Expert Opinions

What's In Store for the Energy Sector?

Victor Barcot and Bhavika Parikh
Victor Barcot and Bhavika Parikh Energy Investment and Corporate Banking
October 23, 2020

The domestic energy sector has seen increasing volatility over the past two decades.  On one hand, innovation and a friendly - or at least ambivalent - regulatory environment, along with access to previously abundant capital, have driven domestic production to heights not previously achieved.  Recent technological advances – hydraulic fracturing and increased operational efficiencies foremost among them – have put to rest the concept of a fossil fuel shortage for the foreseeable future.  As a result, the United States finds itself in a position of energy independence.

But the future of the domestic energy industry seems less certain, both in the short and long term. Recent global dislocations have resulted in higher crude supply and lower crude demand, placing significant downward pressure on prices and, in turn, marginal producers. From this year’s price war between OPEC and Russia to the continuing economic pain inflicted by the coronavirus pandemic, nothing seems to be going right. The many bankruptcies and muted investor interest in the sector are evidence enough. IEA believes the outlook for energy supply and demand balance will remain “fragile” for the foreseeable future.   

Beyond current market dislocation, the specter of a massive shift in energy and climate policy adds to the tough calculus facing the legacy energy companies. 

The Implications of a Potential Biden Administration 

America is days away from a presidential election, and polls increasingly point to a new resident at 1600 Pennsylvania Avenue.  To understand the implications of a potential Biden administration, we turn to his policy proposals.  Like most campaign manifestos, Biden’s energy plan is long on sweeping statements and short on particulars, but there are three core planks of the energy platform on which we can base our hypotheses.

Biden Energy Platform Plank: Move Ambitiously to Clean Energy

First, he pledges to dramatically shift how we generate power in this country, proposing to “move ambitiously to generate clean, American-made electricity to achieve a carbon pollution-free power sector by 2035.”  If it has a Democratic majority on Capitol Hill, a Biden White House would probably look to enact a comprehensive Clean Energy Plan including a carbon tax scheme to hasten this transition. But net carbon neutral power generation in 15 years is extremely ambitious.  After all, fossil fuels made up 63% of large-scale electricity generation in the U.S. last year, according to the Energy Information Administration.  Of the other 37% of generation, nuclear power accounted for nearly 20%, and hydropower made up less than 7%.  Wind and solar made up just 9% of large-scale electricity generation in 2019. Even if we take carbon free to include carbon capture and other mitigation strategies such as retrofitting existing plants and at the same time assume a tax structure that disincentivizes carbon-intensive power sources, such a quick transformation would prove disruptive.

Opportunities for “Transitional” Fuels

How will this play out?  There should certainly be opportunities for “transitional” fuels leveraging existing critical energy infrastructure led by market participants with vision.  Natural gas suppliers (incl. natural gas pipelines and LNG), as an example, would benefit from a more rapid shift away from coal generation if utilities are allowed credits or can benefit from offsets, but some progressives are skeptical of all fossil fuels and may play policy spoiler here.  Hence, even transitional fuels could be under the microscope with no clear guidance on policy.  

Moreover, the possibility of carbon taxes presents significant risks for legacy energy companies, including the prospect that existing assets become largely unprofitable overnight.  Nuclear should play a role in any carbon-free generation plan, but the cost and approval challenges to get a plant built can be prohibitive.  That leaves us with wind and solar again, but the investment required to achieve significant scale and storage falls short and is much less efficient, which leads us to plank number two.

Biden Energy Platform Plank: Massive Government Investments

The second piece of Biden’s plan calls for “massive government investments in innovation” to drive cost reductions in clean energy technologies, “including battery storage, negative emissions technologies, the next generation of building materials, renewable hydrogen, and advanced nuclear” and to rapidly commercialize these technologies.  Admirable goals, but to date there is no shortage of capital being earmarked for green-energy and/or Environmental, Social and Governance (“ESG”) initiatives.  We are already seeing sizeable institutional investor cash inflows into funds targeting these technological endeavors.  

