The 2020s promises to be a decade of change like no other for the energy industry. It is truly an “undiscovered country from whose bourn no traveller returns”. Energy is a fundamental bedrock of our economy, alongside food & water, communication and finance. Bill Gates recently stated1 that “COVID-19 is awful” but meeting the climate challenge, and the ensuing energy transition, is a much bigger task.
In 2018, the Intergovernmental Panel on Climate Change2 demonstrated what it is at risk: global warming must not exceed 1.5°C to avoid irreversible loss of the most fragile ecosystems, and crisis after crisis for the most vulnerable people and societies.”
To meet this challenge, we need to set and keep to “carbon budgets”. Greenhouse gas (GHG) emissions must more than halve by 2030 – and drop to net-zero by 2050 – to prevent exceeding the 1.5°C limit. This is roughly 7% per annum for the next 10 years as a global economy. To put this in perspective, the economic disruption in 2020 from the COVID-19 pandemic resulted in only a 7-8% reduction in emissions3 4. Power markets, industry and transportation saw the lion’s share of emissions reductions as the economy slowed, and they will need to integrate meaningful action at all levels in order to meet those targets.
As yet, there is not common or scientifically based definition of what “net-zero” will mean. However, it should be noted that deep cuts in emissions are needed by 2050 across all industries for the world to meet the goals of the Paris Agreement. Last year saw a dramatic increase in the energy sector commitments and setting of Science Based Targets, with 40% of these being made between July 2020 and Feb 2021.5
Understanding the various drivers, risks and opportunities from this change are the foundations for raising our knowledge. Scenarios and risk analysis provide risk managers with tools and data to support boards with strategic decision making. Leveraging this thinking into explicit transition plans that map the route ahead will help articulate that vision and extend confidence to investors and wider stakeholders that organisations understand the risks and have a map to navigate themselves towards a more resilient future.
The call to transition the energy system has been heard before. The need to restrict our carbon emissions was first identified in 19926, which led to the Kyoto Protocol7 (1997) and the Paris Agreement8 (2015). So what’s different from previous calls for societal moves to low carbon energy, and how has this become a financial imperative? The answer lies in three key developments:
The rise in prominence of activists and campaigners in the last couple of years, as well as devastation to wildlife and property from the most recent extreme forest fires in Australia, California and across the world more generally, has shifted the public perception of the climate peril further. In the largest poll of its kind, 1.22 million people were surveyed and 64% of participants saw climate change as an emergency requiring urgent response from policy makers.9
The disruption to the economy from COVID-19, plus increasing vocalisation from society, has demonstrated tangibly that policy makers can intervene at the scale needed to keep emissions within the budget. This has been exemplified by the rapid expansion of the net-zero commitments in the latter half of 2020, the rise of low carbon COVID-19 recovery packages such as the European Green Deal10 with 25% of all funding going to climate change mitigation, and the new US administration’s goal of decarbonising the power sector by 2035.
Following the 2015 Paris Agreement, the number and size of financial services climate initiatives has snowballed with perhaps the single biggest accelerator being the recommendations of the Task Force on Climate-Related Financial Disclosures11. Other key initiatives illustrate the deepening of government, industry, and financial activities:
The challenge to transitioning our energy systems is akin to trying to change the design of an aeroplane (body, engines, fuel and equipment) in mid-flight. The transition needs to be managed in an orderly and just manner as livelihoods and well-being also depend upon energy availability.
Energy firms need to set short, medium and long-term emission reductions targets that keep within science-based and apportioned carbon budgets. The energy sector needs to decarbonise more rapidly as other sectors face significant technological barriers and are reliant on the energy industry; these include steel, cement, shipping and aviation.
At an institutional level, 69 financial services companies have committed to set emissions reductions targets in line with the science behind the Paris agreement since 2016, with 15 new commitments made between July 2020 and February 2021. Financial institutions are growing momentum to push for companies and portfolios of investments to be aligned to the Paris agreement including to 1.5°C pathways, net-zero by 2050 latest and/or insistence of an investor vote on transition plans at AGMs.
