Fossil fuel commodity prices are likely to remain volatile with the prospect for further embargos. This is a manifestation of non linear events around a trend and should not be interpreted as a structural alteration of the long term underlying bearish commodities outlook on the basis of declining demand in a carbon constrained world.
Although short-term measures may be needed to ensure system supply security, this should not prompt any more long-term investment in fossil fuel projects which risk new stranded assets and missed net zero emissions targets.
The situation should serve as an accelerator for the energy transition. Policy action will the feedback loop. An increase in fossil fuels on the system will be temporary.
While the energy trilemma – security, affordability, clean – is currently skewed towards security, rising affordability concerns bring risk for fossil fuel companies. Price caps and windfall taxes target fossil fuel assets, possibly a precursor to further asset stranding. Faster deployment of renewables will address affordability in a more sustainable manner. Renewables are now cheaper than fossil fuel in most regions.
BP has been the oil major most exposed to Russia. This will likely push BP to accelerate its energy transition strategy. A number of other oil majors have been forced to take similar charges TotalEnergies and Shell, in particular.
LNG may address security of supply on a short term basis but we would caution investors against extrapolating long term return assumptions in the way such assets may have produced in the past from this current push.
Investors should avoid being tempted to back new fossil fuel power generation plant build on the back of security dominance.
The Russia-Ukraine war could stall automakers’ ability to meet EU fleet average emissions target in 2022, mainly due to disruption in the supply of key components from Ukraine.
Companies should continue to consider the impacts of the energy transition on medium- to long-term price and demand assumptions and the timing of asset retirements, on their current financial reporting.
Strategy and Energy Transition
Increasing the use of fossil fuels on a temporary basis may be a result of the situation, but at the same time, security concerns and elevated commodity prices underscore the need for energy autonomy and greater renewables development and improve relative economics of clean alternatives. Positive feedback loops on deployment at scale could serve as an accelerator for the energy transition. From there on - what it will take to achieve capital allocation into the relevant technologies? What are the implications of a shift from extracted to manufactured energy and the consequences of different industry patterns and supply chains? All these questions relate to the shape, speed and pathway of the energy transition. All the while, the energy transition is inevitable and irreversible, the question becomes how policy, investment and corporates will drive it forward and grasp the opportunities.
As we change the nature of how energy is produced, are we moving from the frying pan into the fire? Dependency on extractive regions may be substituted with dependency on regions dominating the resourcing and processing of raw materials, namely metals, and the production process. Could we avoid or see changes to that? Policy could have an influence at various levels, ranging from security over energy policy to industrial and social policy. Would the positive scale effect from manufacturing concentration be reversed? Would security premiums at a different level become acceptable and affordable? Would we see displacement of manufacturing capacity and resource concentration? Will innovation overcome dependency? History shows that structural change sees little disruption, yet the path there may take unexpected turns.
Needless to say, the required outcomes - to achieve the goals of the Paris agreement including a sustainable temperature - are entirely unchanged. We would also consider whether asking if climate change and required ambitions for change succumb to the current situation is the wrong question. Rather, the questions centre around the implications of the current emissions overshoot and the timing and severity of follow-on consequences.
It's important to recognise that climate scenarios are not forecasts, but are useful tools to understand the pace of changes required globally – particularly within the energy system – to limit global temperature rise to any given level, and the associated emissions pathway. The existing set of scenarios are still valid – for example, to limit global temperature rise to 1.5 degrees or less by 2100 will mean a rapid shift away from fossil fuels, with no space for new fossil extraction projects to go ahead, even with some deployment of emissions mitigation technologies. The imperative to act on climate remains unchanged.
The current significant supply disruption may see a delayed response in global greenhouse gas emissions reductions in the short-term, necessitating even greater emissions reductions in the medium- to long-term to stay within the same carbon budget. A greater drive for energy independence, and thus increased investment into alternative energy systems, may see this acceleration in medium- and long-term emissions reductions, and some scenarios may be updated to reflect this changed shape.
What is critical however is to avoid a new set of scenarios with a delay in short-term emissions reductions, without consequent acceleration of reductions in the coming decades, relying instead on even greater deployment of as-yet-unproved negative emissions technologies in the decades post net zero. Such a strategy would lead to even greater temperature overshoot and thus running an even greater risk of this not being reversible.
Oil & Gas
Oil flows are more easily changeable in the short term (seaborne) compared to gas; changing flows of piped oil, however, can be more difficult and requires lots of new infrastructure.
Gas flows are more complicated – they need more infrastructure investment for both pipelines and LNG (terminals and ships, both of which take a long time to develop).
