The Sustainable Investor weekly (issue 39)
9th September 2022
Topics - European energy policy, environment insurance getting tougher to find, the possible impact of high energy prices on where industry locates, failing water infrastructure, buildings - demolish or re-purpose, and a successful micro EV for emerging markets.
After a longer than planned break, we are back. With a new name, The Sustainable Investor, a new home on Substack, and a new writing team (other than me - who you are stuck with). And more than the name has changed. We are expanding what we cover. We will still produce our important weekly newsflow, but we are adding in depth analysis of issues around sustainable investing solutions, human rights/supply chains and the psychology of sustainability change. We are inspired in our expansion by the success of various other Substack long form (2000-3000 word) bloggers. You would think that in a world of tweets and sound bites, no one wants to think deeply about anything - but that doesn’t seem to be the case.
Sadly, many of the successful bloggers, at least in terms of paid subscribers, are what you might describe as sustainable investing bears. We think some balance is needed, a pro sustainable investing voice - although in our case it comes with a large dose of honesty and cynicism. The problems we are trying to solve are complicated, there is no simple solution for either our planet or for investors. If you want to be helped to think more deeply about the issues being faced by sustainable investors, please subscribe and support our work or even better subscribe and share (see the button at the end of the blog)
That’s enough chat for now, on with the weekly.
The Sustainable Investor - our weekly summary of the key news stories, developments, and reports that are impacting investing in sustainability, the wider climate related transitions, and a greener/fairer society. The important word in this sentence is investing - its perfectly possible to use our capital to support sustainability, and still earn a fair financial return.
This week’s blog has a bit of an energy theme. Our top story looks at why we think the right way to view the current responses to the European energy crisis is to see them as merely the first part of what will be a protected and complicated process. Meaningful policy changes will take a lot longer to emerge, which means investors should not rush to react to the latest news. Staying with the topic of Energy, we examine why some projects and companies are finding insurance harder to get, in a large part due to insurers finally starting to price climate risk correctly. In Our Built Environment, we cover yet another example of our failing water infrastructure, and some issues around building demolition (& reuse). We then go back to Energy, examining the potential long term impacts of high energy prices on industry. And we end this week in Transport, where we flag a very successful Chinese micro EV, its not all about luxury western brands.
Important - this blog does not constitute Investment Research as defined in COBS 12.2.17 of the FCA’s Handbook of Rules and Guidance (“FCA Rules”). See the end of this blog for important terms of use.
Energy : European crisis - Act One
Brussels criticised for moving too slowly (Euractiv)
In a nutshell - what does the story say
According to an un-named government adviser, there is “cognitive dissonance” between national governments facing public pressure to tackle rising energy bills and the slow reaction from the European Commission, which is not directly accountable to the electorate. Over the past week, the European Commission has hastily put several ideas on the table, including a price cap on gas imported from Russia, a demand reduction target for electricity usage at peak consumption times and a “revenue limit” for energy firms making windfall profits from the crisis.
But these are only at early draft stage and should have been tabled much earlier, the government advisor said, expressing concern about the looming political fallout from the energy crisis. Unsurprisingly, the Commission takes a different view, saying, via chief spokesman Eric Mamer, “I believe that we are firmly on track and, once again, that what we will put on the table for the discussion will be all the more helpful because we have taken the time to analyse all the different dimensions of this issue.”
Our take on this
Why is this important ? At the risk of stating the blindingly obvious, as we head into winter, its likely that the European energy crisis will get worse, possibly much worse. Regular readers will know we are normally not big fans of decision making by the European Union. But in this case we have some sympathy. There are no easy solutions to this challenge. Or to be strictly correct, the solutions to this problem really required us to have started in earnest five or even ten years ago, not now.
Politicians are rushing to apply short term fixes. These are going to be essential to get us all through the next year or so, we get that. But they are unlikely to fix the longer term issues, and its the responses to these challenges that investors really need to take notice of. We expect these solutions to start to slowly emerge over the coming months, and they will probably take years to put in place. By this we don’t mean promises to build more renewables, or the hopes around the role for new nuclear, drilling for more oil & gas, or green hydrogen. We mean the fundamental reforms of how our energy system works, especially electricity, but also energy for hard to decarbonise activities.
What other issues does this raise you need to be aware of ? Our concern is that decisions are being taken by politicians in response to the problem in front of them (so fixing the short term rather than long term challenge), and in the absence of a deep enough understanding of how our current energy & electricity system works. You cannot fix it if you don’t understand it. Regulated systems tend to have an inertia of their own (in a physics sense), which is often compounded by the arguments of incumbents as to why change is too hard. So change often needs to be driven from outside.
