31 August 2020

The Republican and Democratic conventions are over, and the US election campaign will shift into high gear. Surely, climate change will be one of the most important topics for the US electorate to consider. Democratic candidate Joe Biden wants America to become net-carbon neutral by 2050, and to eliminate the use of fossil fuels in electricity generation possibly as early as 2035. On the other hand, following the decision to abandon the Paris Climate Agreement, President Trump’s goals are less clearly defined. As in 2016, however, the President continues to vocally support the coal industry, and appears reluctant to embrace the need to reduce the role of fossil fuels. Furthermore, he seems to imply that limitations on hydraulic fracking would endanger American’s hard-won (and desirable) energy independence.

Clearly, the election outcome will help determine the role America will play on this critical global issue. The Chart above illustrates the scale of the challenge. Aside from China, the United States is the world’s largest emitter of Green House Gases (GHGs). On a per capita basis, more strikingly, despite recent reductions, America’s carbon dioxide level exceeds other nations by a large margin.

In a recent blog entitled “Markets are Ignoring Climate Change” (found in my website’s archives), I suggested that despite my belief that climate change will be the most important macro-issue in coming decades, financial markets are giving the topic insufficient attention. During the next critical decade, the direction America takes will have significant implications for the performance of the US and global economy, the relative attractiveness of the nation’s financial assets, the shape of the US energy and transport sectors, and the outlook for the US dollar. It’s time for financial markets to take note!

Europe: Lessons America Can Learn

In my earlier study, I ranked countries according to their ability to mitigate climate risks. The United States ranked a disppointing #20. Europe is providing global leadership in the climate debate; indeed, 16 European countries are less vulnerable to the risks posed by rising global temperatures. To be sure, the region has considerable work to do, but the European Union has committed to carbon neutrality by 2050. The United States has much to learn from Europe’s experience. The Chart above, for instance, illustrates EU nations have reduced CO2 emissions already by 20% during the past three decades, and by considerably more in key countries. American pollution continued to increase during the same period.

It is important to note, America’s performance has begun to improve in the past decade. Fortunately, despite the Trump Administration’s lack of focus on the issue, American consumers and businesses are recognising the consequences of inaction. Nevertheless, the USA has not kept pace with ongoing GHG reductions in Europe. The Chart above illustrates that despite recent US emissions cuts, American CO2 levels remain twice those in Europe (on a per capita basis); indeed, four times as high compared to the best-performing European countries.

A key factor in Europe’s superior performance is that the region uses considerably less energy to produce economic output than in the USA. To be sure, even though US energy efficiency has improved significantly in recent years, Europe’s energy/GDP ratio remains far lower: for instance, Germany and the UK use 30% less energy per unit of output compared to the Unites States (Chart above). Europe’s performance illustrates that conservation and technological innovation aimed at improving energy efficiency has a large role to play in the USA in the future.

In my model, the United States scores well on many climate-related metrics, e.g. a robust health care system, food and energy independence, favourable demographics, and a flexible institutional framework. America’s vulnerability stems largely from weaknesses in its energy system. The Chart above highlights that Europe’s CO2 emissions per unit of GDP are again much lower; indeed, carbon intensity levels in France, Sweden, and the United Kingdom are less than half that in the United States.

The mix of energy sources in Europe’s power-generating system is considerably less carbon-intensive. After tripling during the past decade, renewable energy sources now generate nearly a quarter of Europe’s electricity — more than twice the level in the USA. Meanwhile, while fossil fuels still account for nearly two-thirds of American power, the share of these carbon-intensive sources has declined to 40% in Europe.

Important shifts, however, have taken place in the USA in the past decade. Improved hydraulic fracking technology has increased sharply the share of natural gas in the power sector. Meanwhile, renewables are beginning to play a greater role. Both have come at the expense of coal usage, and the changing mix in energy sources has helped America lower emission levels in recent years (gas is less carbon-intensive than the black rock). So much for President Trump’s advocacy of the coal sector! As the demand for electricity is expected to grow sharply in coming decades — reflecting GDP growth and the electrification of transport, HVAC, etc. — the US energy system’s continued reliance on fossil fuels would limit its ability to achieve meaningful CO2 reductions.

Is Natural Gas Coming to the End of the Bridge?

Despite the availability of vast amounts of cheap US natural gas, the source was intended only to provide a bridge until renewable sources became cost-effective enough to replace high-carbon fossil fuels. What would be the role of natural gas if the USA truly aims to become carbon-neutral? In the Chart above the World Energy Council compares the “carbon budget” consistent with the Paris Accord 2% temperature goal (third bar) with already developed sources of fossil fuels (bar 1).

