How Does Transition To Clean Energy Influence Financial Markets

Role of energy and financial companies in facilitating sustainable investments

Dong Energy

Over the past few years, a recurring theme in the news has been the transition to sustainable energy sources. It may not come as a surprise especially given the current energy crisis influenced by the soaring price of conventional energy sources such as oil and natural gas. Let’s take a look at how companies are adjusting to the new landscape and what actions the public and private institutional investors take to encourage the transition to clean energy.

Before we jump into the article, it is crucial to understand the background and the current environment of the energy industry. Let us consider the events leading up to now. It is 1992, and Rio de Janeiro hosts a UN Conference on Environment and Development, otherwise known as the Rio Earth Summit; this sets the basic framework for climate change mitigation. One hundred fifty-four states sign a document calling for specific research and further approval of policy agreements allowing sustainable economic development. Later on, in 1997, the Kyoto Protocol results in additional support for the deal, and fast-forward to 2015, the Paris Agreement culminated in the climate pact. Although unique to one another, the documents mentioned above have a common denominator: establishing specific requirements, setting realistic goals, and ensuring a reduction in greenhouse gas (GHG) emissions caused by the extraction of fossil fuels. Another significant milestone was achieved not so long ago, during COP26, with 197 countries reaffirming their commitment to the Paris Agreement by signing Glasgow Climate Pact. The highlight of COP26 was an unprecedented agreement explicitly mentioning coal as the single most significant contributor to climate change. However, it was met with rather harsh criticism regarding feasibility by financial services companies. Major news agencies reported that despite public and private institutional investors pledging against further investment in fossil fuels, in line with the COP26 deal, the pact fails to offer policies to prevent them from doing so.

The latter arguments beg the following question: Will energy companies and institutional investors choose to follow the established agreements?

Pivotal Moment For Energy Companies

The most unprecedented trend in the global energy sector is happening right now. Leading oil companies are seriously considering selling large shares of their carbon assets, with others refraining from getting into new megadeals. These developments point to the increasing role of M&A (mergers and acquisitions) in sustainable transformations. Especially these days, when it seems that most stakeholders of carbon-emitting companies have an ever-increasing say in the strategic decisions companies pursue, including achieving sustainability. These decisions often involve the companies’ core expansion directions in mergers, acquisitions, or divestments. However, some question whether these transactions achieve the climate impact that we are hoping for and what more can we expect from the ‘sustainability trend’ in M&A.

With an increase in the number of so-called shareholder activist non-profit foundations, the sentiment in the Big Oil industry is experiencing a shift in the long-term strategic interests. One of them is Follow This, founded by Mark van Baal who realized that major oil companies like Shell were not listening to his concerns as a journalist and decided to act himself instead of giving up. “After ten years, I concluded that Shell does not listen to journalists, activist groups, or governments. The only ones who can convince Shell to choose another course are its shareholders.”, says Mark. However, soon he came across a significant obstacle that required 5 million euros in shares, namely submitting a resolution at Shell’s annual general meeting (AGM). He had to convince many other shareholders for the executives to even hear about his concerns, and unsurprisingly, most of them just wished him good luck in his pursuits. Throughout Mark’s never-ending campaign, more than eight thousand people joined his cause which eventually resulted in a substantial increase to 13% of shareholders not supporting the view and actions of Shell’s board of directors in terms of sustainability. However, it is not easy for large firms like Shell to suddenly transform into new companies. Imagine an oil conglomerate divesting a large part of their heavy carbon assets and transforming into a completely different company even though they realistically understand that those GHG emitting assets provide a higher ROI than clean energy ones. How are they supposed to achieve it within their model of profit- maximization? The achievement is not insanely difficult, but the incentivization and the feasibility within the institutional and societal context and other aspects are essential to consider. An intriguing yet successful example of such transformation was conducted by a Danish energy firm Ørsted. Ørsted decided to change its strategic direction in 2016 by divesting all of its oil and gas activities and focusing only on renewable energy sources. This transition has enhanced their net earnings while lowering carbon emissions per sold energy quantity by a substantial amount.

By far, the most significant concern for Big Oil is lower returns from investments in renewables. According to Mark Lewis, Global Head of Sustainability Research at BNP Paribas Asset Management, oil companies can expect returns of 15%-20% from investments in fossil fuels compared to 5%-10% return from renewables. “The oil sector is completely missing the point in the assumption that because it made 15%-20% before, it can carry on making 15%-20%. Those returns were only possible because there was no competition,” Lewis said. Based on the research conducted by the International Energy Agency (IEA), even with the changing sentiment from the oil and gas companies, their investment outside their core business areas is less than 1% of total capital expenditures. “A much more significant change in overall capital allocation would be required to accelerate energy transitions,” said IEA. In 2020, following Shell’s pledges to divest from coal, they had a significant interest in acquiring a Dutch sustainable energy utility Eneco but was outbid in a €4.1 billion ($4.5 billion) deal. Shell CEO Van Beurden said he regretted missing out on purchasing Eneco. “It did not come about, and we regret it,” he said. “But we have other opportunities. Our commitment to growing the business is completely unchanged.” Based on S&P Global Platts’ Power Plays Database, which tracks eight international oil and gas companies’ approaches to the energy transition, Total and BP are clearly ahead of their competition in terms of installed renewable generation capacity. The US majors ExxonMobil and Chevron have taken a more closely aligned approach with their traditional business models, focusing on improved efficiency, increased biofuels production, and carbon capture, utilization, and storage (CCUS). In 2018, Chevron launched a Future Energy Fund with $100 million under management to invest in “breakthrough technology.” The venture capital fund’s target is investments in EV charging, battery technology, and direct CO2 capture from the air. Moreover, by 2025 Chevron is actively looking at reducing the output of biofuels to 10,000 barrels per day and has already invested heavily in CCUS with a potential interest in approximately one-fifth of the world’s total carbon capture capacity.