The logic behind the need for system reform is both simple and complex. Lets illustrate this with electricity. The simple bit is that as multiple studies have shown, a low carbon electricity grid by 2035 is possible, and at a broadly affordable cost. The complex bit is that the current industry structure is unsuited to the future demands that a system of mostly renewable generation will place on it. And unless we modify the system, we will not be able to connect enough new sources of generation to make a difference.
There are lots of ways our future electricity system will look very different from now, different demand patterns, probably more decentralised, with more storage and interconnections, and a lot more demand management & energy efficiency. All big issues in their own right. Over the coming months we will look at some of these longer term challenges and opportunities, one at a time. For sector experts you will probably go “yes, we know that already”. But in our experience, most investors do not.
This week we start with the Merit Order Model. This is the process by which our electricity prices are generally set, and its the main reason why high gas prices have led to high electricity prices, even in countries with lots of low (marginal) cost renewables, nuclear and hydro. This is one of the bedrocks of how our electricity is supplied and priced, so very important.
To borrow from Florian Mayr … how does the merit order system work? Electricity generation plants with the lowest marginal costs of production, normally renewables, nuclear & hydro, are dispatched (or perhaps more strictly called to supply) first. And this proceeds on, adding more progressively expensive electricity generation until demand for a set time period is met. And, this is the important bit, the last power plant dispatched to meet demand, the one with the highest marginal costs (in current markets normally gas), determines the price for ALL power plants. Yes, you read that right, everyone gets the price set by the most expensive supplier.
Again quoting from Mayr …the underlying idea makes sense. The cheapest providers of electricity earn the most money, encouraging them to finance new investments. And, the other, more expensive electricity generators try to get down their costs, eventually leading to a lower price for the price-setting power plant as well - and overall affordable electricity. If you want a read a decent attempt to explain this from a journalist, one that makes sense to normal people, this is a good one, with comparisons to buying sausages.
Looking forward, you are probably way ahead of me here, but lets fill in the gaps. We know that we are likely to need some (limited) fossil fuel generation to meet the last unit of demand, at least for the next couple of decades. Putting it another way, studies show that a c. 90% low carbon system (with the peaks met by fossil fuel generation) is probably going to be more cost effective than one that has 100% renewables. So, how does this merit order system work in a world where the majority of electricity is generated by low marginal cost producers such as renewables, but where the price set by the highest cost producer ! Short answer is, it doesn’t.
So we need to dismantle our existing system and replace it with something different. Which means changing contracts and regulatory structures, and possibly compensating companies that built capacity to work in the merit order system, but that will earn less in our new way of working. Best guess, even if we started now, is this will take at least five and possibly ten years to get fully up and working. But its something we need to do if we want to solve our future energy issues, and its the solutions to this type of problem that investors really need to watch.
What this new system might look like is not totally clear. In a recent post on LinkedIn, Micheal Liebreich talks about splitting the electricity market into clean and dirty, and creating a transparent market in Power Purchase Agreements (PPA’s). Sadly, this part of the blog has already gone on long enough, so lets leave any more for another day.
Energy : Is climate risk finally getting properly priced by insurers ?
Insurer being sued for refusing to cover climate lawsuit (The Guardian)
In a nutshell - what does the story say
A fossil fuel firm is suing its insurer for refusing to cover a climate lawsuit in a case that could affect the wider industry’s ability to defend itself from litigation. Aloha Petroleum, a subsidiary of the US-based Sunoco, filed a claim against AIG’s National Union Fire Insurance Company of Pittsburgh earlier this month, arguing it had failed to protect Aloha from the mounting costs of defending climate-related claims by local governments in Hawaii.
The lawsuit follows another, filed by the insurance company Everest in June, which is asking Massachusetts superior court to make a similar decision about whether coverage can be denied to Gulf Oil. These are some of the first disputes over insurance coverage for climate crisis litigation to be heard in the courts. Both insurance companies say climate litigation is covered by exclusions for “pollution” in their clients’ general liability policies. If the insurance companies succeed, the fossil fuel firms could be on the hook for millions of dollars in legal fees, in addition to any future damages awarded in court.
Our take on this
Why is this important ? These cases are part of wider moves by the insurance industry to reprice or even terminate some types of climate and ESG related risks. Historically, companies and individuals have assumed that insurance cover would be available. Its almost been seen as a right. To be fair, this was never really a reasonable assumption. Some risks have been beyond the ability of the private sector to cover on their own. For instance, in the US, the National Flood Insurance Programme provides Federal government support for the insurance of properties etc in Special Flood Hazard Areas, with c. 5.1m policies in force (this is a good summary of how it works from Forbes). I am not sure that this is a good precedent though, as it’s not clear that governments would be keen to take on the risks in the Aloha Petroleum or Gulf Oil cases !
