Jed and guest Patrick Kent, CFA, CMT, explain the science behind biophysical economics, unravel the intricate relationship between energy and the real economy, and shed light on the profound impact energy has on our financial system.

Podcast Transcript

00:00 – 01:52
Jed Dorsheimer         
Welcome. My name is Jed Dorsheimer, and I will be your host of the Plugged In podcast brought to you by William Blair. Energy is everything. I would argue that, really, if we are like fish, then energy is like the water. And you can't get capital formation, at least in the real economy, without a surplus of energy, which is why the Industrial Revolution was so profound.

But putting these pieces together is often difficult and sometimes can seem esoteric. And so we've had some great guests on. I have a lineup of many more great guests. And one of the things that I thought would be useful to you, our listeners, is every third podcast to try and get somebody from industry.  In this case from the financial industry.

So we will try and apply the science that you tend to hear from the Dave Murphy's or Nate Hagan's in the previous podcasts, and we can then take that in today with Patrick Kent, apply that in terms of how do we think about that in our daily business? How does that put food on the table, so to speak?

So I'm pleased to have with me today Patrick Kent. Patrick and I are good friends. We co-founded the Biophysical Economics Institute with some others together.

And with that, I'll turn it to Patrick to maybe tell us a little bit more.

01:55 – 01:56
Patrick Kent
Thanks for having me again.

01:56 – 02:54
Jed Dorsheimer
Yeah. Yeah, it's good. I'm looking forward to this being a regular event, particularly walking around and showing you the different stuff we're doing here on the on the farm. I guess first thing and I kind of came up with my journey to biophysical economics actually by begrudgingly buying this farm and thinking about some of these things and having horses and thinking about the role of energy and how that flows to the economy.

And we ended up co-founding an institute together around some of these topics. And I thought it'd be a good place to start just to you know, we had Nate Hagans talk about energy blindness. Dave Murphy talked about some of these concepts that we've been working on together and thought it'd be great to have you maybe start talking about your journey to biophysical academics and then I'd like to really spend most of the time getting into what that actually means and how to apply.

02:54 – 05:34
Patrick K
Yeah. Now that's great. I mean, I go back and start sort of back when I was studying for the CFA. I mean I was teaching myself a lot of economics and reteaching it because I took an appalling lack of that kind of stuff in my undergrad.

And so when I began reading through a lot of economics textbooks, it was certainly in kind of a neoclassical economics as it's presented to most, you know, finance people. It just seemed like an appalling lack of sort of thinking around, I'd call it sustainability, but just sort of the key foundational things that we accept as true in economics.

And yet that sort of flies in the face of like how the natural world really functions, right? You know, I think conceptually we think of the economy as this kind of perpetual motion machine of consumers and producers and exchanging income through these markets. And it's all a very nice, efficient mathematical model. But the reality is the world's a lot more messy than that.

If we think about how does that system, our economic system has grown relative to the size of the natural world, not surprisingly, we're seeing impacts, right? We're seeing what we call externalities that are impacting that. And so, where my kind of journey to biophysical economics really started, it was more just thinking about like, why are these distortions like these things that we're focused on that are like these problems that we were highlighting, whether it's environmental degradation or it's income inequality or it's these other things like, you know, these are why are these happening right?

And sort of understanding some first principles. And, you know, they're I'm sure there's probably many, many ways to sort of look at that as a lot of different answers that might be given. But certainly, one of the things that I realized is I just think it's a fact that economics generally, as we learn it, just hasn't properly accounted for some certain things.

And so our model, the way we think about how wealth is created is not an accurate one, for example. Right? And necessarily what Nate Hagans would be getting at, and Dave Mercer probably brought up as well, just the fact that energy is not really an explicit term in the production function. Right? We just think of it as capital and labor and, as you know, Steve Keim, the economist, had said that capital without energy is a sculpture and labor without energy is a corpse.

And that is a reality, right? It's the flow system that makes it all work. And the system sort of adjusts size to that. And I think understanding more explicitly how that both like systems thinking, natural sciences and most importantly, energy and thermodynamics play into the economic models where biophysical economics, I think, has the potential to be a powerful tool, certainly as we're developing if the institute is successful.

05:35- 06:38
Jed D
I like how you describe that. For me, I think one of the problems that I observed is that there's just a basic fundamental misunderstanding of basic nomenclature in terms. The buzz word I've spent 20 years in and out of something that's considered sustainability. Very few people like what I like to blow their minds is go to a sustainability conference and ask somebody to define what sustainability means, and they'll be like, Well, yeah, I feel like I'm in, you know, coming up with six minute abs in [There’s] Something About Mary.