Big Oil faces an existential challenge ahead. Will it maintain its position as a dawning industry while chasing potentially unprofitable projects? Or, as in the case of Ørsted, be able to reposition itself to sustainable energy markets? The Ørsted “start with a clean slate” approach seems like a challenge for larger oil and gas companies that would have to undergo a severe and painful restructuring to achieve it. However, ExxonMobil’s and Chevron’s outlook on the broader industry that divestments from fossil fuel assets shift the emissions problem from one company or country to another reasonably suggests the need to look at the issue on a global scale.

Institutional Investors Are Adjusting Their Approach

The energy transition will impact every aspect of financial markets and the economy. The Glasgow Financial Alliance for Net Zero (GFANZ) stated that achieving Paris Agreement goals requires an economy-wide transition in which “each company, bank, insurer, and investor will have to adjust their business models, develop credible plans for the transition and implement them.” Moreover, The International Renewable Energy Agency (IRENA) expressed that the private sector has a better opportunity to allocate assets to clean energy to finance the transition. Reuters Global Markets Forum states that these investments are likely to come from funds leveraged through banks and the private sector, institutional investors, and debt financing. “Around 80% of this is expected to come from the private sector, with debt financing growing to a 60% share within that.”, IRENA deputy director-general Gauri Singh said. The disruption caused by the COVID pandemic made a profound impact on M&A and has transformed the market. The pandemic has served as a wake-up call to society on the importance of ESG and has sped up the process of promoting a sustainable economic recovery. Since COVID-19, the energy sector received over $300 billion in investments in 2020, increasing over 2% before the pandemic. Following a significant asset sell-off amid a pandemic, some oil companies, including BP, Total, and Shell, have announced radical strategic shifts. Coupled with Carbon Tracker’s research suggesting that by 2030 more than half of coal power plants in the world will become unprofitable, it indicates that clean energy slowly but steadily becomes economically feasible.

As market participants tailor their investment approach for the energy transition, we shall see significant changes in capital allocation and capital flowing in new directions. In the past, a typical oil and gas company would allocate capital across its upstream (exploration and production), midstream (pipelines and perhaps LNG), and downstream operations (refineries, storage, distribution, and retail). Each of these businesses has a distinct capital expenditure and will need to readjust its portfolio of assets and balance sheet. In this sense, a surge in M&A activity becomes much more likely. Especially if we look at the North American and European financial sustainability landscape, it is expected that opportunities will emerge for private equity and global infrastructure funds to become involved in funding this capital re-allocation. There will be short-term opportunities to make specific and profitable deals, but it is harder to predict the longer-term market evolution. In the past, it may have responded to long-term strategies such as enabling companies to build up a physical presence in developed and emerging markets of the world. Hence, we should expect deal-making in the global financial sector to become more dynamic and focused on sustainability.

Nevertheless, most investment banks have managed to sit on both chairs simultaneously. In 2021, Citi topped the global rankings for the value of renewables M&A deals it arranged at around $6.3 billion. On the other hand, it advised on oil and gas deals worth $49.3 billion, suggesting that an oil and gas deal has a 7.8x higher chance of proceeding than a deal in renewables. JPMorgan Chase arranged renewables deals worth about $5.2 billion versus $87.7 billion in oil and gas. Goldman Sachs Group recorded figures of $1.4 billion and $94.6 billion. Another investment bank, Morgan Stanley, recorded $2 billion and $50.7 billion in renewables and fossil fuels respectively. “Conversations with oil and gas companies reflected both a focus on future developments and current market realities,” said Rob Santangelo, Global Co-Head of Energy and Transition Investment Banking at Credit Suisse. Even so, some oil and gas bankers are cautious about embracing their own institutions’ new focus on cleaner energy. “Some banks are still in a big-project power generation mindset. I think they need to think a bit more flexibly as projects become smaller and solutions more bespoke,” said Jonathan Maxwell, founder and CEO of London-based fund Sustainable Development Capital.

The current trends and sentiments in both financial and energy industries seem to converge on one focal point: the increasing importance of an energy transition in the global effort to mitigate the effects of climate change. Thus, it requires societal, economic, and political will and action. Is sustainability yet another viral trend in the ever-changing landscape of numerous industries aiming at acquiring the funding from investors to get and keep a renewable energy asset as a tick in a checkbox? Or is it something meaningful that will start an effective and influential domino effect in sustainability? While we search for an answer to these and several other questions, we can conclude with one piece of advice from Deloitte. While there are challenges associated with the valuation of new sustainable businesses that help create a more carbon-neutral world, mergers and acquisitions can act as enablers via divestitures to mitigate tangible and intangible risks.