Energy transition: An economic transition Chapter 1: Climate change, all change?

The global economy urgently needs to be transformed to a far lower carbon version. The challenges this will pose for the oil and gas sector are immense – and could even prove existential for some companies. We are still at the very early stages of this transformation. It is certainly not clear how all the changes and their consequences, both intended and unintended, will play out. It cannot be the case that there is only one ideal strategy for the sector or for any one company. There could be a range of successful strategies, calling for different choices at different times. For any given company, the successful strategy will depend on their assets, regional footprint or expertise (especially in the power sector), and their management of the capabilities needed to survive change. The management will also need good timing, clear, consistent, truthful communication (with shareholders and employees) and a ruthlessly honest review process as events unfold.

The debate is often couched in ethical terms, in the form “since, by implication, it is all – or largely – the sector’s fault, the oil and gas companies should become renewables companies to deliver the solution”. However, the bulk of changes will have to be on the demand side, throughout the economy: this should be demanded of all companies, institutions and the public. In other words, there needs to be an acknowledgement that the oil and gas sector cannot, by itself, provide all the answers.

Negotiating the results of changes in the demand profile for oil and gas will be an exercise in capital allocation and risk management, in the face of extreme change and uncertainty. Other industries have faced such challenges, but this sector’s are exacerbated by the very long lifecycles of projects. The presence of National Oil Companies (NOCs) in producing countries which are, in some cases, extremely dependent on oil and gas revenues – with different pressures, options and time horizons – adds further complexity and uncertainty.

Confounding some expectations, the International Energy Agency (IEA) sustainability scenario (1) has 80% of change coming from efficiency throughout the economy, far outweighing the substitution of renewables for carbon-based fuels; not just a reduction of carbon intensity but also of energy intensity. The term “economic transformation” to a lower carbon emissions economy therefore seems more appropriate than “energy transition”, which underplays the pervasive and comprehensive changes needed.

The changes have only just begun: Paris and beyond

The Paris Agreement of 2015 largely encapsulated measures already in progress or in the pipeline. The policies within the Nationally Determined Contributions (NDCs) do not guarantee that temperature change will be limited to 2C, let alone the 1.5C now widely cited as necessary. The next round of policies (effective from 2025-2030, assuming the Paris mechanism holds) therefore needs to be much stricter and applied throughout the economy.

• Despite the focus on transport and power generation, there will need to be significant improvements in building design, agriculture, and industry. 
• Demand patterns will be changed by decarbonisation and decentralisation, as energy systems move from large scale power generation and system wide transmission to a more local, distributed structure.
• Digitalisation and data management will increasingly allow energy use to be optimised at all levels. 
• Consumers will have greater opportunity to make choices and demand alternatives.
• Importantly, developing countries are moving in the same direction. In some cases, in the absence of legacy infrastructure, they can even move faster and with greater impact than developed countries (for example, China and Saudi Arabia, where the command economy and building of new cities from scratch gives great scope for a new model).

The IEA has identified 38 sectors throughout the economy that need to be transformed, of which only four (solar PV, lighting, data centres and networks and electric vehicles) are on track.

A “carbon wedge” between producer prices and the cost to consumers of equipment and practices that use carbon based fuel may be enforced by legislation or regulation. This could range from a more widely applied carbon price to the maximum power of your hairdryer, but it is important not to forget the enlightened self-interest of the private sector. Every new design, product, service or data management tool that enables less energy to be used is a business opportunity, largely beyond the oil and gas sector. One implication may well be that capital needs to be allocated away from the sector into the wider economy in order to enable this investment.

These changes will affect every part of the oil and gas companies’ business models. Managements will be considering the implications for their core businesses (oil, gas, refining, petrochemicals) as well as deciding whether to diversify into new energy or low carbon energy sectors or related businesses, products and services. There are clear challenges in terms of timing, risk management and communication in each case.