In today’s issue:

  • Diversification is not a free lunch after all
  • Decentralisation or inter-reliance?
  • Why didn’t the USS Enterprise use solar panels?

Do you think the UK should diversify its electricity production? A bit of hydropower here, some wind turbines in the North Sea, a nuclear power plant there… that sort of thing.

It certainly sounds good. Isn’t diversification safer? Doesn’t it make things more reliable? Don’t put all your eggs in one basket…

As American finance professor Harry Markowitz said, “diversification is the only free lunch in investing.” Students have been regurgitating his theories ever since.

But, as the Behavioural Investment blogger Joe Wiggins put it, “Diversification isn’t free; it is painful and difficult to achieve.” According to Wiggins, that’s because you have to hold investments you don’t want to.

Diversified green dream believers needed to own soaring coal stocks in 2022 and 2023 to offset terrible losses on their green energy holdings.

And climate sceptics needed to own green energy stocks during the two years before that in order to capture the impressive gains there.Investing your money in something you disagree with is not a pleasant experience. But diversification demands being agnostic. Otherwise you might miss out on the gains that make it work.

Of course, the whole energy transition is really about discriminating against certain forms of energy in favour of others. Back to that in a moment.

What’s the price of diversification?

Diversification can be very expensive to achieve in practice. How many baskets do you need to buy to avoid putting all your eggs into the same one? Where should you keep them all? Who do you trust to hold them?

It sounds silly, but consider the investment version. The amount of time, effort and fees involved in spreading risk are a real pain in the neck. Especially if you want to truly diversify, meaning into non-financial assets and foreign assets.

Just doing your taxes on a diversified portfolio can become such a time consuming and expensive burden that it simply wasn’t worth diversifying. And that’s before we consider the cost and time it takes to manage and rebalance diversified portfolios.

I’m worried we’re going to discover that a diversified electricity grid has the same shortcomings as a diversified portfolio. It’ll be too expensive, time consuming and difficult to manage. These costs will outweigh the benefits we presume we’ll get.

Perhaps we should put our eggs into one basket and watch it closely

Decentralised or inter-reliant?

A few months ago, I explained why the decentralisation of energy cannot occur with renewables. Their intermittent power creates inter-reliance across the grid, not stability.

Diversification is a weakness because you only need one part of the grid to fail for the whole grid to fail. And when you diversify your energy sources, the list of possible failures rises dramatically.

Thus, a lightning bolt can strike one part of the grid and households in three different counties experience a blackout. That’s what happened in the UK in 2019.

It’s the same with diversification in investing. You might think you’re building a portfolio that is more stable thanks to the broader asset allocation. But is it really true?

Diversification relies on the idea of low, no or even negative correlations. Assets like gold, bonds, stocks and property tend to go up and down at different times. By investing in a mix of them, the gains in one sector offset the losses in others. Overall, your portfolio’s value can grow over time in a more stable way by diversifying your investments between them.

But correlations aren’t stable. The moment that diversified portfolio managers fear most is when all correlations go to one. This means that all their investments move in the same direction at the same time. In such a scenario, diversification becomes useless.

The irony is that, during a crash, this is more likely to occur. Even a diversified portfolio of stocks tanked in 2008. Recently, even stocks and bonds have been moving in tandem. That’s very unusual – they’re supposed to trade in opposite directions in order to offset each other. That’s the point of diversification. But inflation has a habit of trashing both stocks and bonds because it means interest rates will go up.

The same frustration applies to gold. Investors are often disappointed when the price of gold falls at the onset of a financial crisis. That’s because they expect the gold price to be negatively correlated to stocks. But in a crash, the gold price tends to fall alongside stocks, at first.

I like to think of diversification as a fair-weather friend. It appears to work when you don’t need it. But when things go wrong and you hope diversification will save you, correlations can surge and everything falls in price together.

We’re making the same mistake with our future electricity system. By insisting on a diversity of supply in order to make things look stable, we are actually just adding vast costs without benefit. But they will all fail us together.

What the Germans call a Dunkelflaute is so dangerous precisely because it combines a lack of wind and solar at the same time for a prolonged time. And, given they do happen, diversification between the two doesn’t avoid the crisis.

Who is in charge?

Complexity is another issue introduced by diversification for the sake of it. It’s difficult to manage a grid with a diverse range of power sources. It’s also difficult to manage a diversified portfolio. Do you really want to spend your time, effort and money doing so? Or do you want to worry as little as possible about power and money in your retirement?

What we risk ending up with is an electricity grid so complex that it will get extremely expensive and technical to run. Making the grid flexible, digitising it and introducing ways of making energy demand flexible are all complicated things which our energy system will rely on in the future.

Given the bungled rollout of smart meters so far and information I have heard from those inside the power industry, we’re in for a rude and expensive surprise.

Yes, of course there are plenty of scenarios where specific electricity sources are best suited. Hydropower in Scandinavian countries, for example. But we seem to be forcing diversification of electricity purely for the sake of it. We don’t need wind turbines in the middle of nowhere when we can produce emission-free power where we want to.

Here’s another way to think about it: did the fictional future USS Enterprise use a diversification of power sources? Was its hull covered in solar panels? Did it have an EV charging point docking plug?

I never watched the show. But I’m assuming it didn’t. A little research suggests the ship used deuterium stored in cryogenic slush. But let’s not dig into that any further. Instead, ask why the starship didn’t diversify its power sources.

Because it would not have been economical or functional to install a variety of energy sources. Better to have one source of power that consistently functions.

Obviously national and international energy grids are different to starships. But what if the specific point I’m making still applies? What if diversification for the sake of it is just not a good idea?

There is a far less diversified model we could compare it with…

France’s power supply is not diversified

Is France’s 70% nuclear-powered electricity supply more or less fragile than those around it? Why?

I think it’s precisely the lack of diversification that makes France such successful and stable power provider. Lower power prices, lower carbon emissions, lower energy price inflation, biggest exporter in Europe, and so on…

The French have recently traded in their plans to cut nuclear energy to 50% of energy supply. They also abandoned their renewable energy targets too.

This much to the consternation of the EU, which is pressuring them into a more “diversified” approach.

Why are the French fobbing off the EU?

Because the immense value of France’s lack of energy diversification has grown obvious over the past few years. If you’ve got nuclear, you don’t need the rest.

It is now obvious that diversification of power sources is not optimal. Just as it is now obvious that a portfolio diversified between stocks and bonds won’t protect you during every type of crisis.

In this context, the UK’s target of 25% nuclear makes as much sense as building a levee along 25% of a river. The water will just go around it. For a levee to hold, you need to cover 100%. And only your weakest point matters.

So it is for an electricity grid. It’s when the wind doesn’t blow and the sun doesn’t shine that you find out what the grid can handle. And our power demand will be much higher than what batteries and 25% nuclear can provide on a diversified grid. The result will be a system wide blackout because the system is inter-reliant instead of decentralised.

And, because the UK will be integrated into one national or even international system, that blackout will be unnecessarily widespread. A completely different experience to the localised blackouts of the past.

All this because of the cult of diversification.

Until next time,

Nick Hubble
Editor, Fortune & Freedom