Are fossil fuels really back in business?

As lenders withdraw finance from fossil fuel projects and major producers shift toward lower-carbon alternatives, those problems will only be accentuate, with supply-demand mismatches increasingly leading to volatile fuel prices that will play havoc with generators' cashflows. Stability and certainty have always been valued qualities in business. The very ungoverned excitement of energy fuel markets now contains the seeds of their own decline

From the price action, you'd think that fossil fuels are back in business. Since breaking above $100 a metric ton in May, the price of coal at Australia's Newcastle port - a benchmark for Asia, which consumes about three-quarters of the world's soot - has gone almost vertical, hitting a record $173.10 a ton Thursday. The key regional contract for liquefied natural gas, the Japan-Korea Marker, is in similar territory, hitting $18.02 per million British thermal units the same day. That's not a record, but it's still the third-highest spike LNG has ever seen, during what's typically the low season for a commodity that tends to surge amid winter's heating demands.

If you think of futures prices simply as a vote on the path ahead for the commodity in question, that should worry a world that needs to decarbonize. This view is simplistic, though. Commodity prices don't rise and fall based on the level of demand itself, but rather as a result of the mismatch between demand and supply. A world in which fossil fuel consumption is on a long-term downtrend can still see handsome prices for fossil fuels in any period when supply falls faster than demand.

The current price spike has multiple sources. One is the diversion of Russian gas from Europe to Asia, while another is China's coal-to-gas switch. Then there's the relatively warm, dry summer that's reduced hydro generation and increased pressure on air conditioners. Most important, though, has been the bounce back from 2020's bout of economic sickness, which has sent electricity consumption surging - and with it, the dirtiest forms of generation.

One of the biggest drivers for growth in renewable power's energy share over the past decade has been flat or declining electricity demand. Adding wind and solar capable of supplying 5 per cent of a country's grid power can drive a sharp reduction in emissions if output remains constant or falls. If, however, grid use climbs 5 per cent, then all that new renewable capacity won't make a shred of difference to emissions. If it climbs 14 per cent year-on-year - as China's did in July - then it's likely to be fossil fuels that make up the shortfall.

That situation can turn even the economic disadvantages of coal and gas in their favor. For years now, the growth of renewable power with zero fuel costs has been pushing thermal generators out of use, dealing a severe blow to their economics. Fossil power plants need to be in operation for 60 per cent to 80 per cent of the time to turn a profit, but the last time China's fleet hit that level was all the way back in 2011. For most of 2019 and 2020, the figure was well below 50 per cent.

That very underutilization, however, means that there's substantial ability to turn up the gas when demand starts surging. Delivering an extra megawatt-hour from a thermal generator operating at half capacity only requires finding some fuel on the global markets for coal and LNG. If you want to increase wind and solar generation beyond current levels, you'll need to build a whole new power plant.

That sounds like bad news for decarbonization - and in the short term, it is. Still, the current price spikes also provide a reminder to generators of why the days of thermal power are numbered. At current prices for Newcastle coal, even the most efficient power plant will be paying upwards of $60 per megawatt hour just for its fuel. In the largest markets of China and India, the cost of brand-new wind or solar generation is half as much, or less. Even renewable power plants backed up with batteries to provide on-demand electricity are competitive with fossil fuels at current prices.

That's the ultimate reason why the world will switch away from the historic role of carbon as the solid base of electricity systems over the coming decade. Renewable generation is priced at the time of installation, and doesn't vary in cost over a multi-decade project life. That gives enviable certainty to grid operators whose revenues are typically fixed by the government, especially when compared to commodities like coal, whose price can increase threefold in 12 months, as they did over the past year.

As lenders withdraw finance from fossil fuel projects and major producers shift toward lower-carbon alternatives, those problems will only be accentuate, with supply-demand mismatches increasingly leading to volatile fuel prices that will play havoc with generators' cashflows. Stability and certainty have always been valued qualities in business. The very ungoverned excitement of energy fuel markets now contains the seeds of their own decline. (Bloomberg)