Energy transition: the greatest switch capital markets have ever seen
By David Nelson, Climate Policy Initiative (CPI) Energy Finance
This article is published in The Beam #6 — Subscribe now for more on the topic
When we think of the changes a clean energy transition will bring, we often think of a transition from high to low carbon technologies. But even the most engaged energy pundits tend to gloss over what may be one of the biggest changes of all: how we pay for and finance the energy we use, and what that may mean for the investors, industries, and companies that provide that energy.
Our work over the last decade at Climate Policy Initiative (CPI) has shown that the transition will result in a very different mix of energy investors, new types of opportunities and financial vehicles, and big changes to the existing structure of familiar energy companies such as utilities. Markets and industries will be transformed to match the operating characteristics and investment risk profile of the new technologies.
If we successfully manage the withdrawal from current energy investments, we will enable the smooth transition from historical high carbon assets that can also fill the intermediate gaps of our energy supply, while avoiding the negative impacts on the global financial system that an abrupt, delayed, or disorganised abandonment of historical energy investments could have. For the transition to succeed, we will need new markets that give the right incentives to develop new sources of flexibility, such as demand management and energy storage, that help balance the intermittency of wind or solar power.
Our research suggests that if we make these changes to investment, market and business models, the total cost of the clean energy system will be significantly lower than the current fossil fuel driven energy system. If, however, we pursue the energy transition based on existing financing structures and markets, we could find ourselves with a bill that far exceeds current costs.
To understand why, we need to take a financial perspective on three key differences between our existing energy system and a future low carbon system.
First, investment and financial markets are all about risk and risk management, who is willing to take on risks, and how much they need to be paid to take on that risk. It may, at first, seem counterintuitive, but most of the investment involved in a low carbon energy system is intrinsically less risky than current fossil fuel related investments. Less risk means different investment vehicles and different investors, but also different market structures to manage those risks effectively.
As an example, energy companies can spend billions of dollars to drill 10,000 foot wells that might, or might not, produce oil. The value of that oil will rely on a market whose price depends on economic growth, how many other drillers have been successful, and even global political risk. The price could be US$30 per barrel, or it could be US$160. As an investor, I would take on these risks if they are well managed by the company, but I would want double digit, 10–15%, annual returns.
By contrast, the risk of building a wind or solar park is lower, and once the park is running, operating costs are much smaller and more predictable. The amount of wind or sunshine might vary, but the production risk is very small compared to oil exploration. Prices tend to vary mostly because oil, gas or coal prices vary, influencing electricity markets. A world without fossil-fueled energy generation, or one designed to reflect the intrinsic risks of low carbon energy, would have much more stable electricity prices. And a world with greater electrification — which is one of the important pathways to a lower carbon economy — would have more stable energy prices.
In fact, for an investor, renewable energy investments look much more like bonds than the equity investment common to the fossil fuel industry. We have found that in the long term renewable energy costs can be brought down by 15–20% per unit of energy, if we restructure the investment and corporate vehicles around the properties of renewable energy, rather than coal or gas.
As we set out in our paper on the Clean Energy Investment Trust, doing so requires a degree of financial innovation, including creating new types of investment portfolios to diversify risk, and investment concepts to manage development and repowering of the projects. Such a concept can enable investment into lower return, bond like structures for over 95% of the project cash flows while still achieving investment grade levels of risk. The lower cost of financing results in a lower cost of energy.
Second, lower carbon energy is often more local with less dependence on globally traded commodities such as oil, coal or gas. Investing in a powerplant that sells power to local urban residents in local currency in an emerging market is a very different investment proposition than investing in an oil platform selling in crude oil in dollars to the global market, even if the two are located 10 miles away from each other. Thus, local investors, who are already exposed to local currency risk, are the natural investors. However, even though many emerging markets are developing significant investment capacity, our analysis suggests that as much as US$200 billion a year of investment will be needed from international sources to meet the future local currency investment needs of a low carbon energy system.
Distributed generation also moves significant investment from investment banking to commercial banking. The true investor is now the homeowner deciding how to use their credit capacity, rather than the bank investing in energy.
Third, stranded assets, where investments decline in value because they are no longer needed in the new energy landscape, is the transition risk that features most prominently in the minds of investors.
At CPI we have built models that show the impact of a transition to a global low carbon energy system on the value of every coal, oil, gas field and power plant in the world. Our models suggest tens of trillions of dollars of value are at risk, but a good portion of this risk lies with governments — in the loss of taxes, royalties, and value in state owned enterprises — rather than investors. Our models suggest that lower demand will keep fossil fuel prices much lower, indeed the decline in expected future prices for oil, gas and coal, is far more important to stranded value than in declines in output. However, lower fossil fuel prices will benefit consumers and economies. In fact, our analysis shows that when benefits to consumers and the lower cost of capital are taken into account, there could be a multi-trillion dollar net benefit to the global economy of the energy transition over the next two decades.
Unfortunately, the lost value will be concentrated in countries, industries, and financial institutions. For example, our work on the impact of a global transition on the South African economy suggests that if the transition were to happen sharply and haphazardly, the loss of value from South Africa’s coal industry would more than double the country’s debt to GDP ratio, up to a level that would exclude it from any credit markets and possibly cause widespread default. Many other companies, investors and resource dependent countries could find themselves in similar situations.
But with planning, well defined and executed transition paths, avoidance of investment in new assets that risk stranding, international support, and new financial tools and insurance products, the systemic impact of this concentration of risk can be avoided, allowing the global economy to enjoy the overall economic upside of a lower carbon economy, along with the clear environmental benefits.
CPI analysis suggests that the transition could have a significant impact on financial markets. Under current industry and investment models, governments and large energy companies would need to increase their annual investment by 20–30%. However, in a more optimal world, we have also found that global investment by both the public and large energy companies could fall 10–30%. Institutional investors, commercial lenders, new types of energy funds, and households will make up the difference. But this require new investment concepts, dedicated and well thought out transition mechanisms, and new energy market designs. The choice is ours to make.