A tug-of-war transition

If you are confused by what a 19th century athletic contest has to do with an energy company’s capital expenditure, allow us to elaborate. Investors’ perceptions of their time horizons and priorities play a significant role in their willingness to embrace sustainable investing practices for climate change.

On the one hand, some traditional value investors prioritize short-term effects at the expense of the long term. This does not only refer to a prioritization of short-term returns and dividends but highlights that certain investors are unable to consider the urgency of long-term investing without an immediate threat. We have seen investors shift their processes for war- or pandemic-like events, but the urgency of the climate crisis does not trigger the same fear response.

On the other, a separate group of sustainable investors and non-governmental organizations (NGOs) are able to take action quickly, prioritizing their investments in line with achieving climate goals. Legacy oil companies are therefore caught between the sustainable investors and NGOs (combined with a lot of media attention) demanding a quick transition and traditional value investors who worry about the destruction of value often associated with aggressive transition strategies.

Indeed, the European majors provide quite a few recent examples of poor capital allocation decisions. BP was the first oil major to commit significant capital to renewable energy via investments in solar and wind projects. Specifically, they launched a USD 200 million campaign in 2001 to rebrand BP into Beyond Petroleum and established BP Alternative Energy to consolidate their low-carbon activities in 2005. These projects lost them over USD 8 billion.¹ By some estimates, had the capital been invested at BP´s cost of capital via oil and gas or share buybacks, BP´s share price would be around 45% higher. Cases like this emphasize the importance of considering the pragmatic realities before diving in.

There also appears to be a significant disconnect between governments’ public statements about reducing fossil fuel production to address climate change, vs. their actual policies and plans that continue to support and incentivize increased fossil fuel extraction and use. Despite 151 national governments pledging to achieve net zero emissions, a major report from the United Nations Environment Program (UNEP) found that governments globally plan to produce around 110% more fossil fuels in 2030 than would be consistent with limiting warming to 1.5˚C.²

Another group of stakeholders contributing to the intensity of this tug-of-war is consumers. While there seems to be general consumer openness and demand for sustainable energy solutions to replace fossil fuels, concerns around the affordability of this new technology may trump any desire to transition quickly. With the consistent prevalence of fuel poverty³ and the post pandemic cost of living crisis, consumers are looking for assurances around protection and assistance before their sentiment can turn into action.

Difficult decisions and tough trade-offs will need to be made.

So as we approach 2030 and near the deadline for certain climate ambitions, difficult decisions and tough trade-offs will need to be made. How can these energy companies that are pivotal in steering the global energy transition balance the competing interests of environmental sustainability, economic viability and energy security, when deciding where to allocate their CapEx?

This game of tug-of-war would be less challenging if both teams dropped the rope for a second and stepped back to examine the current progress towards the net-zero goals and reduction of fossil fuel use. Both sides would find that many hard truths need to be confronted before picking the game back up.

Firstly, as Vaclav Smil puts it, the global goal of zero carbon by 2050 is unlikely due to our current reliance on fossil fuels.⁴ The demand for fossil fuels is not falling as quickly as expected and people have been unrealistically optimistic about the pathway to achieving these targets. Moreover, the “speed, scale, and modalities (technical, economic, social, and political) would be historically unprecedented.” We cannot compare this transition to any previous energy transition we have endured. Never in a previous energy transition have we actually reduced the use of the previous fuel, nor have we ever moved to a less dense form of energy.

For example, we are still using the most wood we have ever used (traditional biomass energies still supplied about 5% of the world’s primary energy in 20205), despite the transition beginning over 100 years ago. With the green transition now, not only do we want to introduce renewable energies, but we want to reduce the use of coal, oil and gas, not in 100 years, but in 30 years. This makes it nine times as difficult.

Even more demanding is that, according to The International Energy Agency (IEA), we have not yet reached the peak of the global consumption of fossil fuels and are only projected to by 2030.⁵ The scale of this disruption must happen in a very short period of time. And creating the infrastructure for renewables, including batteries and electric vehicles (EVs), is very energy intensive. In fact, China is producing most of our solar panels and wind turbines, and they are using coal to do it (the most energy-intensive step in the solar-panel manufacturing process occurs in a Chinese region where coal accounts for 77% of power generation).⁶ On a positive note, we do believe China’s coal production is likely to peak soon and their emissions should start declining accordingly.⁷

Ultimately, simple quick-fix solutions will not work. Cutting fossil fuel production too quickly is not only increasingly difficult given the strong demand, but also counterintuitive. If you cut fossil fuels too quickly, they could become extremely expensive and cause a massive economic shock. This will hurt consumers negatively, and carry potential knock-on effects. For instance, when people are worried about losing their job they tend to worry less about the climate. Moreover, if China cuts coal, which it is using to create solar panels and wind turbines, then the cost of renewables is likely to go up. People do not appear ready for that. By considering what is feasible in practice, investors can balance some of the noise coming from both sides and hone their expectations of CapEx allocations accordingly.

Transition trade-offs

By taking a step back, a clearer view of where energy incumbents should be positioning their CapEx emerges. Although we believe there will be positive return opportunities with any transition pathway, it is not an easy balance to strike.

Oil and gas companies need to have strategies with strong industrial logic and the potential for returns that are acceptable to shareholders.