Shell became the first oil and gas major to offer a vote on their transition plan, with BP and Equinor24 also set to allow a shareholder vote on their emissions reduction targets in 2021. In the United States, shareholders have filed 79 climate-related resolutions so far in 2021, compared with 72 in 2020 and 67 in 201925. Other climate-related topics for votes at AGMs in 2020 include climate competency of directors and lobbying.26
For the power sector, emissions reductions need to 76% by 2030 to achieve 1.5°C, with near zero reach by 2040-204527. This is because:
Although the sector currently still attracts plenty of investment, energy companies should now have investment strategies which are clearly linked to the energy transition. For oil companies, this could mean investing in renewables projects, or, in the case of pure-play exploration and production firms, taking serious action to cut emissions from their operations. They also need to scale back their operational emissions in the short to medium term, reduce exploration activities and begin the transition away from this form of energy during the two next decades. This is likely to mean the retirement of some fossil fuel assets, many of them earlier than anticipated at the design stage, diversification into hydrogen production via renewable energy, and reversing the flow of carbon back into the long-term carbon cycle through carbon capture and storage.
Before 2030, we are likely to see some major climatic events which will accelerate the sense urgency policy makers feel they need to change in the ways we make energy available for power, transport, industry, agriculture and domestic use. Rewiring business models to respond to these dynamics will require many structural barriers to be overcome, especially as the past will not necessarily be the best guide for the future and require new financial tools.
This is where risk managers have an important role to educate Boards on the wave of change on the horizon across a range of issues. At a macro level, this might include shifting geopolitics as we move from world economic powers of petro-states to electro-states. This could see a drop of 51% in government revenues from oil and gas over the next two decades29. Geo-political power30 in the energy transition will derive from the
Economies will also need to deliver against the Sustainable Development Goals, particularly the just transition in providing affordable energy and decent jobs. Energy businesses will need to improve their knowledge of these changes, retraining and reapplying their workforces to deliver the new infrastructure build rapidly.
The energy transition is not going to be just a like for like replacement – systems thinking will be needed to create of hubs of interlinked industries, and to scale rapidly the new energy infrastructure: carbon capture and storage, hydrogen and renewables. It is likely to change the dynamic of how we do business both at industrial scale and at retail.
Electrification will offer different business models as generation patterns are changing31. Power grids will need to be expanded to cope with the increased electrification of our energy systems but also be able to cope with two-way push-pull of supply and demand.
These systems will not only have to engineer the GHG emissions reductions needed to meet tough Paris-aligned targets. They will also have to take into account the rapidly changing pricing of solutions such as solar, wind and battery storage.
The energy transition is a 30-year+ global industrial and societal revolution. Three key things will be needed for this: political will, public support and capital. The energy industry has to rebuild trust as many initiatives to rebrand as green have failed in the past. This also makes it unlikely that claims without evidence of action will be labelled greenwashing this time.
Increasing public concern and activism is driving the political will to find an orderly energy transition. Transparency will also be demanded by the financial institutions that provide the capital for the transformation. There is a growing call for regulators and the financial services sectors to act as stewards of the climate risk and hence to the energy transition.32 33 These financial institutions are already under pressure to decarbonise their portfolios and support that transition.
Disclosure using the recommendations of the Task Force on Climate Related Financial Disclosures (TCFD) can provide transparency in this area to investors, providers of capital and insurance, and to society as a whole. Increasingly the TCFD is being seen as a framework by regulators for climate disclosure: UK and New Zealand are explicitly bringing in the TCFD as mandatory, but it is also being considered by the EU, Japan, USA, Canada, Australia, Switzerland, France, Hong Kong and Singapore.
Energy businesses, and governments that rely and support them, will need to adopt a systematic approach to the energy transition challenge. At Willis Towers Watson, we take the following approach with our clients:
In order to plot a course through the transition, a map is needed. While none of us can profess to having a crystal ball, scenarios can be used to help navigate the risks and opportunities to each organisation in the new territory ahead. A range of publicly available scenarios have been completed for the Energy and other extractive sectors that give an industry view, and these can form the basis of more tailored, site specific analysis.
