The role of the capital markets in driving the energy transition

by David Stent, Content Manager, The Energy Council

The energy transition has not only created a paradigm shift in the sources of energy supply, but it has also instigated a revision of the methods and processes the financial sector utilises when deploying capital.

Capital markets have played a pivotal role in the successful development of the oil and gas sector: e.g. providing capital through institutional investors and reserve-based loans via banks, while the sector in return generated healthy returns to investors and lenders alike. Capital providers have over time become comfortable with the cyclical nature of oil and gas and learned to rely on built-in mechanisms to counter high and low-price environments, as well as significant innovation that created efficiencies within capital and operating expenditure.

However, the need to decarbonise has initiated a holistic reconsideration of the role of capital markets; particularly how they can facilitate access to capital to stave off climate change, manifesting itself as a growing requirement for financiers to take responsibility for how and where they deploy their capital.

“This Is a Transition, Not A Cliff”

Galid Lahdahda, Managing Director, Global Industries Group, Oil & Gas and Chemicals at Standard Chartered, took part in the Energy Council’s Asia Pacific Energy Assembly and conveyed the need for the industry to show appropriate leadership. “This is a transition, not a cliff. Although we are in a period of acceleration of transition efforts and positive feedback loops will further hasten this process, there remain physical bottlenecks limiting the pace of transition; replacing fossil fuels with carbon free alternatives will hence take time, and during that period oil and gas needs to remain competitive.”

Galid also spoke about the need for conventional players to maintain and capitalise on their strengths: developing and harnessing new technologies, managing large complex projects and, more broadly, their innate understanding of how the energy markets operate; if they are targeting a meaningful role in the transition. Besides, as they own and operate many of the assets that require decarbonisation they will not be able to escape being part of the solution.

Industry players are now quickly coming to the realisation that if they do not evolve, they run the risk of getting locked out of the capital markets as a result of the increasing societal and regulatory pressures they face. The oil and gas industry has been called out for their historic attitudes toward greenhouse gas emissions, but alienating these actors will not bring about the required change. Instead, we can create incentives for those businesses with a capacity to act to make tangible impacts to their carbon footprint, and beyond.

Finding The Balance

In order to undertake wholesale change that will support the transition, it becomes necessary for governments to consider energy, environmental and other policy reforms that acknowledge regional constraints. The desire for an accelerated energy transition within OECD nations must be balanced by the reality that the developing world might have to prioritise security, affordability and efficiency over diversification and environmental credentials. This balance must accept the need to maintain but decarbonise oil and gas production, while at the same time providing ample capital for carbon neutral energy sources.

The paradigm shift in energy production also requires investors to recalibrate their portfolios. Ranging from reservoir risk to development risk to commodity price risk, oil and gas has a higher risk profile than renewables, and investors expect to be rewarded accordingly. Renewable energy has a more predictable cash flow profile and congruent lower associated risk; resulting in lower required returns from investors.

Beyond the existing known risks, the introduction of carbon taxes, credits, quotas and/or pricing will ensure that high carbon emitters must manage their exposure to greenhouse gas emissions. If they don’t, they face reduced future income or worse, stranded assets. Investors similarly will have to consider the impact of these environmental risks on their portfolio and discern between parties that deal with these risks effectively and parties that don’t.

Lahdahda emphasized how banks focus on understanding the risks associated with the energy transition: “How will the competitiveness and viability of borrowers, wider industries and national economies be impacted by the additional costs that conventional energy sources will incur as a result of the energy transition, or equally by insufficient or slow adjustment to this new reality; and, how will portfolios and markets rebalance in reaction to this?”

At the same time financiers also recognize the transition as a major opportunity: “The energy transition has opened up many new opportunities that require plenty of capital, including sustainable projects as well as commercialisation and roll out of new technologies; it is here where financial institutions can be a real catalyst for change in mobilising and directing capital. For instance, in Standard Chartered’s footprint markets in Asia, Africa and the Middle East there is a tremendous opportunity to leapfrog legacy carbon intensive solutions through adoption of emerging technologies. Furthermore, these new solutions can generate significant additional economic participation.”

Tools to Serve The Transition

Sustainable mechanisms have become the focus for the wider investment community to promote a positive shift in corporate behaviour; ranging from green loans and bonds to sustainable linked bonds, essentially products that encourage action by providing improved terms when predefined ESG objectives are achieved. While these have had a measure of success in European and American capital markets, the Asia Pacific market is currently constrained by loosely defined and non-standardized ESG regulation, inevitably leading to a higher level of risk exposure as the transition matures.

Companies with a high-level of exposure to greenhouse gas emissions who seek to push the line with capital providers will encounter conflict as investors are becoming increasingly intolerant of inaction. The likes of BlackRock and Temasek have gone above and beyond regional ESG policy by communicating proactive reductions in their emissions exposure.

Balancing Energy Security Concerns

Transition strategies must take considered, regional approaches to achieving decarbonisation successes and acknowledge there is no one-size-fits-all method to achieving the objectives of the Paris Agreement. The primary concern for most nations is to ensure that their citizenry have access to energy that is affordable and consistent, and aids economic growth.

Although the cost of renewable energy supply has now become competitive with that generated from fossil fuels, large sunk-cost investments, intermittency and spending needed to integrate grid infrastructure remain a barrier to accelerated adoption.

Policy and regulation should seek to promote diversification over wholesale change, while considering the flexibility required for future energy supply. For instance; LNG as a transition fuel can support infrastructure for a hydrogen future; offshore gas production can be powered by renewable sources; brownfield sites can be re-purposed for carbon storage.

These conflicts of priority create a complex path that will not benefit all parties equally – there will be losers and there will be winners of the transition. The solutions provided through the capital markets, incentivising change within business through financial products, offer the first signs of a roadmap down this long and uncertain path.

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