Investing in Oil and Gas Transition Assets En Route to Net Zero - Center on Global Energy Policy at Columbia University | SIPA - Columbia | SIPA Center on Global Energy Policy
Investing in Oil and Gas Transition Assets En Route to Net Zero - Center on Global Energy Policy at Columbia University | SIPA
Fossil Energy
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Achieving the goal of net-zero greenhouse gas emissions by 2050 requires a substantial reduction in the share of high-emitting fossil fuels in primary energy consumption. A scenario from the International Energy Agency (IEA) for reaching the net-zero target envisions oil demand in 2050 dropping by 75 percent, natural gas by 55 percent, and coal by 90 percent.
The magnitude of this challenge underscores the difficult reality of having to operate, maintain, and even invest in oil and gas assets (“transition assets”) before eventually phasing some of them out. To keep energy markets in balance while staying on the net-zero pathway, no investments in new oil and gas fields are required; however, given expected decline rates from current fields, the IEA estimates that continued investments of $400–500 billion per year until 2030 are needed in existing sources of production—including in new fields already approved for development.
Investments in clean energy have increased and now represent a 1.5 to 1 ratio with fossil fuels, but these investments need to be scaled up dramatically, to a ratio of 9 to 1, by 2030 to be consistent with the net-zero path.
As such, phasing out transition assets too early may result in wild swings in oil and gas prices, raising energy security and affordability concerns, similar to what has transpired since Russia invaded Ukraine. Oil and gas price volatility can be an additional incentive to accelerate the energy transition, but in the short term it may move the world further away from the path to net zero. In 2022, for example, the world shifted to more carbon-intensive fuels, particularly coal, resulting in record-high emissions.
This commentary focuses on the investments needed in oil and gas assets—without setting aside decarbonization goals—to act as a bridge until renewable energy and other clean energy technologies are deployed at an adequate scale.
After exploring these issues, the authors suggest options for policymakers and financial institutions to help ensure adequate financing of existing, new, and retiring oil and gas assets to engineer an orderly transition without disregarding climate goals.
The Covid-19 pandemic and resulting demand destruction led to oil and gas investments falling to the decade’s lowest levels in 2020 across private companies involved in upstream, midstream, and downstream activities (see Figure 1). The 2021–22 period of high oil and gas prices did not lead to a significant increase in capital spending by private companies despite record profits.
Why did record profits not translate to a commensurate increase in capital expenditures by private companies in 2022? Oil and gas companies have been under pressure to maintain profitability and capital discipline after years of poor returns for equity investors. As a result, the cash windfall has been directed toward paying down debt, paying dividends, and buying back stocks. The total debt of private oil and gas companies
Compared with the relatively slow recovery of capital expenditures by private companies, NOCs have been investing more heavily in recent years, particularly those based in the Middle East. Their share of total oil and gas investments rose to an average of 48 percent in the five years ending in 2021, versus 43 percent over the previous five years (see Figure 2). In almost every year from 2015 to 2021, the annual capital spending by state-owned oil and gas companies, most of which are based in emerging market and developing economies,
Given the greater lag in reporting by many state-owned companies compared with private companies, there is not yet sufficient data for 2022 to ascertain if the trend continued last year. Nevertheless, conservatively assuming that capital expenditures for state-owned companies with missing data in 2022 were the same as in 2021, total investments by both private and state-owned oil and gas companies can be estimated to be close to $600 billion in 2022. Considering that this estimate is only for companies with market capitalizations greater than $500 million, and notwithstanding that a small portion of the capital expenditures are toward renewable projects,
What is driving the relatively muted recovery of investments by private oil and gas companies, and is it likely to pick up? Past performance and future outlook are the major determinants of the capital discipline taking place in the sector. Part of the future outlook incorporates policy signaling of diversification away from fossil fuels in energy transition scenarios. Despite the recent backlash,
Poor performance in recent years: Although publicly traded oil and gas companies performed well last year, computing returns on a longer horizon—such as rolling five years—shows that they have underperformed against the S&P 500 index since 2017 across upstream, midstream, and downstream sectors (see Appendix 2, Figure A-4). The low company-level returns of publicly listed oil and gas stocks are in line with the low internal rates of return (IRRs) of hydrocarbon projects, which declined from around 20 percent during 2011–15 to 15 percent in 2019–20.