These forward-looking assessments will be fundamental, as the past may not be reflective of what is to come; indeed, the pace of change over the last year has shown that there are some surprises ahead. The rate of net-zero targets, the rapid decrease in renewables costs, together with the exclusion of financing and support services, has forced a number of withdrawals from fossil fuel projects. For instance, the Australian Utility firm AGL announced in December 2020 an AUD$2.7 billion loss due to rapid market changes (including “behind the meter” technologies such as home batteries and electric vehicles and falls in power prices)34.
Given this, it is important to build scenarios that can help energy companies show sensitivity to changes in the market and resiliency of their business models to such changes. New and existing fossil fuel assets need to measure over what timescale they will be profitable against these scenarios; adding the climate dimension can strengthen decision making here.
The first step in scenario analysis is to build scenarios that explore plausible emissions profiles. The NGFS has recommended using three key scenarios:
Shared Socio-economic Pathways (SSPs) are used to plot technology and market changes in the transition scenarios (1) and (2). The IPCC 1.5 special report35 highlighted four potential pathways (P1-P4) to illustrate use of various fuels and technologies in the energy mix. This range of choice highlights that there are many technological and business model choices to achieve the overall greenhouse gas reductions needed. In making the choice, it is important to consider what the output of the analysis is needed for:
The good news is that risk managers can be proactive in addressing transition risks; furthermore, many industries are finding that the insurance sector is uniquely placed to help them, given its experience of being on the front-line of managing the impacts of a changing climate over many decades.
Risk, opportunity and scenario analyses are the cornerstone tools for creating a transition plan and being able to model this over the timeframes involved is at the heart of our Climate Quantified™ framework. We can help put scenarios together, identify and quantify the risks ahead, identifying cash flow changes, asset value at risk, equity value at risk and opportunities to maximise profitability during transition.
The risk financial impact and likelihood work needs to be conducted on an asset level basis, with scenarios in detailed enough form to model likely changes in severity of physical climate impacts at enough granularity. Sectoral and regional transition pathway choices also need to take into account the speed of market, policy and technology changes.
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During our work with companies and governments, we have found the following examples of climate-related risk:
A new additional concern for both energy companies and governments that may be pursued through the courts is the potential for “stranded liabilities”. This occurs where there are insufficient funds to properly retire assets (e.g. oil & gas fields) to protect human health and the environment.38
Costs and budgets for transition, alongside policy, are also changing quickly – the IPCC will shortly release its latest 5-year update on climate (AR6)39, synthesising research from across the scientific world. Given that annual GHG emissions have not yet started to go down meaningfully, it is likely that this report will indicate the rate of decarbonisation needs to accelerate, rather than slow down.
Most scenario work though is focussed on smooth orderly transitions (e.g. a smooth transition of carbon pricing to ~$100 per tCO2e by 2030). The modelling of high impact, low likelihood risks (“Green swans”40) is important it enhances the disorderly modelling to include rapid changes in market and regulatory sentiments (e.g. sudden shift of carbon pricing in 2030 from ~$40tCO2e to $250tCO2e).
Once scenarios and risks are plotted, asset level assessments of impacts and likelihoods need to be completed to understand the potential for changing landscape to affect profitability. Risk managers are uniquely placed to ensure their companies are prepared to meet the increasing expectations of disclosure by investors and regulators, embed climate risk into existing frameworks and ensure Boards are taking a strategic approach.
At the heart of this is achieving the balance of keeping to science aligned targets whilst achieving cost-effective transition by:
In assessing the climate risks and opportunities for an energy firm, it is likely that a cross-over for certain generation sites will take place. This potentially turns assets into liabilities (i.e. stranded assets41) as the cost of continued use of a high carbon asset is more than commissioning new low carbon power (usually a combination of storage with wind and/or solar generation).42
New renewable energy as a source of power, and as a way of manufacturing green hydrogen, is expected to be cheaper than operating old fossil fuel plants globally by the end of the decade43, and LCOE comparisons already have many renewable technologies operating at below the costs of conventional fossil fuels.44 Carbon capture and storage at fossil fuel generation assets needs much higher costs of carbon to be competitive.
The wave of pressure to close coal mines and generation plants is just starting to be felt for gas generation. It is predictable now that attention will continue to be focussed on coal-related and arctic/oil sands production assets and will expand further to all fossil fuel-based assets in this decade.
