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Fossil fuel investment to grow in 2022 despite net-zero risks

25 February 2022 Cristina Brooks

Oil and natural gas sector profitability is currently having a moment, but whether oil and gas E&P technology spending rises or falls through 2050 depends on the will of investors.

The question was a key focus of IHS Markit's latest insight report, titled "Global energy sector investment to 2050: An analysis of IHS Markit scenarios and net-zero cases."

It assesses annual investment—in the cleantech, power network, and fossil fuel sectors—through 2050, using IHS Markit long-term energy and net-zero scenarios.

The report looks at future investment in "legacy" technology investment areas related to oil and gas exploration and production, LNG supply, fossil fuel refining, as well as coal mining.

Whether "legacy" E&P investment declines hinges on two factors: are there enough cleantech investment opportunities to absorb the available finance, and can traditional E&P companies offer sufficiently attractive returns.

Net-zero energy production requires a shift away from "legacy" tech and towards cleantech finance by 2050, but it is far from certain there will be enough spent on cleantech to reach net-zero, IHS Markit and others have concluded.

A 16 February academic study found that cleantech investment by BP between 2010 and 2018 was just over 2% of capital expenditure, focused mostly on biomass and wind.

Meanwhile, Shell spent 1.33%, mostly on biomass, and American counterparts "lagged well behind" at around 0.23%, the study's authors said.

BP and Chevron both increased production of natural gas between 2016 and 2019, according to the study.

Upstream returns rise alongside risks

Upstream investment globally is projected to increase this year, as oil prices increase, crude oil demand reaches pre-pandemic levels, and natural gas price strength is underpinned by the current crisis in Ukraine.

Rising oil prices because of lower global supplies last year were good for oil and gas producers financially, with global international oil companies that steered away from cleantech enjoying high profitability, an IHS Markit upstream insight report found.

As oil prices rose 50% between 2020 and 2021, the oil and gas sector became more attractive to investors. The oil price increase has brought on this turnabout even as countries firm up their net-zero goals.

Market observers say some E&P companies have raised their internal rate of return, a metric companies use in financial analysis to estimate project profitability, from 10% to 20%. "This type of capital discipline will quickly change the projects slated for oil and gas production," said Amy Groeschel, IHS Markit associate director in upstream, costs and technology.

Despite the current attractiveness of oil and gas production to investors, future financing options are set to be further constrained as decarbonization targets and limits are set by public and private financial institutions.

In one example, the US joined 25 countries pledging to end public finance for unabated overseas fossil fuel projects during the COP26 climate summit last year.

Within the same year, Bank of America, the UK's Barclays, and Germany's Deutsche Bank pledged to align their lending and investment portfolios with net-zero emissions by 2050 as part of an initiative launched by the UN: the Net Zero Banking Alliance.

Also last year, the European Investment Bank (EIB) and the World Bank both committed to cut their funding for oil and gas.

"Financing options are limited, which means that traditional E&P companies need to re-examine project economics to ensure attractive returns. This will mean managing costs but also satisfying shareholders on multiple fronts that include both returns and ESG [environmental, social, and corporate governance] targets," said Groeschel.

While mainland China, Japan, and South Korea are yet to follow the path set by the US, these restrictions on finance may lead to the deferral or cancellation of commercially viable oil and gas production projects, IHS Markit upstream analysis found.

Cleantech competes with upstream

The ratio of cleantech investment to legacy investment plays a key role in E&P capital access and deciding whether the world reaches net zero.

However, in three of five of IHS Markit's scenarios, cleantech investment is too low to reach a net-zero energy sector by 2050.

In 2021, mutual funds, hedge funds, and pension funds, for example, snapped up green bonds such as those that invest in cleantech, despite cleantech equities lagging in returns compared to oil technologies.

For renewables, however, current electricity market structures create a glass ceiling for investment. "The pace of additions has outrun the capacity of power markets to absorb them," wrote IHS Markit's Cleantech Director Conway Irwin in a recent report.

Over the next three years, a slower pace of growth for global wind and solar capacity additions than in 2021 is expected, due to the ending of COVID-19 economic stimulus by many nations. Growth of private sector capex spent on renewables will slow as well, the report predicted.

Over the next three decades, the global energy sector will require investment of approximately $65 trillion (at today's prices) to reach net zero.

One factor that may prove critical to reaching net-zero is how much aggregate energy sector investment is poured into the Asia-Pacific by 2050, as net-zero scenarios forsee far more investment in the region.

Posted 25 February 2022 by Cristina Brooks, Senior Journalist, Climate and Sustainability

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