Impacts will be felt beyond Europe – e.g., European countries may be prepared (and able) to pay higher prices for LNG cargoes originally destined for elsewhere (thus creating a supply shortfall in countries outside of Europe). LNG flows can be highly responsive to price fluctuations and may become the ultimate premium commodity with difficult to predict flows.
Companies that are making significant profits have the option to a) increase investment into new oil and gas assets; b) increase cash returns to investors; or c) invest into new businesses that are sustainable in a low-carbon world, such as renewables. With current high prices, companies may be tempted to increase investment into new projects, particularly those that have been stalled in recent years given their high costs, and the lack of investment during the first year of the Covid-19 pandemic. It is likely that we will see some increased investment, particularly in shorter-cycle projects such as US unconventionals, but potentially across all project types.
For new investments, there is, however, a time delay between sanctioning projects (committing capital) and the start of production; oil and gas projects will in most cases produce for multiple decades. These time delays expose such investments to potential significant changes in long-term commodity prices as well as shorter-term volatility. Large, capital-intensive, projects (inc. e.g., LNG) are particularly impacted. As a result, companies sanctioning for the future based on recent pricing – especially during periods of elevated pricing vs long-term trends – are potentially in for a future shock once prices return to longer-term averages, particularly if over-investment leads to prices falling below long-term trends. Companies must be aware of these risks, and exercise caution in terms of their sanctioning decisions to avoid eroding shareholder value. As we described in Managing Peak Oil (Jan 2022), to reduce potential exposure to theses time lags, companies could focus on short cycle investments (shale, or further infield development), although these still carry significant potential stranded asset risk
Given the medium-term trends of the energy transition are a reduction in fossil-fuel demand (as a result of policy action on climate and the rise of new technologies such as renewables and batteries), any new supply for which companies are developing assets must be able to come onstream (i.e., provide additional supply) in the short term.
Average timescales from access to first production are 7-10 years, so new production is unlikely to come onstream until 2030, when demand may already be falling rapidly. So given these timescales, and the potential for energy independence concerns to accelerate medium- to long-term weakening of fossil demand, then investment in new infrastructure, and particularly exploration, is at significant risk of failing to deliver expected returns, and thus becoming stranded.
Oil & Gas – Corporate Research
There is the potential for deeply discounted asset sales to Russian, Asian (e.g. Chinese, Indian) and Middle-Eastern companies. If implemented, these will likely produce non-cash accounting charges. There would be no actual emissions impact since only a change of ownership would occur.
Also, a nationalisation / Custodial ownership by Russian government entities could be carried out.
Another option is for the current legal structure to remain in place for the short-to-medium- term until the political situation becomes clearer.
BP and TotalEnergies are more exposed than other oil majors. Following the resignation of its two directors on Rosneft Board, BP changed the accounting treatment of its Rosneft stake from equity accounting to a financial asset measured at fair value. As a result, in Q1 2022 BP reported a $24.6bn net pre-tax non-cash charge for its Rosneft shareholding (including $13.5bn pre-tax impairment to fair value of nil, and an $11.1bn pre-tax charge for foreign exchange accumulated losses previously recorded as comprehensive income). This resulted in a total reduction in BP’s equity of $14.7bn. BP, following the resignation of its two directors on Rosneft Board, has also changed the accounting treatment of its Rosneft stake, from equity accounting to a financial asset measured at fair value. It has to be noted that the main contribution that Rosneft provided to BP in terms of cash flows was its dividend stream ($640m) Until these changes, Russia represented about 1/3 of bp’s production and circa 1/2 of its reserves. The loss of Russian fossil fuel assets will likely push BP to accelerate its energy transition strategy
In Q1 2022 TotalEnergies declared a write-down of $4.1bn related to its Russian activities. Prior to this, Russia represented about 17% of TotalEnergies production and 21% of reserves. The possible negative effect on cash flow (5%) will be likely offset by the positive effect of high oil prices at group level, at least in the short term. Also for TotalEnergies, this may lead to a faster execution of its energy transition strategy.
Shell, ExxonMobil, Eni, Equinor are less exposed, albeit Shell has recorded, at its Q1 2022 results, $3.9bn of post-tax charges. Separately, on 12 May 2022 Shell announced the sale of its Russian retail & lubricant business to Lukoil, the Russian oil major, for an undisclosed sum.
Power & Utilities
The components of the energy trilemma calling for secure, clean and affordable energy have been dislocated. Will the current dominance of security be permanent? We have in the past seen shifts within the energy trilemma whereby particular angles were in focus more than others. Reversal is typical and a fully balanced trilemma is rare.
