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An important mental model for investors to use is the power of feedback loops. These exist in nature everywhere, as well as some of the best and least-loved sectors in the investment universe. Many internet companies are the beneficiaries of positive feedback loops which help create the “network effect.” The more people that use a particular search engine or social network, the more honed the search results become, or the more useful the network becomes to the user. That’s one of the reasons why search networks are a “winner take all,” type of business model. These feedback loops will continue to reinforce themselves until regulators or anti-trust officials take action.
Feedback loops are also why the companies with the best unit economics in a particular industry often continue to be the market leaders. The more successful these companies are with their customers, the more they can invest in product and service, the more attractive their products & services become, and gaining new customers continues to be easier and easier. You can invert this feedback loop to the weakened competitors that compete against firms experiencing virtuous feedback loops. Physical retail stores vs. Amazon, for example. The more traffic declines, the more they need to either raise price or cut spending. The more they raise price or cut spending, the worse the physical experience becomes. Customer services get outsourced to India, and the overall experience becomes miserable for consumers. Lower profits translate to worse customer experiences or worse products, which continue to reinforce the market share declines.
We find feedback loops a particularly important mental model to use with consumer goods, where economies of scale are particularly important. A company like Telecom Italia, which is generating substantially higher returns on invested capital and profit margins vs. its peers is the only telecom in the country that can afford to invest in fiber. As a result, it will take market share away from other fixed line peers, which will increase its profit margins and ROIC, and allow it to further deploy investments in the country, likely allowing it to have a substantial lead on 5G when its time comes.
But there are far more interesting feedback loops in energy markets which are driving behavior in two very separate directions as a result of the market structure in each segment. One reinforces the use of renewables while the other will dissuade the conversion to renewable energy sources.
There’s a cruel irony about the structure of the two major energy markets in the world that will push incentives towards converting the grid to renewables, yet at the same time make electric vehicles less and less likely to become mainstream. We say it’s a cruel irony, because the dream for so many people on the planet would be sustainable energy generation which would in turn fuel electric vehicles. Unfortunately these two realities will be impossible to achieve under the current regulatory structure of the electricity and petrochemical markets.
Because we have a regulated electricity market, one in which the regulators guarantee rates of return for approved capacity additions, infrastructure costs and maintenance expenses are directly passed along to consumers. As more people reach the conclusion that they could actually save money by converting to solar, they push more and more of these infrastructure charges onto a shrinking base of consumers. This in turn makes the regulated electricity increase rates, which further makes the switch to solar compelling for more and more households. As more houses leave the network, electricity rates continue to increase and the incentive to switch over to solar becomes more and more attractive. Unit-level economics of building electricity capacity has always been a small fraction of the actual bills consumers pay to utility companies. Data from the EIA suggests that while companies can often increase electricity capacity at less than $0.01 per kWh, the actual realized priced to consumers in the country has only declined to $0.10 per kWh. The more people that leave the grid, the more these infrastructure maintenance costs gets passed along to its customers. This would be a virtuous feedback loop for renewables and a negative feedback loop for fossil fuels like coal and natural gas.
Exhibit 1: Cost per kWh of various sources of Energy
This will also exacerbate the grid’s balance between renewables during sunny and windy periods as well as having the backup fossil fuel infrastructure to kick on when conditions warrant additional capacity. This standby capacity will be used less and less, yet will still be structured for peak demand, meaning we’ll have significant over-capacity and under-utilization in the electricity markets. This will be passed along to consumers, and will also make night-time electricity more expensive, which is crucial given this is the major period anticipated for the charging of electric vehicles. Fossil fuels will continue to be the major source of night-time electricity generation, which means that electric vehicles will continue to have a larger carbon footprint than fuel-efficient gasoline vehicles.
Aside from Nuclear, which will see almost zero capacity increases in the future thanks to the Fukushima disaster, the cheapest and lowest-carbon emitting way to generate night-time electricity is a combined cycle natural gas plant. This will generate 1.22 pounds of CO2 per kWh which means that after the average transmission loss of 7%, a 301-mile range for the Tesla 85 kWh battery will require energy that generates a carbon footprint of 104 grams / km (the standard unit of measuring carbon output). In contrast, many Toyota and Lexus models are already beating this carbon footprint, and the Prius carbon footprint is already 14.5% lower than Tesla’s Model S. Sure, the Model S has more power than the Prius, but assuming the night-time charging dynamic of electric vehicles doesn’t change, the carbon footprint of fuel efficient gasoline vehicles will always be lower than electric vehicles. In most parts of the country, night-time electricity generation still comes from coal, so the Tesla carbon footprint is even worse than our example. Talk about an inconvenient truth!
