Strap in for a Bumpy Ride

Disruption caused by soaring gas prices underlines need to ramp up investment to accelerate transition to clean energy.

Asset owners actively engaging and investing to support a smooth and rapid transition to clean energy may have been disturbed by headlines rippling across the world in response to the recent spike in gas prices.

These include power rationing in China, due partly to reduced coal consumption to meet greenhouse gas (GHG) emissions targets, as well as rising gas bills and petrol shortages in the UK, partly attributable to a dysfunctional domestic heating market structure and a post-Brexit shortage in HGV lorry drivers.

These particular manifestations of the transition from fossil fuels may be short term, but with investment declining sharply, suggesting further volatility to come, they serve as a reminder that bumps in the road to renewable energy reliance will have real impacts on daily lives.

Could members of the public now have concrete reasons to question why their gas bills are racing higher and they don’t have the petrol they need to get to work?

“Is this what the move to clean energy really is?” they may have asked. “A return to the 1970s?”.

Such concerns may cause tabloid editors to dig out old theories about wind turbines that don’t spin, but they can also have political consequences, especially for the host country of COP26, given its key role in encouraging global leaders to accelerate the push to net-zero.

“During any energy price crisis, there is a political temptation to revise ambitions relating to decarbonisation and the low-carbon transition,” wrote Luke Sussams, VP ESG and Sustainable Finance Research at Jefferies, in a note during the crisis. “The likelihood of scaled back decarbonisation ambitions has increased.”

Nevertheless, populist-minded UK Prime Minister Boris Johnson this week asserted that the UK will shift all electricity generation away from fossil fuels by 2035. With renewables accounting for 43% of UK electricity in 2020, this is an ambitious target, requiring significant investment.

Crisis points

Before turning to where the extra capital should be allocated to accelerate the green energy transition, it is important to look at the factors behind the surge in prices.

Jefferies’ Sussams highlights the structure of the EU wholesale electricity market, which results in the most expensive power source used to meet total demand setting the price for the entire market, meaning higher gas prices automatically increasing power bills for consumers.

“On the demand side, a cold (2020/21) winter led to higher demand for residential heating at the time of the year when suppliers are usually filling storage tanks. European gas storage levels are reportedly at 10-year lows. Furthermore, widespread remote working has all contributed to a 7.6% YOY increase in demand in the first quarter,” he wrote.

In addition, renewable power generation in the summer months was lower-than-expected after hot weather and low wind speeds. With widespread closures of coal plants across Europe in the past few years, output from renewable power sources is almost exclusively balanced by natural gas power. This applies in the EU and the UK.

“The rising price of carbon set within the Emissions Trading Scheme (ETS) has also contributed to the high power price. The rising EU ETS price has pushed the costs of natural gas-fired power generation higher, which itself sets the overall price for EU wholesale electricity markets,” Sussams added.

Sussams tells ESG Investor that the crisis was foreseeable and the need for substantial and diverse infrastructure investment to support transition widely predicted.

“Any report written in the last five years has said the transition to lower carbon and renewable power sources needs to be supported by investments in demand response systems, grid flexibility, interconnectors and energy storage,” he says. “Otherwise, the total system costs for the power sector end up being higher in the long run. The UK spent £150 million over two weeks in September firing up coal-fired powered plants for standby power.”

Investment needed

In particular, Sussams highlights the need for investment capital to flow into solutions to enhance grid resilience and stability. This means bringing energy storage onto the grid, as well as enhancing and expanding grid interconnectivity and demand response systems which better match demand and supply.

“There have been very few incentives for utilities to make that investment because it benefits all of them at the expense of just one. There is a free rider complex going on,” he says. “Governments need to solve that problem and incentivise utilities to make these investments in the quality of the grid not just in power generation assets.”

Sussams believes many asset owners are currently looking elsewhere in the power sector for investment opportunities, such as cabling and upstream infrastructure around wind power, rather than the power generators themselves.

“We know that investors are beginning to be a little bit more tentative around the power generation utilities because of regulatory risk in the sector increasing due to this crisis,” he adds. “Governments could follow the model in Spain which has ruled that it will recoup around €3 billion of excess profits from the utilities and give it back to the people during this time.”

