Assessing the Threat of the Energy Transition Part 1: Power

Summary //

• While most would agree that renewables are a long-term threat to hydrocarbons, there is less agreement on what constitutes long term. Energy transitions likely take longer than one might expect as coal demand exemplifies.
• Energy consumption and policy around the world vary significantly. While electrification and decarbonization are key themes in developed economies, it is easy to overlook the fact that approximately 3 billion people were dependent on solid fuels like wood, animal dung, charcoal, coal, or kerosene-fueled stoves for cooking in 2018.
• Sweden, which is at the forefront of the energy transition, is targeting carbon neutrality in 2045 – 25 years from now. Even European energy majors are targeting carbon neutrality by 2050 for their operations and oil and gas production.

Investors regularly ask for our views on the threat of the energy transition to traditional oil and natural gas companies, particularly with a view to midstream. The buzz around renewables has only increased given the release of Vice President Biden’s clean energy plan calling for net zero emissions for the US by 2050. Furthermore, the historic stimulus package passed by the European Union last week requires spending to be in line with the goals of the Paris Climate Accord, and nearly a third of the spending is earmarked for battling climate change. Also last week, Apple (AAPL) committed to becoming carbon neutral across its business by 2030. With increasing momentum for carbon reduction targets and mounting support for renewable energy, where does that leave oil and natural gas companies?

As with many things, the first step in responding is to admit there is a problem facing the industry – yes, renewables are a long-term threat to businesses oriented around hydrocarbons. While most would agree that renewables are a long-term threat, there is not necessarily agreement on what constitutes long term – is it a decade? Twenty years? Fifty years? What technological breakthroughs will be required to facilitate a wide-scale transition? How will government policies impact the pace of this transition?

While the forthcoming energy transition raises more questions than answers, this week’s two-part series addresses the threat of renewables for oil and gas, focusing on some of the key concerns for investors. Today’s piece examines demand for power generation, and Thursday’s note will discuss the threat of electric vehicles for oil demand. Carbon neutrality and net zero emissions are used interchangeably throughout.

Different markets have very different energy profiles.
To state the obvious, energy consumption and policy around the world vary significantly. While electrification and decarbonization are key themes in developed economies, it is easy to overlook the fact that approximately 3 billion people were dependent on solid fuels like wood, animal dung, charcoal, coal, or kerosene-fueled stoves for cooking in 2018. Sadly, an estimated 4 million people die prematurely each year due to household air pollution from these cooking practices and a lack of access to cleaner energy. To help address this health crisis, India has been distributing stoves and liquefied petroleum gases (LPGs include propane, butane, and isobutane) to low-income households since 2016. The program helped India become the second-largest LPG user globally, and in early 2019, government officials were projecting that LPG demand would increase by 34% to 2025 and by 80% to 2040. While other countries may be limited in replicating India’s success with LPGs, the need for cleaner cooking fuels in developing countries could drive an increase in LPG demand for years to come.

On the opposite end of the energy spectrum, Europe is the frontrunner for the energy transition with some countries having defined targets for achieving net zero emissions. Leading the way, Norway’s parliament approved a proposal in 2016 to achieve carbon neutrality by 2030. Norway’s target, which was moved up from 2050, is impressive, but it also bears noting that more than 95% of Norway’s electricity comes from hydropower. The country is expected to have to purchase carbon credits to achieve the 2030 goal given significant oil and gas production. Neighboring Sweden is targeting net zero emissions of greenhouse gases by 2045. For context, Norway and Sweden have populations of 5 million and 10 million, respectively. Furthermore, according to an International Energy Agency (IEA) report from April 2019, Sweden’s total carbon emissions at that time had been static since 2013. Elsewhere in Europe, the United Kingdom is targeting net zero emissions in 2050, as is France – in line with the Paris Climate Agreement.