Many of the common ways of achieving transition plans that have been proposed involve swapping out coal for high efficiency gas and/or introducing carbon capture and storage. This is often cited as being the most economical method. However, given the rapid changes in the costs of renewable energy and storage, this may not remain the case. The EU Sustainable Finance Taxonomy gives guidance for issuers of debt of what technologies are “sustainable” through its classification of technologies that “Do no significant harm” and “Contribute solutions”.45 There is also concern that a $1-4 trillion carbon investment bubble may burst in this decade.46
Developing an appropriate retirement and divestment plan is also key part of any transition plan. In the early part of the transition, divestment of assets may be financially feasible but, whilst improving the carbon balance sheet, might not deliver the emissions cuts at system levels. Already there has been some call for governments and industries to work together to create the energy equivalent of “bad banks” to retire high carbon assets.
But investment in renewables isn’t going to be a get out of jail free card. Value chain impacts will also need to be considered as many of the rare earth elements that will grow in demand47 are currently being mined in regions where human rights and/or severe impacts to the health of local population and their surrounding environment48 49.
Having a climate strategy and transition plan needs to be delivered in the company. Like any strategy, there are a number of key areas are important to successful delivery:
Strategies and plans often fail because company cultures and staff values are not aligned with the goals. It is crucial to work with both HR, talent and reward functions to implement these plans.
Short and medium-term targets are also needed that align with the goal of getting to at least 50% reduction in emissions by 2030. Incentive plans need to be focussed on achievement of the emissions reduction targets set. Willis Towers Watson’s recent survey have found that four in five companies plan to change their ESG measures in executive pay plans over the next 3 years.50 We work with companies globally to help them implement this.51
Sustainable and green finance has grown hugely in the last couple of years52, despite COVID-19, and is expected to exceed $1 trillion in 2021 and possibly accelerate from there, with demand outstripping supply. However, many of these existing financial instruments focus on purely financing zero carbon or near-zero carbon activities. Exclusionary principles deployed in finance industries mean that many companies are finding rises in the cost of capital and/or difficulty in raising capital and insurance.
New transition finance instruments are being created to help companies that could reduce emissions significantly and are willing to action a transition strategy. Access to these debt instruments are subject to pre-conditions that their transition plans and performance align to the Paris Agreement.
Demonstrating that climate action is taking place, governed well, with a robust strategy and with performance measurements, is seen as key to meet conditions of investment, whether debt, insurance or equity. This is also an opportunity space.
Our team have been helping to define the climate-related metrics and reporting recommendations behind frameworks such as TCFD and CDP, the two pre-eminent disclosure frameworks for climate disclosure. One of the key components is transparency of process, progress and what is yet to be done. Benchmarking performance against peers and being able to learn from leaders in transition planning from across multiple industries is at the core of our research and helping you successfully use your disclosure for stakeholder engagement.
While there may be challenges ahead, the mainstreaming of issues such as ESG and recognition of transition risks presents a strategic opportunity for risk professionals, particularly in the energy sector. As Boards grapple with these issues, risk managers can play a lead role, providing not only risk quantification and analysis but also insight to inform strategy in a rapidly evolving risk landscape to secure organisational resilience.
