WEO 2016 also warns of disjointed scenario if energy transition is delayed.

Scenarios are not forecasts

The scenarios produced by the IEA, and indeed those from the US EIA, are not forecasts of what the organisations expect to happen. They have been frequently misrepresented as such, however. The selective use of scenarios which fit business as usual for the fossil fuel industry we believe is misleading for investors trying to understand the energy transition.

Turn the scenarios upside down

As scenario analysis is mooted as a useful tool to understand the risks of the energy transition, it is clear that using a scenario with no changes in technology and policy (the CPS) or the new policy scenario (NPS) (AKA the ‘no new policies scenario’), which includes what is already known about and set to come into force does not help companies or their shareholders understand risk and opportunity. Planning for such a lack of policy change is an increasingly dangerous strategy in an increasingly volatile and uncertain market.

Furthermore, the extent of the low-carbon shift has been faster to date than reflected in many scenarios. Consequently, we think it is more useful for risk management purposes to use low carbon scenarios as a way of testing business resilience. The new baseline should be the IEA 450 (2°C) scenario, which as this WEO shows is not a static reference point in terms of the pathway to delivering the emissions outcome.

Using this baseline allows investors to compare variations between companies and their assumptions, and therefore perceive how aligned management is with their view of the energy system going forward.

The case for a low-carbon transition is unavoidable

Big steps have been made in the transition to a low-carbon economy over the past 12 months. The IEA have acknowledged this progress and have adjusted the 2016 450 scenario accordingly. Although the scenario still achieves a 2°C outcome on the balance of probability, this is now achieved through more renewable energy technologies, less coal and CCS in the power sector and greater electrification in the transport sector.

Figure 1 shows that solar PV is the big winner in these revisions, growing by 44% more than in the 2015 450 scenario by 2040. Wind power has also been revised upwards. This growth largely comes at the expense of coal fired power, which makes a far smaller contribution to this 2°C scenario than in the previous year.

Figure 1: The IEA’s 2016 450 scenario sees significant changes in power generation on last year

The downward revision of coal in this year’s 450 scenario is an acknowledgement of the structural headwinds facing the sector, which have often been highlighted in Carbon Tracker’s work. It is also in response to assumptions on the contribution of carbon capture and storage (CCS) being halved. The 2016 450 scenario assumed 430GW of power plants are equipped with CCS in 2040, whereas last year’s WEO put this figure at just over 900GW. The IEA state this reduction is in response to “the slow pace at which this technology is being tested and deployed in practice”.

Finally, the IEA have focused far more this year on the potential growth of electric vehicles (EVs) than in the past. This has led to another upward adjustment across all scenarios. In the central New Policies Scenario (NPS) this was from 57 million in 2040 to 150 million in the 2016 WEO. The 2016 450 scenario also appears to have increased its EV assumption to 700 million by 2040, displacing 6mbd of oil consumption in the process. The IEA’s WEO calculations exclude potential subsidies and fuel taxes and so these estimates could very well be on the conservative side.

Post-Paris implications

As well as making huge strides on the technological side, the low-carbon transition was cemented in policy with the December 2015 Paris Agreement being ratified in November 2016. This has led this year’s WEO to include scenarios that limit global warming below 2°C, i.e. the ‘well below 2°C’ scenario (WB2°C) (equivalent to 1.84°C of warming) or ‘1.5°C scenario’. IEA carbon budgets assume a 50% chance of delivering the climate outcome desired and, as one would expect, the carbon budget decreases with lower global warming targets – refer Figure 2. It should be noted that the 50% likelihood budget for 1.84°C is equivalent to a 66% likelihood budget for a 2°C outcome. So to put it another way, the IEA has considered the 66% probability of a 2°C outcome as well as its usual 50% probability.

Figure 2: Carbon budgets across climate scenarios and the impact on fossil fuel demand in 2040

Figure 2 shows the consequences for fossil fuels from climate constraints are stark. Oil demand in 2040 in the WB2°C scenario is 63mbd, almost a third down on today’s levels. This falls to 40mbd in the 1.5°C. A similar downward trajectory is evident for gas consumption in 2040 across the different climate outcomes.

Demand misread and wasted capex

The 2016 WEO provides a perspective on Carbon Tracker’s core concepts of stranded assets and wasted capital expenditures (CAPEX). For the IEA, the extent to which risk exists from stranded assets depends on whether the low-carbon transition is orderly or disorderly – something Carbon Tracker frequently highlights as well.

In an orderly transition, with governments pursuing ‘unambiguous policies’, ‘there is no reason to assume widespread stranding of upstream assets for oil’. The IEA do assert however, that in a 450 scenario, the risk of stranded assets is higher because of a combination of falling demand and lower prices, something that will mean oil “companies are valued less”.

The IEA supports Carbon Tracker’s contention that a more disorderly or “disjointed” low-carbon transition, based around overly optimistic readings of future demand, could be highly damaging to the oil and gas industry. For example, according to the 2016 WEO, the NPS comprises 190 billion barrels not needed in the 450 scenario, potentially wasting $200bn in exploration costs, not to mention lost revenues. Overall, companies are worth 20% less in the 450 scenario than the NPS, largely as a result of a lower oil price assumption.

The industry must be wary of disruption

The 2016 WEO includes a ‘disjointed scenario’ that sees oil demand fall 30 billion barrels in 5 years, wasting $380bn of investment. Most critically however, this scenario leads the IEA to conclude that:

‘the later the transition to 2°C is deferred, the more difficult and disruptive it promises to be for the upstream oil industry’.

In light of the potentially destabilising political events with the UK’s exit from the EU and the victory of President-elect Donald Trump, understanding and analysing such ‘disruptive scenarios’ is likely to become more essential than ever, whether technological, regulatory or political.

James Leaton, Research Director, Carbon Tracker

Luke Sussams, Senior Researcher, Carbon Tracker