Think at London Business School
Wednesday 29 June 2022
Smoove CEO Jesper With-Fogstrup, EMBA2021, on leadership, fearless conversations and supporting more people to be out in business
By Laura Kennedy
Hélène Rey, Professor of Economics at London Business School and David Kotler, Chief Executive of Access Corporate Finance and an Executive Director of New Energy One Acquisition Corporation (NEOA), sat down to discuss our changing climate and the pressure on organisations to adapt and thrive. We captured some of their conversation.
David Kotler: As a banker, I’m looking at it from a money perspective and the figures coming out of the most reputable studies on this are just staggering. We’re looking to have to spend $130 trillion between now and 2050 to get to net zero. That translates to around $4.5 billion a year, every year, if we have any hope of capping global warming at 1.5 degrees.
Governments and the private sector are going to need to work hard to find the capital to affect the energy transition, and it’s not going to be easy. Take the European oil majors alone. The top five have a market capitalisation of more than $500 billion. That’s a huge amount of capital to have to transition.
Financial markets, businesses and policymakers are going to have to get very creative and think quite differently about how we finance this. Commercial banks in particular will need to be inventive if they’re going to be able to move their loan books away from traditional clients into new areas. We are seeing some traction in the insurance sector, where big players like AXA are no longer willing to lend money to oil and gas projects. But the challenge remains huge: how can the market deploy the vast amount of capital that we need to drive the energy transition.
Hélène Rey: From the macro-economic point of view, it’s just as daunting.
Covid-19 gave us a glimpse of what’s at stake. In 2020 global emissions dropped by 6% during lockdowns. But the trade-off for the global economy was devastating, with negative growth of -3.5% and even worse for advanced economies.
To reach our target of 1.5 degrees, we would need to reduce emissions by at least 6% every year between now and 2030. This is out of our reach, unless we radically change the structure of our economies. Doing this would entail huge investment, as David says, and entail knock-on effects for businesses and investors that are hard to predict.
The thing is: we really don’t have much choice. In terms of economic costs, climate change is another black swan, just like the crisis of 2008. Black swans are extremely costly and disruptive events, which are hard to predict. For climate change, some economists are speaking of a green swan. The difference is that we already know it is coming and we can already say that costs will be huge. There is therefore a real imperative to start defining the incentives, policies and business responses to meet this huge challenge now; and to focus resources on the technologies we need to drive the energy transition. Things look pretty bad for us if we don’t act immediately.
DK: As green technologies have evolved over the last few years, there’s been a concomitant drop in their costs. We’re also seeing tremendous improvements in energy efficiency across areas like solar energy and offshore wind turbines; especially as capital investment in these technologies has picked up. One of the most promising and exciting technologies under development right now is hydrogen, which has multiple applications in shipping and air travel and beyond.
That said, we still need to see more collaboration between governments and private sector financial institutions to really unlock the potential of green technologies. One good example of this is the original subsidy regime for offshore wind in the UK, which included a Government backed Green Investment Bank that helped to crowd in private capital. More of these kinds of mechanisms are needed around the world; particularly in hydrogen where we want to see production scaling up and costs coming down.
There is a cause for cautious optimism in the upswing in energy efficiency driven by technology. That and the increasing flow of venture capital and alternative forms of funding into new energy businesses, as investors around the world look for “the next Amazon” in renewables.
HR: In Europe there are also some encouraging initiatives recently. The Next Generation EU recovery package has a significant amount of money earmarked for green projects, and there’s a collective desire to bring together the right minds and resources to pull off the next break-through in this space.
The challenge we face here is two-fold: there’s a need to change production technology but at the same time, we need to drive scalability and global transferability. It’s not just about pushing the frontiers in science; it’s also about ensuring that other countries – emerging economies and less developed ones in particular – can also benefit from green innovation. We need to see greater diffusion of new technologies all over the globe.
We also need to replace our legacy energy production – the so-called brown technologies. And the solution here is probably a price system or carbon tax. In the EU this is starting to happen, with the price of carbon rising recently to 60 Euros per ton. China has introduced a similar emission trading system, though prices remain low there with surging demand for energy. Nonetheless, increasing the cost of carbon systematically and predictably should have the effect of incentivising investment in renewables, as brown technologies provide lower and lower returns over time.
