“A forecast is a prediction; we are saying what we think will happen. A stage is different. . . is generally looking much further ahead and trying to build a picture of the future with extreme uncertainty.” — Seb Henbest
It is impossible to predict the future without some level of uncertainty. When we make investment decisions on assets with multi-decade horizons, our forecasts will eventually break down. But while we don’t know what the 2050s will bring, we can imagine pathways that provide reasonable variations of what that future might look like. For investment managers, prioritizing one scenario over all others can have far-reaching consequences.
This is especially true when it comes to the net zero energy transition.
There are multiple equally valid paths through the transition, all with different technology mixes and varying time horizons. Therefore, a simple discounting of cash flows in a somewhat predictable “economic” scenario, with rational actors reacting to techno-economic considerations and the policies likely to be enacted, is not necessarily viable. Energy investors need to consider multiple outcomes because the outcomes are, well, very diverse.
Research providers, think tanks, sell-side analysts and industry groups compete for investors’ attention. Their goal is to win our business or influence our decision-making. Your base case often depends on your background.
Those with a background in oil price assessment or renewable energy modeling might be prone to availability or anchoring bias. Many large energy players with high exposure to an abrupt net-zero transition construct their own scenarios, often driven by their own agendas. Gas transmission system operators (TSOs) and their industry groups envision a bright future for their stakeholders, whether through the continued use of natural gas or rapid shifts to hydrogen. For example, Shell’s “Energy Transformation Scenarios” – Sky 1.5, Waves and Islands – attracted a lot of attention: its Sky 1.5 route assumes a larger role for oil and gas than forecasts issued by the Intergovernmental Panel on Climate Change (IPCC) and other such bodies. There is also much talk about how hydrogen will fit into the energy mix of a climate-neutral Germany, but there is no consensus on what role it will play or where it will come from.
Given the abundance of organizations promoting their own scenarios, investors should approach them with caution. We recommend a three-step evaluation process:
- Apply some filters and remove the obviously conflicting predictors.
- Review the target forecaster scenarios and decide which ones are most applicable to your investment philosophies.
- Consider the performance of the investment objective and how plausible paths might diverge from its assumed base case, which is often the “economic” scenario. This is where a careful assessment of environmental, social and governance (ESG) factors and the resulting risks can help assess how the future may deviate from the intended path.
There are other things to consider. Social factors can drive higher emissions scenarios. Rising energy costs could affect spending on heating, transport and food. By increasing the cost burden on the low- and middle-income population, this “green inflation” could lead to widespread political and social unrest. Policy makers could be pressured to subsidize the consumption of fossil fuels. This has already happened in Latin America, Africa and Southeast Asia and constitutes a potential headwind that could delay our eventual exit from fossil fuels.
Of course, the tailwinds that pull us away from traditional fuel sources can be even more powerful. Shock events have strained supply chains and volatile fuel prices fuel calls for a renewable path to energy independence. Climate change-related risks are top of mind for much of the population, and as climate-related crises grow ever more serious, popular support for sustainability should be translated into public policy that help propel the world towards a net zero scenario by 2050.
In addition to political developments, transformative technological innovations are also possible. In fact, small modular nuclear reactors may be deployed faster than expected or electrolysis hydrogen costs could fall below $2 per kilo sooner than expected.
Choosing our path
Some investors may be tempted to allocate based on their economic case and not assume any significant technological or political change. But they need to consider the possibility that these investments could get stuck and prepare accordingly, to take the hit or extract enough value in advance.
Alternatively, some investments may transition. Carbon assets have transition potential, provided they have a future in a hydrogen-based fuel scenario or can be adapted for carbon capture and storage (CCS). Both paths could contribute to reaching net zero by 2050. But will they? We do not know. There is too much uncertainty about the ultimate cost and effectiveness of transitioning these assets, especially when they could be displaced by lower-cost technology.
The more prudent approach, then, may be to focus on assets without regret. They are likely to work on all the most viable pathways of the energy transition: more renewable energy, more short- and long-term storage, a stronger grid, heat pumps and district heating should be central to a carbon-free future.
When faced with such critical decisions, we must explore scenarios beyond our economic base case. We cannot assume rationality among all actors: the transition to net zero will not be easy. There will be periods of slow progress, potentially followed by abrupt changes in the face of extreme weather events, technological advances, political upheaval, pandemics, or other developments.
It is important to plan for the future, so we must be smart, careful and deliberate about which future we choose.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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