Energy transitions: smart business, smart policy, smart politics and good outcomes
· 9 min read
To avoid extremely damaging climate turbulence, it has long been clear that decarbonising the global economy is an urgent priority and that the world is nowhere near to following a pathway towards this objective at the necessary pace. This is a threat to the wellbeing of every person on the planet and their progeny.
This realisation is stimulating much hand-wringing and blame, as well as being used by governments to justify policy initiatives of variable effectiveness. None of this, however, is stimulating the levels and types of investment that are required.
Rather than throwing up our arms in despair, however, this essay asserts that good investments can be motivated at a much-accelerated pace because:
Curbing climate damage requires completely rewiring the world economy to change the way we use energy from fossil fuels to operate, build and move almost everything we do, and also addressing our degradation of natural systems through deforestation and soil erosion. Approximately 2/3 of damaging emissions come from our use of energy and 1/3 from our abuse of nature.
These are not small tasks, but there is some progress and there are points of light such as the rapid pace of growth in power generation from solar and wind, sales of light-duty electric vehicles, and the spread of carbon markets and decarbonisation commitments. These are far from sufficient, but they were not happening 10 years ago and yet today they are. Our goal now has to be accelerating progress by continuing to promote these changes and, crucially, by lighting the blue touch-paper so that multiple additional changes take-off at pace as well.
Technically, we know what is required. Multiple scenarios from credible sources all highlight 5 core technical areas:
The detailed technical challenges are different in different sectors of the economy, requiring customised solutions and tailored investments. However, it should be well understood by now that the macro-economic drag of investing in energy transitions will be modest, and likely to be much less than the drag that would be imposed by damage from climate change itself if the shifts are not made.
The challenge is at the “micro” level as the “costs” and the “benefits” are not evenly distributed or aligned. This is the really tricky problem of coordinating and aligning the motivations of more-or-less everybody. This requires new policies and regulations, new market designs and pricing mechanisms, new business developments and changes in supply chains. Effective alignment demands much more vigorous collaboration across public-private, industry and business boundaries.
Much of modern progress has been driven by a combination of collaboration in enterprises to get major developments accomplished and also competition in markets that give financial incentives for effective activities. We have seen both these mechanisms play out powerfully in the astonishingly fast development and deployment of Covid vaccines, with intensive collaboration and knowledge-sharing across world-wide scientific and clinical communities, and also competition among different organisations and businesses to deliver their new best vaccines to market as quickly as possible.
Similar mechanisms have been in play looking back at several energy transition developments that have already “taken off” and that we now take for granted. Alignments have created fertile ground, pioneers have acted decisively and demonstrated possibilities, then many competitors have followed to avoid being left behind. In this way, industries like solar and wind power have “taken off” growing at 20, 30 or even 40% per year globally as increasing deployment drives down costs and initiates a virtuous cycle.
This was also the case with the take-off in sales of light-duty Electric Vehicles (EVs). These had been toyed with for many years but then business pioneer Elon Musk recognised that attractive policy and market conditions had come together in California to enable Tesla to initiate a new kind of “super-premium”, “computer-on-wheels” electric vehicle business. This triggered a global EV “take off” as other vehicle manufacturers and policy-makers elsewhere responded to Tesla’s early successes. This case is particularly interesting because it demonstrates not only high early-stage growth rates but the potential commercial value from being a successful pioneer in such a high-growth market with a niche premium sector. In just a short time, the market value of Tesla has grown to be an order of magnitude greater than that of traditional behemoths like General Motors or Ford.
Recognising the importance of both competitive dynamics and pioneers is the key to catalysing the multiple take-offs of additional developments required to decarbonise the economy. When developments “take-off” they really do so very vigorously because competitive dynamics flip the industry equilibrium as soon as a pioneer demonstrates even potential attractiveness. Multiple players then act quickly as “Fear of Missing Out” is activated, particularly if the existing industry equilibrium has already become highly competitive and typical returns have been driven to low levels (as is often the case in mature industries).
Businesses and policy-makers need to anticipate this fierce competitive dynamic, and not be misled into expecting slow and steady future changes. While it may take time for background policy or value-chain alignments to emerge, once they do then take-off growth can become almost explosive.
As suggested above, pioneer businesses are also key in triggering take-offs.