To start with, oil and gas companies need to have strategies with strong industrial logic and the potential for returns that are acceptable to shareholders. While the transition is a massive shift for the energy industry, commercial realities mean any investment needs to make business sense. As with the BP examples earlier, market participants had worries about uncompetitive investments and sold shares.

Some comfort can be found from the fact that investor reactions are not universally negative to aggressive transition strategies; some early leaders like Neste and Orsted have been market darlings despite near-complete abandonment of fossil fuels. Why? Because they had clear strategies based on widely acknowledged competitive advantages.

Incumbents could therefore consider cutting high-grade capital investments in upstream businesses so they shrink over time, while simultaneously investing in hitherto more niche areas of the energy transition where they have a real competitive advantage. One way to ascertain how and where these may lie is to look at patent applications. An often-overlooked fact is how many green patents are actually filed by energy incumbents (according to some studies, they produce more and of higher quality).⁸

We know this to be true when it comes to biofuels, where oil majors tend to have very strong positions as this requires refining skills that are very similar to what they do in their fossil refineries, or in carbon capture & storage (CCS) where oil companies have been doing it for over 40 years and have immense expertise. To reach a net-zero scenario by 2050, CCS needs to expand 120-fold to offset around 45% of emissions.⁹ This is an area where the fossil fuel companies should take the lead given their competitive advantage. The prevalence of supportive regulations and the ability to offer ‘carbon capture as a service’ will be a major advantage here for the majors or those with competitive advantages.

Ultimately, innovative energy projects may be inherently riskier than traditional investments for two main reasons and we believe this should be reflected in higher discount rates for fossil fuel extraction projects.

Firstly, the risk of stranded assets or obsolescence of oil and gas company assets as a result of technology advancements has gone up. Green policy aside, there is a risk that as top scientific talent shifts towards jobs in innovation in green tech, new solutions could render oil and gas expensive and obsolete, leaving assets stranded. We foresee the combination of solar and low-cost electrolysers for green hydrogen as the single biggest risk to fossil fuels.

The second issue relates to oil majors’ social license to operate. A portion of the world blames these companies for climate change, which creates an environment conducive to heightened political risk. In a worst-case-but-possible scenario, an unhappy politician could use this as justification to nationalize their assets. Their political risk is therefore extremely high and returns need to compensate through the form of higher discount rates. To put this into context, we believe that, through a combination of these factors, oil and gas companies are at least as risky as frontier markets which attract a 20% discount rate.

Despite seeing a derating of the European majors, as they refine their strategies and incorporate more industrial logic, this could reverse. There is also a temporary time phase effect where the investors use the same historical multiples while looking at the lower cashflows of renewables. A few years on, they could realize the discount rate also declined, making it less value destructive vs. initial calculations.

Additionally, energy majors could pay out cash to investors who could then in turn reallocate it to attractive climate solutions elsewhere in the market. This could include share buybacks which have surged in recent years. We believe strong capital discipline and investment in areas where these companies have competitive advantages are key to a successful strategy for shareholders.
 

Transitioning fast, and slow

The suggestion of a slower transition is admittedly a little discouraging, but historically issues have arisen when companies transitioned too quickly. We have also seen evidence of this not sitting well with company management for fear of investors fleeing. Indeed, Steven Chu (former US Energy Secretary under the Obama administration) shares his experience of advising Shell on their energy transition: share price pressure mounted as a result of having more ambitious targets than their peers, despite most of their CapEx still in oil and gas.¹⁰ They subsequently dropped an important climate target in March. Chu aptly highlights that, while global temperatures have broken records for 11 straight months, markets are still punishing companies making green investments.

The energy transition is an irreversible path, and energy incumbents must continue to adapt their CapEx strategies to align. The urgency and scale of the problem makes any degree of tolerance difficult. And yet we do need the incumbents to play a key role in decarbonizing society.

The future will likely see a more diversified energy portfolio with a steady shift away from fossil fuels towards renewables.

In our view, the future will likely see a more diversified energy portfolio with a steady shift away from fossil fuels towards renewables. If fossil fuel companies put forward convincing strategies that commit to a plan for reduction, no new reserves and deliver shareholder returns, there is the potential to end this tug-of-war game with handshakes all around.

¹  The renewable energy strategies of oil majors, Energy Strategy Reviews, November 2019
²  Production Gap Report, UNEP, November 2023
³  Annual fuel poverty statistics in England, Department for Energy Security and Net Zero, 15 February 2024
⁴  Halfway Between Kyoto and 2050: Zero Carbon Is a Highly Unlikely Outcome, Vaclav Smil, 2024
⁵  World Energy Outlook, The IEA, October, 2023
⁶  The True Cost of Chinese Solar Panels, Time, 18 January 2024
⁷  China’s emissions set to fall in 2024 after record growth in clean energy, Carbon Brief, 13 November 2023 
⁸  The ESG - Innovation Disconnect: Evidence from Green Patenting, European Corporate Governance Institute, 11 January 2021
⁹  Scaling the CCUS industry to achieve net-zero emissions, McKinsey & Company, 28 October 2022
¹⁰  Steven Chu: ‘Wall Street analysts are totally amoral’ on climate, Financial Times, May 27, 2024