Global context for the energy transition

Expanded global awareness has not yet translated into lower emissions

It is widely accepted that greenhouse gases (GHG) emissions from human activities have been the cause of rising global temperatures. The main components of GHGs are carbon dioxide (CO2), methane, nitrous oxide and three groups of fluorinated gases – sulphur hexafluoride, hydrofluorocarbons (HFCs) and perfluorocarbons (PFCs).

Despite widespread understanding and, arguably acceptance, that reducing GHGs, in particular CO2, is a necessary goal for the global community, the transition to a lower carbon future has not been a smooth road. It was not surprising that global CO2 emissions rebounded strongly by 9.8% alongside the recovery in global economic activity in 2021. However, the marked gain in emissions of 27.4% in 2022, which was broad-based across economic sectors, was unexpected.

This jump in CO2 emissions occurred despite progress on the policymaking front following the COP26 summit in Glasgow, Scotland, which concluded on 13 November 2021. The conference resulted in a higher level of global cooperation on climate change in many specific areas. A key element was the adoption of the Global Methane Pledge, which aims to reduce global methane emissions by 30%, based on 2020 levels, by 2030.

Methane is the second largest component of greenhouse gas (GHG) emissions and is estimated to account for roughly half the net rise in global average temperature since the pre-industrial era. Furthermore, agricultural uses and the energy industry account for about 80% of methane emissions.

In the oil and gas industry alone, implementing existing technology alongside known best practices could cut global methane emissions by 11%. Since methane falls within Scope 1 and Scope 2 emissions 1 There are three levels of CO2 emissions identified. Scope 1 covers emissions from sources that an organisation owns or controls directly. Scope 2 refers to emissions that a company causes indirectly when the energy it purchases and uses is produced. Scope 3 encompasses emissions that are not produced by the company itself, and not the result of activities from assets owned or controlled by them, but by those that it is indirectly responsible for, up and down its value chain, such as emissions from consumer motor vehicles and aircraft. , having targets for methane reduction could help many companies to make progress on their goals in the short term, even as they progress towards what is largely a net zero ambition by 2050.

More broadly, coordinated progress on reducing methane emissions could be a relatively easy win for the industry since decreasing methane emissions would have a more immediate and direct effect in halting the rise in global temperatures than would be possible with the current policies announced for reducing CO2. In fact, 11 companies reviewed for this report have signed on to the Aiming for Zero Methane Initiative, sponsored by the members of the Oil and Gas Climate Initiative (OGCI). (See figure 1-1)

Figure 1-2: Aiming for Zero Methane Initiative

Sources: Capital Economics and Aiming for Zero Methane Initiative (https://aimingforzero.ogci.com/)

Europe is accelerating its energy transition strategy

Prior to the invasion of Ukraine, Europe was the destination for 75% of Russia’s natural gas and around 20% of its oil. In response to the invasion, the EU placed embargoes on Russian oil and faced a near total cut-off from Russian gas supplies.

The EU has now taken concrete steps to make itself independent of Russian fossil fuels by 2030 via the REPowerEU initiative, launched in March 2022. The policy has resulted in the EU forging deals with international partners on energy supply, including increased liquefied natural gas (LNG) from the USA and Canada and increased gas supply from Norway. In addition, the REPowerEU plan accelerates the pace for increasing the share of renewables, with a target of renewables in final energy consumption equal to 45% of the total by 2030.

In June 2022, the EU Council adopted its “Fit for 55” package, initially presented by the EU Commission in July 2021. This set of measures is aimed to enable the European Union to reduce its net greenhouse gas (GHG) emissions by at least 55% by 2030 compared to 1990 levels. The EU member states adopted a common position on the EU emissions trading system (EU ETS), effort-sharing between member states in non-ETS sectors (ESR), emissions and removals from land use, land-use change and forestry (LULUCF), the creation of a social climate fund (SCF) and new CO2 emission performance standards for cars and vans.

Peak oil demand is even nearer on the horizon

Oil and gas companies face a challenging task ahead – often colloquially referred to as the “trilemma”. They must be able to provide the world with the oil and gas it needs through the energy transition, and it must be affordable. At the same time, they must also progress their own energy transition, reducing GHG emissions, primarily CO2 and methane.

Evidence of the progress of the energy transition from a consumption standpoint is the assessment of peak oil demand. In 2020, Capital Economics estimated the peak would occur by 2030, and decline thereafter. Based on developments during the last two years, such as faster EV and hybrid vehicle adoption, peak oil is now likely to occur in the latter part of this decade, perhaps as early as 2029 according to the ICA.

Oil consumption is expected to decline at an average annual rate of 1.5% between 2030 and 2040 but to pick up the pace of decline and fall faster at an average annual rate of 3.7% between 2040 and 2050.

