Since the Industrial Revolution began, coal, oil and natural gas have been the dominant sources of energy for everything from heating homes to powering vehicles and industries. But energy sources will change dramatically in the decades ahead, as centuries of heavy reliance on hydrocarbon energy sources gives way to a clean-energy transition.
The Paris Agreement to limit global temperature increases has put momentum behind the transition. So have disruptions to the natural-gas supply from conflict in Europe and concerns about energy security. This year’s Inflation Reduction Act (IRA) in the US, which allocates nearly $400 billion to promote clean-energy development, will also provide a sizable boost.
The transition won’t be linear or smooth—reinventing a century-and-a-half-old global energy system in just 20 to 30 years is a monumental task. Wind power, for example, is a powerful natural resource, and there’s plenty of land for wind farms. But permits are needed, localities must agree to farm sites and turbines have to be built. Energy storage is needed for when the wind isn’t blowing, and the energy source has to be integrated with the power grid.
Redesigning energy production and distribution brings unprecedented opportunities. In order to reduce carbon emissions and mitigate climate change, annual investment in decarbonization solutions is expected to increase nearly fourfold over the next decade, from $1.2 trillion in 2020 to $4.3 trillion, according to the International Energy Agency. Companies that provide relevant decarbonization solutions should see powerful secular growth tailwinds in demand for their products.
For investors, it’s critical to understand how the transition will shape the landscape of opportunities: one approach is to think about them in four broad cohorts, as explored in AB’s Disruptor Series.
1) Hydrocarbon Firms with Clean-Energy Options
Because the transition will play out over multiple decades, traditional energy companies will play a key role. At their core, they have the capacity to produce hydrocarbon fuels that the world still needs as clean-energy capacity ramps up—and to power the development of clean-energy infrastructure.
As the need for fossil fuels declines over time, these core businesses face a declining enterprise value but generate substantial cash flow. A significant amount of this cash is being invested in decarbonization technologies that will enable the transition. They’re also making their production processes cleaner by investing in more efficient production technology and methane leak reduction. They’re also providing natural gas, a transition fuel that can replace coal for on-demand or baseload power, which renewables aren’t yet well-positioned to do. And they’re investing in low-carbon energy sources.
This push for innovation offers investors what amounts to a cleaner-energy “option.” Hydrocarbon majors are among the leaders in clean-energy patents, including geothermal energy—an area in their wheelhouse. Hydrocarbon energy firms are well-positioned to evolve into more holistic energy providers as the transition unfolds, and they could look very different in a few decades’ time. And they’re readily accessible through public equity and debt markets.
Because most hydrocarbon operators produce fuel inputs that power traditional engines rather than generating electricity directly, their role in the transition largely ends at the electron, where other clean-energy cohorts step in.
2) Core Renewable-Energy Mainstays
A diverse range of energy sources will be taking the mantle from hydrocarbon fuels over time, including renewable stalwarts like solar and wind energy. These energy sources are rapidly gaining traction and increasing scale, making their pricing attractive relative to both traditional fossil-fuel power generation and other clean-energy sources that are either emerging or earlier in their lifecycles.
While fossil fuels remain the dominant energy sources, renewables are growing much faster. As per the Office of Energy Efficiency and Renewable Energy, US solar capacity has grown to a point where it can power the equivalent of 18 million average homes. In 2020, there were more installations of wind power than solar for the first time in years. Of course, more capacity is needed from these sources, meaning more investment opportunities throughout the renewable value chain.
Take solar power. In addition to sourcing and refining silicon to make solar cells, solar panels must be built and power inverters created and connected to convert the electrical current from DC to AC. Also, consider the massive construction and technological resources needed to build and operate a 300-foot-tall wind turbine with individual blades weighing several tons. Many providers of the products and services critical to building out renewable infrastructure aren’t traditionally thought of as part of the “renewable” ecosystem, but they directly enable the transition and will benefit from its acceleration.
They also need a growing amount of storage capacity for energy that’s generated intermittently from the sun and wind, and that energy must be connected with power grids efficiently in order to supply households and businesses. These roles fall to a third cohort in the energy transition.
