Glimmer of hope in clean energy investment?
The road to Net Zero is unpaved and getting steeper by the day. If we have any hope of reaching the end of the road, the world needs to invest in – among others - a clean energy sector to take us there. Despite some progress, policy pledges for decarbonization and their implementation continue to fall short, as does investment in the energy transition, but the latest IEA Report on Energy Investments provides a glimmer of hope: the significant increase in clean energy investments since 2021, if continued through 2030, would, on aggregate, exceed the IEA’s announced climate pledges scenario (APS) (consistent with a temperature rise of around 1.7 degrees in 2100). Understanding the forces behind the recent increase in clean energy investment is crucial, especially against the backdrop of the energy crisis. As the IMF recently noted, the impact of an energy price shock and a carbon price increase, while similar, are not the same. Indeed, the energy crisis seems to be impacting energy investments in ways that both help and hinder the transition, such as an expansion of planned LNG supply in Europe. This highlights the need for clear and credible climate policies to ensure that the energy transition continues.
Net-Zero by 2050 requires a swift decarbonization of the energy sector. Policies that raise the cost of emissions (a carbon tax or ETS) are key to incentivizing a switch toward a cleaner energy system, but investment in developing that alternative, clean energy system is crucial. This switch is likely to cause near-term macroeconomic costs, but many climate and economic models agree that a smoother, earlier transition will help minimize them. One way to attempt to quantify the macroeconomic costs (both short and long-term) is by assessing the economic impact of a higher carbon price.
Carbon price shock vs oil price shock
As the IMF noted in an article titled “Near-term Macroeconomic Impact of Decarbonization Policies,” (2022)1, while it is tempting to compare a carbon price increase to an oil supply shock, as both cause the price of fossil fuels to rise, there are important differences. First, an oil shock increases the revenues of fossil fuel producers, while a high carbon price lowers (net) prices for them and instead generates revenues for the state. Those revenues can be used to offset macroeconomic costs, support hard-hit sectors, or to invest further in the energy transition. Furthermore, oil price shocks are generally seen as temporary and are usually unexpected, while carbon pricing should be introduced (and raised) gradually and should be seen as a permanent policy feature. If designed and implemented with credibility, a carbon price should help deter investments in fossil fuels.
Russia’s invasion of Ukraine came against the backdrop of a swiftly closing time window for ensuring a smooth and orderly transition to a low-carbon economy. The war caused an energy crisis and spike in prices, especially in Europe, while the limited time left for the energy transition is spurring policymakers (again especially in the EU) to implement stronger carbon-pricing policies. Understanding the differences between a carbon price shock and a standard energy (oil) price shock is therefore especially important as both are clearly having an impact on the global and European energy landscapes. In this light, the IEA’s recent report2 on global energy investment from 2021-2023 (estimated) provides interesting data.
Unlike most reports related to the climate crisis and transition, the IEA report offered a glimmer of hope that the world is moving in the right direction on mitigation. In particular, it highlights that clean energy investment is now increasing at a faster pace than investments in fossil fuels, and that the annual ratio is expected to be 1.7:1.0 in favor of clean energy in 2023. And while the report is not all roses (obstacles remain, particularly in developing economies), they do note that a continued acceleration in clean energy investments at the same pace means “aggregate spending in 2030 on low‑emission power, grids and storage, and end-use electrification would exceed the levels required to meet the world’s announced climate pledges (APS).” The APS does not put the world on track to keep global warming below 1.5 degrees, but it could be enough to limit warming to 1.7 degrees. Digging further into the report, it is noteworthy that of the fossil fuel industry’s windfall profits in 2022, only 48% is being funneled back into oil and gas supply, compared to 82% five years ago. While significantly lower than before, the 48% reinvestment still represents a 6% increase in total oil and gas investment, thanks in large part to the higher profits due to the energy price shock. Still, the lower share of reinvestments seems to imply that the ongoing policy push toward an energy transition is holding back fossil fuel investments from being even higher, as investors want to avoid the risk of stranded assets.
Stranded asset risk increased by energy crisis
According to a recent report by Climate Action Tracker (CAT) (November 2022)3, the risk of stranded assets is especially large in the Liquified Natural Gas (LNG) sector. The energy crisis raised worldwide concerns on energy security. In response, many governments, pressed by risks of critical and imminent energy shortages, decided to overwhelmingly increase their investments in LNG infrastructure instead of fully doubling down on renewables, efficiency and electrification. The EU, which was impacted heavily because of its strong reliance on Russian energy exports, decided on a mixed policy response. On the one hand, the bloc set out more ambitious targets on renewables and energy efficiency and amped up investments to support these targets. On the other hand, the EU also frantically tried to secure fossil gas deliveries from outside of Russia and to procure LNG import infrastructure. According to CAT, since the invasion, 25 new LNG terminals have been announced in the EU, a capacity equivalent to around 41% of the EU’s total fossil gas demand and more than needed to replace gas imports from Russia (imports from Russia in 2021 were 155 bcm while new infrastructure would bring the import capacity to 168bcm).
These projects are especially concerning as the IEA’s updated Net Zero by 2050 scenario (NZE) estimates that fossil gas demand needs to be at least 30% below 2021 levels by 2030 and more than 60% below by 2035 (World Energy Outlook, 2022). This implies that already existing capacity exceeds what’s needed in 2030 under NZE. By investing heavily in additional LNG capacity, we risk getting thrown further off the net zero emission path. CAT calculated that the LNG capacity expansion plans (under construction, approved and proposed), if ever fully in use, could increase emissions in 2030 by over 1.9 GtCO2e per year above emission levels consistent with NZE. The current LNG infrastructure plans leave us with two possible scenarios for the future: either the assets are not used and become stranded or they are used and we have a carbon lock-in.
While an oil price shock and carbon-price increase are inherently different, both represent an increase in the cost of fossil fuels, and both have been at play in the global economy, and especially the European economy, since late 2021. What the IEA report suggests is that the two indeed do function differently, but both may be contributing to the (still too slow) decarbonization of the energy sector. The energy crisis has had a push and pull effect, on the one hand strongly increasing investments in clean energy by highlighting the need for energy security and boosting consumer preferences for electrification, while on the other allowing investments in fossil fuels to rise further as (a smaller part of) windfall profits are being reinvested. An higher carbon price has a more unidirectional impact as it almost exclusively encourages renewable (and not fossil fuel) investments. Hence, it becomes clear that clear and credible policy communication on rising carbon costs is key to ensuring a timely energy transition.
1 World Economic Outlook, October 2022: Countering the Cost-of-Living Crisis (imf.org)
2 Overview and key findings – World Energy Investment 2023 – Analysis - IEA
3 Global Update - Gas expansion overtakes climate - Nov 2022 (climateactiontracker.org)