The Climate Agenda Will Cause Prices to Increase
On November 1st, over 100 World Leaders met at Glasgow, UK for the two weeks long COP26 Climate Summit to address the Climate Crisis and keep the Paris Climate Agreement alive. The COP26 is expected to be the most important and impactful environmental gathering since COP in Paris in 2015, which led to the Paris Climate Agreement. The key objective of the United Nations led Paris agreement, is to ensure that we keep the global temperature to below 1.5 degree Celsius as compared to pre-industrial level. As this high level and highly politicized summit prepares to take place, most countries attending continue to be in a quasi-recession caused by the global pandemic that started in early 2020. The global economy lost nearly $8.5 trillion in output since then. With this background, both crude oil and natural gas have hit a seven-year high, while consumers in the United States are paying nearly a dollar more for gasoline than they did in 2020. In the EU, natural gas prices rose 4 times in 2021, sending household energy bill to unprecedented highs. These rising prices have caused a significant increase in food, energy and transportation costs, weighing heavily on consumers who are beginning to feel the inflation pressure.
Oil prices and inflation are interlinked, and as crude oil prices increase, a general rise in the price of goods and services throughout the economy follows suit. As money supply continues aggressively and President Biden seeks to secure approval from Congress for an over-ambitious climate investment package (as part of the original 3.5 trillion-dollar Infrastructure Bill), crude oil prices could be driven to a new all-time high. As oil and gas corporations aim to return to the pre 2020 production levels, the Fed will expand its money supply, potentially accelerating further the inflation. What we are seeing in this market, is that the demand for crude oil and gas exceed the supply. This is in part due to increased reduction of new production and exploration due to the increased ESG compliance, monitoring and climate regulation. This in turn, we will keep commodity prices high adding more inflation pressure and thus potentially slowing down the global economic recovery.
The pressure on oil companies to reduce oil and gas exploration and adapt their business models to a low-carbon world has increased significantly since the Paris Climate Agreement was signed in 2015, and as of recently, the climate debate has inflated considerably the interest in ESG. This has slowed down the coming on stream of new oil and gas projects keeping in the ground new resources due to fear of new regulations and increased public scrutiny. Companies are making these cuts because they want to save money and return more money to shareholders through higher dividends.
The resulting reduced supply will generate negative supply side externalities, which Deutsche Bank summarizes as follows: ‘ESG is a negative supply shock that internalizes the climate costs of the production of goods and services. This negative supply shock should be inflationary until technological advances absorb these costs. ” As a result, oil companies may not be able nor willing to bring more crude to market because of the new ESG momentum.
We must accept that, in the short term at least, we are going to have to pay more to meet the Paris Climate Agreement (this is summarized with the zero-carbon emission by 2050), and this will cause prices to rise across most sectors.Additionally, the energy prices may stay high for a while as the supply side will be slow to catch up. Traders should be aware of new commitments and new frameworks coming out of the COP26 Summit, specifically updated Nationally Determined Contributions (NDC), as some of the bold statements coming out of the Climate Summit may impact the market. However, unless countries implement these policies (which many will fail to do), simply making a statement won’t have any impact on the energy industry or the market in the medium to longer-term. Many governments want to impose restrictions and regulations on the use of fossil fuels and carbon emissions. However, this will not fly if it comes at a higher societal cost than estimated.
While we are strong believer of ESG and remain optimistic of the positive momentum around the COP26 Climate Summit, in the short to medium term, climate negotiations, and ESG regulation pressure, may accelerate “runaway inflation”, resulting in a potential short term hyperinflation trend. And the potential damage of the energy crunch is far from limited to economic recovery, as it also become a significant challenge to the early-stage green energy transition. As nations struggle to enhanve their energy security, climate pledges and decarbonization ambitious plans become secondary as countries struggles to supply to end users cost effective energy solutions.