Despite these exceptions, the principle still holds. For most businesses, being able to obtain suitable insurance is a key element in their investment case. Its absence exposes investors to value destroying claims. We think investors need to prepare for a new world, where insurers decide that certain climate related events are so likely to occur, that they stop covering them. The recent US Insurance Regulator State of Climate Risks Survey, conducted by the Deloitte Center for Financial Services identified that “more than half of the regulators surveyed indicated that climate change was likely to have a high impact or an extremely high impact on coverage availability and underwriting assumptions”. Given climate science consensus, this should not come as a surprise.
What other issues does this raise you need to be aware of – this is not the only area where the insurance industry has become unwilling to provide cover. It’s becoming well understood that insurance for homes located close to at risk coastlines is becoming harder to obtain and/or more expensive. But its not just flooding and weather impacts. The promoters of the Carmichael thermal coal project in Australia are apparently still struggling to obtain insurance cover. And the East Africa Crude Oil Pipeline project was reported back in April to be in a similar position, in this case based on a mixture of human rights and social/environmental harm questions. Another example is in mining, specifically tailing’s storage. This article sets out in some detail how the insurance market for this type of cover has changed post the Brumadinho tailings dam disaster, which killed 270 people.
The implication for companies and investors is that we should not assume that cover will continue to be available, especially for those operations that are likely to cause material environmental or social/human rights harm or that are located in places where we should have reasonably assumed floods and weather related disasters would occur. In some cases, governments may step in but, in the absence of material redesigns or perhaps insurance companies taking a different role, many projects are likely to become un-investible.
Wastewater : Under investment has consequences
Jackson, Mississippi has no safe tap water for the foreseeable future (Yahoo News)
In a nutshell - what does the story say
Recent flooding, operational failures and under staffing at Jackson, Mississippi’s primary water treatment plant, combined with decades-long infrastructure decay, resulted in an indefinite failure in the supply of safe tap water to Jackson’s 180,000 residents. Mississippi Governor Tate Reeves declared a state of emergency in and around Jackson, the state capital and largest city. The state health department has warned that tap water is “not even safe to brush teeth with or give to pets”. Residents had previously been advised to boil all water before drinking. The Federal Emergency Management Agency head said it is still too soon to say when all Jackson residents will have safe running drinking water.
Our take on this
Why is this important ? The United Nations determined that access to clean water and sanitation facilities is a basic human right and it’s one of the 17 Sustainable Development Goals. In 2020, 2 billion people still lack safely managed drinking water, including 771 million who were without even basic drinking water, half of whom live in sub-Saharan Africa. In developed nations too, there have been a number of well documented cases of impaired drinking water, most notably the Flint water crisis.
Investing in clean water, sanitation and hygiene is estimated to generate a return of US$21 for every dollar invested in the form of improvements in quality of life, reduced pollution and reduced healthcare costs. By 2030 water demand is expected to exceed current supply by 40% unless water use is “decoupled from economic growth.” Globally, approximately 19% of total water withdrawals are used for industrial purposes, on top of the 70% used for agriculture.
What other issues does this raise you need to be aware of – investing in water treatment and wastewater disposal has been a big asset class for many decades. And yet this event, plus recent similar problems with sewerage disposal in the UK, suggest that some apparently developed countries still have a lot of work to do.
A 2016 US Government Accountability Office report pointed to the risks of cities with declining populations and corresponding declines in ratepayers leading to under investment in water and wastewater infrastructure. And a 2019 joint report by the DigDeep Right to Water Project and the US Water Alliance concluded that race was the strongest predictor of water and sanitation access and poverty was a key obstacle in the US.
The federal infrastructure bill passed in 2021 will provide financial support but will take time to trickle down as it is allocated to state legislators with concerns being raised about political motives when it comes to dispersal. The UK faces a similar challenge with the dumping of sewage and capital is potentially going to be allocated for improvements and expansion of water treatment facilities.
Reducing the burden on treatment facilities, and hence reducing the need for investment, can also come from the commercialisation of grey water systems where water is collected and reused from showers and sinks in, for example, toilet flushes where the water does not need to be potable. These can be commercial or residential and are being explored in water stressed countries such as India. They can also be used for garden irrigation and, with the right local treatment technologies, for agricultural irrigation too.
Scaling up the availability of Urine-diverting toilets which have a urine collection basin at the front of the toilet bowl, draining to a separate tank from the solid waste can greatly reduce the water required for flushing. A key advantage is their applicability globally in both with dried faeces being used in agriculture post composting - composting toilets are another alternative here. Urine also requires far less treatment, thereby reducing the stress on treatment plants.