Performance is worse when adjusted for risk: The lag of oil and gas stocks looks even worse on a risk-adjusted basis due to the elevated volatility—especially when computed over a long investment horizon—of oil and gas prices in recent years. On a five-year rolling basis, the volatilities of both oil and gas prices—based on the nearest futures contract—are close to the high end of their respective historical ranges.
Expectations of low risk-adjusted returns in the coming years: In addition to low returns in the recent past, expectations of future returns from the oil and gas sector are not rosy, either in absolute terms or on a risk-adjusted basis, for several reasons:
Policy signaling:The current level of oil and gas investments is consistent with announced climate pledges by countries, indicating that companies are rationally adjusting to the progression of policy developments. Policy signaling about the declining role of oil and gas in the energy transition, as well as the expected fall in oil prices in the long term, is likely influencing capital allocation decisions by private companies and investors, especially given the long horizons of these investments.
While some blame ESG considerations for the current spate of low investments in the sector, third-party surveys suggest that the financing of oil and gas projects by the largest global banks dropped less than 10 percent in 2021 from 2018’s level.
Major global banks, like other large companies, have committed to aligning their lending and investment portfolios to meet net-zero emissions by 2050. More importantly, a significant number of banks have also committed to meeting intermediate targets as part of the Glasgow Financial Alliance for Net Zero (GFANZ),
These targets don’t prohibit financial institutions from lending and investing activities related to the oil and gas industry. Instead, they imply increased selectivity and scrutiny of the fossil fuel sector’s commitments and progress on emission reduction.
How financial institutions go about meeting their net-zero targets is also important. Decarbonization goals that are met by divesting from fossil fuel assets instead of investing in technologies to mitigate emissions can have the unintended consequence of transferring these assets to operators with lower environmental commitments and scrutiny, which may stall or worsen the level of greenhouse gas emissions and slow the energy transition—the so-called transferred emissions problem.
Although oil and gas investments are trending in line with climate pledges announced by countries, net-zero scenarios assume oil production will fall in response to the decline in oil demand.
Investment decisions need to be made for three broad classes of transition assets in the oil and gas space: existing assets, new assets, and retiring assets. Key players in these decisions are policymakers, financial institutions, and asset owners. This section focuses on the intersection between finance and policymaking for each of the three classes of transition assets to ensure energy security and affordability while meeting net-zero goals.
Premature retirement of existing fossil fuel infrastructure can lead to an energy deficit, but extending their lifetimes can hurt climate goals.
The financial sector has been making tangible commitments under their net-zero pledges to reduce financed emissions related to the companies they finance and invest in.
Because NOCs represent roughly 50 percent of current oil production and hold around 80 percent of oil reserves, it is difficult for the sector’s decarbonization efforts to have a material impact without engaging them. Bond investors have the potential to play an important role by pressuring NOCs to reduce emissions, given the need of NOCs and their shareholder governments to roll over debt.
For existing oil and gas assets, the role of policymakers is on the execution side, since the frameworks and policy decisions are already in place to a great extent.Examples include the Zero Routine Flaring by 2030 initiative, a sectoral pledge launched with the support of the World Bank in 2015;
Another area for policy consideration is refineries. The 2 million barrels per day of refinery closures in Organisation for Economic Co-operation and Development (OECD) countries since the start of the pandemic
The idea of no investments in new oil and gas fields has gained traction and is supported by oil and gas companies appearing to align their capital spending with announced climate pledges. Nonetheless, there are instances where new oil and gas investments may make sense for financial institutions as they combine decarbonization goals with energy security.
While the role of policy is limited here, one area where there may be space is in providing incentives for building resiliencyin energy systems for energy security purposes. One example is facilitating the building of commercial and strategic product inventories close to demand centers.
Oil and gas assets are expected to remain a part of the energy system for many years, and therefore not much attention has been paid to developing frameworks for their eventual retirement, decommissioning, or repurposing.
