Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No. Market forces and technological innovation have been far more impactful on the energy sector than environmental regulations. Investors should maintain exposure to private energy and publicly listed energy equities, rather than view this event as a reason to overweight energy exposure.
The Paris climate agreement was nonbinding, and, by itself, did very little to regulate the energy sector. US state and local environmental and energy policies are generally considered more influential than federal regulations. Withdrawing from the Paris agreement will not block state- and local-level actions to reduce emissions and to deploy low-carbon technologies. Immediately after the announcement, three states—California, New York, and Washington—formed the US Climate Alliance, a coalition for states committed to adhering to the restrictions on greenhouse gas emissions in the agreement and to serving as representatives for the country on the issue.
Pressured by the global supply glut in crude oil and natural gas, energy equities have fallen sharply in 2017. In fact, immediately after the US administration’s announcement on the Paris accord withdrawal, concerns about continuing production prompted a sell-off in energy equities and oil and natural gas commodity prices.
The outlook for US energy production will be determined more by market conditions (like oil & gas prices) than environmental regulations. Driven by lower input costs and unconventional drilling technology, US shale production has increasingly become a manufacturing process. Improvements in well development technology have enabled US producers to make profits at much lower oil prices.
The withdrawal from the Paris accord is highly unlikely to revive the thermal coal industry. In fact, in the immediate aftermath of the announcement, coal stocks sold off due to concerns that the exit could unleash a global backlash against coal interests outside the United States. Market forces, technological innovation, competition from cheap natural gas, and the EPA’s Mercury and Air Toxics Standards have pushed the US coal industry into decline. In most of the United States, generating electricity with coal is more expensive than with natural gas, solar, and wind.
Although government subsidies helped wind and solar gain an initial foothold in power markets, economies of scale and technological innovation drive their competitive economics today. In 2015, the addition of global renewable power generation capacity actually exceeded the capacity added by fossil fuels. In an increasing number of countries, unsubsidized wind and solar projects are outcompeting coal and natural gas. It is estimated that in more than 30 countries, wind and solar have already reached grid parity without subsidies, and the World Economic Forum estimates that about two-thirds of all countries should reach grid parity in the next couple of years. More specifically, they note the average levelized cost of electricity (LCOE) for coal has hovered around $100/MWh for over a decade, while the cost of solar has fallen over the last decade from about $600/MWh to around $100/MWh for utility scale photovoltaic (PV). Wind LCOE is about $50/MWh. By 2020, solar PV is projected to have a lower LCOE than coal or natural gas–fired generation throughout the world.
Ultimately, we expect the withdrawal from the Paris accord to contribute to continued volatility in the energy sector. First, leaving the Paris agreement has increased market uncertainty, and companies may be reluctant to invest in expensive projects like nuclear power plants without some assurance that future policies will remain consistent.
Second, and longer term, the absence of consistent and clear policy signals from the US government to investors will hurt the fossil fuel industry. If fossil fuel consumption remains high in the near term, governments may eventually seek to address climate change through sudden and sharp measures. The new policy direction would likely increase the probability of large-scale stranded assets and severely damage the oil & gas industry.
This lack of policy is likely the reason that many companies, including major integrated oil & gas companies, asked the United States to stay in the Paris accord. As ExxonMobil CEO Darren Woods recently stated, the industry “need[s] a framework like that to address the challenge of climate change and the risk of climate change.”
For all these reasons, we don’t believe the withdrawal from the Paris agreement boosts the prospects for traditional energy investments, and advise investors to simply maintain exposure to private energy and publicly listed energy equities, rather than view the withdrawal as a reason to increase energy exposure.
Originally published on June 6, 2017
Robert Lang is a Managing Director in Cambridge Associates’ Real Assets Investment Group.
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