Persistent flooding was a key factor in the ultimate failure of the water treatment plant in Jackson. Various urban solutions are being explored such as the sponge cities concept and other nature based solutions to reduce the risk of excess storm water leading to flooding and associated damage. These are important considerations in broader urban planning. Plus, from a regulatory perspective, in many countries, excess storm water is often permitted to mix with waste water and sewerage.
Finally, as part of the energy transition there is the question around “will there be a net increase or decrease in the competition for water”? As industrial processes are refined to become more water efficient, will this be offset by certain green energy technologies increasing water consumption? For example, approximately 2.2 million litres of water is needed to produce one ton of lithium. A topic for another day.
Built Environment : alternatives to demolition
Noida twin towers demolition: Supertech chairman explains how the land will be used now. (CNBC TV)
In a nutshell - what does the story say
Supertech’s illegal twin towers in Noida Residents were demolished on August 28th following a Supreme Court ruling that the towers were constructed in violation of the UP Apartments Act 2010. Supertech believed that they had full approval in 2019 “strictly in accordance with the then prevailing byelaws.”
Our take on this
Why is this important ? Yes, we loved the photo, and buildings being demolished make for dramatic TV, but the story raised an important question for us - why do we seem to so willingly accept buildings being demolished to be replaced by “something more modern”, rather than pushing harder for refurbishment. After our decades working in the City of London, it can sometimes feel as if most of the city has been demolished and then rebuilt (we know that’s not true by the way). As engineer’s we get that building codes and planning rules are really important, but ultimately its the tenant that decides. Are we missing a trick by demanding energy efficient buildings, as defined by what we need to spend to use them in comfort, rather than the whole life emissions ?
The built environment is an important area of focus for sustainability. It represents over one third of global final energy use, generates nearly 40% of energy-related GHG emissions (which in themselves are 75.6% of total GHG emissions) and consumes 40% of global raw materials.
It is predicted that by 2050 more than two-thirds of the world population will live in urban areas putting upward pressure on those built environment numbers, all else being equal. Embodied carbon contributes about 8-10% of global emissions compared with the aviation industry which contributes roughly 2-3%.
What other issues does this raise you need to be aware of – In this particular case, there was debate surrounding the buildings approval process. Is a rethink required that takes a more holistic view of planning, rather than on a building by building basis taking into account infrastructure and services? Although we may hate planning rules and regulations, used wisely they can be an important tool for cities and communities to ensure that they get the sustainable urban environment that they desire.
A similar demolition in the municipality of Maradu in Kerala two years ago offers clues to potential issues. One resident claimed that cracks had appeared in the roof of his house as a result of the controlled implosion that demolished the Alfa Serene twin apartment block, while another said his neighbour died from Covid-19 complications while waiting for INR4m ($60,000) compensation. Dust from the rubble and that needs to be cleared from the site, to make way for the next construction can linger in the air causing pollution and exacerbating conditions such as asthma. The Central Building Research Institute has installed black boxes in the towers to obtain data to help design future demolitions.
When buildings are no longer fit for their originally intended purpose, do they actually need to be demolished? Citigroup chose not to demolish its 42-storey skyscraper in Canary Wharf and instead opted for a retrofit, thereby saving potentially 100,000 tonnes of embodied carbon. On the flip side, staying with London examples, the retailer M&S was recently given consent to demolish its iconic art deco building in Oxford Street London, despite the plans being at odds with the mayors own climate change commitments. There are a number of ways in which the footprint of the built environment can be reduced - from planning and design, to thermal efficiency and material usage. We shall cover these in a later blog.
Energy : will high energy industrial users relocate to cheaper energy countries
World's second-largest steelmaker closes European Plant (OilPrice.com)
In a nutshell - what does the story say
Global steelmaker ArcelorMittal is to close one of its two blast furnaces at its steelworks site in Bremen, Germany, from the end of September due to an "exorbitant rise in energy prices" undermining the competitiveness of steel production. Weak market demand, a negative economic outlook and persistently high CO2 costs in steel production were other reasons given for the company's decision.
On top of that, from October onwards, there will be the German government's planned gas levy, which will further burden us,” said Reiner Blaschek, CEO of ArceloMittal Germany. Aluminium smelters in Europe have also been closing in recent weeks, due to sky-high energy prices.