The Ukraine conflict has shifted the emphasis of the energy trilemma in Europe away from clean energy in favour of security of supply and affordability. Government intervention or regulation has increased at the expense of deregulated markets to mitigate commodity price volatility. Price caps and windfall taxes are primarily funding affordability rather than additional, faster deployment of renewables. However, the need to diversify away from Russian gas should stimulate an acceleration in renewables longer term, particularly in solar, wind & hydrogen. From a US perspective, we anticipate further MOUs and HOAs to be signed over the next 12-18 months for additional LNG capacity. Questions remain on the duration of contracts with European and Asian counterparties.
If a plant is maintained for security of supply purposes, it bears the consequences of market vs non-market-based revenue structures. A plant that might no longer be sustainable/its value recoverable on a market revenue basis could face reduced load factors as the electricity system changes, leading to policy consequences ensuing, which in turn might alter the risk profile of such plant.
We must distinguish wholesale power prices and final retail rates. The former are driven by market forces and the generation mix which is predominantly driven by the merit order where renewables rapidly move forward. The latter meanwhile largely reflect policy costs, although retail markets do take direction from the wider wholesale market.
Both markets had recorded large price increases even before the Russian invasion of Ukraine, as a failure in Europe to deploy lower cost and lower risk renewables at a fast enough rate to replace retiring coal units left the continent overly dependent on gas for its power sector needs. This, coupled with the wild swings in demand brought by the pandemic which global gas supply could not keep pace with, triggered hugely volatile price swings.
The additional disruption to Europe’s gas supplies that will come from ending pipeline imports from Russia will keep energy prices well-supported in the short- to medium-term, and government intervention to protect end consumers in the retail market from the impact of further price rises in the wholesale market may be necessary. These measures are likely to include retail market price caps being rolled out in more European countries.
But ultimately, the simplest way to bring down prices in the long-term is to increase the amount of lower cost and lower risk renewable capacity in the system, and nations must avoid locking the consumer into high prices over longer periods by turning towards these cheaper and cleaner technologies rather than further increasing market dependence and exposure to volatile and expensive fossil fuels.
We are now looking at the security of supply picture on a much broader scale given the current crisis. Most of the arguments against renewables previously have been focused on quite narrow or system levels, with the assumption that gas plants are always going to be sitting ready to provide reliable energy supplies in the absence of wind or solar energy. It is clear now however that having to rely on some of the most volatile political nations in the world for fuel requirements does not guarantee energy security and brings the significant risk that those supplies can be cut off at any time. Building a power system centred around renewables plus storage and proper demand side management gives nations the opportunity of energy independence and should therefore be a priority.
Ultimately it is crises like the current one we are seeing that can prompt rapid change and shifts in outlook for policy makers and investors. The narrative around fossil fuels is changing and the arguments are building by the day against a long-term reliance on them. Net zero ambitions now not only represent the best scenario for the climate, but also for nations in achieving independence from fossil fuel markets.
Investors should avoid the temptation to back new fossil fuel power generation plant build on the back of security dominance.
Some small-scale flexible gas-fired units may still have a long-term role to play as system backup, as our Put Gas on Standby report from 2021 shows, but the current crisis has demonstrated that now is certainly not the time to be increasing dependence on gas for energy sector needs any more than is necessary. This means no more large-scale CCGTs, the majority of which were already facing a high risk of stranding owing to expectations of forced closures earlier than planned meaning developers will never recover initial investment.
The world has been chronically underinvesting in low carbon capacity for way too long now, and the mismatch between supply and demand that this has created is certainly not a signal to slow down investment in renewables and prolong the fossil fuel investment era, creating new stranded assets, but actually a rallying call to accelerate low carbon capacity investment.
Power and Utilities – Corporate Research
E.ON holds a stake in the Nord Stream 1 pipeline which may be impacted.
Uniper owns 11GW of generation assets in Russia and has now had to stop the divestment process of its Unipro subsidiary. There will clearly be questions as to even long-term realisable value. It further has impaired its loan to Nord Stream 2. Engie is another lender to Nord Stream 2.
Enel’s Russian business contributes about 1% to EBITDA (earnings before interest, taxes, depreciation and amortisation) and includes gas fired power plants.
If generators source alternative long term contracts for gas supply, those contracts could become onerous. Beyond direct impairment risk on Russian assets, European gas generators could ultimately face impairment risk if their assets cannot source competitive fuel substitutes, will run at yet lower load factors than is already the case and be marginalised further by an accelerating energy transition.