And so if you kind of look at the Latin root of the word, it actually means to cradle or hold. And if you add in life is a self-replicating organism that can experience consciousness, then all of a sudden that starts to take hold or form. Yeah, and we get familiar, certainly in finance, we tend to get familiar with a lot of buzzwords.

And I love asking like, okay, what does that mean? Does it mean to you?

06:38 – 07:12
Patrick K
Yeah, oftentimes it's like there's lacking of a first principles, understanding of why that term is even being used or how that term is defined. And, I as you know, I think we've probably talked about before, I find there is a sustainability in investments and finance can oftentimes sometimes I think, suffer from a tautological problem of just being like sustainable finance is financing sustainably, right?

It's just this like circular. Well, yes, but what are we trying to accomplish and what's the actual, like really first principles. The reason why we're here. Which is kind of my point about externalities and sort of the friction between the models, right?

07:12 – 07:19
Jed D
Like that's now celebrated is a circular economy. Yeah. Which is the very definition of a perpetual motion machine.

07:19 - 07:49
Patrick K
Right. And, I've always been like my skin crawls a little bit when I hear that because I understand the essence of it. Like the yes, it is meant to what it's meant to mean. But I think we want specificity in our terms here. And a circular economy is not something that is really achievable.

But we could have what is achievable, maybe like a hyper efficient economy might be one that we can talk about being a possibility, but that's not circular. It's just sort of minimizing waste, heat, or resource waste.

07:49 – 08:47
Jed D
Yeah, I find that we have more in common with classical economic theory as a student of history. If you go back and look at the classics and even go back to the French physio grads, right? Biophysical economics was what was in practice because we had a simple economy and just for our audience, I like to describe, if you go on a trip to Bali and you kind of get one of those little hats over the over the water and you decide you're going to carve your own boat and catch the fish, then you can you can live off of something that is just above your sustenance.

The problem we have today is we have this complexity that has arisen to have fire and police and paved roads and lights that can come on at any time. It requires a level of inefficiency or redundancy that leads to something that's not super sustainable.

08:47 – 12:00
Patrick K
It's an incredibly complex system. We have, right? That is a function of largely of how much energy we have to flow through the system. And we've had an enormous surplus of energy that's been available flowing through the system for well over a century and has allowed us to reach this level of complexity. That is really, I think, the key to understanding biophysical economics.

What is it? Why is it maybe useful? It's really just I think of it as just frame or changing the framework through which we're evaluating the economy, society, but obviously when it comes down to it, before we bring it all the way down to the earth here to portfolios and investments. Right. How are we going to think about using this as to enhance the framework for better looking?

I mean, when I think of in finance and certainly in investment management, right, there's always this kind of desire to learn, you know, as much as possible about the state of the world right now, slightly faster than someone else. Right? We might call that having an edge on an investment, right? That you have like this idea of like, oh, I figured out what's going on and arbitraging something, but I think there's a huge amount of misunderstandings and distortions that are actually happening in the market, which creates enormous opportunity if you just shift the lens through what you're looking at it. All right, so like applying kind of biophysical economics, it starts to be, I think, a way of thinking about that. What does that even mean? Let's like, we bring it again down to some practical ways you might bring this framework into investment analysis. I think of three and sort of at least three immediate ways that you could do that.

One is at the macro level, we've talked about this like thinking in terms of the cost of energy and you've talked about this. I think, in some of your printed materials as well. The amount of work in a barrel of oil an MCF of gas, a kilowatt hour, electricity…that, doesn't change. That is what it is.

And then through whatever conversion or efficiency, you get a certain amount of work. So the real economy is a function really of just how much available energy there is. Then there's the monetized economy, which is GDP, which is sort of like you stretch that blanket over the bed and almost get most of it. But that's what the real economy and that's ultimately a cash flow metric.

What we really care about is like, what are these activities monetizing or are being monetized. And in that sense, we care about money supply, we care about credit creation, we care about Federal Reserve policy, we care about whether liquidity is increasing or decreasing. But what's interesting is one of the places I think about is just including energy in that term entirely.

If like just thinking about it as energy prices rise. I mean, we're just talking about the fact that Brent's back here at $87, $88 a barrel, that's kind of climbing. I look at that and it's like that's tightening liquidity because now to buy a barrel of oil is going to now cost more than it did, which means to get that same amount of work that you were getting, that barrel now costs more.