The Figure illustrates that fossil fuels can play no additional role in the world’s energy mix if the 2%C target is to be achieved, and must be sharply reduced to attain the more ambitious 1.5%C target. (The Chart presents global data, but the outcome is similar in the USA alone). Indeed, all future increases in energy demand would need to be met by carbon-free energy sources. Therefore, the role of natural gas can only be maintained (or grow) either if oil and coal usage is curtailed or if technological advances are made in carbon sequestration and storage. Furthermore, while gas burning does emit less carbon than coal and oil, the advantage may not be as great as initially imagined. The production of gas creates large amounts highly toxic methane, as does pipeline leakage during gas transportation.

The future role of natural gas is at an important tipping point. The highly-esteemed Rocky Mountain Institute indicates that America’s gas infrastructure is old, and large-scale upgrade investments will be needed imminently, especially in US states with ambitious CO2 emission reduction targets. Making these investments would be warranted only if natural gas has an ongoing role to play in America’s energy mix. As gas’ environmental benefits may have been over-estimated, many believe it’s contribution to America’s electricity generation may be peaking. As I anticipate coal’s role in US power generation will be virtually eliminated in coming decades, declines in natural gas usage are likely to be gradual.

Even so, if the USA is to adhere to a carbon budget consistent with the Paris 2% goal, overall fossil fuel usage can play no additional role in meeting anticipated future increases in US electricity demand. Therefore, energy must come from other non-carbon sources. The Chart above illustrates that dramatic declines in solar and wind prices now make renewables competitive with fossil fuels. Of course, it may not always be windy or sunny! However, following sharp declines in battery storage costs, electricity generated by renewable sources (and stored) may soon also become the least expensive way to meet unexpected, temporary energy shortfalls (the Chart below was provided again by RMI). Renewables’ time has finally arrived!

Challenges in Transport and Agriculture

The next American government will also face important climate challenges in both the transportation and agricultural sectors. The transportation industry accounts for nearly 25% of US carbon emissions. The next Chart underscores America’s continued heavy reliance on oil, the dominant energy source in the transportation sector (and the overall economy).

Petroleum-guzzling small trucks and SUVs now account for over 70% of US light vehicle sales. With the average age of US vehicles over 12 years old — and 25% are over 16 yo — the industry is ripe for change. The United Kingdom, for example, has banned the sale of petrol and diesel cars after 2035 as part of its plan to achieve carbon neutrality by 2050. If the next US administration intends to meaningfully reduce carbon dioxide, similar goals wil be required. Large-scale investments in charging infrastucture and battery performance (which is improving rapidly) will be necessary, and are part of the Biden-Harris economic program. As I expect EVs to account for 50% of the cars on American roads by 2050, generating electricity via low-carbon sources is vital. Hydrogen may have a large role to play in long-haul trucking, international shipping, and rail transport.

The United States enjoys a large, highly productive agricultural sector, which is a net exporter to the rest of the world. As enviable as that sounds, obviously this sector will be vulnerable should rising global temperatures lead to more volatile weather patterns, e.g. increased droughts, flooding, etc. In addition, agriculture accounts for over 10% of world-wide GHG emissions, primarily highly-toxic methane. The Chart indicates the US agricultural sector is the world’s fourth largest producers of GHGs. In coming decades, therefore, I expect American farmers will invest heavily in productivity enhancing technologies aimed at mitigating climate risks.

Strategic Considerations

• Financial markets are paying insufficient attention to climate risks. Despite the US dollar’s recent depreciation, the greenback is still overvalued and the Euro undervalued (Chart above). Based only on climate factors, I would expect the opposite. Greater vulnerability to climate risks is an additional structural headwind for the American currency.
• Following sharp declines this year, US real interest rates are only about 50bp higher than European yields. This may not be enough to compensate for the additional US climate vulnerability.
• Regardless of the outcome of the US election, American consumers and business will continue to take actions to mitigate climate risks. However, these efforts have proven to be insufficent. Governments must establish targets and goals to ensure change. Some form of carbon pricing may be inevitable.
• Reductions in GHG emissions do not have to come at the expense of GDP growth. Indeed, Europe’s economy continued to expand while reducing CO2 emissions since 1990. As the Biden-Harris climate program essentially replicates Europe’s commitment to carbon neutrality by 2050, I do not view the plan as radical.
• The time for renewables has arrived. Fossil fuels will lose share in the mix of American energy sources. Coal usage may be eliminated entirely by 2050. This will allow the share of natural gas usage in US electricity generation to decline gradually. The electrification of transportation will reduce the usage of oil products.
• Lower reliance on fossil fuels will not threaten American energy independence: unless the US plans to import French nuclear, Brazilian hydroelectric, or German renewable energy! However, the rationale for further large-scale investment in fossil fuels would need to be questioned, IF the Paris climate goals are taken seriously.