January 2022 Issue
As climate change awareness and activism continues to grow across the globe in both the commercial and public spheres, increasing attention and focus has been placed on what we have come to know as the ‘energy transition’.
This shift from traditional energy systems and markets based on fossil fuels to greener and cleaner sources involving renewable energy and technology is not only the subject of increasing global citizen scrutiny but has also been informing government policies, impacting stakeholder scrutiny and strategy both in relation to currently operating assets and for future projects across the energy and infrastructure sector.
This article considers recent international, corporate and financing trends as well as some of the international developments, including following the recent COP26 discussions, proposed to further the energy transition objective.
The energy transition
The energy sector has for some time differentiated between the traditional energy systems that are primarily based on fossil fuels such as crude oil, refined fuels coal and natural gas, and energy produced using cleaner energy sources including, among others, wind, solar, hydropower, geothermal and biomass power.
Such energy can be applied for purposes of electricity generation, for the heating of buildings, the firing of industrial plants and the powering of vehicles across the transportation sector. In more recent years, however, the significant drive to reduce CO2 and methane, greenhouse gas emissions resulting from fossil fuel combustion processes has fuelled a global drive toward the decarbonisation of the energy sector to protect against the further far-reaching impacts of climate change.
The mot du jour for the sector has become ‘energy transition’, denoting, according to the International Renewable Energy Authority, “a pathway toward transformation of the global energy sector from fossil-based to zero-carbon by the second half of this century.… Renewable energy and energy efficiency measures can potentially achieve 90% of the required carbon reductions”.
A switch to traditional renewable energy production accounts for only one aspect of this energy transition process, since industry is looking increasingly to the electrification of industrial and construction processes and as the solution in the individual and public transport sectors. This is coupled with significant investment in energy storage and carbon capture solutions required to support the clean energy drive, the scale up of nascent know-how and the digitalisation of ‘smart cities’ such as Neom in Saudi Arabia.
How the ‘energy transition’ is manifesting in the energy sector
A number of trends have presented in recent years across the energy and infrastructure sectors more broadly, both relating to public and private stakeholders and market activity and also the way in which this is impacting different ultimate energy sources, causing numerous ripple effects, some of which are set out below.
Corporate identity and strategy. The setting of national and supranational energy transition, zero or low carbon policies is mirrored in the strengthening of institutional policy requirements and investment strategies of private and public sector debt and equity energy and infrastructure investors. Additionally, with growing public awareness surrounding climate change, market participants are faced with mounting social and environmental pressure to progress with the transition to cleaner energy sources. This has ultimately resulted in significant changes to many corporate identities in the energy sector, enabling businesses to stay agile, profitable and responsive to stakeholder requirements, while also maintaining their reputation in the market.
Some bigger corporates have rebranded or set up renewable energy within their group with increased investments in e-mobility, battery storage, renewable energies and energy supply, including BP Lightsource, Total Energies, EON and QatarEnergy. The setting of net-zero emissions targets is a powerful driver, with sustained efforts being made to decarbonise operations and value chains.
The market has also seen a significant amount of M&A activity, with national oil companies such as Saudi Aramco and ADNOC taking steps to free up their balance sheets through the sale and leasing of hydrocarbon assets, and in some cases, even initial public offerings. This facilitates the reallocation of capital toward renewable investment, limits the risk of future stranded hydrocarbon assets and comprises a corporate strategy shift toward sustainable energy. Meanwhile, other medium-sized entities, such as Ørsted, have taken longer term strategy decisions to move fully away from hydrocarbons and invest fully in renewable energies.
Reputational and stakeholder pressure has also been exerted on and impacted the policies of financial institutions that invest in the sector, as they are regarded as having significant power in shaping the transition of energy away from traditional hydrocarbon fuels.
Investor appetite and identity. The debt and equity markets for investment in the renewables sector continue to be liquid, including with respect to the nature of the institutions that are active. Traditional industry sponsors investing in the equity of both greenfield and brownfield projects are increasingly investing alongside purely financial investors, including institutional investors, pension funds and private equity.
While many lenders active in the oil and gas sector continue to be present, in particular for natural gas and liquified natural gas (LNG) projects, others such as the European Investment Bank and other multilateral institutions are either being required to fully reallocate funds away from fossil fuel projects or have strict policy requirements to be met before the green light can be offered to hydrocarbon investment.
The increasing investment in energy transition projects is facilitated by the downward trajectory of renewable energy cost of capital, by recent spiking gas prices and further by internal policy requirements to contribute positively to the climate change picture. Environmental, social and governance (ESG) is for all investors, not only a critical part of upfront investment decisions, but also a feature of monitoring, reporting and compliance requirement relating to the assets on an ongoing basis.
Gas and energy transition. The ongoing role for natural gas as a key part of the energy mix continues, since the replacement of coal with natural gas as a fuel will alone have an impact on air quality through the reduction of CO2 emissions. The International Energy Agency (IEA) describes the potential in the US and European power sector in particular to reduce up to 1.2 gigatonnes of CO2 emissions through the switch of power plant fuel consumption from coal to gas, with appropriate price and regulatory support in place. As a point of reference, the IEA provides that doing so would reduce global power sector CO2 emissions by 10 percent and total energy-related CO2 emissions by 4 percent.
Driving innovation. The technology for traditional renewable energy is long proven, but the generation of renewable energy is only one part of this energy transition story and the potential application and storage of such renewable energy remains a critical focus and an area rife for innovation. The development of energy and battery storage is part of this, including potentially enabling two-way flows of energy from batteries that help combat the intermittency of renewable energy production and ensure the capability of national grids to meet baseload requirements at peak times.