Simon Puleston Jones, chief executive of Climate Solutions, a capital raising and strategic consultancy business, says investors many need to increase their risk tolerance if society is to successfully address the climate crisis at the scale and pace needed through effective investment in the energy transition.

“More direct investment in companies and infrastructure projects is required. Institutional investors must massively increase their level of investment in equity, debt and project finance opportunities in private markets,” he says.

“Ultimately, the recent energy crisis demonstrates the need for a diverse, cleaner, energy mix. The sensitivity of the economy to increases in oil and gas prices demonstrates that we’re a long way from attaining the tipping point on clean energy. Many trillions of dollars still need to be spent to complete the necessary transition, on both the supply and demand side.”

Puleston Jones suggests the investment opportunities are spread over a wide landscape, with some oil majors investing heavily in the energy transition, while thousands of SMEs create innovative solutions focused on more efficient clean energy generation, transmission, storage, and application.

“Both a top-down and bottom-up approach are to be strongly encouraged and invested in,” he says. “Largely, it’s not about inventing new solutions, but about scaling up to critical mass those we already have. The intellectual property and projects relating to the implementation of those solutions often reside in private companies, whose stock is not publicly traded, and their infrastructure projects.”

Price volatility

The scale and complexity of the transition to clean energy means that investors may need to look beyond the energy sector itself, renewable or otherwise, and anticipate some uncertainty along the way.

“More investment is definitely needed in clean energy and, more widely, to support the energy transition. However, there are a number of challenges that lie ahead, particularly as Europe looks to shift the energy mix from 20% towards 50% renewables in the next decade, which will result in increasing price volatility,” says Alistair Perkins, Head of Infrastructure Debt & Project Finance, NN Investment Partners.

“More investment is therefore not only needed in clean energy generation but also in improving energy transmission, interconnectivity, storage, smart grid and metering technologies and energy efficiency. We need to work together with all carbon-intensive industries, so not only big oil but also manufacturers of steel, cement, chemicals, foods, and agriculture. We need to provide additional capital needed to decarbonise all these sectors.”

He agrees with Puleston Jones that investors can do more to identify and support the innovative energy companies and technologies creating clean energy.

“Investments are required both to decarbonise many existing carbon-intensive industries as well as investing in clean energy,” he says. “We can best minimise disruption in the transition by focusing on three factors: improving energy security of supply; improving resilience and improving affordability.”

Government action

Other drivers notwithstanding, private sector investment flows more quickly when the public policy provides clarity and certainty.  Kingsmill Bond, Energy Strategist at Climate Tracker, says increased government action is also important to encourage the push to clean energy.

“Transitions are never smooth, and bumps and bounces are inevitable. Especially given the many global bottlenecks caused by Covid-19,” Bond says. “High fossil fuel prices are a wake-up call to retool policy faster to accommodate and deploy more renewables. Investors should reduce their exposure to dying fossil fuel industry and companies unable to transition and reallocate to the new growth leaders and the disrupters. The crisis comes from high fossil fuel costs. The lesson is obvious. Reduce your fossil fuel dependence and get on with it.”

Perkins agrees that the energy transition has now reached a critical stage and agrees that governments need to step up.

“The challenges that lie ahead cannot be solved by the private sector alone since there is a key role for governments to take a strong lead position through bold policy and regulation to ensure the long-term stability and sustainability of the market,” he says.

Alongside Johnson’s 2035 declaration, there are clear signs from other major jurisdictions that governments are listening and will use COP26 to provide more details on the road to transition. These include China’s gradual withdrawal from coal, the US infrastructure investment bill and Europe’s Green Deal, reiterated yesterday at the ECOFIN Council’s latest meeting.

“We don’t think the crisis will derail or slow the transition to lower carbon power sources,” says Sussams. “The European Commission has reiterated that the best way to prevent a future crisis is to accelerate the path to renewable sources and to become less dependent on natural gas.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

Copyright © 2023 ESG Investor Ltd. Company No. 12893343. ESG Investor Ltd, Fox Court, 14 Grays Inn Road, London, WC1X 8HN

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