Security Concerns Add Urgency to Global Energy Transition

Russia’s invasion of Ukraine has caused enormous human suffering and upended the previous political consensus in Europe. It’s also prompted concerns that Western countries will be distracted from environmental priorities as they struggle to replace embargoed Russian oil and gas. But data suggest otherwise—that the global energy transition is accelerating and that the widespread effects from the conflict bolster the secular growth case for renewable energy.

Investment in Renewables Is Set to Soar

According to the International Energy Agency’s (IEA’s) “Net Zero by 2050” roadmap, the world already had enough operational oil and gas fields and coal mines before the invasion to meet anticipated demand in their pathway to 2050. But increases in renewable energy generation and energy efficiency were behind target, despite impressive growth rates. As the IEA put it, “The path to net-zero emission is narrow: staying on it requires immediate and massive deployment of all available clean and efficient energy technologies” (Display).

Now, as the world faces higher hydrocarbon prices and as Western Europe is confronted by an absolute shortage of gas, the pressure is growing to economize on consumption, phase out Russian oil and gas, and substitute renewables. We expect investment in clean energy to surge in response to the existential threat of attack and the need for energy security.

Meanwhile, as renewable output ramps up, the Western world must still find ways to avoid an imminent energy deficit from reduced Russian oil and gas supplies. Addressing this problem will temporarily expand oil and gas exploration and production, but we don’t believe it will reduce the long-term pace of the transition away from hydrocarbons.

Higher Prices for Oil, Gas, Power and Carbon Make Renewables More Attractive

For Western countries, the invasion of Ukraine can only strengthen the case for much higher production of renewable energy as part of a more secure, sustainable energy infrastructure. Effectively, the Ukraine crisis adds urgency to the global energy transition by highlighting the increased need for energy security.

Until recently, hydrocarbons were cheap by historical standards and renewables were just becoming fully cost-competitive. Power prices in Europe (and the US), stable for several years, recently soared as natural gas prices rose and the supply/demand balance tightened (Display, right).

Russia’s invasion of Ukraine has profoundly changed the outlook. On top of energy security considerations, the economics of renewables have improved versus fossil fuels—driven by higher oil, natural-gas and electricity prices. Higher and more volatile energy prices make renewables relatively more attractive and new technologies like electric vehicles (EVs) relatively more affordable. The price of carbon has also risen—another factor making clean energy more attractive (Display, left).

Renewables Are Now Price-Competitive…

The IEA and others now believe that wind and solar power are price competitive with, or cheaper than, fossil-fuel power in two-thirds of the world’s countries. As a result, direct subsidies for renewables have now largely been phased out.

Prices for renewable-generating assets in the secondary market are rising sharply, demonstrating that renewable generation is now fully cost-effective and attractive to investors—who are currently paying between 1.5 and two times as much for existing clean-energy assets as they were two years ago.

Another way to quantify the robust appetite for renewable energy is through movements in the prices of power purchase agreements (PPAs), long-term agreements for the purchase of energy between renewable developers and consumers. These prices have risen materially since the first half of 2020 across Europe.

Because PPAs feature an agreed-on price over a long period, they can be particularly attractive when hydrocarbon prices are volatile. Buying renewable energy is also a reputational positive for energy-intensive consumer businesses such as airlines, enabling them to demonstrate cleaner supply chains.

…with Attractive Investment Characteristics

As a result of these developments, we believe investments in clean energy projects offer visible long-term growth potential with defensive return characteristics.

Over a medium-term five- to 10-year horizon, clean energy represents a strong secular growth story. The energy transition program will be the primary growth driver, and is now accompanied by the greater need for energy security. Two other developments may also spur growth in renewables. First, energy demand typically expands with economic growth, and it would take major advances in energy efficiency for that relationship to be broken. Second, stubbornly high hydrocarbon prices would also speed the adoption of clean energy sources.

Together these factors should make clean energy one of the foremost defensive growth sectors in the foreseeable future. Clean energy, as is the case with oil and gas, has the added attraction of offering a potential hedge against inflation. We also believe that companies whose products and services help conserve energy and reduce net carbon emissions may be similarly attractive.

Investment in the Energy Transition Has Already Accelerated

Last year, global spending on the energy transition was up 30%. That’s after posting 19% growth in 2020, and 10% compound average growth from 2014 to 2019, according to BloombergNEF statistics (Display).

Consumers are adapting fast, too. For example, in a weak market for vehicle sales generally, global EV sales have kept rising strongly in 2022, with two million vehicles sold in the first quarter—that’s up 75% from the same period in 2021 (according to the Global EV Outlook).

Further Growth in Renewable Capacity Faces Bottlenecks

European and other governments have acted promptly to bring forward their decarbonization targets and to announce new renewable projects and energy conservation measures, with the European Union’s (EU’s) REPowerEU plan a notable example. However, these ambitious programs face practical obstacles.

In theory, it should be possible to expand capacity in solar and onshore wind power, and to create a bigger role for hydrogen, relatively quickly. In practice, though, labor, supply-chain and planning issues all create bottlenecks. And to be truly clean, hydrogen must be generated from renewable sources. It may not be until the 2030s that the world has enough excess clean energy to make hydrogen a substantial contributor to the share of renewables. And while European and other governments may favor relaxing planning controls, they will likely face stiff opposition.

Costs are a further constraint, given the rising prices of metals and components. So the energy transition will be a complex journey.

Oil and Gas Still Have a Place in the Energy Mix

Replacing Russian energy will be an enormous project. Considering the practical obstacles, renewables alone can’t fill the gap over a five-year time frame.

The world currently has less than 2% spare oil capacity (according to Saudi Aramco), which could swiftly be absorbed by normalizing demand in the airline industry and/or the end of COVID-19 lockdowns in China. The crisis in Ukraine further aggravates an already tight supply position. Re-allocating existing oil and gas supplies worldwide is problematic—for instance, creating the infrastructure to transfer more US and Asian liquid natural gas throughout Europe is a multiyear project.

This leaves a continuing role for new oil and gas exploration as well as production in the interest of energy security. Meeting that need presents a dilemma for the energy industry, as companies need assurances from national governments that they will back capital expenditures in low-carbon secure projects through the term of the project life (typically 10 years). Without government endorsement, oil and gas firms are unlikely to develop the necessary assets. Politicians also face tricky decisions in terms of allocating the cost of transition among consumers.

Investors Have an Important Role, Too

Investors’ aversion to oil and gas companies has curbed these firms’ willingness to invest in upstream oil and gas and led them to divert cashflows to stock buybacks and investment in the energy transition. As a result, new oil and gas supply will likely be constrained and prices will stay higher for longer. Low-income groups, particularly in emerging economies, will be hit the hardest by this expense. Faced with a lack of energy security, affordability and availability, emerging countries, in particular, will simply burn more coal, further increasing environmental damage.

Investors willing to engage with oil and gas management teams to advocate action—rather than shunning them and divesting—can help ensure that these companies have robust energy transition plans in place. Renewables remain a fast-growing but relatively small part of the energy mix, so oil and gas companies continue to be vital for today’s economy. Investors that disregard that fact risk abdicating their responsibility to encourage progress. By actively engaging, they can play a key part in reducing the impact of the current energy crisis and ensuring an orderly evolution to clean energy worldwide.