Electricity vs gas - The devil is in the details

There is always a lot of noise around clean energy policies. Today’s politics is all slogans and soundbites, and clean energy is a frontline issue in the West’s culture wars. We see this reflected in the share prices of the many of the companies in our environmental themes, which sometimes seem to act as barometers of pure sentiment, with little regard for underlying fundamentals.

But underneath the noise and headlines, the transition to a low carbon economy is in many ways a dry, technical and detailed affair. Companies generally use technical specifications to reduce their carbon footprint. Gains in efficiency and yield are generally measured in tiny increments. And the details of how those noisy headline policies are actually implemented, can have profound implications.

A great example of this is in the current fight to electrify heat. At the moment, space heating is still dominated by fossil fuels. Systems for using coal and natural gas have been embedded for hundreds of years. They have the advantages of incumbency, including perfected supply lines, and network effects.

But, the scientists on the electric heat side are catching up. Heat pump technology, where heat is effectively conjured out of thin air, has moved on leaps and bounds in recent years. We are big fans, with investee company Trane Technologies making the pumps themselves, and other holdings such as Infineon deeper into the value chain.

Outside residential heating, things are moving on too. The Electric Thermal Solutions division of portfolio company Spirax delivers ever-higher temperature, more consistent and more flexible electric heat, for all kinds of industrial uses. So the range of applications where fossil fuels beat electricity for heat is shrinking fast.

There is, of course, another big advantage for electricity, in that its price will only fall in the long term. In the last decade, the cost of solar power has fallen by around 80%¹, and onshore wind, 40%². And this cost curve is still a long way from completion.

So why isn’t electric heat being adopted more quickly? Well, one reason is that the playing field isn’t always level. And this is a great example of a small detail that could really help to speed things up.

The key metric to understand this is the electricity-to-gas price ratio. This is how much a unit of electric energy costs, relative to the same unit of energy provided by natural gas. In most of Europe at least, natural gas is the leading fossil fuel source of energy, as coal has largely been phased out.

If the electricity-to-gas ratio is high, then the cost of switching to electric heat from natural gas will be high. Too high, for example, to encourage consumers to make that switch to a heat pump.

But what determines what this ratio is? Well, obviously there are some “natural” market features which determine the relative prices of the two sources. Having abundant natural gas, or a very developed gas grid network, will make gas relatively cheaper. This works the other way too, of course. This is why WHEB is investing in companies that help build more green electricity, and a bigger and better grid, through holdings such as FirstSolar, Schneider Electric and TE Connectivity.

Crucially, there are market distortions which can also tip the scales one way or another. In many countries with above-average electricity-to-gas ratios, such as Belgium, Germany and the UK, government policies, and taxes, can be the sand in the gears.

Many readers will be familiar with the concept of fossil fuel subsidies, which remain remarkably widespread even in rich countries. These can be buried in the supply chain and in tax codes, or more visible in adjusting the price of fossil fuels.

Ironically, even some levies designed to boost low carbon alternatives can be part of the problem. Here in the UK, for example, electricity generation is subject to carbon pricing, but no carbon taxes are applied to gas or oil for residential use. And what’s worse, there are surcharges such as the Electricity Generator Levy and Feed-in Tariff charges, which are currently only applied to electricity bills.

With electric heat adoption trailing way behind decarbonisation targets, these anomalies haven’t gone unnoticed. The power industry globally is pushing for a fairer share of the burden to fall on heat-generating fossil fuels.³

Where these anomalies arise, most governments will want to straighten them out. But, staying with the example of the UK, the noise now dominating the debate on heating is around the Winter Fuel Payment…. and whatever attention the price ratio had, has been lost. Of course, the Winter Fuel Payment is a very worthy subsidy for the elderly to stay warm in winter… but it does unfortunately also benefit the entrenched dominant heat provider, fossil fuels.

It also makes the decision to rebalance between electricity and gas that much more controversial. But this remains another detail that will need to be fixed on the road to a low-carbon future.

¹ https://www.irena.org/-/media/Files/IRENA/Agency/Publication/2017/Nov/%20IRENA_Sharply_falling_costs_2017.pdf
² https://www.irena.org/-/media/Files/IRENA/Agency/Publication/2017/Nov/%20IRENA_Sharply_falling_costs_2017.pdf
³https://www.ft.com/content/9092d563-320f-4dd2-b283-e8eb4a2a9298