The Climate Policy Initiative found climate-related investments grew by 70% to $579bn between 2013 and 2018.  In June, an industry research report noted green-energy investing will account for 25% of all energy spending in 2021 and surpass spending on traditional fuel sources like oil and gas for the first time ever.  The same report posited that should the US aim to hold global warming within 2 degrees Celsius, a key priority of the Paris climate accord which Biden has pledged to rejoin, the pivot to renewable energy sources will create between $1 trillion and $2 trillion in yearly infrastructure spending, or an investment opportunity as big as $16 trillion through 2030. This is before the massive federal spending we are likely to see materialize.

Additionally, it remains to be seen if pouring cheap capital into the ESG ecosystem will yield the desired results.  At present, we cannot even be certain there are enough opportunities out there to invest in given the glut of cash and the immature nature of these newer endeavors.  A new generations of clean energy entrepreneurs, project developers and management teams has yet to emerge to satisfy the project appetite (and piles of cash) of this latest funds flow away from traditional energy funds and into these newly created green funds, whose investment charters in many cases are so narrowly focused that they miss the opportunity to participate in the much needed transition phase opportunities that in many cases already exist.  A key case in point from a personal experience is the inability of designated green funds to invest in zero-sulfur diesel generated from biomass if that diesel’s end use is earmarked for a combustible engine even though this fuel easily qualifies for renewable fuels credits (RINs) from the federal government.  This is just one example where we currently miss the mark.      

Finally, the ability of the government to effectively invest in renewables and other clean energy technologies also remains in question.  Federal investment in R&D is a mixed bag, particularly if it is based on partisan goals rather than outcomes. Short of instituting a Manhattan Project initiative for advancement of clean energy technologies, this effort is likely to result in limited progress.  We need look no further than gas-to-liquids, clean coal plants and ethanol.

Biden Energy Platform Plank: Preventing Local Environmental Damage

The third key plank in the Biden energy plan, tucked into something of a catch all category, calls for increased monitoring and oversight with the purpose of “reducing leakage of toxics, and preventing local environmental damage.”  Much of this falls into the regulatory realm, which can be enacted without legislation, either through the Department of the Interior or the Environmental Protection Agency.  

We are likely to see a ban on new permits related to fossil fuels on federal land, as well as a reduction in leasing of federal lands for energy purposes.  At present, a blanket ban on hydraulic fracturing looks unlikely.  We would expect that energy-related approvals from the EPA will clock in around 18-24 months compared to the 6-9-month turnaround we have seen under the current administration.  

More aggressive oversight is likely in the cards for everything from leaks to safety inspections.  New and existing technologies – drones and remote sensing – will allow regulators to enhance monitoring capabilities in a significant manner.

Broad Consequences for America’s Energy Independence 

All of this has consequences broadly for America’s energy independence.  Existing producers are likely to be shut out of vast energy reserves, primarily on federal lands. They will take a hit on sunk costs in several key geographies.  And they are staring at potentially millions in fees and settlements for operating the exact same way they do now.

Where does this leave the domestic energy sector?  Just like the past decade and a half, the next 15 years will see uncertainty and volatility in spades.  What we do know is that the world will eventually move away from fossil fuels.  It is simply a matter of how quickly.  

Investors will increasingly seek out renewable and green projects, to the extent they are viable.  The policy environment for legacy carbon-heavy producers will get more difficult.  But serious questions remain.  What emphasis will be placed on solar and wind, and how soon will it scale and become more competitive?  In the interim, will natural gas and LNG truly be treated as transitional fuels?  Will there be requirements for domestic sourcing and American made technologies to drive this change?  All that we know now is the basic framework, so we can only speculate.

Come January 20, a theoretical Biden administration will seek to accelerate a shift away from fossil fuels.  The pace and precise manner in which it is executed will likely be dependent on the composition of the United States Senate.  

Positioning the Country for a Carbon-Neutral Future 

If done thoughtfully, the next administration should seek to position the country for a carbon-neutral future utilizing American energy resources in a transition period while taking advantage of the current energy infrastructure as well as newly formed capital now available in the ESG and green energy sectors.  

However, it’s possible that zealotry could outweigh pragmatism.  In this case, we could see massive spending without objective or oversight.  There could be a lot of throwing money around to any given green initiative.  Longer term, the massive gap between intentions and reality could even widen.  

The path toward a truly carbon free energy future presents incredible challenges and is not clear cut, and many people and institutions are grappling with what exactly that will look like.

 

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