How will the surge in the prices of oil, gas and coal impact the transition to low or zero carbon sources of fuel? In the second part of our Q&A on the energy sector, experts from our credit, equities and ESG teams contemplate the challenges and opportunities in the pivot to green.
Read this article to understand:
- The different pathways being taken by energy majors in the transition
- How income investors may be affected by transition dynamics
- How the current economics of subsidy-free renewables are inhibiting investment
Elevated commodity prices around the world have reinvigorated debate about what happens next in the transition. Are companies moving fast enough with the capex required to switch to greener forms of energy? Or will radical action be needed to force them to confront a future no longer defined by fossil fuels?
In the second part of our Q&A on the energy sector (also see part one – Energy in focus: The last hurrah for fossil fuels?), we ask experts from our credit, equities and ESG teams: Derek Foster, senior credit analyst (DF); Chris Murphy, equity income portfolio manager (CM); Rick Stathers, senior ESG analyst and climate lead (RS); and Lei Wang, senior credit analyst (LW), for their thoughts on different strategic pathways and the factors inhibiting change.
Would splitting the energy majors into ‘clean’ and ‘dirty’ parts ultimately add to shareholder value and help tackle climate change, or could it be detrimental?
LW: In my view it would be detrimental. It is the line being taken by hedge funds trying to make quick money. Renewables companies need equity capital to fund growth. If you split these companies into two, it will hurt their renewables arms. They need cash from traditional exploration and production (E&P), which is highly cash generative now, to feed into the renewables side, which may not make money for years.
From a credit perspective, it would be negative. Spreads keep widening on the debt issued by the traditional players, because there are a limited number of buyers, and that’s making financing more difficult. There are fewer people stepping in with support. They are experiencing a harsh funding environment; life is not easy, even with plenty of cash coming in. They are dealing with regulators and environmentalists at the same time, and even if the outlook is improving from a credit perspective, they are getting more and more devalued.
Do you think hedge funds will get their way?
LW: I don't think so. The attacks from hedge funds are small, based on wishful thinking. But those involved do make a lot of noise. Should these splits happen, I would expect hedge funds to sell shares quite quickly.
I am aware of a discussion about how one company might sell its exploration and production assets to private equity, and just retain the downstream and chemical operations. I thought there would be an announcement in spring, but the Russian situation will probably put it on hold, because Russian production currently accounts for about 20 per cent of output and I don’t think the transaction will take place.
DF: There is a dichotomy, not only of strategy, but of market, because reactions in the US and Europe are different. The US majors have no issue with access to capital; spreads are getting tighter, equities are rallying. These companies have outperformed their European counterparts over the last 12 months as well as the last five years. But the strategies of companies like Chevron and Exxon are quite different to Equinor.
Europeans seem to be transforming themselves into renewable power companies
Europeans seem to be transforming themselves into renewable power companies. American majors are going down the route of carbon capture and sequestration, as well as applied technology. It’s an interesting dichotomy, and it will be fascinating to see which path is most successful. From a planetary perspective, perhaps we should embrace both. The International Energy Agency (IEA) net-zero scenario suggests you need both to achieve the Paris goals, and these firms have the capital and expertise to throw at the problems. While potentially unpopular, it is my opinion that we need to address climate change with a “kitchen sink” approach, including investments in decarbonisation technologies like CCUS, plastic recycling, and low carbon fuels.
LW: Oil majors are generating so much free cash. I asked Equinor recently why it was not speeding up capex on renewables and was told economic returns are the driver. If a project is not expected to make an adequate return, it just won’t invest. Many wind projects are underwater because of raw material, logistics and labour costs. Companies would rather carry out share buybacks and increase dividends than speed up investment in economically unviable renewables projects.
So, the lack of an immediate return is limiting investment in renewables?
RS: For the bigger picture, I'm influenced by Jeremy Rifkin, author of The Zero Marginal Cost Society, in which he highlights the point of capitalism is to reduce costs. We have done it with communication; we have free communication over the Internet. We have done it with education. But now we have energy to address. Remember with renewables, once you have done your capex, operating costs are low.
There are other elements to consider, too. Collectively, we subsidise fossil fuels, and it would certainly be possible to reallocate that subsidy to the renewables sector. Then we have another question about the cost of carbon; we currently do not integrate the social cost of carbon and apply it to all projects everywhere. When looking at this, we need to be aware that we have a short window in which to act to prevent catastrophic climate change. We have had 60 or 70 years developing a fossil-fuel dependent economy, and those actors are still influencing political decisions today.
Has anything in the US policy environment changed since Biden’s arrival?
DF: Change is slow. There have been impediments to prevent Biden doing anything drastic, but I think he's pragmatic in his approach.
