fossil fuel

Carlo M. Funk, Head of EMEA ESG Investment Strategy, SSGA

Energy Transition Well Underway: SSGA

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The transition of the global economy to renewable energy, away from fossil fuel, is well underway and this decade will come to be known as the decade where the demand for fossil fuels peaked.

As far as coal is concerned, the peak in global demand is already well behind us, reaching its zenith in 2014. Gas and oil demand are likely to peak sometime over the next 15 years.

For investors, this means changes in both the energy sector and the global economy will follow rapidly as the implications of the transition become increasingly clear, a recent report by State Street Global Advisors (SSGA) and Carbon Tracker Initiative says.

“Using assumptions of the growth rate of total energy demand (1.3 per cent) and growth rate of solar and wind supply (17 per cent), we can forecast that fossil fuel demand will peak in 2023,” the authors of the report say.

“We believe the 2020s should be called the ‘peaking decade’.”

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We believe the 2020s should be called the 'peaking decade'

The report, titled 2020 Vision: The Coming Era of Peak Fossil Fuels, was written by Carlo M Funk, Head of EMEA ESG Investment Strategy at SSGA, and Kingsmill Bond, New Energy Strategist at the Carbon Tracker Initiative.

Funk sees a number of key investment risks stemming from the transition.

“It is important for investors to realise that climate change and the transition to a low-carbon economy will have impacts on many dimensions,” he says in an interview with [i3] Insights.

“This includes country risks, especially if petroleum states fail to reinvent themselves, corporate risks for companies whose business models are part of the fossil fuel value chain, systemic risks, for example with regard to changes in consumer behaviour, and stranded-asset risks as there is a danger the market is complacent and underestimates the amount of assets that need to be written off.

“Having said this, we now have realisable and tangible data points, such as a company’s carbon intensity or embedded fossil fuel reserves, in the revenue model that we can incorporate in portfolio structures. And investors should take advantage of that.”

According to figures from global energy company Shell, the fossil fuel sector has US$25 trillion in infrastructure assets and many of these assets will become unviable. But how much exactly will become stranded is hard to say, Funk argues.

“Assigning an exact number regarding the amount of assets that will have to be written off is difficult because stranded assets don’t only constitute the rather obvious areas such as underground fossil fuel reserves, but also overground infrastructure assets,” he says.

“But given the fact that about a quarter of listed financial markets have a connection to the fossil fuel industry, it is easy to see that the transition of this industry will have an impact on many portfolios.”

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Given the fact that about a quarter of listed financial markets have a connection to the fossil fuel industry, it is easy to see that the transition of this industry will have an impact on many portfolios

In fossil fuel exporting countries, such as Australia, it is not only the coal and gas sectors that will be affected, but the banking sector will also be negatively impacted.

“The banking sector plays an important role in the support and the financing of the respective regional economies,” Funk says.

“Having said this, banks will also likely have to assess climate-related risks on their books with more scrutiny going forward. One example is the European Investment Bank, which has announced that it will phase out fossil fuel financing after 2021.”

SSGA argues that mitigating climate risk should be a priority for all investors and they have various ways to manage these risks, from simply screening out companies with high emissions and fossil fuel reserves to more sophisticated approaches that allow investors to mitigate risks but also benefit from climate change-related opportunities.

Ultimately, the choice of style will depend on investors’ investment objectives and risk tolerance, the company says.

However, investors should not stand still as history shows change can happen quicker than expected.

“The peaking of global coal demand in 2014 was little anticipated by industries and investors who believed China and India would drive future demand,” SSGA says in the report.

“The peaking and decline of oil and gas is likely to follow a similar pattern. Investors should, therefore, be fully prepared for the energy transition and the disruption it will likely cause to geopolitics, countries, sectors and companies.”

With more and more companies restricting or abandoning fossil fuels, the transition to a low-carbon economy seems to be in full swing. But Funk warns this shift is not happening universally across the globe.

“We can still see regional differences when it comes to the belief systems and how progressive investors think about this topic. Overall, we see investors getting more and more educated. [But] sometimes incumbents and the associated lobbyists hold on to outdated assumptions for too long,” he says.

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Energy demand growth will largely be driven by emerging markets. And with the parameters around the adoption of renewables becoming more and more attractive, including costs, we will see an increasing part of this demand growth being directed towards renewables

Asked how these risks impact on passive investment strategies, as some investors have argued that implementing an environmental, social and governance (ESG) policy makes passive less so, since proxy voting takes a fair bit of involvement, he answers: “If the mandate is to track a third-party index, then this is by definition still a passive strategy.

“Proxy voting has existed for a long time and passive investors also have had stewardship and proxy voting strategies in place. So this is nothing new.

“It is probably just a little more visible and in the headlines due to the recent ESG and climate trends.”

Perhaps surprising is that SSGA believes emerging markets could take the lead in driving the energy transition, ‘leapfrogging’ developed markets in their transition.

Partly this is caused by the complicated subsidy regimes in place in many developed countries, something emerging markets don’t have to deal with.

Developing markets already overtook developed markets as the largest source of capital expenditure on renewables in 2015.

Forecasts from the International Energy Agency indicate over the next 25 years, 27 per cent of energy demand growth will come from India, 19 per cent from China and a further 19 per cent from the rest of Asia.

“Energy demand growth will largely be driven by emerging markets. And with the parameters around the adoption of renewables becoming more and more attractive, including costs, we will see an increasing part of this demand growth being directed towards renewables,” Funk says.

To read the full SSGA report, titled “2020 Vision: The Coming Era of Peak Fossil Fuels”, please click here.

This article is paid for by State Street Global Advisors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.