With the US poised to rejoin the Paris Agreement under the incoming Biden administration and the proliferation of net-zero commitments from various governments, the romance between equity markets and renewable-energy goes from strength to strength.
But in all the excitement about the future of renewables, a bigger truth is being overlooked: the underlying reason for the astonishing transformation of renewables over the past decade from niche to mainstream competing head-to-head with fossil fuels is economic rather than environmental.
Wind and solar are intrinsically deflationary, whereas fossil fuels are intrinsically inflationary. This has huge implications for the distribution of value across the global energy system over the next three decades.
Just consider the difference in the economics of renewables versus oil.
With wind and solar, there is no need to explore for reserves or drill a well to exploit them — you simply have to build the infrastructure in the right place to capture the energy that is already there and that is freely available once that has been built.
It is therefore all about economies of scale, and as these kick in and are then complemented by technology improvements, capital-investment costs fall dramatically over time while the short-run marginal cost of production is zero.
For solar, in particular, the decline in costs has been spectacular, with IRENA estimating that over 2010-19 the average cost of utility-scale installations fell by 80 per cent. Onshore and more recently offshore wind have also seen dramatic cost reductions over the past decade.
Moreover, as new renewable-energy projects typically come with offtake contracts giving long-term visibility on price, the financing can be done primarily with debt. With interest rates at historic lows, this has the double benefit of giving new projects a very competitive overall cost of capital while allowing the small portion financed by equity to achieve high single-digit or even low double-digit returns.
By contrast, with oil the cheapest reserves are exploited first, and as these are depleted more expensive sources of supply are tapped that are more difficult to access and therefore more expensive to find and develop.
Technology improvements can mitigate the extra cost of exploring for and developing more expensive resources to an extent — witness, for example, the experience of the US shale industry over the past decade — but the essential point is that the geology of petroleum production is inherently inflationary.
And because the upstream oil industry has always been a risky business, it has always been financed primarily with equity.
Equity investors are willing to accept a higher level of risk than lenders, but they expect higher returns in exchange. And with rising concern about the structural pressures on demand posed by the policy imperatives of decarbonisation, reducing air pollution, and electrifying transport, the required rate of return for equity investors from oil is only going to increase over time.
Add in the impact of COVID-19 on oil demand this year and it is not hard to see why the market is swooning over renewables while souring on fossil fuels: according to the IEA, only wind and solar will see an increase in demand this year, with all other sources of energy suffering a year-on-year decline.
As such, 2020 is a huge moment in the history of global energy markets, as it will be the first year ever in which wind and solar account for 100 per cent of the increase in global energy demand. To put this figure into context, BP data show that in 2019 wind and solar accounted for only 34 per cent of the increase in global energy demand.
Of course, demand for fossil fuels will probably bounce back strongly in 2021 as vaccines are rolled out and economic activity starts to normalise. But a psychological Rubicon has nonetheless been crossed, with 2020 offering a taste of what is to come in energy markets over the next decade.
Where climate change meets business, markets and politics. Explore the FT’s coverage here
As the market share of renewables rises sharply, so more of the global energy system will be subjected to deflationary pressure. Indeed, perhaps the pricing of a significant portion of oil may have to move to long-term contracts, with the returns that have been the hallmark of the global petroleum industry for the last 75 years being eliminated for all but the lowest-cost producers such as Saudi Arabia and other Middle East countries.
Mark Lewis is chief sustainability strategist at BNP Paribas Asset Management
The Commodities Note is an online commentary on the industry from the Financial Times
Twice weekly newsletter
Energy is the world’s indispensable business and Energy Source is its newsletter. Every Tuesday and Thursday, direct to your inbox, Energy Source brings you essential news, forward-thinking analysis and insider intelligence. Sign up here.
Copyright The Financial Times Limited . All rights reserved. Please don't copy articles from FT.com and redistribute by email or post to the web.