However, the main uncertainty facing potential forerunners in the energy transition arena is uncertainty in the timing of when different new developments will “take off”. They are faced with the “too early/too late” investment dilemma. The key question is whether to pre-invest now in building a competitive stronghold for an industry that may eventually take several years to fly but, in so doing, potentially catalyse an early take-off. Or whether to delay investment and react later when industry growth is already established but competitive positions are more difficult to secure. In other words, whether to be a pioneer on the front foot or a follower
Unfortunately, human and organisational biases generally steer institutions towards acting late, but scenarios can help decision-makers recognise that acting early may, at worst, bring only mild economic disappointment but, at best, can lay the foundation for significant company or domestic industrial competitive advantage for years to come. The potential regret of acting late is often considerably greater than the potential regret of acting early.
One of the key challenges for many organisations is that they have become “trapped” by an unhelpful metaphor in the financial assessment of the potential economic value of future opportunities with relatively unfamiliar features. The British statistician George Box has noted that “All models are wrong but some are useful”, but the corollary of this is that some models are not useful, at least when applied well outside the limited area of their usefulness.
Whether senior decision-makers realise it or not, the dominant metaphor being used in most companies for assessing uncertain future financial returns is that of the corporate bond, particularly because it can be easily represented in the spreadsheets that now dominate analysis. A base-case of cash-flows is assumed, with the “present value” of future cash-flows discounted by a fixed percentage to account for the risk that the “bond-payer” may default. Some sophistication may be added through computing sensitivities or assigning probabilities to different elements of the calculation, but the underlying metaphor for the nature of future uncertainty remains the same – i.e. it looks like the risk of holding corporate bonds.
This metaphor may be reasonable in traditional circumstances but, of course, the type of uncertainty highlighted above for energy transition “take-offs” looks very different. We may be confident that the potentially “explosive” take-off of particular approaches will occur in the next 5, or 10, or 15, or 20 years, but just do not know precisely when. We may be able to secure long-term competitive advantage if we are a forerunner, but not if we are a later follower, and, indeed our own actions could trigger the take-off. The potential regret of investing to be a forerunner may simply be poor returns until take-off actually occurs, while the potential regret of waiting may be foregoing significant long-lasting economic value.
Scenario thinking is essential for grappling with the shape of uncertainty under these circumstances, and the simple discounted cash-flow (DCF) model is inadequate, even misleading. In contrast, even a simple model that considers DCF appropriately within the “boundary scenarios” of take-off occurring soon or alternatively after a delay of several years, combined with a business investing early or later, is already more illuminating. In fact, my own evaluations reveal that it would already be economically and commercially shrewd for businesses to invest seriously as pioneers in most of the technical areas identified earlier in the essay that are primed to take-off during the timescale of energy transitions.
A few businesses seem to be attempting this, but not as many, or as aggressively, as the type of commercial competitive perspective developed above should encourage. Of course, not all pioneering activities will succeed over the long-term if competitive strongholds can not be secured or if it takes forever for take-off to occur. Nevertheless, the vibrancy of the Venture Capital markets and the significant market value generated by companies like Tesla, Orsted, NextEra Energy and Neste indicate what can be achieved.
Adopting the perspectives outlined in this essay (e.g. already anticipating high-growth take-offs, scenario thinking, minimising regrets, surfacing niche premium market opportunities, and recognising the potential long-term competitive advantage of participating in take-off) will not only enhance commercial advantage for fast-moving companies but also drive faster energy transitions overall in a reinforcing cycle.
Similar considerations are pertinent for policy-makers seeking to build social capital by developing domestic economic competitive advantage alongside delivering environmental benefits. They should recognise the international competitive dynamic in policy-making between different economies. They should then focus on creating significantly favourable conditions to enable, motivate and reward more pioneer businesses in new target energy-transition areas while also encouraging lively competition in areas that have already taken off.
Finally, given the possibility of explosive take-off occurring within a political cycle, with resulting economic, job-creation and environmental benefits, then intelligent politicians should recognise the potential political capital that can be generated through promoting these approaches.
In summary, therefore, scenario thinking and stimulating take-offs in a targeted and well-designed way can be a sweet spot combining smart business and smart policy with smart politics.
Who will become the new forerunners in energy transitions, generating significant commercial, social and political value?
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