Balancing risk and return: Navigating the energy transition in the fossil fuel sector
Context
The scientific consensus indicates that, to limit the rise of the average global temperature to 1.5°C, production of coal, oil, and gas must drastically decrease by 2050, alongside increasing investments in the renewable energy sector.
Canada has committed to reducing its greenhouse gas (GHG) emissions by 40 to 45% by 2030 compared to 2005 levels.
To ensure a ‘just transition’, these ambitious targets need to be part of an energy transition plan that not only achieves global climate goals but also supports workers and communities currently dependent on these industries.
With mounting pressure to address climate change and transition towards sustainable energy sources, traditional risk assessment and return optimization must adapt as stakeholders navigate the complexities of an evolving energy landscape.
This paper explores how shifting market dynamics, regulatory frameworks, and technological innovations in the fossil fuel sector are reshaping investment strategies.
Scenario analysis
The Investment and Strategy teams at Desjardins Global Asset Management (DGAM) have analyzed three main potential climate scenarios based on compliance with current or forthcoming legislative policies, as well as the systematic risk these policies represent for the fossil fuel sector. The table below describes the three scenarios:
Scenario | Description | Oil production in Canada | Liquified natural gas production in Canada |
---|---|---|---|
Stated Policies 2.5°C Stated Policies Scenario (STEPS) – International Energy Agency (IEA) Net Zero by 2050 – A Roadmap for the Global Energy Sector | This scenario, which provides a projection of GHG emissions based on current policies (such as carbon pricing), shows stable demand for oil, with neither growth nor decline. However, there is a medium-term growth outlook for natural gas production, leading to global warming of 2.5°C by 2100.
| Slight increase until mid-2030s, then gradual return to 2021 production levels.
| Increase in exports by 2030, which are sustained until 2050. Increased market share for Canada.
|
Announced pledges 1.7°C | This scenario proposes a reduction in fossil energies through the implementation of various government promises that are more binding for reducing GHG emissions related to the fossil fuel sector, to eventually align with net zero and to limit warming to 1.7°C by 2100.
| Decrease due mainly to a faster transition to electric transportation and renewable energy.
| Increase in exports by 2030. Decrease in North American consumption reflected in lower Canadian production.
|
Net Zero Policies 1.5°C | This scenario calls for a drastic reduction in fossil fuel production, with net zero alignment starting today to achieve net zero emissions by 2050 and global warming of no more than 1.5°C by 2100.
| Decrease in global demand of 40 to 70% by 2050. No new oil field development from 2021 and phaseout of oil-fired power plants by 2040.
| 80% decrease in overall demand by 2050. No new gas fields developed from 2021.
|
Based on existing policies, in addition to aiming to represent the current alignment of GHG emission reduction efforts in recent years, the scenario that is unfolding is the “Stated Policies” Scenario. In other words, it is the scenario with the least uncertainty regarding the actions that governments should take in the coming years.
Desjardins Global Asset Management’s approach
The analyzed scenarios allow us to establish the probabilities of pivotal moments in the energy transition. This helps us assess the timing of opportunities and risks.
In all the scenarios considered, demand for oil and natural gas will remain at a sufficient level for Canadian production until the mid-2030s. However, uncertainty regarding the sustainability of the oil industry’s current business model increases significantly from 2030 to 2050, as projections indicate a decrease in both demand and production.
Our approach to portfolio construction with companies in the fossil fuel sector is to consider a higher uncertainty factor and significantly higher risk after certain pivotal years in the transition, such as the peak of oil consumption. Thus, no major oil or gas extraction projects are necessary to meet demand, which is expected to peak soon, allowing us to decarbonize rapidly while meeting the increasing demand for energy.
Beyond the various decarbonization scenarios, other factors of uncertainty come into play when we analyze supply and demand forecasts for fossil fuels in Canadian and global markets. Here are a few additional examples to consider:
Oil sector
We anticipate greater pressure on the oil sector in the medium to long term. For example, since 60% of global oil consumption is used by the transportation sector
New technologies
With the aim of reducing the negative effects of fossil fuel exploitation, the Canadian industry is focusing on carbon capture, utilization, and storage (CCUS) technologies to continue to produce, or even grow, while reducing emissions. Although promising, these technologies present a risk as the sole solution to secure the future of the fossil fuel industry. Despite the pooling of knowledge and the promise to inject nearly $24 billion into this technology by 2030
Natural gas sector
Natural gas is seen by many as a transitional energy, particularly for reducing the use of coal in electricity generation. A number of countries are aiming for carbon neutrality in the electric power sector, including Canada, with a target of 100% net zero electricity by 2035.
New projects
According to the IEA’s Net Zero Report, major new projects for extracting new oil and gas beyond 2021 are no longer necessary, as policies align with the net zero objective. In other words, oil and gas producers must now focus entirely on production and growth within the margins of their current operations, as well as on reducing their GHG emissions from existing assets.
Financing structures
Financing structures also play an important role in our risk assessment. A financing structure for an operating project, with gradual amortization and thus deleveraging, may be considered less risky over the long term and of better quality. Also, credit agencies seem to be increasingly integrating physical and transitional risks into their ratings. A sudden downgrade of an issue or issuer can impact portfolio management, construction and as well as its performance.
Conclusion
In summary, the closer we get to 2050, the more we think the climate urgency will be taken seriously by governments, which will accelerate their transition initiatives and policies. If legislation is delayed, it will only become more stringent when imposed.
Although some technologies bring hope and could even offer growth to the fossil fuel sector, they are slow to produce tangible results. Ultimately, companies will have to adapt to this transition by modifying their operations or incorporating low-carbon technologies into their activities if they want to remain profitable.
It is imperative to recognize that the factors described above will need to be considered in navigating the complex landscape of the energy transition. As governments, industries, and financial institutions grapple with the challenges and opportunities presented by decarbonization efforts, proactive adaptation and strategic planning will be crucial to ensure resilience and sustainability in response to evolving market dynamics and regulatory environments. Embracing innovation, investing in renewable-energy technologies, and integrating climate considerations into the investment decision process are essential.
For more insight into the dynamics of the fossil fuel sector, don’t hesitate to reach out to our team.
Pierre-Alexandre Renaud
Senior Advisor, Responsible Investment