The Economics of the Energy Transition: Where the Macro meets the Micro

I had the opportunity to attend the COP28 Climate Conference, held in Dubai at the end of 2023, which brought together global leaders, scientists, policymakers, and financiers to address critical climate-related challenges. What really struck me about being on the ground was a renewed appreciation for just how complex the energy transition will be—it was powerful to have the opportunity to connect with so many public and private sector stakeholders across industries and geographies. A few months after the conference, I was fortunate to have a conversation with Tim Gould, Chief Energy Economist at the International Energy Agency (IEA), and Ekkehard Ernst, Chief Macroeconomist at the International Labor Organization (ILO), where we discussed the energy transition and the impact to the global economy. In this article, I have highlighted some of my reflections from this discussion and their relevance to Brown Advisory’s sustainable fixed income investment strategies.

You can listen to the conversation (approximately 35 minutes long), here:

The energy transition, once a distant consideration, has now emerged with an urgency that commands the immediate attention of policymakers and investors alike. Tim's assertion during our discussion encapsulates the gravity of the situation: "We are in a difficult, fractured international environment. So, the fact that countries were able to come together and agree with unanimity... was significant.” This hard-won unanimity at COP28 represents not just a diplomatic achievement but an unequivocal declaration of global intent towards a sustainable future. However, it will not be without its challenges.  

Successfully navigating the energy transition will require a massive economic transformation, larger than the industrial revolution. As fixed income investors, it is important that we understand how the energy transition flows through key macroeconomic indicators – from inflation to employment data—and then how that flows through to the companies that we invest in and their ability to capitalize on this economic transformation. The conversation sheds light on everything from energy costs, labor implications, and the concentration of the critical minerals supply chain—all of which are important risks for us to evaluate in our underwriting. It also illuminates the multi-trillion dollar financing gap, an area of tremendous opportunity for us as fixed income investors. 

Economics of the Energy Transition

During our conversation, Tim mentioned the IEA’s most recent projections show demand for each of the fossil fuels (coal, oil, gas) peaking before the end of the decade. Of course, in the highly inflationary environment we are in, coupled with rising geopolitical tensions, energy costs are of utmost concern to many consumers and policymakers. Fortunately, the cost curves of key clean energy technologies have come down significantly over the last few years. He noted 80% of new capacity added to the power markets in recent years has been low emissions technologies, a proof point that “the economically rational choice is also the clean choice.” The key, however, will be to deploy this type of investment at scale. The IEA projects that annual investment must climb to $4.5 trillion by the year 2030 from roughly $1.8 trillion today, in order to successfully limit global warming to 1.5 degrees Celsius.

Achieving this may be particularly challenging in today’s environment where governments are already highly indebted and need to balance fiscal stability above all else. Tim elucidated this point, emphasizing that “public funds are squeezed... so it's really about using those public funds wisely, strategically in order to leverage much larger volumes of private capital.” Furthermore, it is important that “affordability and fairness” stay at the center of the conversation. He challenged the notion that energy security and energy transition should be viewed on opposite sides of a spectrum. The need for a balanced approach is paramount—one that considers the intricate interplay between maintaining energy security and advancing the growth of new, sustainable energy systems. 

Adding into the conversation, Ekkehard brought into the focus the importance of understanding the labor implications of the transition — labor often enters the transition conversation in the context of a “just” transition, however stable employment is central to a well-functioning economy. This transition extends beyond the mere switch in energy sources; it encompasses a comprehensive restructuring of the global workforce that will span many sectors and geographies. ILO conservatively estimates the transition will bring about 25 million new jobs¹ (relatively small when considering a global workforce of 3.5 billion people), but if you consider the transformation needed in agriculture and other sectors, the opportunity, particularly in emerging and developing markets becomes much larger. A challenge here is that labor market data is notoriously “patchy.” Ekkehard notes that "we don't really have a good assessment on the local and more granular effects," underscoring a gap in our current understanding—a gap that investors must bridge through enhanced due diligence.  

