Border taxes: a carbon curtain has descended?

As Europe advances its decarbonization agenda, a ‘border adjustment mechanism’ has now been proposed to mitigate carbon leakage. Its initial formulation is modest. But it will snowball. And ultimately divide the global economy in two. Hence this 15-page report lays out our top five predictions for CO2 border taxes to reshape energy markets and the world.

In 1946, Winston Churchill made his famous ‘Iron Curtain’ speech, prophesizing decades of tensions between different economic systems in the West and elsewhere. The concept of a carbon curtain is similar, and is laid out on pages 2-4 of our report.

These wheels are now firmly in motion, as Europe has proposed a carbon border adjustment mechanism, in order to stem carbon leakage, as it tightens its environmental policies. For those who prefer not to read the Commission’s entire 291-page leviathan, we have summarized the key features on pages 5-6.

Expansion is inevitable. Page 7 argues for domino effects, where CBAM will be emulated by other Western economies; and then broadened, first into the manufacturing sector, then universally.

There will be five investable consequences of these escalating border taxes, which we spell out on pages 8-15. They could be extremely constructive for the gas/LNG industry, pre-existing renewables assets, and some lower carbon economies. But we also see major losers in the coal industry, higher-carbon countries and victims of inflation.

Lithium: reactive?

Lithium demand is likely to rise 30x in the energy transition. So this 15-page note reviews the mined lithium supply chain, finding prices will rise too, by 10-50%. The main reason is moving into lower-grade ores. Second is energy intensity, as each ton of lithium emits 50 tons of CO2, c50% due to refining spodumene at 1,100◦C, mostly using coal in China. Low-cost lithium brine producers and battery recyclers may benefit from steepening cost curves.

Inflationary feedback loops increasingly matter in the energy transition. Decarbonization technologies themselves need to be decarbonized. But this tends to re-inflate their costs. Page 2 re-caps this issue and why it matters.

An overview of the lithium supply chain is spelled out on pages 3-7, across the three major categories of “brine”, “mine” and “refine”. In each case, we aim to highlight the key numbers and energy costs.

An economic model of mined lithium can thus be derived on page 8. We outline what price is needed for a 10% IRR across the value chain.

The first re-inflation risk is the direct cost of decarbonization, which is quantified on pages 9-10, including carbon prices, energy costs and materials costs.

The second and larger re-inflation risk is the need to move into lower ore grades, to meet a 30x increase in future lithium demand. This is quantified on pages 11-12.

The impacts on batteries and electric vehicles are then translated through on page 13. We conclude that OEMs may consider backwards-integrating, to secure supplies.

Who benefits? Steepening cost curves are best for those at the bottom of those cost curves. And possibly also for battery recycling. We have screened 20 companies and discuss our conclusions on pages 14-15.

Phasing out gas: five hidden consequences?

Phasing out gas is likely to be a policy choice made by some cities or States, as part of the energy transition. The purpose of this note is simply to examine possible consequences. Which could be stark. Somewhere after c75% of customers have been shed, costs balloon by 70-170% for remaining customers, methane leaks worsen, local gas distributors suddenly go bankrupt, and governments must step in to ensure safe decommissioning and reliable backups. Taxpayers foot the bill.

A baseline: how do gas utilities work?

As a starting point, the typical, small municipal gas network might serve a few thousand to a few tens of thousands of customers, charging around $700 per household per year (60mcf pa at $12/mcf) (note below), and more for larger consumers, such as industrial/commercial consumers (data also below).

Network effects mean that costs are a function of the customer count. Furthermore, costs will rise if the number of customers falls. For example, a recent technical paper has evaluated 250 shrinking utilities in the United States, over several years, concluding that customer losses tend to yield 0.5-to-one revenue declines (Davis, L, & Hausman, C. (2021). Who Will Pay for Legacy Utility Costs? Energy Institute WP 317).

In other words, $1 of lost revenue typically results in $0.5 of additional revenue being raised from remaining customers. The idealized maths of this process are captured below…

Specifically, we estimate that if a gas network falls to c20% of its original size, the remaining customers would be likely to pay 70% more (rising from $700 pa to $1,200 pa) while the gas utility’s ability to earn a profit has effectively been wiped out. The balance could be different in practice. But let us explore the consequences of this scenario…

Five hidden consequences of phasing out gas

(1) Tipping points? The more customers leave a gas network, the faster costs start rising for remaining customers. In turn, this might accelerate the rate at which new customers leave the network. So the shift away from incumbent gas networks could start slowly, then accelerate, then happen particularly quickly. This suggests governments wishing to phase out gas may need a good plan up-front, before this sudden acceleration sets in.