Fossil fuel generation assets will see further reductions in load factors and profitability as companies are unable to pass through high levels of commodity costs in oversupplied markets or markets with rapidly growing renewables deployment.
Supply focused companies will see existential risk made up of a toxic cocktail of margin compression, price caps, and rising regulatory risk as policy combats deteriorating affordability. Risk compounds for integrated names and increases proportionately with their exposure to fossil fuel generation which may see windfall tax risk in the rare events of substantial pass through onto power prices.
Because of the higher commodity price curves, renewable economics are becoming more attractive. As a result, higher commodity prices could serve as a catalyst for renewable expansion in utility capital and resource plans.
Conversely, utility capital spending plans could also be curtailed in the near term, as consumers battle with inflation and higher commodity prices.
Sempra Energy (SRE.US) aims to reach a FID on additional liquefaction trains by the end of 2023. This is a key aspect of their growth story. Sempra has recently signed a Heads of Agreement with RWE for supplying 2.5mtpa LNG over 15 years. Should European and Asian offtakers refuse the terms on long duration contracts, these projects would be taken off the table. Conversely, if offtakers are willing to agree to long duration supply contracts these assets would operate for 20 years and NZE appears less likely.
Uranium supply contracts are typically long duration, Constellation Energy Group (CEG.US) said recently they have enough supply for the next few years. To the extent that new supply agreements are priced significantly higher than before, the marginal cost of power would increase and these nuclear assets would become less economical.
Cleantech
India and China combined, control the renewable energy manufacturing and export market. Following the war in Ukraine, the price of steel has increased substantially. Although this may be a short-medium term increase until the duration of the war is more clear, this would undoubtedly have a knock-on effect on the equipment price for solar and wind (I.e., Solar photovoltaic metal mounts, and wind turbine metal stands and blades). As a result of this price hike, this will increase the Levelized cost of electricity (LCOE) for solar and wind for countries that purchase renewable metal equipment from India or China. An increase in the LCOE, may once again make renewables more expensive than electricity from coal or gas However, this can be short term phenomenon. Either component prices revert downwards; or manufacturing learning rates increase; or innovation leads to substitution or alternative solutions. This the nature of manufactured energy where reinvention and substitution leads to an ability to overcome technical or economic challenges.
This all depends on the duration of the war and its impact on the energy market. If impacts are long-lasting, resulting in a strong increase in LCOE for solar and wind, then this could make the NZE2050 pathway more challenging to achieve as relative economics of renewables may deteriorate. Again, though, as in the nature of manufactured industry, chances are innovation can overcome this. This has been the case with great technology improvement in both technologies and a technology curve where the end does not seem near yet.
As energy prices continue to rise as a result of the Ukraine-Russian war, this has presented an opportunity for green hydrogen. Unlike fossil products, green hydrogen can be produced relatively anywhere with favourable wind or solar conditions. Carbon Tracker projects that hydrogens’ role in decarbonising power will be minimal, however, its role will be vital in providing energy storage and backup power.
Scaling up hydrogen will require a large sum of investment. We estimate an investment size in excess of USD 1.3 trillion to build a successful hydrogen economy for the power sector. This is assuming an onshore wind system will provide energy to produce the hydrogen.
Autos
There is no doubt that the conflict in Ukraine is affecting automotive supply chains and therefore production of low/zero-emission vehicles. Disruption in the supply of key components from the Ukraine, such as wire harnesses (used in both internal combustion and electric vehicles), will be a production headwind for the sector, in addition to the on-going semiconductor shortage.
The EU emissions targets that automakers selling vehicles into the region must comply with are based on average fleet emissions, rather than a defined electric vehicles sales target. It is unlikely that automakers will not meet compliance in 2022 as they will shift production/sales mix to meet EU targets.
Prices of fuel at the pump have increased dramatically, even before the war in Ukraine. This has changed consumer sentiment and demand for BEVs is increasing.
Both Ukraine and Russia provide important battery materials required for electric vehicles (nickel ore and refined battery grade nickel, respectively). Russia is a leader in the supply of battery grade nickel, with one Russian company providing approximately 20% of global supply. As trade with Russia becomes restricted, the price of batteries and therefore BEVs will increase because of the scarcity of battery grade nickel. Automakers will pass on the increased price of commodities onto the consumer, to maintain margins, which are already narrow compared with their ICE counterparts. In addition, electricity prices in Europe are rising, making recharging less cost effective (but still significantly less expensive than refuelling a conventional car). Rising BEV prices caused by the conflict, as well as electricity price rises, will be a headwind for the automotive energy transition. However, a record number of BEVs were sold in Europe in Q1 2022, suggesting some resilience in the market. Even with BEV price increases, total cost of ownership (of which fuel price is a large part), is becoming increasingly important for consumers.
