As the world faces the urgent need to combat climate change, the energy industry is undergoing a transformative shift towards a net-zero future. Governments are committed to addressing the sources of climate change, and consumer preferences are evolving, placing increased pressure on commodity consumers, processors, and producers to reduce carbon intensity. This drive for sustainability has led to the introduction of carbon taxes and environmental regulations, creating a strengthened connection between markets with high greenhouse gas (GHG) emissions. The private equity industry could be instrumental in this arena, the convergence of various energy markets and its impact on achieving a net-zero future will be the next page in growth in the energy sector.

The convergence of previously isolated markets to incorporate the carbon intensity of production has the potential to cause price volatility across industries. When energy demand becomes connected to traditional markets, new price clearing mechanisms are established. For example, the renewable-fuels market has experienced high levels of convergence in recent years. Ethanol production, driven by blending mandates like the Renewable Fuel Standard (RFS), has led to the corn market converging with the gasoline market. As a result, corn is now priced against gasoline due to its integral role in ethanol production.

Similarly, the soybean-oil market is experiencing an early-stage convergence with energy markets, primarily due to its importance as a feedstock for renewable diesel. Renewable diesel, a chemically identical biofuel to petroleum diesel, has seen increased production due to policies like California’s Low Carbon Fuel Standard (LCFS), aiming to reduce the carbon intensity of transportation fuels. As more states implement similar standards, the renewable-diesel market is expected to grow, driving considerable industry investment.

The convergence of energy markets presents challenges and opportunities for industry players. Renewable fuels must compete with electric-vehicle batteries, hydrogen, and traditional petroleum fuels for transport-sector demand. Supply and demand dynamics in renewable fuels will influence prices, with blending regulations, tax credits, investments in production capacity, and competing agricultural demands for feedstocks playing crucial roles.

Carbon taxes and carbon-trading markets will also impact renewable-fuels, shaping the most effective parts of the market. Government policies will determine incentives, taxes, and the scale of each energy source in the transport sector, further shaping market dynamics. Additionally, increased investment in hydrogen could affect power generation and traditional oil and gas sectors in the coming years.

Since the signing of the Paris Agreement in 2015, countries worldwide have committed to reducing GHG emissions and striving for net-zero emissions by 2050. As renewable fuels continue to grow, new regulations and technological advancements will lead to further market shifts. Let’s explore two use cases to illustrate this market convergence, volatility ratios, and shifts in the corn and ethanol market, as well as the soybean oil and renewable diesel market.

Corn and Ethanol Convergence

The corn market has significantly converged with the gasoline market since 2005 due to the increasing importance of ethanol in the broader energy market. Ethanol, producing lower GHG emissions than gasoline, is blended to reduce emissions in transportation fuels. The ban on methyl tert-butyl ether (MTBE) in the US further increased ethanol consumption, as it was the only price-competitive and widely available substitute for MTBE. This transition from MTBE to ethanol exemplifies the transformative effect of convergence on market dynamics.

Soybean Oil and Renewable Diesel Convergence

The soybean-oil market is currently experiencing early-stage convergence with energy markets due to its significance as a feedstock for renewable diesel. Policies like the Low Carbon Fuel Standard in California are driving the accelerated production of renewable diesel, providing a renewable alternative to petroleum diesel. As more states adopt similar regulations, the renewable-diesel market is expected to grow, leading to further convergence with the energy industry.

The long and short of it all is that the convergence of energy markets is a crucial step towards achieving a net-zero future. As governments implement stricter environmental regulations and consumers demand sustainable alternatives, industries are forced to adapt and innovate. The transformation presents challenges with price volatility and competition, but it also opens up opportunities for private equity along with early leaders to capitalize on new profit pools. As renewable fuels continue to grow, market dynamics will continue to evolve, shaping the future of the energy industry on its path to sustainability.