The Energy Trilemma: Affordability, Security and Climate

Potential for Paris-aligned gains to replace Russia-inflicted short-term pain at COP27.

If the aim of restricting climate change to within the Paris-agreed 1.5°C increase over pre-industrial temperatures was hanging by a thread at the end of COP26, subsequent economic and geopolitical events appear to have dealt a blow to those ambitions – at least in the short term. Over the medium to longer term, however, conflict-induced soaring energy prices and the associated fears for energy security are working in favour of reaching targets.

Despite the precariousness of the pathway to net zero, COP26 generated a renewed sense of urgency and optimism as to how to support emerging markets and deal with heavy greenhouse gas emitters. This was thanks partly to strong representation from the investment industry, and the private sector more broadly.

“COP26 was one of the most interesting since Paris as, for the first time, the private sector took the limelight,” said Pierre Abadie, Group Climate Director and Co-head of Tikehau Capital’s private equity energy transition and decarbonisation practice. “Unlike previous COPs, you had a group outside of the direct negotiations committing to invest in the condition of our planet in a way that aligned with the requirements to decarbonise the economy.”

Among the most high-profile private-sector developments during COP26 came from the investor and financial alliances, with the Glasgow Financial Alliance for Net Zero (GFANZ) – representing over US$130 trillion of private capital –  confirming the sector’s collective commitments to net zero, building on the pioneering work of the Net Zero Asset Owner Alliance (NZAOA), both a forerunner and sub-sector member group.

“The system is finally committing a number of the right magnitude to ultimately support human beings to live on earth,” said Abadie. “For me, this was the main outcome from COP26 because it shifted the onus from the politicians and regulators towards the real economy.”

Beast from the east

The sense of optimism at COP26 turned out to be short lived.

“We quickly went from the positivity of COP26 into 2022, which has presented a range of challenges for us all,” said Neil Brown, head of equities at GIB Asset Management. “You have to view the excitement of Glasgow against the backdrop of what’s happened since.”

Russia’s invasion of Ukraine and the corresponding energy crisis, inflation spike and political instability it inflicted on the global economy brought into question whether this act of military aggression should be seen as a help or hindrance to the energy transition.

“In the near term, it has clearly been a setback,” said Tom Nelson, Head of Thematic Equities and Co Portfolio Manager, Global Natural Resources at Ninety One. “If you effectively take Russian supply out of the equation, then you are going to need a replacement in short order and that means more liquefied natural gas (LNG) is going to get pulled into Europe and greater coal consumption.”

Subsidies for the production and consumption of coal, oil and natural gas was already increasing in 2021 before the invasion of Ukraine. According to analysis from the Organisation for Economic Co-operation and Development (OECD) and the International Energy Agency (IEA), support almost doubled in 2021 from the previous year as the global economy rebounded post Covid-19 and energy inflation took hold.

Shielding households from surging energy prices is a deeply embedded policy response which makes it more difficult for countries to balance COP26’s pledges to phase out fossil fuel subsidies with protecting the electorate. The current geopolitical situation in Europe is making the balancing act more difficult.

Russia’s war against Ukraine has caused sharp increases in energy prices and undermined energy security, according to OECD Secretary-General Mathias Cormann. He called for measures to be adopted that protect consumers from the extreme impacts of shifting market and geopolitical forces in a way that “helps keep us on track to carbon neutrality as well as ensuring energy security and affordability.”

Yet, as the latest United Nations Environment Programme’s (UNEP) annual gap report shows, policies currently in place point to a 2.8°C temperature rise by the end of the century, suggesting a need for urgent system-wide transformation to deliver the enormous cuts needed to limit greenhouse gas emissions by 2030.

For many, Russia’s action has improved the potential for that system-wide transformation. The International Energy Agency’s (IEA) World Energy Outlook for 2022 contends that “the global energy crisis can be a historic turning point towards a cleaner and more secure future”.

It notes that, alongside short-term measures put in place to shield consumers from the impact of higher prices, “many governments are now taking longer-term steps. Some are seeking to increase or diversify oil and gas supplies, and many are looking to accelerate structural changes”.