So the real economy has cost more cash flow to that primary source of work in the real economy. So that's one place I like to keep that in terms like keeping in mind as we think about tightening and loosening policy, that we're also thinking about what's happening with energy prices at the margin because those are now also acting that way.

12:00 – 13:18
Jed D
So let's pause there for one second. Let me just try this on. What I heard from you is in the macro, the real economy is a function of energy production and available energy and the total amount is always going to be one, but the usable amount is going to differ based on the entropy, the way something can’t be recovered, right? That creates our real economy. Now, we fractionalized that in the form of a nominal economy, I think is the bedspread that you're trying to fit over that as much as you as you can. In the role of a central bank should be to adjust the productivity of that fractionalization of the real economy.

So I totally agree with how you're looking at that. I think where some people have gotten lost is we've forgotten about real and we focus all it on nominal, assuming that the central banks are God in terms of being able to, but not realizing that their role is the intermediary. And if you don't actually have the energy production or where that that energy policy, how that's being developed then the whole thing starts to unravel or fall apart.

13:18 – 15:14
Patrick K
And so now it's coming back. So that's one way in which I think about it is that you want to apply this to macro, right? That does at least one place where you can begin to think about it. I think an ancillary, another way in which this can be utilized is sort of thinking around theme development or how that nominal GDP is going to shift between activities.

So as energy prices climb, then the consumer has less to spend on something else. And gasoline prices are up and you either drive your car less or you buy less of something else. Right. And so, we can see that at a at a secular like some macro level, we can see themes then develop, right? And as we were talking about for the podcast, if I look at a theme that's developing in the market as like the energy transition, climate adaptation, reshoring, all these things that we want to do.

Well, that's an enormous amount of just matter acceleration. Like we're going to do a lot of digging, a lot of building, a lot of like moving things around. One that's very energy-intensive, too. It's an enormous amount of just engineering and construction work. The sheer amount of infrastructure we're talking about is just like the golden age, that of engineering and construction, right?

I mean, and just supply/demand of energy, of people who know how to build that kind of stuff. That's sort of an emergent area is just again, applying the framework to look at events to sort of see the unintended consequences coming. And some which create investment cases, potentially. Last one, and I think you've probably done even more here than I have, is sort of applying some of these principles for technology evaluation.

So when we have something presented to you as the next best thing to sliced bread, that's going to solve X, Y, or Z around sustainability or the economy, like having enough knowledge to ask the right questions around energy intensity, right? The dead horse I beat a lot is like the idea of direct air carbon capture, right?

15:14 – 15:17
Jed D
Well, that's gotten a lot of press lately.

15:17 – 16:23
Patrick K
Yeah, but stop and think about what that is, right? We've taken energy that was trapped in molecules compressed under thousands, millions of years of pressure, dug it out of the ground, released the energy, and put a ton of leftover material into the air. And now somehow, you're going to capture that and pull it back down and force it underground or force it into something else with less energy than you got out of it in the first place?

That doesn't really seem to pass basic thermodynamics questions right from the start. It's sort of like a lot of these solutions. It's a little bit of a bait and switch. It effectively depends on having an incredibly cheap source of energy, well, yes, if we have an incredibly cheap source of energy that's carbon free, we could do anything.

I mean, of course. Sure. Then that doesn't matter. That's not your limit. That's not your budget. Then sure, you can try almost anything, but as soon as you start thinking about it, it's like, well, we have an energy budget. There's only so much you can do. Is that the best use of the energy or is there some other thing you might want to use it for?

16:23 – 17:39
Jed D
Oh, where to go here? I think part of this comes back to the fallacy of infinite substitute ability, which I think has done more damage than anything else. The basic concept that we're somehow decouple from the system and what I mean, the system, the biosphere, the economy that we're somehow above or separate from, instead of part of which I kind of come back to the basic butterfly effect principle.

And the problem with the butterfly effect for those who aren't familiar with it is that if a butterfly flaps its wings, it has an impact. Even as minute is, they can't be measured. There is some impact. Or, goes to the Copenhagen double slit experiment, for example, without getting into quantum mechanics. And so the idea then is we're part of this system and as part of this system we for most of the industrial revolution, were fish without questioning the water around us, which is energy. And now as things become tighter, it's almost forced into the frontal lobe to kind of contemplate over “how does this change the other?”

17:39 – 19:05
Patrick K
Yeah, I think that's because we're starting to reconcile that. Right? So, another theme, I talked about engineering construction, but another theme that sort of developed and I wrote this about three years ago, we did a piece on Frontier Themes about three years ago. I wrote this thing on the on the coming sort of renaissance in nuclear technology.

