Recent developments and trends in energy transition

The term “energy transition” refers to a long-term, structural change in all components related to the production, conversion, delivery and use of energy. Over decades the global energy system has repeatedly been transformed as innovation and scientific discovery have led to significant changes in the use of primary energy sources. The current energy transition is not a simple shift from oil & gas (O&G) to renewables, but rather a case of an increasing number of O&G majors looking to expand their current energy mix and contribute towards lower emissions.

The Covid pandemic is likely to permanently modify behaviour in many ways that directly affect the prospects of energy transition, for example, many commentators predict less commuting and business air travel. The pandemic led to a 6% fall in energy demand globally in 2020, the largest fall in more than 70 years (source: International Energy Agency). There was a still larger fall in CO2 emissions, down 8% (or 2.1 giga tonnes) in 2020 on an annualised basis (source: IEA). Both demand and emissions have since rebounded, but around the world many governments are putting climate change at the centre of their pandemic recovery plans.

Against this changing backdrop there are many long-term pressures and complex issues forcing the traditional O&G majors to rethink their strategies and expand their energy mix. Our research has identified the following eight key drivers:

Peak oil demand brought forward

We believe that ongoing measures to contain the virus will accelerate the move towards less oil-intensive GDP growth. So although we expect non-OECD oil demand to grow until the early 2030s, we now forecast peak oil globally to occur around 2030. That implies a scenario of falling demand, an ample supply of oil and gas, and lower marginal costs.

“The recovery from the Covid pandemic will see demand for oil rebound from the levels of 2020, but, among other things, given the likely long-term impact of Covid on many areas of life it now seems reasonable to bring the forecast date for peak oil forward to 2030,” says Norman Wisely, Partner in the Oil and Gas Team at CMS.

“It looks as if there will continue to be less business travel, more working from home, and other trends that will diminish demand for oil in the long term. The issue is no longer one of when oil will run out, but rather of when will the transition to other forms of energy take over,” mentions Charlie Denham, an Associate in the Oil and Gas team at CMS.

Lower O&G capex in the short term

The oil majors reacted to the impact of Covid and falling oil prices by announcing cuts in spending and new production of between 10% and 30% compared with their original plans for 2020. Overall, that represented a fall of 25%, or $66bn. Those cuts seem to have fallen mostly on O&G (with cuts of 36.5% to upstream activities and 30.8% to mid-/downstream activities, respectively – source: IEA). Renewables by contrast have been largely spared, with a cut of just 3.2%.

“The O&G majors’ capital expenditure is unlikely to recover to pre-Covid levels. Under the influence of the pandemic, companies cut back their expenditure and that will continue. So even though we expect oil to continue to play a big part in the energy mix for years to come, very large new projects may no longer be attractive when these represent decades of future commitment,” said CMS’s Wisely.

“Oil and gas is going to continue to play a big role in the energy mix. In many areas there are still no substitutes, and as the majors divest, we will continue to see independent companies, many of them privately-backed, buying up the assets that the majors want to sell. This is only to be expected. When the cost of North Sea production is roughly $20/barrel and oil sells for $65/barrel, companies can still make money out of oil and gas production.”

But the prospect of an earlier date for peak oil is certainly being seen in asset disposals and balance sheet write-downs. In the UK the majors continue to divest non-core oil and gas assets, have sold and are selling their pipelines and terminals to groups like Ineos and Kellas, then paying to use those facilities. And the majors are writing down the value of their assets to reflect the fact that they are now worth less.

“Those write-downs will have an impact on their balance sheets and their ability to raise new funding,” said CMS’s Denham.

Investment in oil and gas has been hardest hit and renewable power generation least impacted

Annual change in global energy investment by sector between 2019 and 2020 (%)

Capex cuts announced by 15 majors amount to USD 66bn – a 25% drop from initial plans

Announced revisions to 2020 capital expenditure by sample of 15 oil and gas companies (USD billion above zero, and % below zero)

Increased interest in ESG funds

Sustainable investing has been a long-term trend for several years and around $3trn of institutional assets now have an ESG rating. As well as investors’ growing wish to support moves to limit adverse impacts of climate change, this trend has been helped by the relative outperformance of ESG funds, including during the sharp, Covid-driven market sell-off in March 2020.

There is scope here for companies to gain an advantage over competitors. Several O&G majors have good ESG scores, led by Royal Dutch Shell with 87.9, indicating excellent relative ESG performance and a high degree of transparency in reporting material ESG data publicly (source: Refinitiv). Other majors that currently score well on this measure are Repsol, bp, Total and Eni.

“Of the three elements in ESG, the most important for the oil majors is the “E” – environmental issues,” said CMS’s Wisely. “Companies are increasingly analysed according to their compliance with ESG concerns, and to some extent they compete with each other on those criteria.” adds CMS’s Denham.

However, the O&G industry’s perceived, long-term structural decline continues to be a driver for divestment by some institutional investors.

Refinitiv ESG Score for a sample of 15 oil and gas companies (Index, 100=best, 0=worst), as of 22 February 2021

Large-scale joint action by Europe 

Globally many governments have chosen to use Covid-related stimulus packages (already totalling $15trn) to promote clean energy as well as economic recovery. The EU has dedicated 30% (€550bn) of its support to green initiatives over seven years. This includes a target of a 50-55% cut in emissions by 2030 compared with 1990 levels. The fact that low-carbon stimulus programmes create relatively more jobs helps to support this approach.

Shift in US policy on climate change 

US President Biden’s administration has adopted a far more pro-active approach to the environment and climate change, including bans on new O&G leases and the ambitious aim of the US power sector being carbon pollution-free by 2035.

