Energy Transition Public Equity & Debt: Joining ’Em

Presented by:

The energy transition is gaining momentum from a global push to achieve Paris Accord goals, and investors’ ESG sensibilities are pressuring traditional energy companies to decarbonize.

That doesn’t mean fossil fuels will go the way of the dinosaur. In fact, many of the industry’s top analysts and investors say oil and gas can coexist with renewables.

Indeed, if the stars align, traditional energy companies may not only become cleaner firms, they could also find new streams of revenue in the process.

But first, energy companies of all stripes need cash.

“One out of every three professionally managed investment dollars in the United States is in an ESG fund. That’s $16 trillion debt plus equity.” —Pavel Molchanov, Raymond James

An infusion of investment worth trillions of dollars is critical to investors’ apparent mandate that oil and gas companies work to cap global warming at less than 2 C relative to pre-industrial temperatures.

And bankers say the money will flow to those companies willing to evolve.

“One out of every three professionally managed investment dollars in the United States is in an ESG fund. That’s $16 trillion debt plus equity,” said Raymond James senior vice president and energy analyst Pavel Molchanov.

The figure was about half that four years ago, Molchanov added in Hart Energy’s Energy Transition Capital Conference.

“It’s not a matter of whether there was a Democrat in the White House or oil prices were high. It has nothing to do with any of that. It’s just a secular trend that there’s more money flowing into ESG funds,” he said.

“And believe me, you do not want to be on the wrong side of ESG funds.”

$7 trillion every year

Meeting the Paris Accord’s greater goal of capping at 1.5 C by 2050 requires massive change in the capital base, said Kassia Yanosek, a partner at McKinsey & Co.

She leads the firm’s practice that helps oil and gas clients develop viable decarbonization strategies. Yanosek led a billion-dollar private equity fund focused on solar and wind. At the time, more than 70% of the returns were generated from public support.

“Today, we’re in a much different space with costs having come down,” she said.

“Meeting the Paris Accord’s greater goal of capping at 1.5 C by 2050 requires massive change in the capital base.” —Kassia Yanosek, McKinsey & Co.

More than 70% of current oil and gas demand will be replaced by renewables, she added. To make that a reality, investment on the order of $225 trillion is required, she said. That’s about $7 trillion every year between now and 2050.

Companies are taking a variety of different strategies. ConocoPhillips Co. is doubling down on low-cost, low-carbon intensity oil and gas. And it is being rewarded by the market for taking that strategy.

While it has been making significant growth purchases—acquiring Concho Resources Inc. in early 2021 and, more recently, Royal Dutch Shell Plc’s assets in the Permian Basin—the net effect is lower cost supply and lower carbon intensity, she said.

Meanwhile, BP Plc and Shell are transitioning their portfolios via select divestment and nonoperated joint ventures.

And Occidental Petroleum Corp. is focused on a wholesale change in its business model. In effect, it is betting on its prowess in carbon capture utilization and sequestration (CCUS) to become the carbon management business of the future, she said.

“It starts with their competitive advantages and creating a business around that,” Yanosek said.

‘Win the game’

Molchanov listed myriad options that oil and gas companies can tap to gain ESG fund appeal. Some firms diversify their revenue sources beyond oil and gas by investing in solar and wind farms, building electric vehicle charging infrastructure, constructing hydrogen plants, investing directly in clean energy startups or simply tweaking legacy oil and gas operations to operate more cleanly.

And in the case of CCUS, companies such as Occidental, Denbury Inc. and Talos Energy Inc. are finding ways to make money by selling the carbon or storing it for other industries.

“You do not have to put your head into your hands and cry because ESG funds don’t like you,” Molchanov said.

“As long as you don’t fight them—at least not too publicly—and you have a coherent decarbonization strategy for your business … you’re going to win the game.”

Capital providers, both public and private, are seizing the opportunity to finance decarbonization strategies, both within and beyond the fossil fuels industries.

But within the $16 trillion number, Molchanov noted, the biggest chunk of roughly $4 trillion is invested in climate funds devoted to reducing the risk of climate change and avoiding transactions that make it worse.

“Does that mean they will never own an oil and gas stock? No,” he said, adding that oil and gas companies have opportunities to benefit their own bottom lines when they work with climate-minded investors instead of against them.

“In general, it would be a moot point to fight this megatrend,” Molchanov said.

20% of U.S. GDP

Traditional energy clients need the assistance of finance experts to navigate the energy transition, said RBC Capital Markets managing director Nick Woodruff. About a third of his time is in helping them swim in a stream awash with ideas that run the gamut of clean technologies; wind, solar, biodiesel, renewables and even lithium projects are on the table.

“The global footprint on decarbonization is not going anywhere.” —Nick Woodruff, RBC Capital Markets

About $3 billion was invested in carbon capture in 2021, which is triple the amount that was invested in 2020, Woodruff said.

He estimates another $1 trillion in private money, in addition to government credits, is needed for carbon capture’s full contribution to meeting the Paris Accord. All told, it would be $5 trillion for carbon capture.

“That’s 20% of the U.S. GDP that needs to get invested in carbon capture,” he said. “One thing that needs to really accelerate is subsidies and credits.

“A lot of the economics alone right now are not standalone strong enough to get projects off.”

ESG-focused exchange-traded funds are outperforming the broader S&P 500, and cash invested in solar is expected to double capacity through 2030, he said. Battery storage, CCUS and other strategies are important parts of Woodruff’s discussions with oil and gas clients.

“The global footprint on decarbonization is not going anywhere,” he said, noting that 75 countries (as of mid-October 2021) have announced zero-carbon ambitions, and others were expected to follow.

‘No decoupling’

If the options seem endless, so are the questions of how to finance them. Some industry players and companies with first-mover advantages are effusive about technologies such as CCUS. But much of CCUS’ success can depend on federal 45Q tax credits.

“We don’t know how well that is going to evolve,” said Andrew Chen, CIT Group Inc. managing director.

Similarly, biodiesel is generating excitement among his clients, but Chen said RIN credits in renewable fuels are important in that mix too. “We don’t know how that’s going to interplay,” he said.

Still, lending portfolios that were once weighted 80% toward oil and gas are flipping. Especially on the lending side, many banks are evolving into ESG roles.

Still, Chen said, bankers cannot dismiss oil and gas completely. “Renewables are going to be complementary to oil and gas,” he said. “There’s no decoupling the two.”

Senior secured debt

Debt markets have seen funding from government policy, credit subsidies and private investment. But the broader market dictates the terms, Chen said.

“Renewables are going to be complementary to oil and gas. There’s no decoupling the two.” —Andrew Chen, CIT Group Inc.

For example, early wind projects were generally financed by production tax credits. Without that assistance, the massive buildout of wind capacity, especially in Texas, likely would not have happened, he said.

Now that the wind projects are more mature, solar technology is growing in appeal. “But we’re also seeing that, without the tax equity markets interplaying with the debt markets, that also would have never come to fruition,” he said.

Essentially, government policy and credit assistance are critical to early stage technology development.

“If that goes forward, then we’ll see a lot more of these projects getting financed.”

Moreover, mature technology is more likely to appeal to lenders, Chen said. Without tax equity, senior secured debt is hard to access. But debt markets are evolving, and lenders want to use creative but stable methods of financing new and important technology.

“Banks are like big elephants,” he said. “They follow each other into the space.”

CIT was among the first to finance solar, but that worked only when there were accompanying power purchase agreements.

Banks look at “the downside risk. Equity always looks at the upside risk,” he said. These counterbalances are “always key to getting a lot of these projects financed.”