Policy action

In undeniably tough conditions across 2022, a huge amount has been done. Three pieces of legislation in the US have made nearly US$1 trillion of public money available for its clean transition, China and India are building enormous renewables capacity with plans for even more, REPowerEU signals policy intent to build more renewables and decrease dependence on fossil fuels, and Japan has its Green Transformation (GX) programme, a 10-year roadmap for decarbonisation.

“Is it enough?” asked Brian Hensley, Partner at specialist climate policy consultancy Kaya Advisory. “Far from it, but its moving in the right direction in the medium term. Governments need to step in with accelerated policy guidance.”

The short term is challenging but: “External shocks can accelerate change,” said Ed Baker, Senior Policy Advisor, Climate and Energy Transition at the Principles for Responsible Investment (PRI). “And the forces behind the transition which have been building for many years now –  the technology, the economics moving in favour of clean energy, the alternative sources of energy and the growing public awareness and support for action in many countries – are driving things forward.”

The energy crisis is a setback due to the growing use of fossil fuels and the generation of greenhouse gases but, in the longer term, it should accelerate the transition by highlighting the stark realities of fossil fuel dependence.

“When we think about the three things that will drive the transition, it’s the cost of supply, security of supply and environmental impact,” said Ninety One’s Nelson. “And things just got a whole lot better for renewables in the sense that, on a cost equivalent basis, they’re more attractive than ever; on a security of supply basis, they are incrementally more attractive; and in terms of  environmental impact they are clearly much better than fossil fuels.”

Mispriced risks

That said, financial markets are liquid and fast moving whereas physical capital is relatively slow moving. This means climate risk is still largely underestimated by the financial markets, a situation which has the potential to redirect investment flows into less sustainable areas and away from where it’s needed most. Oil and gas companies, for instance, are making strong returns in the present environment and the share price of some have rocketed since their mid-pandemic lows.

“In a sense, there’s a double problem here,” said Nelson. “Many of the current frameworks effectively incentivise investors and allocators to avoid the dirty stuff in terms of real-world outcomes and impacts, and investors are beginning to feel the effects of not having exposure to some of these areas.”

It underlines why investors feel it is important that policymakers react, and to a large extent have reacted to the current energy security issues, to accelerate the shift to the transition.

“One of the really powerful things about the regulatory action we’ve seen this year is the direction of travel,” said Brown at GIB Asset Management.

Policy is vitally important in setting direction and improving accountability, but the issues around climate risk have been known for years and some might argue investors need to make decisions based on their own independent and individual time horizons.

Many investors are getting on with it, even without regulators providing all the answers. The science behind climate challenge has been there for all to see for years.

“The science tells us that we are going to be confronted by an adverse climate situation over the next decade,” said Abadie. “Investors are going to need a strong assessment of climate risk in their portfolio as this is one of the main risks they will face.”

That does not mean divesting to ensure the portfolio looks good in the quarterly report. The mood has moved from exclusion to robust engagement, understanding and helping companies – even the heavy polluters – to develop a clear strategy for moving a more decarbonised business model, and potentially be becoming a provider of solutions.

“Those companies aren’t just worthy of inclusion, but are potentially a really attractive investment proposition,” said Nelson. “And that’s something that is becoming more widely accepted.”

There breadth of opportunity offered by the renewables transition is only now becoming apparent. It is not all about producing more energy but ensuring there is circularity, efficiency and sustainability in the system. Sustainability also needs to extend to the supply chain.

“As the IEA has highlighted, it’s very important that we don’t swap geopolitical risk from gas for political risk for clean energy with another country,” said the PRI’s Baker. “The production of some of the clean energy technologies are actually very heavily concentrated in just a handful of countries.”

The energy trilemma of affordability, security and climate will be high on the agenda in Egypt at COP27 along with transition investing. There is a growing sense that this year’s COP is an African one. “We can expect to hear a lot more around the African component, and the emerging market one more broadly,” said Nelson.

Only time will tell whether it will be possible to revive the sense of collective optimism and endeavour that was generated in Glasgow.

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