Posted on - 24 Sep 2021
As Editor of Battery Materials Review and Head of Research for Westbeck Capital’s Volta Energy Transition fund, over the course of the past several years I’ve noticed a number of trends that I would suggest that many people who are outside the direct ET wouldn’t notice, and perhaps those who are deep within it also are not noticing. One of the key trends that worries me is inflation.
This five-part series discusses the impact that different aspects of decarbonisation are having, and are likely to have, on consumer costs. The areas I’m discussing in this blog-series are:
1. Impact of a moratorium on oil & gas exploration
2. The hidden cost of the EV roll out
3. Renewables in their current form are not the promised land
4. Cost pass through effects from materials
5. Concluding thoughts
In this part, I’m going to discuss a theme which seems to be passing below the radar, except for a select group of specialist analysts. As such, it perhaps hasn’t received the attention it deserves.
There are a number of different elements to the energy transition; we have already discussed the decarbonisation of transport and of power generation in previous parts of this series. Another sector where there are profound impacts from the energy transition is in the decarbonisation of industry.
Heavy industries, by their very nature, can be extremely power-intensive, and some (like the steel industry) are also extremely carbon-intensive because of the processes that are an essential part of manufacture. In this section I want to talk about some of the changes that we are seeing to heavy industry and the impacts that this will have on costs as these changes flow through from the industrial into the consumer complex.
Steel is a core industrial material; in fact, it is the most widely-used metal in the world. The major problem with steel from a Green perspective is that the most common process for the production of steel (Basic Oxygen Furnace method or BOF) requires the oxidation (burning) of coal (which produces CO2), while the slightly cleaner Electric Arc Furnace (EAF) method also requires use of hydrocarbons (although the heat source is electric rather than from coal) but these can be in the form of slightly cleaner natural gas.
To give some perspective, according to McKinsey, in 2018 every tonne of steel produced emitted an average of 1.85 tonnes of CO2, or 8% of global carbon emissions, and c.70% of global steel is produced via the BOF method. As a result, the move to decarbonise the steel industry is a major priority for industry and governments.
Key technologies around the decarbonisation of steel manufacture include:
• Focus on efficiencies in BOFs including utilising pulverised coal injection (PCI), natural gas or biomass; maximising the iron ore content used or using coke oven gas as an energy source. These processes can reduce CO2 emissions but not eliminate them;
• Utilise biomass reductants. Again, this would not eliminate the production of CO2;
• Carbon capture and storage or usage;
• Increase share of EAFs (providing they are powered by clean energy or hydrogen).
• Molten oxide electrolysis (MOE) powered by clean energy or hydrogen.
The last three alternatives are realistically the only options which would have the potential to eliminate carbon emissions altogether. But they are all expensive.
Analysis by BNEF suggests that the levelized cost of net-zero steel (LCOS) for MOE, utilising clean power sources is currently c.US$1300/t, while for hydrogen EAFs (which by the way, probably wouldn’t run on clean hydrogen for many years to come) the cost is US$790/t. These are materially above the LCOS for BOFs and EAFs currently. While these costs are expected to fall substantially by 2050, there’s a lot of time between now and then, and the bulk of the fall is likely to be back-end weighted.
The requirements of decarbonising the steel industry, therefore, are likely to push up the cost curve for steel manufacture. This will have a flow through effect on steel prices. Steel is a core component of electrical goods, household goods, cars, planes and ships and is also the basis for the construction industry. Higher steel prices will have an inflationary impact on prices of manufactured goods in the future.
Not to labour the point but steel isn’t the only industry which utilises carbon-intensive processes. The petrochemicals industry is based on hydrocarbons and, even closer to home, in the battery industry, the manufacture of synthetic graphite is extremely carbon-intensive. The decarbonising of these industries is, like in steel, capital intensive and adds cost to the bottom line.
Also, within primary industry there are processes that are extremely power-intensive. These are themselves carbon-intensive when power for a country or region is derived primarily from hydrocarbons, as is the case in China, India and Indonesia. Here I’m talking about smelting of metals like aluminium, copper, nickel and zinc as well as production of nickel and nickel pig iron from laterite sources. There is a move afoot to make these industries cleaner, but that in turn requires investment in power generating capacity or, where a production site moves in its entirety, investment in new production in a region with a clean power grid, which normally means a developed country. Such countries almost always have higher costs of business associated with them, which again means that production costs are higher and that selling prices have to be higher too.
Another factor on the supply side is China’s move towards net zero for its primary industries. While China is moving a bit slower than many countries (unless there are any announcements at the forthcoming COP26 meeting), there is no doubt that China’s government now deems it politically unacceptable to be over-producing in power-intensive materials beyond the country’s domestic consumption.
As a result, we have seen quite a clamp down in areas like aluminium and steel production. In April (effective 1 May), China cancelled its VAT rebates on exports of crude steel (including hot rolled coil and rebar) and cut its tariffs on ferrous imports. While not just targeted at high carbon emissions (partly it was to reign in high iron ore prices), certainly carbon emissions are one element that Beijing looks to be trying to tackle. When taken into consideration alongside the Central Government’s clampdowns on the aluminium and graphite industries, it is clear that China is trying to cut down wholesale overproduction in power- and carbon-intensive industries.