For things to change, Biden is going to have to utilise more sticks than carrots
Change really takes place at the agency level, then the state and then travels through Congress. But getting anything through Congress now is difficult. For things to change, Biden is going to have to utilise more sticks than carrots. He has not been overly successful because a lot of oversight lies with the state and Texas is not Washington DC. That is the reality.
Are there any reasons for optimism?
LW: Shell is speeding up its efforts in terms of its low- and zero-carbon projects and making acquisitions. Equinor has also embarked on some large and costly projects, but the company is mindful about selecting the right ones. Power generation is regional, and many markets are regulated differently, so the key questions need to be approached differently in each case. It is not like oil, which is a global commodity.
The other point is that consumer behaviour could make a major difference, but it will take time to see change.
RS: There is a danger we underestimate disruptive technologies. Past IEA forecasts and many other scenarios underestimated the cost declines in wind and solar, and energy storage. That is potentially very positive, because it could mean that rollout is a lot quicker than we anticipate. Clearly, we have challenges with raw material costs impacting the trajectory, but perhaps necessity will once again prove the mother of invention.
There have been studies showing the volume of green patents emerging from traditional oil and gas companies. Are you witnessing innovation on the ground?
LW: The Nordics are very upfront in developing hydrogen, even among higher-yielding companies. It’s early-stage technology, but there are a lot of companies involved in that on the industrial side. That could lead to potential breakthroughs, but not yet.
You still need customers; it is not just about having a production facility and making the product
Ultimately, you still need customers; it is not just about having a production facility and making the product. There are lots of emerging markets making announcements on hydrogen as well. We are also seeing carbon capture being explored offshore in the Netherlands, but I don’t think it is economic as things stand.
What has been the role of litigation in driving change?
LW: Almost every week there is news Shell (the target of the most high-profile litigation to date) is moving ahead with projects it promised but has never made progress on. There are changes in behaviour, not large ones, but the projects look legitimate. There has been investment in India, which is a market where it can achieve a guaranteed return on capital;1 that’s why both Total and Shell are looking more closely at it. But other countries do not offer that guarantee so there is less incentive. These are small announcements; they are not headline news, but they are changing the landscape.
CM: If companies are not driving into a more friendly carbon environment, I suspect litigation will increase. That’s the nature of the world. But I think the real change that is needed is with carbon pricing, and that needs the hand of regulators and governments. If the world sits back and thinks oil companies will reform themselves, they will keep waiting. The companies will simply drag their feet. I see certain parallels with tobacco; it was not in the interests of the tobacco companies to change. But there are differences too: we have had to use hydrocarbons because we have not had alternatives.
In fixed income, what can you say about the visibility of income streams, when there are so many factors at play?
LW: In my view, more focus on ESG is likely to contribute to a higher gas price. In these circumstances, I'm confident most issuers will be able to maintain their credit ratings. But the unknown variable is how investor behaviour changes and whether investors ultimately refuse to have exposure to fossil-fuel producers. That creates certain technical difficulties; I try to avoid issuers with the greatest headwinds and allocate to smaller, less well-known, and cheaper names.
The visibility of future profits is important
DF: The visibility of future profits is important. Occidental Petroleum is a high-yield, formerly investment-grade issuer, and the US leader in direct air capture. The company believes that arm of the business could be as large as its chemicals business. It is currently the number one producer of chloralkaline products, including chlorine and the PVC pipes used in plumbing. If Occidental is right, and it gets direct air capture to work, that could generate a strong, visible income stream. But the activity is currently reliant on tax credits from the US government.
Many of these approaches by the majors are at the development stage: blueprinting, acquiring intellectual property, trying to understand which avenues to test. So which path will they go down? Figuring that out is exactly where we are right now.
What about the equity side, and the implications for income investors?
CM: It is an issue in the UK. I have low exposure to the energy sector, which is currently a drag on performance. Everybody is trying to value these businesses in relation to the spot oil price and short-term cashflows, which are strong. But my view is that the long-term terminal value of many businesses should be lower, and the cost of equity higher, because of risks on the horizon, including litigation and the scale of change needed.
Where does nuclear fit into this picture, if at all?
RS: Nuclear is perceived as a low-carbon option in the UK, but we have never found a solution for dealing with waste. We just call it ‘spent fuel’ and deposit it underwater in storage tanks for 50 years. That’s a big issue. We have sites where they are proposing underground storage, which will have potential risks to groundwater reserves as well.
Around a quarter of the world's nuclear sites are at high risk from sea-level rise
From a climate perspective, around a quarter of the world's nuclear sites are at high risk from sea-level rise. The other concern is that they need a lot of water for cooling. In France, there have been occasions when parts of the nuclear fleet had to shut down because river temperatures were too high to enable the water to be used to cool the reactors sufficiently.
