Turning up the heat on the energy industry?
In our view at Willis Towers Watson, geopolitical risk is increasingly being recognised by company executives and boards as a concern of paramount importance. Indeed, research from the Cambridge Centre for Risk Studies shows a 40% increase in risk to cities’ GDP from geopolitics and security over the past four years, totalling almost US$140 billion in 2019, the biggest growth of any risk factor1. For the energy industry in particular, recent expert testimony to the US House of Representatives emphasised the close intertwining of geopolitics and energy security, noting for example pressure on gas supplies from Russia to Europe, owing to the ongoing conflict in Ukraine2. This year is likely to be one where nascent trends of geopolitical instability continue to foster uncertainty and hazards in the energy market landscape.
Energy industry particularly affected Energy companies have traditionally been particularly sensitive to geopolitical fluctuations. With assets and people spread across the globe, often in locations with tenuous political and security situations, energy companies have been required to grapple with associated risks to investments and operations. Energy companies have also historically had fraught relations with governments who seek tight reins on the industry; just consider the fate of Standard Oil3. In the 21st century, such existential threats are perhaps less likely to come from government imposition, but instead from shifts in market forces towards cleaner energy creation and consumption, driven by public awareness of the environmental impact of current practices. As much of the world seeks to move away from fossil fuels, energy companies will need to diversify to survive.
Far distant time horizons Companies in the energy sector look at time horizons which are far distant compared to those viewed by other sectors. As an industry whose shape was fundamentally imposed on it over a hundred years ago in 1911, it must look similarly far into the future to see the trends that are likely to shape it going forward. The Shell Scenarios team4 is perhaps the most well-known practitioners of this kind of thinking, putting together models exploring the state of the world out to the year 2100. By comparison, the UK Ministry of Defence’s quadrennial Global Strategic Trends assessment, which is partly used to inform long-term defence procurement plans, looks 30-35 years into the future, so it is clear that the energy sector is exceptionally forward-looking.
In order to understand what the future may be like, it is imperative to understand the present. One of the most effective uses of scenarios is to take an envisioned future state and work backwards to establish signposts that are indicative of that future state. If one of these signposts can be seen today, it means the envisaged future is a possibility. Presented here are four geopolitical drivers of risk seen today which can serve as signposts, although the future they point to is for the reader to deduce according to their own scenario analysis. Geopolitical instability The risks associated with interstate and intrastate conflict remain high. A list of 10 conflicts to watch in 2019, published by Foreign Policy5, contains some of the usual suspects, but also some entries which may not have been on everyone’s radar:
Although the list can be debated (for example, tensions in South China Sea is not just a US-China issue, and in our view Libya should make the list), it is noteworthy from two perspectives:
This does not just introduce direct risks to assets and people in and around these areas, but may impact the wider industry if supply is interrupted or OPEC decisions are made on the basis of geopolitical instability.
Climate change The physical risks associated with climate change are well documented (rising sea levels, increased severe weather events) yet the geopolitical processes which underpin these risks are less understood. Driven by bodies like the UNFCCC, international agreements on emissions limits are not based just on science, but also on political and economic imperatives. For example, President Trump’s decision to withdraw the US from the Paris Agreement reflected less a concern with the empirical data and more the perceived impact on domestic US politics and economy. The energy sector is not merely a passenger in these processes, but can leverage its position as a technology leader to advise decision-makers whose actions are liable to shape the industry in both the near and far future. Cyber As the world enters the fourth industrial revolution, there is an exponential growth in connected devices. This is not limited to consumer devices such as phones and laptops; indeed the majority of new devices are in industrial settings, used for remote measurement and control of operational systems. This Industrial Internet of Things (IIoT) creates greater efficiency and allows the implementation of automated, AI-driven processes. At the same time, more devices and more connections introduces new attack vectors on a larger attack surface. The inability of industry to control these and apply sufficient security standards generates impetus for governments to introduce regulations and legislation, such as the EU’s Network and Information Security Directive (NISD), which impacts the energy industry and carries stiff penalties for infringements.
Trade The successes of populist political movements, exemplified by President Trump in the US and Brexit in the UK, suggest that globalisation is losing momentum. In its place are more conservative trade relationships and protectionism, inviting close scrutiny of the trade policies of some of the world’s biggest economies. Among these uncertainties and shifts, business opportunities will realign as some markets open up for participation while others become more restrictive. For the energy industry in particular, the recent mixed fortunes of South American politicians (for example Jair Bolsonaro in Brazil and Nicolás Maduro/Juan Guaidó in Venezuela) is likely to shape oil and gas trade policies on that continent over the coming years.