And what led me there was sort of thinking about this, right, that now everyone's kind of probably familiar with the fact that like we've kind of changed our two and a bit on nuclear, right? But even just three years ago that I was when I threw this out, there was a frontier theme. People looked at me a little like, really?

I was like, well, there's just no there's no way to get to a carbon free energy grid in any conceivable type of timeframe if you're going to shut down all your nuclear. It doesn't make any sense. Not only should we not be shutting it down, we should probably be reinvesting in it, and we should be maybe even considering building more of it.

That was not the tune three or four years ago. And oh boy, that's changed a ton since then. We've seen Japan reverse course on it. France is now talking about reinvesting in their fleet, which is well over 30 years old, produces 70% of their energy above their electricity or more. They were originally talking about where they're going to sunset that now they've gone completely around.

They now want to reinvest in it and maybe even build more Germany starting to come around on it. Sweden came around on it just a couple weeks ago. I mean, we've had in the IRA there were additional subsidies to our existing nuclear fleet. So that's completely switched gears. But that’s what's happening.

19:05 – 19:05
Which is a good thing.

19:05 – 19:52
Patrick K
No, but should we talk about concrete examples of this thinking? Like that was pretty it was kind of a contrarian view three years ago. Like when I said when I said that out loud, you're like, wow, that's not going to happen. But, here we are, because the biophysical reality, the thermodynamics of this were undeniable.

There's just no way to get where we want to go if we're not going to take the least bad option, which is to sort of continue looking at vision. And as you pointed out before we started recording, that's on old tech. We're even evaluating this on tactics, you know, goes back to the sixties and seventies, really like we haven't really spent the time and money to look at newer technologies.

We underinvested in this technology for decades, so who knows where we could be with that. We should be really looking more carefully.

19:52 – 20:31
Jed D
Yeah, I agree.

I think this is a classic example of where, you know, using and applying what's largely lived and been kept in an academic vault could be commercialized in a way that if we don't have a solid energy understanding, well then you are literally building skyscrapers on quicksand. You don't have a bedrock to build off of.

20:31 – 20:56
Patrick K
Yeah. If you're if you're in denial about how this system really, truly functions, I just don't I don't know where to go with it, right? If we really think money makes the world go around, but we can just print more of it. This is kind of the modern monetary theory sort of debunking, which is sort of how is that possibly work?

If you just create more claims on the existing resources that doesn't necessarily create more resources.

20:58 – 21:04
Jed D
I should try that with my bank, you know, with my mortgage, you could just say, hey, listen…

21:04 - 21:40
Patrick K
I think I brought this up on a previous podcast, right? That like, it just comes down to, you know, and here's a good example of where like the traditional thinking of like traditional economics brought to business school finance students who then kind of go on to sort of think this way, fascinating anthropology of what is money.

And we come back and we just say, Oh, well, it's a store of value, it's a relative measure. It's like we already have this like, and yet it's like a medium of exchange. We have the right answer already. And yet to us, you like to look at this like biophysical economic framework.

21:40 – 21:41
Jed D
5-11 mega joules.

21:41 – 22:12
Patrick K
Yeah, it's well, what it really is, I can hand over this paper or wire tape. That's an outdated phrase, wiring money, but it's really kind of like my expectations. I get something in return. If I get something in return, I have work, then it took energy to accomplish that. So, embedded in every single dollar is exactly what you're saying is like an embedded amount of energy in every single dollar. If you just print more, you know, have less energy in that dollar. So, what do I mean? You're going to inflate prices, right?

22:12 - 22:27
Jed D
And that is just a future call line on energy with an added embodiment to the interest. And so the idea that you can you know, again, it comes back, we're saying the same thing, you can't print your way out of a box.

22:27 - 22:36
Patrick K
I mean, everybody kind of knows it, right? You either you either pay it off in the future, like in real terms or you default on it implicitly or explicitly.

22:36 - 23:07
Jed D
But if we did find, say, a highly concentrated source of energy, that is a way the system and the system works. That's a surplus. Then you can not only deal with your debts that have been incurred, but you can also get real growth, which is exactly what we saw in the 1800s with the advent of the Industrial Revolution, where we changed the productive function with mechanization and new energy sources that were highly toxic.

23:07 - 23:13
Patrick K
Yeah, I think that's where you and I like part ways with some of the kind of de-growth group, right? There's a lot of.

23:13 - 23:15
Jed D
I'm not in the de-growth group.

