In the energy sector, many investments are still needed before the energy transition is complete. Both investors and financial institutions are eager to invest in sustainable energy, in energy efficiency and innovation. There is no lack of enthusiasm and it seems that there is no shortage of funding too as a result of the low interest rate environment.
“The fear over financial risks due to climate change and the link with the need for an energy transition is not new.”
At the same time, the call to stop investing – or in other words to divest – in certain parts of the energy sector becomes stronger. This ‘divestment movement’ mainly aims at the reduction of investments in the exploration and production of fossil fuels like coal, oil and gas. Several large investors ask for more action from the International Oil Companies (IOCs). They are asked to identify the financial risks of climate change and align their investments with the Paris Climate Agreement goals. The fear over financial risks due to climate change – for instance due to stranded assets – and the link with the need for an energy transition is not new. We have already seen reports from the ECB, the Bank of England and the Dutch central bank (DNB) warning of possible financial risks should the energy transition progress too abruptly. Some time ago I wrote about this in my column ‘the Carbon Bubble does not exist’.
The real economy is still strongly dependent on fossil fuels, especially oil and gas, and large investments and financing are still needed for further exploration. Here, too, we see a rise in risks. Not only financial risks, but also risks to the security of supply of these commodities and therefore the risk of negative impact on the economy. The question is whether the risk of tempering investments in oil and gas too quickly may result in an unexpected negative impact on our economies. Below I lay out some of the factors to be considered when assessing these risks.
“Shifts in the demand for energy do not necessarily move in tandem with changes in investments on the supply side”
To meet the Paris Climate Agreement goals the usage of fossil fuels will have to drop massively. At the same time, we see that in large parts of the world people are still confronted with immense energy poverty. Indeed, even today there are still hundreds of millions of people who have no access to the electricity grid. Due to the expected rise in welfare and the rise of the global human population, global energy demand will continue to increase fast. To some extent, this rise in demand will be met by renewable energy, but the other part will still have to be met by fossil fuels. As a result, global demand for fossil fuels will also continue to rise, especially in emerging markets. But since investments in fossil fuels are under pressure, it will become more and more difficult to meet the global need for oil and gas demand in the coming years. Shifts in the demand for energy do not necessarily move in tandem with changes in investments on the supply side. As a result, investments in oil- and gas-production may decline too abruptly. This could not only lead to shortages of oil and gas, but also to a loss of expertise in geology and drilling. Both are not only important for oil and gas exploration, but also for other energy sources such as geothermal, which will be part of our future energy mix.
The call to reduce investment in the exploration and production of oil and gas to minimise financial exposure is mainly targeted towards the IOCs. These stock-exchange listed energy companies have all started their transition towards a more sustainable business model. Some companies are on a faster transition path than others. Investors often express concern that these companies are not able to adapt quickly enough. However, these companies are actually able to shift their portfolios significantly in a period of just 6-8 years. In other words, they can adapt to the needs of the end consumer rather swiftly. This is possible because they have reduced a large part of their reserves in recent years. Roughly 90% of all global oil reserves are held by the National Oil Companies (NOCs). If we see stranded assets in due course, the financial risks for investors will therefore not be as big as some may fear today. Nevertheless, that does not mean that countries who own these NOCs do not have any financial risks (alongside various indirect risks).
“Price gains of the so-called marginal barrels will have an economic impact”
Small shortages can – in current market circumstances – lead to strong oil price gains. And the price gains of these so-called marginal barrels will have an economic impact. A common rule of thumb is that a $10/bbl increase of oil prices leads to a reduction in economic growth of roughly 0.2pp, and a rise of inflation by 0.1-0.2pp. A price increase of $10-20 is manageable for the economy, or the end-consumer. However, if due to a lack of investment shortages become bigger and bigger, oil prices could jump towards for instance USD 146/bbl, the 2008 record level. In that scenario, economic growth could contract by more than 1.5pp. This would mean consumers paying much more for oil-related products (like fuel, plastics, clothing, and so on) – money which cannot be spent on other consumption goods.
A higher oil price should increase the economic feasibility of sustainable solutions. However, this also comes with economic side-effects. Reduced financial capability on the back of high oil prices could also hurt the investments in renewable energy. This is why I am calling for appropriate and controlled adjustments to investments in the energy sector. This applies to both renewable energy (steadily more investments) and on the fossil side of the mix (gradual reduction of investments in order of carbon intensity).
This column has been published in Dutch on Energiepodium.nl