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Climate and energy are more closely intertwined than ever

The energy crisis was already wreaking havoc with energy transition plans. Heatwaves this summer have exacerbated matters. Does the crisis put climate change targets at risk? Alexander Bernhardt explores. 

We seem to be in an endless cycle. Energy supply shocks following the outbreak of war in Ukraine have resulted in governments hastily organising energy security strategies to diversify fossil fuel imports and mitigate the impact on households and business. The price of gas has skyrocketed, improving the economics of more carbon-intensive coal. These events have clear implications for greenhouse gas emissions and the climate.

A summer of significant heatwaves has painted a clear picture of how climate change can further exacerbate energy supply problems. Low river water levels and high temperatures have affected fuel supplies and power provision.

How can this cycle be broken?

The immediate response

After gradually closing the taps, the Kremlin now says that flows of Russian gas to Europe through the Nord Stream 1 pipeline will remain curtailed as long as the West maintains its sanctions against Russia. This has added to pressure on European Union (EU) countries to speed up the bloc’s RePowerEU plans, rebuild inventories and advocate an economical use of gas.

While those plans have a significant renewables component, EU member states have also committed to building new liquefied natural gas infrastructure. Liquid natural gas (LNG) may be less carbon-intensive than coal. However, taking into account methane emissions from transporting it – often over long distances – and, depending on its source, fugitive emissions, its greenhouse gas footprint makes shipped LNG considerably worse for the climate than piped gas.  

Recent analysis for the Financial Times found that European governments will spend EUR 50 billion this winter on fossil fuel infrastructure and supplies, more than four times the EUR 12 billion earmarked in RePowerEU. There are plans to build 26 LNG terminals. Nations are due to spend more on coal for power stations that were due to close and now have lifetime extensions.

Exacerbating the issue, the Rhine’s low water levels, for example, have meant coal-laden ships can only sail with partial loads, affecting the operation of coal stations on its tributaries. There is a higher demand for gas in countries whose hydropower facilities have been affected, such as Spain and Portugal.

Exhibit 1: Electricity generation by source (world)

These climate-induced exacerbating factors are set to become more frequent in the future.

They are increasing the cost of energy. Higher demand for coal combined with logistical problems have contributed to the price of a tonne of hard coal reaching USD 450, compared to USD 60 at the start of 2021. Germany, the Netherlands, the Czech Republic and Greece have all increased their coal production or mining activities in response. Meanwhile, certain factories in Europe have shut down to avoid the high energy costs.

In China, hydropower levels are also down in the water-stressed southwest, which is resulting in more coal being burned for power generation as well as factories shuttering.

EU member states have been putting energy security schemes in place. Germany has implemented energy efficiency measures. It has now exceeded the EU’s recommended gas storage target of 80%. Its average import prices of natural gas, oil and coal have risen sharply, increasing 132% year on year in July. It is extending the operation of at least one nuclear power station, and it and France have agreed to exchange gas and power if needed.

The EU is also planning to bailout firms and households struggling with record high energy costs, supported by a levy on power generators.

The impact on climate targets

European policymakers are characterising the gas and coal diversification push as just a stop-gap measure. However, there are concerns the investment in new infrastructure could lock in reliance on fossil fuels for longer than otherwise would have been the case.

The crisis has increased the carbon price in the EU ETS as gas contracts have surged and coal generators bought allowances for hedging purposes. A high price may well be good to limit emissions. However, the European Commission has promised EUR 29 billion in aid to ETS participants to partially compensate energy-intensive companies.

The Commission is also planning to sell additional carbon allowances to fund RePowerEU, a move that has attracted criticism, along with its proposal to waive Do No Significant Harm requirements when it comes to investing in ‘security of supply’ projects.

Analysis indicates the energy efficiency measures to be implemented in EU member states will offset the emissions from increased coal usage. However if coal becomes a longer-term trend, it will be harder to meet emissions reduction and climate goals.

Invest in clean energy for security

From an ESG investment standpoint, we believe it is important to note that funding clean energy capacity does not just help meet climate targets, it is now viewed as a key strategy to improve energy security.

Climate change, energy security and inflation are all interlinked (see Exhibit 2). Moving away from fossil fuels and to a clean energy system will help ameliorate all three of these problems, as we have previously explored.

Exhibit 2 Energy security inflation and climate change are interlinked

In short, for EU climate targets to be reached, it is important the stop-gap is just that and does not lead to a longer-term increase in fossil fuel use. If the energy shock speeds up the deployment of clean energy capacity, this could alleviate energy security concerns while protecting climate targets. Analysis suggests more clean energy capacity could eliminate the need for new infrastructure for gas imports.

Policymakers are already responding to this opportunity – ‘Exhibit A’ in this case being the Inflation Reduction Act in the US.

Following this shift in the policy environment, investors will have a key role to play in redoubling fiscal support and helping to break the fossil fuel-insecurity-inflation cycle.

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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