These drivers have directly-linked risks; consider, for example, the risk to business operations through improperly secured cyber systems. Importantly however, the linkages between the drivers create second and third order effects which introduce additional risks to companies and organisations. Regulatory landscape The energy industry is especially susceptible to new regulation, largely driven by climate change imperatives. The general public has woken up to the threat of climate change and is demanding action from policymakers. Already, several countries have committed to restricting sales of new road vehicles powered by internal combustion – for example full bans in Norway by 2025, the UK by 2040 and China at an unspecified near-future date – which will dampen the appetite for oil and petroleum. The shipping industry, prescient of likely regulation to come, is likewise searching for alternative sources of propulsion and will be a declining user of oil-derived products while aviation, despite greater technological challenges to adopting alternative energy sources, is also subject to more stringent regulation to limit emissions. The energy industry is well aware of these trends, but governmental action, which has until recently been half-hearted, is increasingly likely to be committed to change that will fundamentally impact the industry. Supply chains A diversified international supply chain presents significant risk. With regards to the IIoT, which is becoming as entrenched in the energy industry as it is almost every other industry, the cyber security shortcomings of many devices has left companies operationally exposed. Even if a company has comprehensive oversight of their own systems, there are few frameworks to determine if suppliers and sub-contractors maintain equivalent standards. Unless identified and mitigated, a vulnerability in a suppliers’ device introduces this vulnerability to a company’s own systems. Moreover, geopolitical tensions can affect supply chain capacity. Recently, several Western countries invoked national security as grounds to ban Chinese networking equipment manufacturer Huawei from supplying products to critical national infrastructure. Such bans, fuelled by geopolitical considerations, are liable to affect the energy industry supply chain. Workforce availability The energy industry requires access to a highly skilled workforce. The core of energy industry workers comes from engineers and scientists who are in increasingly high demand. This is partly a problem of supply, with insufficient people being educated in the subjects and trained in the skills to meet the needs of the industry, especially as these needs shift away from drilling holes. However, workforce availability is also affected by geopolitical exigencies: security turmoil creates unsafe areas, the political will to embrace migration is decreasing, and we will soon begin to see the first ‘climate refugees’ displaced by environmental changes caused by climate change. These factors may impact industry’s ability to hire local talent, transfer personnel to international locations, or transport workers to operational field sites.
Taking a holistic approach The key to managing geopolitical risk is to take a holistic approach and understand the linkages between risk drivers. Drivers and risks are in a ‘many-to-many’ relationship, where one driver can cause multiple risks, and one risk is caused by multiple drivers. Sometimes these causalities are not direct, but manifest as second- or third-order effects, and some risks only manifest through a particular combination of drivers. Making sense of such a complex picture is not easy, as the US military’s infamous spaghetti diagram of the Afghanistan insurgency illustrated (See Figure 1).
Distinct lenses A more useful method to think about these issues is through distinct lenses. Lenses can help isolate risks to view them more clearly, to then be recombined into a holistic picture. For the energy industry, six particularly useful lenses might be: investment and return, people, business resilience, climate and environment, reputation, and cyber (see Figure 2 below). These capture the core geopolitical drivers, some of which have been elucidated above, and can be expanded into a mesh of interconnected risks.
Useful analytical tools In order to evaluate the potential impact of these risks, it is also possible to utilise analytical tools such as VAPOR from Oxford Analytica, which turn qualitative findings into quantitative assessments. By assigning monetary value to risk percentages (likelihood multiplied by consequence), these tools turn the risk from intangible problems to tangible opportunities that can be understood in business terms, without deep geopolitical expertise. No one credibly claims to be able to predict the future, but by employing lenses to observe geopolitical signposts, it is possible to illuminate potential futures and manage the risks contained therein.
Andreas Haggman is an emerging risk analyst heading up our newly-established Emerging Risks research hub at the Willis Research Network.
1 https://www.jbs.cam.ac.uk/fileadmin/user_upload/research/centres/risk/downloads/crs-global-risk-index-exec-summary-2019.pdf 2 https://www.bakerinstitute.org/media/files/files/a8d62514/ces-medlock-testimony-052218-.pdf 3 https://www.geoexpro.com/articles/2011/11/the-standard-oil-story-iii-the-rise-fall-and-rise-of-the-standard-oil-company 4 https://www.shell.com/energy-and-innovation/the-energy-future/scenarios/meet-the-shell-scenarios-team.html 5 https://foreignpolicy.com/2018/12/28/10-conflicts-to-watch-in-2019-yemen-syria-afghanistan-south-sudan-venezuela-ukraine-nigeria-cameroon-iran-israel-saudi-arabia-united-states-china-kurds-ypg/