Investment in electricity storage capacity means a reduction in constraints on the transmission network and deferral of major infrastructure upgrades. Wood Mackenzie and the US Energy Storage Association (ESA) have cited data illustrating that more than 2100 megawatt-hours (MWh) of energy storage was installed in the US in the fourth quarter of 2020, representing an increase of 182 percent over the previous quarter. In the bid to decarbonise, carbon capture storage initiatives are also being pursued with government incentives to protect against the release of CO2 into the atmosphere. One such example is Occidental Petroleum, which has partnered with Carbon Engineering to build a plant to annually capture and bury 500,000 metric tonnes of CO2.
There is increasing interest in funding projects that combine renewable energy generation, the newest hydrogen and ammonia technologies and industrial processes as a means of revolutionising the carbon heavy production processes that have traditionally contributed to greenhouse gas emissions. One such example is the H2 Green Steel project under development in Sweden, which aims to produce 5 million tonnes of fossil-free steel annually by 2030. Another is the newly formed venture between Fertiglobe, Scatec and Egypt’s sovereign fund to develop a green ammonia project in Egypt.
Finally, the electrification of the transportation sector forms a critical part of this picture, both from an individual and public transport electric vehicle (EV) perspective. Recent technological advances in EVs have led to a growth in EV manufacturers’ market share, although fully electric vehicles only accounted for 2.6 percent of global car sales and 1 percent of global car stock in 2019, according to the IEA.
Aggressive investment strategies into EVs and further development of regulatory frameworks, particularly in the wake of COP26, suggest that the pace of growth will accelerate in coming years, and promising results have already been seen in the first quarter of 2021 where global EV sales grew by 140 percent compared to the same period in 2020. The Northvolt EV battery manufacturing facility in Sweden is an example business contributing to this picture with a first of its kind, large-scale project, in which high profile financing institutions and industry stakeholders alike have invested in the equity.
What is clear, however, is that a huge amount of upfront capital investment is required to facilitate innovation, with an estimated $200bn investment over the next 10 years needed to facilitate EV infrastructure, according to McKinsey’s 1.5-degree-pathway scenario, and $700bn for hydrogen-production capacity.
Government incentive. Governments around the world have introduced combinations of policies, subsidies, incentives and legislation to encourage investment in furthering the transition toward green sources, including legislation ensuring feed-in tariffs guaranteed for a minimum term, tax breaks, grid priority for renewable energy producers and competitive auction processes that help to drive energy prices down. Additionally, steps are being taken to actively prevent future development in the hydrocarbons sector, for example, with Denmark cancelling all upcoming North Sea licensing rounds in anticipation of ending oil and gas production in the North Sea by 2050.
Germany’s Renewable Energy Sources Act (EEG) was introduced two decades ago and has played a substantial role in the country’s shift toward energy generation from renewable sources, most notably wind and solar power. The more recent amendment to the EEG in 2021 specifically enshrined, as its guiding principle, the aim of ensuring all electricity generation and consumption within the country will be carbon-neutral before 2050. This European Green Deal proposed €1 trillion in sustainable investments over the next decade.
In another part of the world, we have seen numerous successful wind and solar projects being developed following tender processes and otherwise through incentive implementation as part of the feed-in tariff regime implemented by the Egyptian government in 2014. In short, supranational policies have to be supplemented by policy implementation at the national level and public investment in energy transition.
Developments in regulatory frameworks are also contributing to the growth of EVs and will continue to play an important role. By the end of 2020, more than 20 economies had announced targets to phase out internal combustion vehicles over the next 10 to 30 years, according to the IEA. Under the European Union’s ‘Fit for 55’ initiative, the European Commission has proposed much stricter 2030 emissions reduction goals (a 55 percent decrease for cars and a 50 percent decrease for vans). This will lead to the acceleration of EV deployment, as while consumer EV demand is impactful, government regulation and policy is also crucial in shifting the market toward the uptake of EVs.
Green bonds. The financing market is itself also evolving with green bond issuances encouraged to finance environmentally sound and sustainable projects that foster a net-zero emissions economy and protect the environment.
What’s next for the energy transition?
The recent announcements following COP26 represent in many respects a ‘compromise’ deal on climate but also demonstrate the currency of the energy transition, and will incentivise major change in the energy sector. In that context, we would expect many of the above highlighted trends to continue to apply and in some cases to accelerate through the COP26 agreement for countries to revisit and strengthen their current emissions targets to 2030 in 2022, with action to be taken on phasing down fossil fuels, in particular unabated coal power and inefficient fossil fuel subsidies. The pressure on governments to reduce emissions targets should continue to spur the development of government frameworks and incentives to support the renewables sector, and bioelectrochemical systems.
Similarly, the discussion regarding the commitment to net zero by 2050 puts a spotlight on the energy transition, as transformational changes are required to the way in which the world produces and consumes energy. The continued efforts and collaboration among the international community in this regard will be vital in achieving the aims envisaged in the energy transition.
John Dewar is a partner and Suzanne Szczetnikowicz is a senior associate at Milbank LLP. Mr Dewar can be contacted on +44 (0)20 7615 3004 or by email: jdewar@milbank.com. Ms Szczetnikowicz can be contacted on +44 (0)20 7615 3018 or by email: sszczetnikowicz@milbank.com.
© Financier Worldwide
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John Dewar and Suzanne Szczetnikowicz
Milbank LLP
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