ESG Focus: Climate Change Megatrend – Part 2

ESG Focus | Aug 24 2020

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

The energy sector is at the front line of the climate change war and is transforming at a rapid rate. FNArena examines the prospects for the fossil fuel industry's business model and briefly tracks the implications for Australian equities and bond markets

ESG Climate Change Megatrend – Part 2

-The soft underbelly of the fossil-fuel business model exposed
-Have we witnessed peak oil?
-Stranded assets, accounting, liability and the hot potato
-The impact of green investing on Australian equity and bond markets

By Sarah Mills

The biggest global transformation in the world today is the transition from fossil fuels to renewables, and this will drive an even greater transformation – the 4th Industrial Revolution.

It is being driven by decarbonisation policies, and a plunge in the price of renewables. 

This transition to affordable, reliable low-carbon energy is, in turn, transforming the energy sector. Fossil fuels are being denied capital and renewables are attracting it.

Analysts note this trend will test the resilience of long-term financial and operational strategies of fossil fuel companies and create both risk and opportunities for equity and fixed-income markets. 

The weak underbelly of the fossil fuel business model

The fact that fossil fuels are falling so hard and so fast reflects a business model that has externalised risk and internalised profits.

It has done this by relying on subsidies and tax breaks for profitability and risk-abrogation; and capital from coalitions of the willing who are banking on continued government support. Its potential to spark geopolitical conflict also counts against it.

The industry’s saviour has been the lack of viable competition, but that is no longer the case. Renewables in contrast no longer even need subsidies to compete. Some technical barriers remain, but the pace of technological change in the energy sector is breathtaking.

What’s happening with subsidies

Every year since 2009 the G7 and G20 have committed to phase out fossil fuel subsidies along with related commitments under the Sustainable Development Goals (SDGs) and the Paris Agreement. 

This essentially means that anyone investing in fossil fuels are betting against the House – a risky strategy.

According to the International Energy Agency, government subsidies to the fossil fuel industry total roughly US$400bn a year, money that has, to date and after expenses, gone into the pockets of industry investors. 

Recognising the critical role carbon plays in the economy, many investors have demonstrated a willingness to bank on a slower transition, or alternatively are willing to trade the volatility.

After all, the G7 governments alone, despite their commitments, continue to provide at least US$100bn in subsidies to the production and use of coal, oil and gas. 

The German government, for example, has paid billions in compensation to fossil fuel and nuclear energy companies as it shifts to renewables. If this model were to be followed globally, it would suggest potential pay-offs in other countries. But this is not a certainty.

One thing investors can count on, however, is an average decline in government subsidies over time given they increase systemic and political risk, countering the SDG goal of reducing inequality (which we noted in Part 1 of this Climate Change series, is inextricably linked to the climate change SDGs), and has broader implications for markets in the long term.

Governments are only likely to continue to subsidise or side with the industry to the extent that it reduces shock to their economies from the transition.

From a direct ESG perspective, the industry has long relied heavily on capital from institutional and private investors to fund new projects. These funding sources include banks and direct shareholders.

This is drying up rapidly as institutions, financiers and insurers exit or reduce their climate-change exposures to fossil fuels, as well as divert energy allocations to renewable competitors.

Funds that are still flowing to fossil fuel producers are increasingly coming with sustainability conditions, so the cost of capital for new projects is rising, further underlying the industry’s structural weaknesses.

Have we witnessed peak oil?

The International Energy Agency (IEA) noted in February that global energy-related CO2 emissions stopped growing in 2019, as renewable energy costs plunged, even as the world economy expanded nearly 3%. 

This suggests a tipping point may have been reached, one which could potentially have triggered an oil crash independent of covid-19 and the Saudi-Russian oil wars, as markets adjust to the new paradigm.

Covid-19, meanwhile, has brought the ballooning industry risk into stark relief, sending oil prices into negative territory and testing the world’s storage capacity to the limit. Most importantly, it proved the industry is broadly unprofitable (without and despite its massive subsidies) in both good and bad times.

In 2019, the MSCI World Index was up almost 24% in US-dollar terms, while the MSCI World Energy Index returned just more than 12% and has underperformed its wider global equity equivalent in four of the last five years. 

Low returns, rising volatility and intensifying competition, make the industry increasingly unappealing.

Covid-19 also brought to the forefront the spectre of reduced petrol consumption through work-from-home shifts; potential carbon infrastructure restructuring related to 4IR; reduced consumer demand for tourism, particularly international tourism; a sharp reduction in corporate travel; and reinforced the push for global onshoring and optimisation of supply chains. 

Citi in its Global Economics Review, says research on past pandemics reveals a legacy of persistent negative effects on economic growth – one that lasts for several years reducing energy demands. The analysts also perceived intensified deglobalisation to be the biggest structural risk to the global economic outlook. 

None of this bodes well for fossil fuels.

Investors in energy equities are being advised to carefully balance their interests between renewables and fossil fuels and ensure that the fossil fuel companies they invest in are “best in class” from an ESG perspective.

This is because, with the exception of regulation, it is the flow of ESG funds into energy companies that will likely save them from early collapse and protect them against growing volatility in the sector. 

High dividend yields of 5%-plus are no longer sufficient to provide a buffer against volatility that can trigger permanent losses in excess of -30%, and the associated asset impairment, storage costs and redundancy.

In Britain for example, 37% of electricity production now comes from renewables. 

Investors there are experiencing painful losses in high-yield and private-debt holdings linked to fossil fuel investments. This experience is being repeated around the world.

We will examine the high-yield fixed income market in a separate article.

All of this suggests that we may have witnessed, or be approaching, peak oil. However, the fourth industrial revolution is yet to be rolled out. It will require investment and energy. But if the world is to main on-track with the Paris Agreement climate goals, emissions must fall one way or another.

Risk profile for fossil fuels

Fossil fuels face four main climate change related risks.

  • Regulatory action
  • Reduced fossil fuel subsidies and market competition.
  • Sociopolitical stigmatisation
  • Transition risk

Regulatory action: Governments directly or indirectly drive more than 70% of global energy investments, according to the IEA, so government policy has a huge impact. 

The world’s governments have made their intentions clear, committing to the Paris Agreement every year since 2009, and that commitment is intensifying. Expect more regulation.

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