Energy Transition: The Greatest Switch Capital Markets Have Ever Seen

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 disorganized 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.

Read more at Energy Transition: The Greatest Switch Capital Markets Have Ever Seen