This article was originally published on franklintempleton.com by Stephen Dover, CFA.
Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.
As Germany ponders its energy security, climate change and economic challenges, the difficult choices it faces arise out of decisions made—and not made—over the past half century. Germany may not want to start its “Energiewende” (energy transition) from here, but it has no alternative.
In what follows, we examine the current state of the German energy dilemma, how it has evolved, and the choices the German government, industry and ordinary citizens face, knowing the reach of their decisions span potentially conflicting economic, strategic and environmental objectives. The path Germany takes will have broad investment implications.
High dependency on imported energy
Germany is the largest user of energy in Western Europe and the seventh largest in the world.1 However, Germany has relatively few natural sources of energy supply—it imports about two- thirds of its energy needs.2 Fossil fuels (oil, natural gas and coal) account for over 75% of Germany’s total energy consumption.3 Of the one-third of Germany’s energy needs that are met by domestic production, renewables (wind, solar and biomass) now account for about 40% of total, with nuclear accounting for another 12%.4
Energy powers modern economies. It serves both households and businesses. Manufacturing is a particularly important user of energy. For example, in Germany, the chemicals industry alone accounts for about a fifth of total industrial electricity consumption.5
How Germany got here
For most of its history, energy security has been a primary aim of successive German governments. Equipped with coal to fuel its 19th century modernization, Germany built an economy based on coal, steel, electricity, chemicals, and engineering──foundations that have endured to the present. But as petroleum replaced coal as the primary source of transportation energy in the 20th century, Germany became increasingly dependent on imported energy. In times of war or crisis, Germany resorted at various times from 1914-1945 to synthetic liquid fuels to replace scarce oil supplies.
As Germany emerged from the rubble of the Second World War, its focus returned to coal, supplemented by oil and natural gas imports, as well as an extensive rebuild of the (West) German electricity grid. Germany was instrumental in the founding of the European Coal and Steel Community, the precursor to today’s European Union (EU).
In response to soaring energy prices and the national security threats posed by Middle East oil embargoes in the 1970s, Germany began to invest heavily in nuclear power. Yet, two factors ultimately stymied nuclear power’s development in Germany. The first was widespread opposition by young people, who increasingly found their voice in the nascent Green Party, now part of the governing coalition. The second, was a series of worldwide nuclear near disasters culminating with the nuclear meltdown in Fukushima (2014), which slowed, stopped, and eventually reversed German nuclear ambitions.
Facing the risks of uncertain Middle Eastern energy supplies and fading support for nuclear, Germany turned East. With openings already underway in the form of “Ostpolitik” (engagement with East Germany) and “Wandel durch Handel” (Change via Trade), Germany was at the forefront in the 1970s and 1980s of efforts to increase ties with countries behind the Iron Curtain, including the Soviet Union.
A tenuous partnership
With the collapse of the Soviet Union in 1991, Germany’s strategy appeared to pay off. It was believed that a more democratic and open Russia could be a strategic energy partner, given Russia’s vast oil, natural gas and coal reserves. Heavy investment in pipelines and natural gas storage facilities took place over the subsequent three decades, all with strong support from successive German governments.
And it went beyond fossil fuels. In the early 1970s, plans for an energy transition began to come to fruition as Germany became an early adopter of carbon-neutral alternatives, including wind, solar and biomass. Policies to address climate change found support across the German political spectrum. Heavily subsidized and costly alternatives will soon account for nearly half of all German electric energy production. Due to the high cost of alternatives, German households pay roughly 40% more for electricity than the EU average and over 60% more than in neighboring nuclear France.6
Germany’s energy strategy has not come cheap in a less direct sense: the heavy reliance on Russia for oil, coal, and especially natural gas—which must be transmitted by pipeline. Prior to the war in Ukraine, 40% of Germany’s natural gas came from Russia. That number has shrunk to 20% and is expected to shrivel to zero by the middle of 2024.7 In fact, this reduction in supply could accelerate as the Nord Stream 1 pipeline, the primary supplier from Russia to Germany, is undergoing routine maintenance in July. There is a rising possibility that flows to Germany will end after that.
How is Germany responding?
An expansionist Russia was not what Germany expected after the fall of the Soviet Union. Trade and globalization were supposed to prevent invasions, wars of choice, and imperial land grabs. Faced with the reality of a hostile Russia, Germany has agreed to embargos of Russian coal and oil. That decision was made easier by the fact that both fuel sources can be sourced with minimal frictions elsewhere.
The same is not true for natural gas. Germany does not now have sufficient domestic capacity to import liquefied natural gas (LNG), even though possible imports from countries such as Qatar, Algeria and Norway are contemplated. Accordingly, new liquefied natural gas terminals are being designed and submitted for building approval to expand the capacity to replace natural gas from Russia with LNG from elsewhere.
The need to immediately diversify energy sources has led to an increase in coal usage. This shift, however, is seen in much of Germany as a temporary bridge towards the “greener” options, some of which have been stalled by an inefficient regulatory environment. For example, installations of onshore wind farms shrunk over the 2017-2019 period due to a slow permitting process. However, starting in 2021 there was more than a doubling in issued permits due to a more streamlined process. The war provides further incentives to continue this pattern of widening the scope of energy supply sources.
What it means for investors?
Germany’s latest energy “turn” opens intriguing opportunities—and risks—for investors. Among them are:
- Domestic German energy production will be prioritized, for example, through alternatives. We foresee a further rapid expansion of wind, solar and biomass energy production, as well as sizable investments in the German and European electricity grids.
- In the medium term (over the next few decades), Germany will continue to import fossil fuels, particularly oil and natural gas. The same is true for most of Europe, except energy-rich Norway and the Netherlands. New sources of natural gas will require investments in LNG terminals and, perhaps, in pipelines via the Middle East, North Africa, or other parts of Europe (Spain, Italy). Similarly, investments in German natural gas and oil storage facilities are likely to be sizable in the years to come.
- In the event of a more serious escalation of Russia’s invasion of Ukraine (e.g., the use of tactical nuclear or biological weapons), public opinion in Germany will demand an immediate sanctioning of Russian natural gas. With a world economy already at risk from aggressive United States Fed tightening, China “zero-COVID” lockdowns, and soaring energy and food prices, recession in Germany and the EU could deal financial markets an acute blow.
Germany is at a critical national security and energy turning point in its history. The challenges it faces are immense, yet they are also surmountable. Shifting to a more secure and greener energy future will take vast amounts of political and financial capital. Germany’s success in balancing competing needs and desires around energy will be a critical factor in determining where to best allocate capital as the turn commences.
Thanks to Andreas Billmeier from Western Asset and Kim Catechis from Franklin Templeton Institute for their contributions to this piece.
Endnotes
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Source: “Germany,” US Energy Information Administration (EIA), December 2020.
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Source: “Germany and the EU remain heavily dependent on imported fossil fuel” by Julian Wettengel. Clean Energy Wire March 14, 2022.
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Ibid.
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Ibid.
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Source: “Energy Consumption,” The European Chemical Industry Council, AISBL.
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“Electricity Prices in Europe – Who Pays the Most?” Strom-Report [EN: Power-Report].
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“Germany Has a Math Problem, and It’s about to Get Worse” by Sarah Lohmann, American Institute for Contemporary German Studies, Johns Hopkins University. September 13, 2021.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investments in foreign securities involve special risks including currency fluctuations, economic instability, and political developments. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.