3) Critical Energy Technologies and Specialties
For every dollar that’s spent on building solar and wind energy capacity, another dollar is required to transport it and distribute it to end customers and to bolster the capacity of the electric grid. That responsibility leaves a critical transition role for technology and specialty functions.
Wind farm developers, for example, may also operate the facilities they develop, ensuring they’re working efficiently and that power is transmitted. Because wind and solar power are intermittent, energy-storage technologies are a priority in creating a more consistent supply. The market for battery energy storage systems is likely to grow rapidly throughout the transition to build out this capacity. The good news is that battery storage costs have declined massively over the past decade, making energy storage economically viable for utilities and homeowners.
Then there’s the “smartening” of the US power grid that will be sorely needed to integrate increasingly diverse energy inputs. Tomorrow’s smart grid is essentially a tech-enabled “traffic cop” at the intersection of energy and technology, juggling available energy capacity while using a wealth of data and two-way communication to dynamically balance energy demand and supply.
The combination of evolving big-energy majors, a growing contribution from renewable energy sources and the critical technology needed to store, transport, integrate and deliver power to the grid still leaves an important gap—decarbonizing hard-to-abate sectors such as industrials.
4) Wild Cards of the Energy Transition
To fill that gap, additional energy sources will likely be needed—some in the very early stages and others with a longer history that could be reimagined to help power the transition.
Nuclear power has been around for many decades, with its popularity having ebbed and flowed. In addition to the accompanying safety concerns, nuclear power has been growing more expensive—at least in the US—as other power sources have gotten cheaper. Still, traditional nuclear power is a meaningful part of the energy mix in a number of European countries, the US and other nations. In many cases, facilities slated to be phased out have been extended to meet energy needs.
Nuclear energy’s second act could come in the form of small modular reactors (SMRs) that can be factory built and more easily assembled on site. SMRs are simpler than traditional nuclear plants, have more flexibility in location and are passive systems, which could address safety concerns. Certain types of SMRs are heat-intensive enough to power heavy industries such as steel, which are beyond the capabilities of solar and wind power. Many SMR designs exist, though it will likely be years before they reach the scale needed to contribute to the nuclear energy mix and energy transition. Progress in fusion technology could also unlock new avenues for nuclear to contribute to the global energy mix.
Hydrogen is a newer technology that could be a gamechanger—a possible Swiss Army knife of decarbonization. For example, hydrogen can be used to decarbonize hard-to-abate energy sources that are highly heat-intensive. It can also produce enough energy per volume to power heavy transport—including large trucks, marine vessels and planes. Historically, hydrogen has been expensive, and more investment is needed to refine the electrolyzer technology and make it much more cost-effective. Also, transporting hydrogen remains a thorny problem. But falling renewable power generation and electrolizer costs should make hydrogen production more economic over the next several years.
Another de-carbonization solution is carbon capture and sequestration (CCS), which is approaching broader economic viability and is a key to reducing emissions from hard-to-abate sources like industrial processes, refining and chemical production. CCS is also being explored for its potential to put captured carbon to other productive uses as an input to certain industries and products—and conversion into other usable fuel sources.
The IRA is likely to provide a big boost for emerging energy technologies, including hydrogen and carbon capture, enabling them to progress along the cost curve, like wind and solar before them. For hydrogen, the IRA extends tax credits through 2042, creating a much longer runway of certainty that will likely stoke interest from a broader range of investors. Monetizing credits up front enables smaller hydrogen firms to finance the equity portion of projects, then secure debt financing in public or private markets. All of this financing activity opens up opportunities for investors to put capital to work.
The Big Picture
To sum things up, opportunities in the clean-energy transition are enormous and wide-ranging. And they span all corners of the capital markets, from public to private and from equity to fixed income. But to effectively capitalize on them, investors must understand the entire value chain—from creation to storage and distribution—for an increasingly diverse mix of energy sources. With better knowledge of the complex energy landscape, investors will be better equipped to identify compelling opportunities that help power the transition.
AB’s Disruptor Series is designed to provide distinctive perspectives on critical issues facing the capital markets today.