DK: I agree that rewards and penalties are a great means of incentivising behaviours. Though, the problem with the penalty is that you need governments to align and have a unified approach. Otherwise, you have the risk of organisations moving operations to lower carbon tax areas, creating market distortions and effectively slowing the transition.
HR: Yes, any differentiation in prices opens the door to carbon leakages and the delocalisation of production – a kind of brown dumping. Carbon adjustment mechanisms are needed at borders to ensure a level playing field. And we need everyone to be on board. Whatever policies and practices we enact in Europe, we still only account for 8% of all global emissions. We need everyone to pull their weight because frankly, we’re all in this together.
We need to find the mechanisms – carbon offset trading markets for instance – that will help create and sustain a truly globalised strategy.
DK: Well recently, we’re seeing the cost of debt increase and the knock-on effect of financial institutions making borrowing more expensive and less available to the big oil and gas companies, as the cost of capital has increased.
Traditionally big oil and gas producers would borrow to invest in new plants that have a lifespan of 30 to 40 years. With the cost of debt on the rise, banks have more doubts about these kinds of long-term commitments. And if you add in the increasing ubiquity of carbon tax and rising carbon costs, they become less and less attractive. The world is starting to change for these brown technology companies, and quite dramatically.
HR: Oil and gas plants are assets, and in today’s economic climate, assets face two types of risk. First, there’s the physical risk, much of it associated with climate change itself: things like drought or flooding. Then there’s the transition risk associated with the price of capital increasing, as well as the take-off in carbon tax, as David says. These risks have enormous implications for the value of assets like oil and gas plants. And banks are increasingly sensitive to their exposure, not only to these risks, but to correlated and interconnected risks in the insurance sector who have to underwrite these assets. Financial institutions, be they banks or insurers, have to grapple with a lot of complexity with these brown companies. And there’s often a dearth of really solid, granular data surrounding plants: where are they located exactly? We do not know enough about the physical risks they face.
Banks have real and justified concerns around the lack of mandatory disclosure too. There is no real transparency or standardization when it comes to companies having to disclose information about their CO2 emissions for instance.
DK: This is an area where the market is nonetheless driving some innovation. We’re beginning to see more and more third-party certification groups that can issue a rating for green-house gas emission – a kind of Standard & Poor set up in carbon footprints. Increasingly, commercial banks and other lenders are demanding to see a full audit of emissions before they approve credit. These benchmarks are moving more, as lenders are also open to public scrutiny and criticism: they don’t want to be seen as lending money to unscrupulous or polluting organisations.
Clearly, there are encouraging signs in the market. Although the challenges ahead remain enormous and there is a long way still to go.
HR: Yes, the window for action is more or less now. Our efforts to slow climate change need to happen as quickly as possible to ensure our goals are realistic or even remote possibilities.
DK: I think companies are going to have to make a decision about whether they will continue to support fossil fuels in the longer term without a concrete plan. My feeling is that organisations are going to be obliged to make a real plan about energy transition; and those that fail to come up with a convincing plan will be penalized in the minds of investors. I think the financial markets provide a market mechanism to penalize, and reward those who take the right decisions.
HR: The way the macroeconomic context is moving, it’s no longer an option to remain static in the corporate world. Relative prices are going to be changing. Climate change is advancing and technology is advancing to keep pace.
To stay ahead, you need to be thinking ahead and factoring in things like the rising price of carbon, new technologies changing the energy scene, and new incoming regulations that are hard to predict. The status quo is no longer a choice.
Hélène Rey is Professor of Economics at London Business School and an expert on the macro-economic dimensions of the transition to net zero carbon dioxide emissions by 2050. David Kotler (MBA 89) is the Chief Executive of Access Corporate Finance and an Executive Director of New Energy One Acquisition Corporation plc (NEOA), an energy transition vehicle which he co-sponsored and which raised £175mm on the LSE in March 2022. He has more than three decades’ experience in the energy and natural resource industries; the most recent of which have focused on renewable energies and the energy transition.
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