This is a complex picture where you can take a positive view from the perspective of carbon metrics, but you also need to bear potential physical impacts in mind. You need to think about intergenerational equity. You must consider there has never been a single, large-scale nuclear plant that's come in on time or on budget. Historically, taxpayers have been the ones picking up the tab. The small-scale modular reactors being proposed by Rolls Royce are novel, they have never been produced, and I don't think there's enough demand to meet the economies of scale they need to be competitive without continuing declines in the cost of electricity.
DF: I agree with Rick, but it is a shame the nuclear option is not considered more frequently. It has become a black sheep, although it could be a viable alternative to be explored.
Conflict aside, as you look across the energy industry, is there anything that particularly concerns you now?
DF: We are very focused on Western emissions and companies. The reality is that if Europe goes to net zero by 2050 on its planned trajectory, that atmospheric gain is 100 per cent offset by emissions from the coal plants China plans to build over the next ten years. 100 per cent! These 160 GW of plants are set to have 40 years useful lives and suggest a real dichotomy to their stated objectives. While we should be focused on Western emissions, we should also keep in mind the world’s largest polluter appears poised to invest in technologies the rest of the world is abandoning.
There are huge assumption gaps. For example, will China, Vietnam and other emerging markets do things they don't necessarily have an incentive to do? In my view, the UN and others need to step up and make sure incentives are there.
The Chinese government is actively exploring renewables, but the major problem is transmission lines
LW: I visited Chinese officials a couple of years ago and they are aware of the situation. The Chinese government is actively exploring renewables, but the major problem is transmission lines. Most renewables are being generated in the north-west of the country where the landscape is mountainous, and population is sparse. There is a lot of solar and wind capacity installed but it cannot be transmitted easily. They do not want to pollute their backyard, just like everybody else, but it takes time and money to address the problem.
RS: China has a net-zero commitment out to 2060, and the Chinese are currently one of the largest investors in green energy. China has been extremely successful in reducing particulate pollution in Beijing over the last six or seven years, which is impressive.
One issue concerning me at the Net Zero Investment Execution Unit is the metrics we are using, whether we focus on production emissions or consumption emissions. The UK government often says we have done well reducing emissions, but what we have really done is offshore emissions to developing countries. If you refocus on consumption emissions per capita, we get clearer focus.
I am also worried the window of opportunity for change is getting smaller and smaller, while the pace we need is increasing the closer we get to 2050. With this war we will undoubtedly see well-funded fossil-fuel companies and their lobbyists pushing the energy crisis as a reason to increase investment in their sector. This will lock in capital, business models and emissions for decades to come.
Achieving the transition to a low-carbon economy requires a radical shift, but to date, everything has been incremental. Could the conflict, combined with the alarming climate impacts raised in the latest IPCC report, encourage politicians to be radical? They could improve energy security by increasing self-generation through decentralised renewables, reduce exposure to foreign imports and address the climate crisis at the same time.
The likelihood of reaching the 1.5-degree target may be low
Sadly, though, from where we are now, I think the likelihood of reaching the 1.5-degree target may be low, and we are likely underestimating what a two-degree world will mean in terms of wider impacts, on migration and so on. In my view, we don't need new oil and gas reserves and we can’t tolerate new investment in them if we are to meet the net-zero goal.
DF: One clarification. The IEA net-zero scenario suggests no new reserves for incremental production; it does not cover replacing existing production. That's a big difference. In other words, the likes of Shell or Exxon need to maintain existing production levels. If they are spending a dollar on capex, what are they supposed to do? Sometimes the headline gets misconstrued that they should spend zero dollars. If they spend zero dollars, the oil price is going to get a lot higher.
LW: I am concerned about the inflationary consequences of changes in the energy market. There is a possibility it could trigger a recession, and if that happens, the switch to renewables might be put on hold because we won’t have money to do it.
CM: I also have concerns about carbon-offset schemes. It feels as if there is a lot of fudging going on. Let's say I produce hydrocarbons, so I buy a rainforest and announce I'm carbon neutral. How does that work? That rainforest is already there. Yes, it’s true some of these forests will be managed and more trees will be planted. But there is a danger this distracts from the root of the issue, and that is the production and use of the hydrocarbon. That brings us back to carbon pricing and the need for more regulation and government action, but it's difficult to know how much appetite governments have for it.
Many commentators see electrification as a possible low-carbon solution. How tough is that going to be to deliver?
LW: I look at metals’ pricing, and all the metals have skyrocketed. Given we have limited supplies of copper and lithium, I don't know if full electrification is physically possible.
Is there any cause for hope?
LW: We have technology; we can get through this. I am confident, although perhaps not in the timescale we are thinking about.
The solution may not look anything like what our models suggest today
DF: Remember the market has solved every crisis humanity has ever faced – and we are going to do it again. It may not be on the exact path we see today, but something will come along. It may be our children who achieve it, but we need to keep the faith and push to do things that make practical sense. If we do, I believe human ingenuity will prevail. The solution may not look anything like what our models suggest today because there are simply too many unknowns, but it’s important we stay optimistic.