Our take on this
Why is this important ? The industrial sector is massively important in terms of employment, the products it creates, and in its energy use and carbon emissions. The sector accounted for 21.5% of total global final energy use in 2019. Plus, a number of materials important for the energy transition require lots of energy to process. For example it requires approximately 65GJ to produce one tonne of copper (18,000 kWh) from mine to copper cathode. That compares with 29,500 kWh for aluminium .
What other issues does this raise you need to be aware of – Currently heavy industry is heavily dependent on fossil fuels to generate the heat and pressure required for processing materials. In the Chemicals sector, steam cracker furnaces which are used to crack light hydrocarbons such as ethane, propane and naphtha to produce ethylene are a good example. Alternatives are being developed, with BASF, SABIC and Linde recently beginning construction of the world’s first demo plant for large-scale electrically heated steam cracker furnaces. The electricity will be produced from renewable sources instead of natural gas, apparently potentially reducing CO2 emissions by at least 90% compared to current technologies.
Plus, will this impact location decisions? Will future industrial complexes grow up around large scale renewable locations? For example Iberdrola are constructing a 100MW PV plant, battery installation and system to produce green hydrogen to be used at an adjacent Fertiberia fertiliser plant in Puertollano. Looking even wider, will the ability to utilise off-grid solar drive growth of industrial facilities in previously underdeveloped parts of Africa, for example?
In addition, almost half of fuel and energy consumption in the Chemical Industry is in the form of heat. Will renewable heat generation processes be able to match the temperature requirements of various important chemical processes and deliver that heat directly (rather than heat-to-electricity-to-heat)? And can Small Modular Nuclear Reactors (GenIV) eventually operate and achieve sensible economics in the centre of an industrial park creating green hydrogen and direct heat for flow chemical processes? To be continued…
Transport : EV expansion is not all about luxury brands
Tiny EV is China's biggest seller (motortrend.com)
In a nutshell - what does the story say
The article is a bit gushy, sorry, but hidden within the PR fluff is an interesting story. According to an article from Automotive News (paywalled – which is why we have used this report instead), the General Motors-Wuling JV is set to launch the Hong Guang MINI EV Cabrio (no connection with the BMW Group owned Mini brand) later this year. The model is a soft-top electric powered take on one of the brand's most popular EVs. Wuling is only committing to building 100 to 200 cars a month, with production apparently to be ramped up as demand grows.
The final price of the EV Cabrio hasn't been confirmed but it’s suggested that it will be between between 100,000 yuan and 200,000 yuan ($14,500 and $29,000). This puts it well above the cost of the original Hong Guang MINI EV, which starts at only 32,385 yuan (approximately $4,700). What is interesting is that there were 426,000 sales of the MINI EV in 2021, making it the best-selling EV in China last year, beating Tesla's by over 100,000 units.
Our take on this
Why is this important ? To us the key long term story is the success of the original MINI EV in China, and the moves by General Motors-Wuling to expand the range into higher price options. Our potential read across is much wider than just China. For many analysts, their view of the likely EV market development is coloured by two factors, China (obviously), and progress in developed markets such as Europe, the US and Japan/Korea (where the big automotive OEM’s are quoted). And while we accept that both are really important, we need to remember that a large proportion of the world’s population lives outside of these markets.
Yes, they currently make up a small proportion of new EV sales (just over 1m) but as incomes rise, we should expect EV sales to grow rapidly. This is an outcome we should welcome, as getting these markets into EV’s rather than using fossil fuels will be an important element in hitting the 1.5 degree or 2.0 degree pathways. But this is not an easy task at the price points for many EV’s. We have written in the past about electric scooters (issue 37), but small/micro EV’s such as the MINI will also be important, as the next step on the transport trade up ladder.
What other issues does this raise you need to be aware of – Safety is the obvious one. As this Autocar review highlights, the original Mini EV’s featured little more than the steel body cage, anti-lock brakes and Isofix anchors for child seats. The newer Macaron adds a driver’s airbag. So much less safety equipment than would be expected in developed markets but again as the reviewer says, “it’s infinitely safer than piling a family onto a motorbike or electric scooter”. Some of the reviews we read highlighted the “utilitarian interior”, low range (120km on the smallest battery size), and long charging times (up to 9 hours), but then that kind of misses the point in the target market, where cost is key.
We appreciate this is a really tough segment for most quoted automotive OEM’s to make money in and it’s not one we expect European or US automotive companies to enter at scale. But it’s a reasonable working assumption that this could be a market segment that Chinese firms focus on when they expand out of their home markets. Which in turn could give them a foothold in future EV markets such as Indonesia, Thailand, and even possibly India (if they can work out a meaningful partnership arrangement). This story could look similar over time to the earlier emergence of Japanese and then Korean automotive OEM’s, so a space to watch. A subject we intend to come back to.
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