23:15 - 24:28
Patrick K
But there’s a lot of division, but there's a lot of people around. I mean, not the fringes around sustainability. Certainly at some of the people around things like biophysical economics, like that, there's this kind of like, oh, well, we just the system has to shrink. It has to be smaller. We have to think in terms of not growing.

I think that's really not the point. The point is not to sort of extrapolate to that. The point is to better understand how this system functions so we can actually make it function better, maybe function bigger. Like we don't have to necessarily say that the only thing to do is to shrink it.

It's just to identify the core underlying problem and treat that problem, which is like we need high dense sources of energy that don't necessarily add carbon in the atmosphere like great. Or you can look at, as we said, fission is a good example. We know of these several handful of companies that are working on fusion. I don't know if any of them will work, but maybe one of them will, or maybe some of them will, or maybe one that hasn't even started yet will right.

Well, right. There's ways that we might end up seeing, like eventually higher energy density, all of these things. But we have to get out of this place of necessarily demonizing things and just think more in terms of technological evaluation. Does this net improve our conversion efficiency? Does it not add more available energy to the system?

24:28 - 25:32
Jed D
Well, and I think to be clear, degrowth can work. It is a solution. The problem is you have to look at the consequences of that solution. And this is where I think Adrian Bejan’s work is just brilliant down at Duke when he talks about freedom in evolution are a function of a movement of energy, movement of ideas, movement of people.

And so therefore to degrowth actually goes against natural order in terms of the thought process, because nobody will choose poverty over wealth, for example. And so you're asking for something that on paper you can, you know, either change the numerator and denominator, but when you look at what's actually embedded in that, it's never worked before, like literally never worked in human history where you've seen an example of that that I can think of. And in most cases where it was tried, the consequences are absolutely horrific.

25:32 - 26:04
Patrick K
He's a fascinating guy to talk to. And some of the stuff he points out, I think it's a lot like a lot of brilliant people. It's like it's almost obvious once he shows it to you and then you're like, well, it doesn't seem that complicated. It's like, Yeah, but you didn't think of it. When he puts sort of the charts, he's shown freedom versus GDP energy use or sources versus GDP, freedom versus GDP. It's like, yes, these things are all connected. And that the freedom of the system allows more energy use and allows the system to get bigger and allows for a higher quality of life.

26:04 - 26:39
Jed D
Yeah. Jevons Paradox, where, you know, I think most use that as an argument or a stalking horse of why energy efficiency can't work. But what they miss is the social utility is actually increased as a function of the increase of efficiency. If our miles per gallon I know that's an old terminology, but if we look at miles per gallon going from five miles per gallon to 50 miles per gallon, my driving usage will change where I will use the vehicle more and bring arguably more utility into my life by having that mobility.

26:39 – 27:35
Patrick K
This is what I actually think is fascinating. Like in this, biophysical economics allows us to actually give real scientific, like thermodynamic reasons for many observations that exist in in traditional economics. Jevons Paradox is the reason why there's like a supply demand curve. I explain to bankers, I talk like it's a law. This happens, but why? You're pointing it out, like because when you suddenly improve the conversion efficiency of your vehicle such that your MPG went from 5 to 50, you reduce the cost of moving a mile with that thing by an order of magnitude. Therefore, I can do a lot more with it. Right? So you do. Because all of a sudden that's a reason why, like when the supply goes up, the price goes down and therefore the demand curve. Then that's why these things sort of happen and there's actual like physical biophysical reasons why this is the case.

27:35 - 27:56
Jed D
We should probably give a plug to the institute where people could go and learn more about this. I think we touched on a lot of superpower concepts that, you know, I'd like to have you back and discuss more, but I'll leave it to you. Do you want to give a plug to the institute and where people can find more information around these?

27:56 - 28:18
Patrick K
So certainly, you can check out the institute's website [SS1] Feel free to donate if you like. If you like what you're reading and you want to hear more of it and want to help fund some more research in the area. In addition, we've also been running webcasts on there so you can feel free to sign up for those and be around. You can hear a fascinating discussions like Adrian or Nate Hagans there as well.

28:18 - 28:21
Jed D
And the institute is now funding this work on its own.

28:21 - 28:28
Patrick K
Yeah, I mean, that's really the goal, right? Is that ultimately we'll just be able to put grants out in the field for more academic work in this area.

28:28 - 28:48
Jed D
And for those who want to learn more about this and applying it to financial analysis, you know, reach out to your salesperson or me directly at William Blair and be happy to share a lot of the work that we've written on these key concepts and topics. So, Patrick, as always, thank you.

28:48 - 28:51
Patrick K
Thanks for having me. I always love having a chat with you.