Since both decommissioning and repurposing are highly capital-intensive activities, the role of financial institutions is critical. However, net-zero pledges may constrain the ability of these actors to finance and invest in these activities due to their high emission intensities, even though they are critical to meeting climate goals. One solution could be to account for these assets differently in the financed emissions limits of financial institutions, to make it easier for them to be considered in financing and investment decisions.
Any such special designation of retiring assets should come with clear guardrails and strict governance to avoid becoming a loophole. Nevertheless, if executed successfully, it could unlock private capital for assets that need to be phased out or retrofitted, facilitating the accelerated greening of brown assets in support of an orderly transition to net zero.
Policymakers also have a crucial role to play in both the responsible decommissioning and divestment of assets.
Decommissioning or repurposing assets: Some ideas include:
In many EMDE, governments are the owners of the reserves instead of oil and gas companies. Thus, responsible companies may not be able to make decisions about phasing out assets, and the only possible solution for them may be to divest. One approach that could be taken to address this problem is providing carbon credits for the decommissioning of assets or their retrofitting—with very strict timelines to phase them out. Such an approach could also incentivize EMDE governments to phase out such assets if financial benefits offset at least part of the opportunity cost of foregone oil and gas revenues.
Addressing divestment of assets to less climate-friendly actors: To improve performance in terms of profitability and emissions, the incentive of companies is to build portfolios resilient to both low commodity prices and high carbon prices by divesting the least productive and highest emitting assets.
In addition to guidelines proposed by the Environmental Defense Fund and Ceres about responsible mergers and acquisitions transactions in the oil and gas industry,
The current level of investments in the oil and gas sector is consistent with announced climate pledges by countries, but is above what is projected for net-zero scenarios and below near-term demand trends. This suggests that companies in the sector are adjusting to policy signals regarding the scaling down of assets and the implied outlook for oil and gas demand. Building on initiatives and frameworks already in place, this commentary laid out additional considerations for new and existing assets to meet energy security and geopolitical priorities within the confines of climate goals.
Where there is an imperative for a more thoughtful approach, both from financial actors and policymakers, is in the financing of responsible oil and gas asset decommissioning or retrofitting—both of which are highly capital-intensive activities. Absent a framework that creates the right incentives, some efforts by financial institutions and responsible companies to meet their net-zero goals could be lost if emissions are not curbed but transferred. Within the reality of the world’s shrinking carbon budget to meet climate goals, there is a need to think about investments in new, existing, and retiring oil and gas assets holistically.
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https://www.iea.org/reports/world-energy-investment-2022.
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[xix] IEA, “World Energy Investment 2022,”
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https://www.unepfi.org/net-zero-banking). See, for example, Alastair Marsh, “Banks Try Quiet Quitting Net Zero,” Bloomberg, October 14, 2022, https://www.bloomberg.com/news/articles/2022-10-14/banks-try-quiet-quit….
https://www.unepfi.org/wordpress/wp-content/uploads/2021/04/UNEP-FI-Gui….
https://www.ft.com/content/0affebaa-c62a-49d1-9b44-b9d27f0b5600. The discord appears to be a case of the banks not wanting to take legal risks by committing to targets set by a third party. This does not exclude the possibility that banks could still follow their emission reduction targets related to the fossil fuel industry.
https://www.woodmac.com/news/opinion/banks-assess-the-impact-of-climate….
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Several Refining Projects Are Scheduled in Asia and the Middle East,” Today in Energy, August 2022, https://www.eia.gov/todayinenergy/detail.php?id=53279.
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https://www.spglobal.com/commodityinsights/en/ci/research-analysis/deca….
https://www.sciencedirect.com/science/article/pii/S0306261921006346. Another study finds that oil field depletion is accompanied by “significant growth—in some cases over tenfold—in per-MJ GHG emissions.” Source: Mohammad S. Masnadi and Adam R. Brandt, “Climate Impacts of Oil Extraction Increase Significantly with Oilfield Age,” Nature Climate Change 7, 551–556. https://doi.org/10.1038/nclimate3347.
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https://business.edf.org/insights/transferred-emissions-climate-princip….
https://www.texasoilandgasattorneyblog.com/texas_oil_and_gas_lawyers_an….
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