Tony Rooke is Director of Climate Transition Risk in the Climate and Resilience Hub at Willis Towers Watson in London. Tony.Rooke@willistowerswatson.com
Lucy Stanbrough is Emerging Risks Hub Leader for the Willis Research Network at Willis Towers Watson in London. Lucy.Stanbrough@willistowerswatson.com
1 https://www.gatesnotes.com/Energy/Climate-and-COVID-19 2 IPCC, 2018: Global warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty [V. Masson-Delmotte, P. Zhai, H. O. Pörtner, D. Roberts, J. Skea, P.R. Shukla, A. Pirani, W. Moufouma-Okia, C. Péan, R. Pidcock, S. Connors, J. B. R. Matthews, Y. Chen, X. Zhou, M. I. Gomis, E. Lonnoy, T. Maycock, M. Tignor, T. Waterfield (eds.)]. 3 UNEP Emission Gap Report 2020, 9 Dec 2020 4 IEA Global Energy and CO2 emissions in 2020 5 Companies taking action, Science Based Targets Initiative. 6 UN Conference on Environment and Development, Rio De Janeiro, Brazil, 3-14 June 1992. 7 Kyoto Protocol, UN Framework Convention on Climate Change, 1997 8 The Paris Agreement, UNFCCC, 2015 9 “The People’s Climate Vote”, UNDP and Oxford University, January 26, 2021 10 European Green Deal, EC, Dec 2019
11 TCFD Recommendations, Financial Stability Board’s Task-Force on Climate-related Financial Disclosures, June 2017 12 “Showing off cleaner hands: Mandatory climate-related disclosure by financial institutions and the financing of fossil energy”, WP #800 Banque de France, Jan 2021 13 Network of Central Banks and Supervisors for Greening the Finance System 14 EU Sustainable Finance Taxonomy, EC. 15 UNFCCC Race to Zero Campaign 16 UNEP-FI & PRI, Net-zero asset owners alliance 17 Net-zero Asset Managers Alliance 18 Investor initiative CA100+ to ensure world’s largest greenhouse gas emitters take necessary action on climate change 19 Bankers for Net-zero, Volans and UK banks 20 https://www.climatebonds.net/transition-finance/fin-credible-transitions 21 https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/climate-transition-finance-handbook/ 22 https://sciencebasedtargets.org/business-ambition-for-1-5c 23 https://www.sayonclimate.org/
24 “Follow This and BP in talks to test shareholder support for climate targets resolution in 2021”, Responsible Investor, Dec 2020 25 “Show us the plan: Investors push companies to come clean on climate”, Reuters, Feb 24, 2021 26 “Record breaking votes, divisive climate pledges and new engagement trends have defined responsible investment in 2020”, Responsible Investor, Dec 2020 27 SBTi Power Sector 1.5C Guidance, Science Based Targets Initiative, June 2020 28 Greenhouse Gas Emissions by Countries and Sectors, WRI, Feb 2020 29 "Beyond petrostates", Carbon Tracker Initiative, Feb 2021 30 The Economist, Sept 2020 31 “Renewables 2021 Market Review”, Willis Towers Watson, Jan 2021 32 “Managing Climate Risk in the U.S. Financial System”, US Commodity Futures Trading Commission, Sept 2020 33 “A call for action – Climate change as a source of financial risk”, NGFS, April 2019 34 Renew Economy and Sydney Morning Herald Feb 2021 35 https://www.ipcc.ch/sr15/
36 “Understanding the impact of a low carbon transition on Uganda’s planned oil economy”, (as Climate Policy Initiative Energy Finance team) Dec 2020 37 "Beyond petrostates" Carbon Tracker Initiative, Feb 2021 38 “The Flip Side: stranded assets and stranded liabilities”, Carbon Tracker Initiative, Feb 2020 39 International Panel on Climate Change, AR6 released in stages over 2021 and 2022 40 Green Swans, Volans 41 “Stranded assets: a climate risk challenge”, B Caldecott, E Harnett, T Cojoianu, I Kok and A Pfeiffer, IADB, 2016 42 E.g. “Duke IRPs focus on new gas-fired generation creating serious stranded-asset risks”, IIEFA US, Jan 2021 43 "Coal-developers-risk-600-billion-as-renewables-outcompete-worldwide", Carbon Tracker Initiative, Mar 2020 44 Projected costs of generating electricity 2020, IEA and OECD 45 EU Sustainable Finance Taxonomy, EC. 46 “Toward Risk-Opportunity Assessment in Climate-Friendly Finance, JF Mercure, 2019 47 "European Commission, Critical materials for strategic technologies and sectors in the EU - a foresight study, 2020"
49 “Responsible or reckless? A critical review of the environmental and climate assessments of mineral supply chains“, Jordy Lee et al 2020 Environ. Res. Lett. 15 103009 50 ESG and executive pay survey, Willis Towers Watson, Dec 2020 51 Executive Compensation, Human Capital Governance and ESG, Willis Towers Watson 52 “Debt engineers tackle climate change with bonds to rewild land”, Bloomberg, Feb 2021 53 “Financing Credible Transitions”, Climate Bonds Initiative & Credit Suisse, Sept 2020 54 Climate Transition Finance Handbook, guide for issuers, International Capital Market Association, Dec 2020
