“A forecast is a prediction; We say what we think will happen. One scenario is different. . . It generally looks much further into the future and tries to create a picture of the future in extreme uncertainty.” — Seb Henbest
It is not possible to predict the long run without some extent of uncertainty. If we make investment decisions for assets with an investment horizon of several a long time, our forecasts will ultimately fail. Although we do not know what the 2050s will bring, we are able to imagine paths that supply reasonable variations of what that future might appear like. For investment managers, prioritizing one scenario over all others can have far-reaching consequences.
This is especially true in the case of the net-zero energy transition.
There are multiple, equally valid paths through the transition, all with different technology mixes and different time horizons. Therefore, easy discounting of money flows will not be necessarily practical in a fairly predictable “economic” scenario – wherein rational actors reply to techno-economic considerations and the actions more likely to be implemented. Energy investors need to contemplate different outcomes because outcomes vary a lot.
Research providers, think tanks, sell-side analysts and industry groups are all competing for investor attention. Their goal is to either win our business or influence our decision making. Their base case often relies on their background.
Those with experience in oil price valuation or renewable energy modeling could also be prone to availability or anchoring bias. Many large energy firms which might be heavily affected by an abrupt net-zero transition are constructing their very own scenarios, often based on their very own ideas. Gas transmission system operators (TSOs) and their industry groups envision a brilliant future for his or her stakeholders, whether through expanded use of natural gas or rapid transition to hydrogen. For example, Shell’s “Energy Transformation Scenarios” – Sky 1.5, waves and islands – attracted widespread attention: Its Sky 1.5 path looms larger for oil and gas than forecasts by the Intergovernmental Panel on Climate Change (IPCC) and other similar bodies. How hydrogen matches into the energy mixture of a climate-neutral Germany can also be widely discussed, but there isn’t a consensus on what role it’ll play or where it needs to be sourced from.
Given the plethora of organizations promoting their very own scenarios, investors must approach them with caution. We recommend a three-step evaluation process:
- Apply some filters and filter out obviously contradictory forecasters.
- Review the goal forecasters’ scenarios and choose which of them work best in your investment philosophy.
- Consider the performance of the investment objective and the way plausible paths might deviate from their assumed base case, which is commonly the “economic” scenario. Here, a careful assessment of environmental, social and governance (ESG) aspects and the resulting risks may help assess how the long run might deviate from the expected path.
There are other things you must consider. Social aspects can result in higher emissions scenarios. Rising energy costs could affect spending on heating, transport and food. By increasing the price burden on low- to middle-income populations, such “greenflation” could lead on to widespread political and social unrest. Policymakers could possibly be pressured to subsidize fossil fuel consumption. This has already happened in Latin America, Africa and Southeast Asia and represents a possible headwind that would delay our eventual phase-out of fossil fuels.
Of course, the tailwinds pushing us away from traditional fuel sources could possibly be even stronger. Shock events have strained supply chains and fluctuating fuel prices are fueling calls for a renewable path to energy independence. The risks related to climate change are top of mind for much of the population, and as climate-related crises worsen, popular support for sustainability needs to be reflected in public policies that help move the world towards net zero. Scenarios as much as 2050.
In addition to political developments, transformative technological innovations are also possible. In fact, small modular nuclear reactors could turn into operational prior to expected, or the price of hydrogen from electrolysis could fall below $2 per kilogram prior to expected.
We select our path
Some investors could also be tempted to allocate based on their economic case and assume there aren’t any significant technological or political changes. However, you could consider the likelihood that these investments could fail and prepare accordingly – either to endure the damage or to generate sufficient value prematurely.
Alternatively, some investments may transition on their very own. Carbon plants have transition potential in the event that they have a future in a hydrogen-based fuel scenario or will be retrofitted for carbon capture and storage (CCS). Both paths could help achieve net zero by 2050. But will they do this? We don’t comprehend it. There is simply too much uncertainty concerning the ultimate cost and effectiveness of transitioning such assets, particularly in the event that they could possibly be replaced by lower-cost technologies.
The most prudent approach might subsequently be to give attention to assets that you would be able to’t afford to regret. These are more likely to work across all of essentially the most sensible paths to the energy transition: more renewable energy, more short- and long-term storage, a stronger grid, heat pumps and district heating should all be central to a carbon-free future.
When faced with such critical decisions, we’d like to explore scenarios that transcend our baseline economic scenario. We cannot assume rationality amongst all actors: the transition to net zero is not going to be smooth. There can be periods of slow progress, which could also be followed by abrupt changes resulting from extreme weather events, technological advances, political unrest, pandemics or other developments.
It is essential to plan for the long run, so we should be smart, careful and thoughtful about what future we decide.
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