Just as the demand implications of India’s LPG program should not be extrapolated to other developing countries, Norway’s 2030 carbon neutrality target should not be extrapolated to all developed countries. Norway and Sweden are leading the clean energy transition, yet their timelines for carbon neutrality are 10 and 25 years away, respectively. Furthermore, carbon neutrality does not imply an abandonment of fossil fuels. Carbon neutrality requires emissions to be offset. Even traditional oil and gas companies are targeting net zero emissions with Europe-based companies leading the way. Lundin Energy (LUPEY), a Norwegian oil and gas producer, is targeting carbon neutrality in 2030, while Eni (ENI) aims to be net zero for Scope 1 and 2 emissions by 2040. Shell (RDS-A) aims to achieve net zero emissions by 2050, and fellow supermajor BP (BP) is targeting net zero emissions for its operations and oil and gas production by 2050. Considering that traditional oil and gas companies are targeting carbon neutrality in the 2030-2050 timeframe, similar goals for developed countries do not seem as threatening.

Energy transitions take a long time.
In a world of instant gratification, it can be hard to appreciate how long a process can take, especially something with the scale of an energy transition. Coal provides a good example of this as it appears to be the most despised fossil fuel given its greater carbon intensity compared to natural gas or petroleum, but it continues to be widely used globally even as developed countries pivot to other energy sources. After a few years of annual consumption declines in the wake of the Kyoto Protocol in 1997, coal demand boomed – growing by 75% from 2000 to 2013 per the IEA.

Despite a seemingly widespread disdain for coal, demand appears largely steady on a global basis. Demand grew by 1.1% in 2018 as power generation from coal reached a new all-time high, with coal accounting for 38.5% of electricity generation worldwide. Prior to COVID-19, which reduced power demand broadly, the IEA was forecasting that global coal demand would rise slightly through 2024. With COVID-19 impacting demand for power generation and industrial use, coal demand is expected to decline 8% this year. The actual demand impact will depend largely on activity in major coal-consuming countries such as China and India. In short, reduced power demand from the pandemic is likely to drive a significant decline in coal demand this year, but otherwise, coal demand would probably have remained relatively steady.

Temporary demand destruction from COVID-19 likely much worse than the energy transition.
The transition toward cleaner energy will be gradual, and different countries will move through this process in different stages. The shift will likely be much less severe than the shock experienced with COVID-19 where demand collapsed around the world at approximately the same time. Amid the overall demand decline driven by the pandemic, renewables (along with natural gas in the US) have gained share for power generation in Europe and the US as plants using fossil fuels were scaled back in favor of solar and wind capacity with lower costs (i.e. if overall demand is weaker, why use more coal capacity with an input cost compared to using freely available sunshine or wind assuming the power is available). However, challenges remain around the intermittency of wind and solar power. A recent study requested by the California Public Utilities Commission highlights the need for battery storage to make solar power more reliable. In that vein, California is working to expand its battery capacity to a little more than 900 megawatts (MW) by the end of this year. For context, California has about 80,000 MW of power generation capacity. Given challenges around intermittency and battery storage, natural gas power plants have often been depended upon to ensure reliable power supply.

Natural gas has long been labeled the bridge fuel of the energy transition given its cleaner characteristics, availability, and lowered price thanks to increased supplies of liquefied natural gas from the US and elsewhere. Even under the IEA’s Sustainable Development Scenario, which assumes the goals of the Paris climate agreement are met, natural gas demand is forecast to grow to 2030, and 2040 demand is expected to be in line with 2019 levels. Given the prevalence of coal in the power mix, there is significant opportunity for power plants to switch from coal to natural gas, particularly in the US and Europe.

What about midstream?
What are the implications of all of this for midstream energy infrastructure? The US is the world’s largest producer of oil and natural gas with significant reserves. Increasingly, US energy is expected to be exported overseas to meet rising global demand. While growing energy demand is often associated with China and India, demand for oil and natural gas is also expected to rise in Africa in the coming decades. Midstream energy infrastructure plays a vital role in connecting energy production with local demand but also in facilitating exports. Setting aside prolific shale resources and improvements in drilling technology, US energy is able to compete on a global scale in part due to significant infrastructure advantages.

Bottom line
While many of us are focused on the green energy transition, it is easy to forget that the more urgent transition for many in the world is a shift away from using biomass for cooking or even securing access to electricity, which 860 million people lacked in 2018. Renewables represent a long-term threat to businesses oriented around hydrocarbons, but the energy transition will likely take a long time as exemplified by enduring coal demand. Even those countries leading the charge toward carbon neutrality are targeting 2045 or 2050, which aligns with the timelines some oil and gas companies are targeting for net zero emissions. While the threat of renewables is real, it also often feels overstated.

Please stay tuned for Thursday’s piece on electric vehicles.