(2) Huge costs for those who cannot switch? If the ultimate size of a gas network falls by 80%, the cost per customer rises 70%. If the size falls 90% then costs per customer rise 170%. If there were some customers who could not switch away from gas (e.g., insufficient capital/credit to make the upgrade), then they would be saddled with very high energy costs. Those most impacted are likely to be those with the least financial resilience. Again, this means governments may need to step in and come to the rescue in some way.

(3) Maintenance costs of the gas networks hardly decrease just because customers are moving away. The pipes are still in the ground. But fewer customers dents the profitability of gas distributors. Hence there may be a temptation to cut back on maintenance spending, or some other financial difficulty for maintaining existing as networks properly. In turn, this could have negative environmental consequences, worsening methane leaks, which already tend to be higher at smaller and more cash-strapped gas utilities (note and data-file below).

(4) Bankrupted distributors? Once c75% of the customers have left a gas network, it will become very difficult for these gas distributors to remain profitable at all, according to our analysis. Thus they may shut down entirely, yielding ‘stranded assets’ and the bankruptcy of thousands of small firms (charted in the data-file above). Critics of the fossil fuel industry often jeer at stranded assets, as though it is some kind of milestone of progress to be celebrated. The reality is that governments would need to step in, take over control of these gas networks, and then pay to have them safely decommissioned. Using taxpayer money.

(5) What alternatives? The old adage for a century has been that a mixture of gas and electricity offers a helpful lifeline in the depths of winter. Gas pipelines tend to be trenched underground. Hence if a vicious winter snowstorm comes through and knocks out the overhead power lines, Mrs Miggins is going to have some kind of alternative heating source and is not going to freeze to death in her home. Again, one of our main question marks over renewable-heavy power grids is whether they will have sufficient resiliency in extreme conditions (note below, looking at hot conditions, but a similar logic applies in the cold).

Conclusions: are there better options?

Our own personal view is that some governments may not be prepared to shoulder the consequences noted above. Nor do they need to. Well functioning gas heating can be perfectly compatible with decarbonization goals in the energy transition, if the gas is used efficiently, without methane leaks, and the residual CO2 is offset or decarbonized at source. This may be superior to ‘phasing out gas’ and dealing with the issues noted above.

Our research below explores a selection of these different themes…

Reforestation: a real-life roadmap?

This 12-page note sets out an early-stage ambition for Thunder Said Energy to reforest former farmland in Estonia, producing high-quality CO2 credits in a biodiverse forest. The primary purpose would be to stress-test nature-based carbon removals in our roadmap to net zero, and understand the bottlenecks. IRRs can also surpass 10% at $35-50/ton CO2.

The correct way to structure a reforestation project is one of the most important questions in the energy transition, but few seem to have cracked the code. This is our conclusion from hundreds of models and discussions, which are summarized on pages 2-4.

Our own interests in undertaking a reforestation project are set out on 5-8, combining personal circumstances, economics and an aspiration to understand the reforestation process in more detail.

What will a high-quality project need to look like? Our expectations and goals are set out on pages 9-12. As transparently as possible. This is a structured list of questions, and our initial hypotheses, to be addressed in future research.

Energy transition: the top ten controversies?

This 11-page note summarizes the ‘top ten’ controversies in the energy transition, based on 2,000 pages of our research to-date, and resultant discussions. Our outlook is increasingly despairing. And inflationary. Yet opportunities do exist to unlock value amidst bizarre and market-distorting policies.

Thunder Said Energy has now published over 2,000 pages of research, plus 400 data-files and models into the energy transition, since its inception in 2019. The purpose of this short note is to look back across all of our work, and ask…

What are the top ten controversies in the energy transition? In each case, we will outline what the controversy is; why it matters; and our own view. There is only one rule for this exercise. To limit ourselves to 1 page per controversy, in order to distill the key points.

The controversies make us fearful that well-intentioned policies may unfortunately be painting the world into a corner, as outlined on pages 2-4.

We hope our work can arm decision-makers with ideas: to preserve value, even create value, by anticipating market distortions. This includes ‘printing money’ by back-stopping volatile renewables, debottlenecking future commodity bottlenecks, improved technologies, and implementing nature based solutions that help the world avoid becoming a waste land (pages 5-11).

Carbon markets: a thought experiment?

The short video below is a thinly-veiled critique of carbon markets, their ridiculousness and the lobbying that seems to be taking place against nature based solutions. To do this, use an analogy from the banking sector, followed by some observations on carbon markets, carbon prices and carbon offsets.