As investors, we believe it will be important to evaluate how countries are investing in their human capital and positioning their workforce to benefit from the transition; meanwhile for companies we will need to continue to assess their ability to attract, retain, and train the necessary talent. Skills training will be key at both the government and company level to drive economic growth, but also to avoid potentially costly backlash. This has been at the center of several recent discussions within our fixed income investment team as we look at both sovereign and corporate investment opportunities. In Indonesia, for instance, we continue to monitor how the country is leveraging their vast nickel reserves to move up the value chain as a key EV battery supplier; and similarly in Brazil, we are looking at how it is leveraging its agricultural resources to enter into the biofuels space. Each of these instances require investment in human capital to build a higher skilled workforce, which if successful, present tremendous economic opportunity. Conversely, the United Auto Workers (UAW) strike last year in the U.S., partially driven by tensions related to the EV transition, demonstrates the potential costs to companies if they fail to proactively think through implications to workers. It also underscores the importance of social dialogue and strong labour market institutions to achieve a successful energy transition as stressed by Ekkehard.  

Opportunity in Fixed Income

To sum up the conversation, it is clear to us that the energy transition will continue to be an important investment theme, particularly for fixed income investors, but the path will not be linear. Just as we do not rely on any one economic data point to tell us how the economy is doing, so too is the case for the energy transition. The onus rests with us as investors to put together the many pieces of the puzzle to help us deliver on our mandate to clients. As Tim points out, the return on invested capital for both traditional fossil fuels and renewable energy have really been quite similar when averaged out over the last several years, but the volatility in fossil fuels has been much higher. At Brown Advisory, we believe our sustainable fixed income strategies play an important role in providing stability in client portfolios, so a focus on downside risk management while minimizing volatility is key.

Time horizon is also an important consideration. As Tim reminds us, “I think there's a tendency in investment discussions and in all forms of debate to focus on very short-term indicators, short-term developments. I think we need to step back occasionally and see the broader direction of travel because we are in a clean energy transition. It's not just being driven by short-term policies. It's being driven by a host of broader economic, technological, strategic considerations.” 

Beyond the necessary considerations for downside risk management, there is also a tremendous opportunity for fixed income investors. We have the ability to invest in both the public and private sector through government-issued bonds (sovereigns, municipals), supranational bonds (including the multilateral development banks), and corporate bonds—all of which will play an important role in the transition. Furthermore, tools such as labelled green and sustainability bonds-- about $1 trillion USD in new issuance in 2023² —as well as emerging blended finance instruments present an increasing area of opportunity, making the fixed income asset class an important channel for the infusion of capital necessary to propel the energy transition forward. 
 

Written by

<sup>1 _{International Labour Organization, Green with Jobs and a Just transition, 2022. https://www.ilo.org/media/373481/download}

2 _{Green bonds reached new heights in 2023, Bloomberg, 02/08/2024. https://www.bloomberg.com/professional/insights/trading/green-bonds-rea…}</sup>

Disclosures

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results.  

Past performance may not be a reliable guide to future performance and investors may not get back the amount invested. All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.

All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned. 

The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities or issuers mentioned. It should not be assumed that investments in such securities or issuers have been or will be profitable. References to specific securities or issuers are to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. 

Sustainable investment considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. Sustainable investment analysis may not be performed for every holding in every strategy. Sustainable investment considerations that are material will vary by investment style, sector/industry, market trends and client objectives. Certain strategies seek to identify companies that we believe may be desirable based on our analysis of sustainable investment related risks and opportunities, but investors may differ in their views. As a result, these strategies may invest in companies that do not reflect the beliefs and values of any particular investor. Certain strategies may also invest in companies that would otherwise be excluded from other funds that focus on sustainable investment risks. Security selection will be impacted by the combined focus on sustainable investment research assessments and fundamental research assessments including the return forecasts. These strategies incorporate data from third parties in its research process but does not make investment decisions based on third-party data alone.  

In the included audio podcast, Ekkehard states that the net number of jobs being created through the energy transition is around 28 million by 2030. However, research by ILO actually estimates this number to be 25 million. https://www.ilo.org/media/373481/download&nbsp;

_{Terms and Definitions:}

_{Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a portfolio and compares its risk-adjusted performance to a benchmark index.} 

_{Duration is a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.}

_{Volatility is the degree of variation of a trading price series over time, usually measured by the standard deviation of returns.}