A package of measures is aimed to cut greenhouse emissions from transport and encourage a move to electric-only vehicles, although there is no deadline for this as yet. The Biden administration has committed to historic investments of $400 billion in the next 10 years for renewables investment and innovation in the sector. The recent Leaders Summit on Climate initiated by the US has emphasized a call for action and raised the expectations of a joint ambitious approach at the Glasgow UN Climate Change Conference later this year.

“The Biden administration represents a radical shift towards taking global action on climate change that will affect the international climate policy agenda,” says Varinia Radu, Head of Oil & Gas for the CEE region at CMS.

“This is seconded by the EU’s recent resolution backing the implementation of a Carbon Border Adjustment Mechanism and a bold ‘Fit for 55’ by 2030 set of policies that are likely to put an expensive carbon penalty on the carbon-intensive industries and will likely influence existing trade schemes.”

Acceleration of hydrogen technology 

There is growing recognition of the potential for hydrogen as a clean energy source for transport, heating and industry. The fact that it can be transported by a variety of methods and is relatively easy to store makes hydrogen an attractive alternative to fossil fuels.

“Using hydrogen is not new,” says Dalia Majumder-Russell, Partner specialising in renewables and energy transition projects at CMS. “The Olympic torch for the Tokyo Olympics is powered by hydrogen. So use of hydrogen has been proven. What’s new is making use of low-carbon hydrogen mainstream. It is a long journey for a new process like this to become established – it took 10 years for solar PV to make inroads into the electricity markets. However, over the last 12 months the policy space around low-carbon hydrogen has certainly woken up. The EU published a hydrogen strategy in 2020, and Hydrogen Europe has been set up as a new trade association to represent the European industry and R&D players looking to support the roll-out of hydrogen and fuel cells technologies.”

“The key challenge now is to create an interface between the impressive development of renewables and a storage system that can solve the problems involved in using such energy for vehicles and aircraft,” says Holger Kraft, a CMS partner specialising in corporate M&A and energy infrastructure.  

The majors are already investing in this sector. For example, bp is working with Orsted to build a 50MW electrolyser and associated infrastructure at bp’s Lingen Refinery in Germany, and Repsol is developing new technology, photoelectrocatalysis using electricity to convert solar power and water into renewable green hydrogen.

Germany is taking a lead with hydrogen just as a generation earlier it built out its solar generating capacity. The country has opportunities to connect hydrogen with clean energy, and energy companies are keen to build out their hydrogen footprint. 

“It is impressive how solar power has changed in Germany over the past 15-20 years,” explains CMS’s Kraft. “It started with a high tariff that encouraged investment and also stimulated the development in China of manufacturing to meet that demand. Hydrogen needs something similar over the next decade, with developments in both cost and efficiency. Based on what happened with solar, there are reasons for optimism.”

The growing interest in hydrogen is not limited to Europe. In Asia-Pac, Australia has a huge capacity to produce hydrogen (both blue and green) and Japan, which is more advanced in the application of hydrogen technology, is keen to buy it. As with solar power, China is expected to become a manufacturer of cheap and fast hydrogen-related technology. Perhaps unsurprisingly, there is even interest in hydrogen in the Middle East where - although there is no shortage of oil - solar power can offer ways of producing green hydrogen and managing its intermittency.

Further cost declines in renewables

The significant decline in the cost of alternative energy generation technologies continues to boost the take-up of renewable energy. Wind and solar are now cheaper than more traditional electricity sources thanks to a combination of decreasing capital costs, improving technologies and increased competition. This has underpinned many O&G majors’ strategy of integrating renewables into their own operations as well as investing outside their traditional business.

The majors’ experience is already very varied across the range of renewable technologies. Shell has a carbon capture venture in Canada and is buying suppliers for electric vehicles. Repsol and Total have experience in operating windfarms and Repsol has a 335MW wind power project in Aragon. 
 
“There have been several days in the UK now with no electricity generated from coal,” said CMS’s Majumder-Russell. “Solar and onshore wind are at times the cheapest source of energy in the UK and several other European jurisdictions, and on occasion electricity prices in the UK have actually turned negative i.e. producers have to pay to have their power taken by the grid!"

“The O&G majors are very keen to get involved in offshore wind. In the latest offshore wind leasing round some areas were keenly contested, for example in the Irish Sea off Liverpool. Consortia led by bp and Total secured more than half of the 8GW that was being auctioned. But the majors are paying high prices to access those opportunities and the less experienced are partnering with more experienced players. An example of that is bp’s purchase of a stake in Equinor’s offshore wind projects on the East coast of the USA, generating enough power for 2 million homes.” 

There have been significant cost declines for alternative energy generation technologies, which has been both a driver for the industry as well as a challenge

Unsubsidised levelised cost of energy (USD / MWh)

Use of oil & gas industry template contracts for energy transition projects

With the entry of the oil & gas industry into energy transitions projects (wind, solar, hydrogen, CCUS, battery, etc.) there has been a marked increase in questions relating to what terms are “market” for these types of projects. The oil & gas industry is largely unfamiliar with the more typical renewables industry template agreements such as FIDIC and NEC, and instead, and especially in relation to the oil & gas supermajors and majors, has developed its own suites of templates which have been used in the last 70 years for the largest projects on the planet, both onshore and offshore.

“The next year will be one to watch as we have seen a period of oil & gas companies contracting on more traditional renewables template contracts, transiting to hybrids of these templates, and very recently tendering on traditional oil & gas industry terms. This is a trend that we expect to continue, with traditional oil & gas industry terms set to become the dominant approach for oil & gas companies carrying out energy transition projects,” said Andrew Shaw, Partner specialising in Oil & Gas and energy transition projects at CMS.