Peak consumption of natural gas is unlikely to occur before the mid-2030s given its importance in electricity generation in the near term, both as a way to displace coal-fired generation but also to act as a stop gap until investments in wind and solar power can be accelerated. 

The USA is now investing in the energy transition at a national level

With the Bipartisan Infrastructure Law adopted in November 2021 and the Inflation Reduction Act (IRA) signed in August 2022, the USA is on its way towards entrenching policymaking for the energy transition at a national level.

Together these initiatives provide US$370 billion to accomplish three goals: accelerate the move towards clean energy, reduce energy costs, and cut carbon emissions by 40% by 2030. The IRA encourages investment in various clean energy sources such as nuclear and hydrogen, as well as carbon capture, utilisation and sequestration, clean energy vehicles and energy storage, as long as they are carbon neutral. It offers Investment Tax Credits (ITCs) and Production Tax Credits (PTCs) for firms generating clean energy.

There have been concerns from the EU that such large subsidies in US clean technology will put US firms at an advantage over EU-based firms, potentially undermining the EU’s green transition. However, alternatively the Act may encourage the EU and other countries to step up green interventions of their own. Indeed, in January 2023, the European Commission unveiled its Green Industrial Plan in response to the IRA.

Global investment in renewables is outpacing fossil fuels

Data from the International Energy Agency (IEA) indicate that energy investment totalled US$2.2 trillion in 2021 and nearly US$2.4 trillion in 2022. The share of clean energy investment has been increasing over time and is now the majority, comprising 59.3% in 2021 and 60.2% in 2022.

The proportion of energy investment directed toward renewables rose to 74% in power generation and 27% in energy supply. This compares to 64% and 20%, respectively, in 2017.

Fossil fuels investment remains a large portion of the investment in energy production and supply at 52%, but its share has been shrinking, down from 59% five years ago.

In terms of power generation, investment in coal-fired generation has fallen significantly by 27% cumulatively since 2017. Although investment in gas-fired generation has increased during the last two years, it had been declining since 2016 and remains 15% below that peak.

In the near term, in terms of energy supply, until more power generation can be diverted towards renewables and away from natural gas and coal, we expect investment in natural gas supply, particularly LNG, to continue as countries diversify their sources. New investments in electricity networks, particularly in the case of the US, will be necessary to handle the expansion of renewable power generation. Thus, fossil fuels may not be the majority source of allocation of funds in energy production and supply for much longer.

As for power generation, we expect the allocation to renewables to remain high for the foreseeable future as countries press to meet their announced commitments on climate change.

Investor interest in ESG instruments explodes in Europe

Investor interest in capitalising on developments related to Environmental, Social and Governance issues (ESG) gathered momentum after 2018. Assets under management (AUM) in ESG funds increased by 55% in 2019, 96% in 2020 and another 53% in 2021, raising total AUM to more than US$2.7 trillion. Investments in ESG instruments declined 9.9% in 2022 but in Q1-2023 have rebounded 9.9%.

Europe has always been at the forefront of this investment strategy and has continued to expand and gain share. According to Morningstar, AUM in European ESG funds accounted for 83.6% of total ESG fund assets in Q1-2023. The USA is a distant second at 10.9%, with funds invested by the rest of the world making up the balance of 5.5%.

Europe has been a global leader in solidifying its climate policy, which has made it possible to generate the confidence investors in the region need in order to allocate funds to an ESG strategy. However, other jurisdictions may begin to gain ground given that new regulations have been proposed and/or implemented during 2021 and 2022.

Sources: Capital Economics, UNCTAD, International Energy Agency, IFRS Foundation

The International Financial Reporting Standards (IFRS) Foundation is a non-profit organization that focuses on setting standards for financial reporting. IFRS introduced the International Sustainability Standards Board (ISSB) in November 2021 and will work to create a global standard for companies disclosing sustainability-related items for their investors.

The EU, UK, and China also created regulations around reporting and disclosing sustainability-related activities in order to provide investors with optimal information on a company’s position and goals related to sustainability.

In the US, ESG reporting requirements will begin to phase in during 2023, even though the rules have not yet been finalised by the Securities and Exchange Commission (SEC). This follows an SEC ruling in March 2022 proposing disclosure of Scope 1, 2 and 3 emissions for publicly traded companies. It is worth noting that US oil and gas companies are already reporting this information in some form.

These efforts to produce more unified standards around ESG investing and reporting are welcome, particularly considering the various criticisms surrounding the investment segment. Not only have ESG fund providers been criticised for the “non green” companies that they hold in their portfolios but in the US, specifically, ESG is being drawn into the political culture wars which are pressuring state and federal level pension funds to stop utilising the investment strategy.

From an oil and gas company standpoint, compliance with increasing ESG requirements in various jurisdictions as well as being able to access third party capital will be key in their thoughts across the coming months and years.