But this overproduction has aided consumers in the past 20 years, by keeping commodity prices low. If China now reduces production in key industries then capacity will either have to be reopened in other (potentially more expensive) countries or new capacity will have to be started up. Both will come with a cost. There is no doubt that China, with its low cost of capital, has kept commodity prices artificially low since it took over as the world’s processed materials production centre. If China now cuts its excess production then there is certainly a high probability that commodity prices will have to rise. Because the cost curve will rise. And there’s no doubt that this will be inflationary.
I’ve talked primarily about metals in the analysis above, but there is another key component of the global manufacturing sector; plastics. Plastics are one of the most widespread materials in current usage and are used in core industries. Whether we talk about synthetic fibres used in clothes, engineered plastics used in manufactured goods or plastic packaging, plastic products are some of the key building blocks for our industrial age.
And the building block for all of these products? Hydrocarbons.
Petrochemicals are produced by the processing of oil and gas. And, as I highlighted in the first blog in this series, I believe that oil and gas prices are set to increase substantially off current levels. If that happens, given the nature of the chemicals industry, which is effectively a margin industry, then costs will be passed through to direct consumers of petrochemical products and on to their customers and their customers. And the buck will stop with the consumer, who will end up paying higher prices for clothes, manufactured goods and packaging…
One final point to make here is regarding the circular economy. Many commentators suggest that recycling could replace significant primary raw material requirements.
But how effective recycling could be at replacing raw materials output varies by industry. In some industries, lithium-ion batteries for example, active materials can be 90% recycled (other materials considerably less so). In others, recycling availability may only be of the order of 20%.
In all industries, it generally costs more to extract and then re-utilise secondary material. I’m a big fan of recycling but readers should be aware that it’s not the panacea that many people make it out to be. Particularly in rapidly-growing industries where there may not be enough material available to impact supply/demand balances. Products derived from recycled materials are almost all more expensive than those derived from primary sources of materials.
The previous points have discussed elements of supply. Now I’d like to talk briefly about demand.
While I don’t see the next 10 years being a supercycle for all commodities, I do see a secular demand event emerging for commodities directly leveraged to the energy transition.
I’ve talked about the structural change in battery materials demand in many previous articles so I won’t labour that point here. But I just want to highlight that the huge build out in renewables infrastructure will lead to a step change in demand for a number of key materials:
• Rare Earth Elements: What are called critical REEs (Nd, Pr, Dy, Sm, Tb) are used extensively in rare earth magnets which are a key element of both electric vehicles and wind turbines. As a result, demand for critical rare earths is set to rise by multiples over the next 10-15 years.
• Steel: While demand for steel in EVs will simply replace the demand for steel in ICEs, the infrastructure build out in renewables will likely lead to strong demand for steel since both wind and solar plants are extremely steel-intensive. Steel is used extensively in wind turbines and in the support structures for solar plants, as well as in transmission and distribution infrastructure.
• Copper: While the “EVs used 4x as much copper as ICEs” trope has widely been discredited, renewable energy is extremely copper-intensive. This is particularly so in offshore wind where each MW of offshore wind capacity uses 9.6 tonnes of copper. Onshore wind and solar utilise 4.3 tonnes and 5 tonnes respectively. Distribution and (some) transmission infrastructure is also copper-intensive.
• Aluminium: While not as conductive as copper, aluminium has been effectively used in long distance power lines and that is likely to continue. It is also increasingly used in vehicles to reduce weight.
To use copper as an example, our forecasts suggest that over the course of this decade, renewables demand will add c.1.1pp (percentage point) to annual global copper demand growth. That may not seem like a lot but, given the trends of lower intensity we see in other parts of the economy, it is likely to be more than half of copper’s demand growth in the latter part of this decade.
All this goes to highlight that demand will remain robust for a number of these core industrial materials over the balance of this decade and into the next one. Given what we have already discussed about supply, what does that mean for prices?
Given that supply for core materials could be constrained, the cost curve will move higher and that demand is likely to be robust, there is really only one likely outcome for materials prices. They’re goin’ up! And structurally, as well.
And given that steel, copper, aluminium and plastics are key components of most consumer goods, this is likely to have an impact on consumer prices and hence on inflation.
The question is really how long this will take before it impacts consumers? It takes a while for higher raw materials prices to go through the industrial system as we have seen in previous major cyclical events. Producers tend to absorb more volatility than consumers but eventually they have to pass on higher prices.
If prices of raw materials go up over the next 10 years by the sort of magnitude that I’m expecting (potentially 100% in many cases), then we are likely talking about substantial increases in costs of goods. That’s not good news for the consumer.
In the next part of this series I’ll round up the conclusions and discuss why I think structural inflation over the next decade is likely to be an unintended consequence of the energy transition.
Matt Fernley is Editor of Battery Materials Review and Head of Research for Westbeck Capital’s Volta Energy Transition Fund.