As demand for BEVs increases, OEMs will look to invest/ strengthen their supply chains for critical battery materials. There will also be continued investment across the value chain in different battery chemistries, reducing the reliance on specific materials and associated supply risk.
Accounting/financial reporting
In the near-term, if European utilities companies cannot pass on the high commodity costs, reductions in profits could lead to impairments of fossil fuel generation assets. Decisions to increase investments in renewables could lead to shortening of fossil fuel asset lives, potential impairments and acceleration of retirements (and so the relevant obligations). In the longer-term, using profits from high oil and gas prices to expand fossil fuel production will increase the potential for stranded assets, especially given the timescales required for decarbonisation. This is particularly the case for energy companies that rely on Europe for revenues (assuming war and the energy crisis is used as impetus to push for more renewables). Additionally, higher prices could potentially accelerate the use of disruptive technologies, such as electric vehicles, and transitions to alternative fuel sources, which could impact a company's forecasted cash flows from using existing carbon-intensive assets and lead to more impairments.
Although the costs of manufacturing batteries and so purchase prices of electric vehicles may rise, if these increases are less than the rising costs of fuel (petrol) then consumers will continue to shift. If costs remain unchanged, companies such as car manufacturers may have to consider the impacts of other shifts in consumer behaviours, including an increased use in public transportation, such as trains or buses, on their forecasted cash flows.
It is important for companies to continue to consider the longer-term impacts of the energy transition, and not to focus on just the short to medium-term market reactions. Assumptions and estimates used in financial reporting such as projected oil and gas prices, estimated production or remaining asset lives should include the impacts of a long-term, downward trend in demand as our system decarbonises. Reduced licensing and exploration due to longer-term, accelerated declines in demand could again impact the value of existing assets and accelerate the timing of retirement of such assets. Long-term fixed price contracts could become unprofitable. Companies with receivables from borrowers that are impacted may see an increase estimated credit losses.
Companies should continue to consider the impacts of achieving net zero by 2050/no more than 1.5 degrees warming (e.g., aligning with scenarios such as IEA NZE) on medium- to long-term price and demand assumptions.
As we note above, companies such as BP, Shell and TotalEnergies have already started to record some impairments related to their investments in Russia. In general, oil and gas companies will need to assess whether existing resources can still be produced. Matters such as reduced demand for such resources could impact a company’s ability to continue to economically produce these resources and so classify such resources as reserves. This will likely lead to declines in the value of relevant investments /assets.
Power and utilities companies such as Enel, E.ON and Engie, with generators or pipelines in Russia could face accelerated impairments of assets that they can no longer access or use, losses on loans to finance such assets, or onerous long-term gas supply contracts that will no longer be fulfilled. They may also experience losses due to the inability to pass on higher commodity costs to the end-user.
The Russia-Ukraine war may further underscore the need to end reliance on fossil fuels and increase the pressure on companies to reflect the financial effects of decarbonisation. As above, companies and investors should also avoid the urge to invest in new fossil fuel power generation plants off the back of security dominance. Impacts on oil and gas prices (including availability and usage), or on forecasted margins, highlight the need for companies to understand and incorporate the medium-long-term financial impacts of energy transition risks (and strategies) into their accounting assumptions and estimates. This includes, for example, assessing:
•the ability, such as financially, legally or from a market share standpoint, to continue to use, manufacture or sell carbon intensive/reliant assets; and
• whether to accelerate the decommissioning of fossil fuel /carbon intensive assets.
Companies operating in other sectors, particularly those dependent on oil and gas for energy and stock (e.g., transportation and chemicals) also need to incorporate the impacts of the risks from changing prices and reduced demand into their financial statements (including, but not limited to, the valuation of property, plant & equipment, receivables and inventory) and reduce reliance on fossil fuel-related activities in line with the energy transition.
Disclosing the impacts of the above issues, which are akin to impacts of the energy transition, enable investors to more effectively assess a company's resilience compared to peers. Additionally, companies who are already investing in renewable energy and energy/resource efficient production may be partly or fully buffered from the impacts of climate related risks. Investing in decarbonisation and energy efficiency is better sooner rather than later, as it will offer protection from the inevitable future volatility in fossil fuels. Again, it is important to consider the impact on current financial reporting, such as whether these investments mean that existing assets may be retired earlier than expected.