The analogy is that if bank debt were like carbon markets, you would never be allowed to re-pay the debt; you would simply be forced to borrow less money every year under a cap-and-trade system, following a byzantine set of rules; until eventually you gave up and went to do business with a different bank.

Conversely, if carbon markets worked like the modern banking industry, using nature based solutions to re-pay the ‘debts’ of carbon emissions, then the world could likely find a genuine, low-cost and verifiable route towards net zero.

Referenced in the video are our latest views on inflation-risks due to energy transition policies, the world-changing potential of nature based carbon offsets, a re-thinking of carbon prices, and hopes for better carbon labelling. Please see below for further details of each one.

Gas turbines: what market size in energy transition?

Combined heat and power systems are 20-30% lower-carbon than today’s gas turbines, as they capture waste heat. They are also increasingly economical to backstop renewable-heavy grids. Amidst uncertain policies, the ultimate market size for US CHPs could vary by a factor of 100x. We nevertheless find 30 companies well-placed in a $9trn global market.

What are CHPs and why do they matter? Gas turbines have been in use for power generation since the late 1930s. They usually range from 500kW to 300MW capacity. We outline how they work, why CHPs are more efficient, and why they could be well-placed for backstopping renewables on pages 2-3.

Five future markets could exist for CHPs. We have quantified the opportunity in large-scale power (page 4), industrial heat (page 5), landfill gas (page 5), EV fast-charging (page 6) and smaller-scale residential/commercial systems (page 6).

The ultimate market can thus be assessed by adding together each use case. But future policies are uncertain. We find the total addressable market in the US by 2050 could be anywhere ranging from $30bn to $3trn, i.e., an uncertainty level of 100x (pages 7-9).

Amazing progress is nevertheless being made, despite the policy uncertainty, as we have tracked new developments from thirty leading companies, aiming to make gas turbines more efficient for the energy transition (pages 10-11).

Blockchain: why so energy intensive?

A single Bitcoin transaction currently uses c1,000kWh of electricity, which is 1 million times more than a traditional payment. Hence this 8-page note aims to explain how blockchain works, why it has been so energy intensive in the past, and how the energy multiplier could be reduced to maybe 100 – 1,000 x in a best case future scenario. Thus there could be a role for blockchain in some use cases in the energy transition.

Power grids: hell is a hot, still summer’s day?

Ramping renewables to 50% of power grids is a growing aspiration in the energy transition. But in some markets, it may result in devastating blackouts during summer heatwaves, as power demand doubles exactly when wind, solar, gas, transmission losses and disruptions all deteriorate. This 15-page note assesses the causes, implications and mitigation opportunities.

In David Copperfield, Charles Dickens’s quasi-autobiographical novel of 1849, Mr Micawber famously summed up his household’s finances: “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery”. So too with the grid. A small tilt from surplus to deficit results in blackout misery, costing billions in economic damages, and hardship for millions of people (pages 3).

High temperatures cause grid balances to deteriorate. Across every single line in our models. This is under-appreciated. It is mostly due to immutable laws of physics (which cannot be over-turned by policy-makers, try as they might). Hence our work aims to quantify these temperature sensitivities for cooling demand (page 3), wind (page 4), gas-fired power (page 5), solar power (page 6) and transmission losses (page 7).

A simple model is constructed, showing how a seemingly well-covered grid, which actually suffers from excess capacity most of the time, can thus fail catastrophically during a heatwave (page 8).

This is where power grids are heading. We outline our models and forecasts across the US, Europe, China and broader emerging markets (pages 9-10).

So what solutions exist? We fear that grids will grow more and more erratic amidst summer heatwaves. Hence we have reviewed 10 opportunities and implications, which may become interesting to investors and companies (pages 11-15).

Moore’s law: causes and new energies conclusions?

Moore’s law entails that computing performance will double every 18-months. It was proposed in 1965. And since then, chips have consistently sustained this pace. We argue such exponential progress has been driven by three positive feedback loops. Can these same feedback loops unlock a similar trajectory for new energies costs? We find mixed evidence in this short, six-page note.

Pages 2-3 explain Moore’s Law, why it matters for the new energies industry, and why sustained, exponential improvements must hinge upon positive feedback loops.

The first feedback loop is down to the laws of physics, unique to the semi-conductors industry, as explained on page 4. It is hard to see how new energy technologies benefit from the same physics.

The second feedback loop is from boot-strapping, as better chips give better computers, which in turn have designed better chips, as outlined on page 5. New energies seem to be doing the opposite of boot-strapping.

The third feedback loop is from learning curves, noted on page 6, which we do expect to occur in new energies. But we must assess each learning-curve case-by-case.