Exhibit 2: Carbon Footprints of Electrics vs. Hybrids
Tesla Model S
Using natural gas-fired electricity
Using regular gasoline
Range / Capacity
301 Miles / 85kWh
To add insult to injury, the Prius will be sustainably cheaper than any electric vehicle. Because the electricity grid is designed to sustain peak utilization, and is chronically under-utilized as a result of this design, infrastructure costs to consumers are already very high. By switching to rooftop solar, consumers are able to convert a much more expensive power source into a competitive power source by free-riding on other consumers paying for the capacity and maintenance of the grid. Already all over the country, many utilities are asking state regulators to allow them to increase the access fees solar houses pay for backup and night-time access to the grid. Thus, this upwards spiral of infrastructure costs being spread over a thinning base may slow a bit as regulators start forcing grid access fees higher for solar houses. This would lower the incentives for houses to switch over to solar, yet it will only slow and not stop the virtuous feedback loop that exists to support the conversion to renewables.
Oil: $50 the new $90
Gasoline and oil markets have the opposite feedback loop. The more people that convert to electric vehicles and more fuel efficient vehicles, the more demand drops. Given gasoline is unregulated and no longer controlled by OPEC, this means that the price of oil will continue to be suppressed by this lackluster demand environment. Even if electric vehicles never become mainstream, CAFE requirements demand improvements to fuel economy that will translate into a -1.3% contraction in gasoline demand over the next 10 years. That’s actually with a growing fleet of vehicles driving the same amount of miles on average. China’s fuel economy targets are even more aggressive than the US CAFE requirements, transforming the two largest oil consumers in the world. While Chinese oil consumption will still grow, as its fleet of automobiles will continue growing (even as we believe the auto sales market is poised for a fairly pronounced contraction), American consumption of oil products will decline steadily over the next decade.
Exhibit 3: CAFE Requirements & Resulting Gasoline Demand Changes
Sources: EPA, BTS, GreenWood Estimates using 16 million SAAR for auto sales.
This means that oil prices are unlikely to remain above $50 for protected periods, though spikes to $100 are probably more likely now that OPEC has very little excess capacity in the event of geopolitical turmoil. This represents a major problem for electric vehicles, as the cost parity under the most bullish assumptions require gas to be around $4 a gallon (oil over $130 a barrel).
Models that investment banks have used to justify their bullishness on electric vehicles has always used gas prices around $4 a gallon in order to justify their models showing wide-scale electric adoption by 2020. From the ones we’ve seen, they also assume very little improvement in the fuel economy of internal combustion engines, even though CAFE standards mandate improvements. Plugging in CAFE standards into UBS’s model showing electric powertrain parity, we can see that battery pack costs will need to decline to less than $60 / kWh in order to give internal combustion engines a run for their money. Even Elon Musk thinks he can’t get to lower than $125 / kWh after the Gigafactory is humming along at 100% utilization. If we add powertrain improvements mandated by CAFE just through 2020, the cost parity reduces to $55 per kWh using $2.00 gas and $0.10 per kWh electricity prices (assuming 10,000 miles driven a year).
Exhibit 4: Cost Parity of Batteries in kWh
Source: UBS’s Model, GreenWood’s Drivers
The unregulated feedback loop in oil markets mean that if Musk is able to lower battery costs even lower than his goal of cutting them in half to $125 per kWh, the contraction in gasoline demand will mean that even $2.00 is perhaps an unsafe floor for gasoline prices. Thus, the more successful automakers are at improving the fuel economy of their vehicles, the less likely consumers will want electric vehicles. Volkswagen, maker of electric vehicles from both Audi and Porsche, said even at the high-end of the market, Porsche buyers are unwilling to pay a higher price for an electric powertrain option. They’ve claimed that there is zero pricing power for specific powertrain options.
Let’s avoid any confusion, we are big fans of Elon Musk and Tesla, and believe the company is going to destroy the premium segment of the auto industry, and take at least 20% of the demand away from German companies, but we don’t believe the company will be successful making mass-market electric vehicles. Cost parity for electric vehicles requires unrealistic assumptions and is battling a very powerful negative feedback loop that the oil market finds itself in.
The only thing that will hasten the adoption of electric vehicles would be a very conservative government rolling back CAFE requirements and mandated fuel economy improvements, which would strengthen the oil and gasoline demand environment and push prices higher. We wouldn’t rule it out, but isn’t it odd that environmentally-focused voters would best serve their interests by eliminating CAFE requirements? We find it very ironic.
The juxtaposition of a regulated and unregulated feedback loop presents great news for the environment when it comes to the electricity grid, and very bad news for the utility companies who will eventually run out of customers to pass along rate increases to. Yet at the same time, a related but opposite feedback loop will prevent electric vehicles from every gaining scale of any significance.
In our next blog post on mental models and microeconomics, we’ll discuss why we think Tesla will be very successful in its future endeavors despite this negative feedback loop for electric vehicles. No other automotive company has one powerful weapon Elon Musk has, which also happens to represent another important mental model for investors to use. Accordingly, we believe investments in electric vehicles by all other OEMs are doomed for permanent negative returns on invested capital. The Nissan Leaf has been an unmitigated disaster from an ROIC perspective, despite being one of the top-selling electric vehicles in the world.
Feedback loops are very powerful and will continue helping winners and hurting losers until governments and regulators intervene and change policy. Until they do, there will be a very peculiar and ironic dynamic influencing the global conversion to renewable and sustainable sources of energy.
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