands relates to some of the old and almost cliche ideas posited by Michael Porter in his 5 forces of Industry Competitiveness. The premise here being that making an above market rate return on capital should be underpinned by a net set of circumstances shoring up competitive advantage e.g., barriers to entry because of significant entry and participation cost, intellectual property, brand strength etc. Therefore, if in this energy value chain capital return on the ground is disconnected from say share performance then that gap must be assessed through this lens to establish what the “true” underlying advantage facilitating returns is. Said in other terms, capturing actual financial capital return requires having a product or service in which what is being provided is not easily replicable or accessible to competition to therefore create a race to the bottom on pricing therefore commodifying said product. Such market dynamics are always worth noting in industries like energy where energy in its raw form such as electrons or fuels are easily commodifiable as they are not distinctly differentiated at the point of actual customer use.
Therefore, other factors would need to be a source of differentiation to justify a capital return e.g. holistic experiential services, integration of energy system and services tying in customer base , excessive capital requirement required to locate geologically complex energy reserves, regulatory protection limiting market participants etc. As stated in this section, the listed return through share price could decouple from this especially in the economic climate that prevailed in the decade before COVID pandemic of relatively low interest rate. In an interesting twist of late, one of the outcomes of the post pandemic financial climate of relatively high interest rates and inflation may actually be a level of correction on this decoupling particularly where businesses are cash and profit negative. Note as well that all of these dynamics are not necessarily limited to public company returns, albeit that they are the most visible demonstrators of the phenomenon. Private companies would also experience the same dynamic though this would play out in the private equity valuation market instead with decoupled true earnings potential versus acquisition values.
Capital Deployment into Energy by the State
Moving on to capital deployment by the state, the concept of return still ultimately lies in return on investment. However, a greater onus is placed on the combination of economic return as well as the social return. The key issue today from the perspective of the energy poor and mostly emerging countries is that they do not have the capital, capital mechanisms , or both to sort their energy poverty. The reason for calling out emerging economies primarily over mature ones in this point is that the reality of energy poverty in the emerging world means the priorities are inherently different at the immediate practical level. While for instance the drive to reduce emissions given the perceived increased risk it presents for climate and environment is a big issue – the plight of the ~2.5 billion energy poor still using biomass and high pollution fuels for cooking and in economies unable to transition economies from primary to secondary and tertiary will be perceived as more immediate – which also bleeds into part of the politics aspect of the energy trillema discussed in the upcoming final Confluence Part III article where the issue of balancing different interests and positions on the energy transition comes into play.
For these emerging economies, which usually already have weak balance sheets, the investment required leaves them at the mercy of whether private or wealthier sovereign capital is willing to deploy in the country to assist in solving energy poverty. There is no doubt that progress has been made in the form of elements like renewables becoming cheaper and quicker to execute (for geographies with renewable resources available), or the growing application of blended finance where private and philanthropic goals capital and debt comes together. Additionally, there is increasing momentum of capital collaboration amongst emerging economies in initiatives such as the recent BRICS members expansion, BRICS development bank expansion as well as African Continental Free Trade Agreement (ACFTA). However, for most emerging economies that do not have necessary economic and political clout, the commensurate structures that allow capital to come in and invest are frequently lacking mainly owing to issues of governance, political stability or macroeconomic challenges that hamper flows of capital and foreign currency creating the feedback loop of low economic development and low energy per capita usage.
In order to not be at the mercy of external capital and create localized organic capital, a positive feedback loop of investment, goods and services flow would need to be created and the long and short of how to do that in the context of emerging economies, requires strategic realization of competitive advantages which is ultimately a matter of governance and co-ordination to execute reforms that are centered around radically raising standards of living. Such items include creating larger common markets for ease of people goods and services movement, coordinated trade policy, coordinated education policy to improve technical skills and critical thinking in population, coordinated use of demographic dividend of having large youth populations etc. In any case, given the globalization of the world economy, capital will always find itself coming to the table if a platform for opporutnity is seen but more importantly broad based self sufficiency and markets generation would be the bigger prize.
Final Thoughts…
The broader discussion on the fairness and equality of capital’s power and capitalism is a much wider and debated topic which requires a wider scope of discussion which definitely feed into this discussion here. However what all this means in relation to the isolated topic around the confluence of factors affecting how the energy transition plays out is that we have firstly, the initial practical technological reality of how energy and its systems work. This was the starting point because all the effort and capital can be poured into low emissions or alternative energy for example, but if it is at the expense of having energy securely available while global energy demand continually grows, then new challenges emerge from a non balanced and orderly approach towards the transition e.g. energy shortfall, or higher cost energy further disenfranchising those without financial capital.
On this foundation, we have the capital flow machine layered on top. How capital flows and rewards those who deploy it will determine the technologies that get pushed towards a critical mass. Realization of this critical mass is what has given us significant cost reductions in many areas relating to the transition and more of this will likely follow on other key breakthrough areas though at a time unknown. The question then is whether capital, and those who accrue its significant influence on deciding the energy transition direction, get their desired return throughout this process while simultaneously solving the trilemma which is the overarching goal society would want to strive for in an orderly and balanced manner. The trillema aspects of secure, affordable and low emissions energy play out practically and tangibly while the capital returns and the assets put in place to earn the return do not necessarily have to be in sync by what is occurring on the ground - adding to the cocktail of complexity that is the energy transition.
