Five energy transition trends to watch in 2022

2021 was an unprecedented year in energy markets and climate policy. As we head into 2022, we have compiled five energy transition trends to watch this year. You are probably drowning in 2022 predictions, so we will keep these insights brief. These topics are based on our current areas of focus - electricity generation and heavy industry - and also reflect some of our outputs in 2022.

1. Keep calm and carry on: Energy crisis could be a multi-year event without policy reform

Markets had their first supply scare of the energy transition era in 2021. Economic growth coupled with supply shortages resulted in EU coal, gas, power, and carbon prices rising 126%, 442%, 341%, and 238%, respectively, in 2021¹. EU gas prices dropped precipitously late last year, due to a jump in LNG deliveries from US producers looking to arbitrage Henry Hub and TTF.

With EU gas inventories low, Russian gas flows weak, cold weather on the horizon, and signs of LNG buying interest from Asia, these price declines are likely to be short-lived. High gas prices have two major implications for EU policymakers: inflated electricity prices and gas-to-coal switching.

Contrary to popular opinion, we are cautiously optimistic the energy crisis will help engender policy reform to reduce the bloc’s reliance on costly gas imports. Governments who fail to ensure a secure, affordable, and fair energy transition are in for a rude awakening.

We intend to publish an analysis showing how EU policymakers can unleash a dash for zero-carbon capacity by tackling non-price barriers.

2. Stuck in the middle with EU: Price formation in the EU ETS could exacerbate CBAM politics

In trading systems with an emissions cap like the EU ETS, the fair value of carbon is a function of the highest cost of abatement in the future, discounted back in real terms. The initial objective of the EU ETS was to increase the operating cost of coal to allow gas to occupy the front of the merit order. Most of the time coal generation is cheaper than gas. Since gas has a lower carbon intensity than coal if the carbon price gets high enough it can become more profitable to burn gas than coal. This level is termed the fuel switch price. The energy crisis has made coal-to-gas switching prohibitively expensive. Based on our analysis, the coal-to-gas switch price averaged €326/t across the bloc in December 2021².

Indeed, the delta between gas and coal prices may increase this year as Chinese production and import policies weigh on the seaborne coal market. If EU carbon prices remain stubbornly high, it could exacerbate the politics associated with the EU’s carbon border adjustment mechanism.

We plan to release a global asset-level steel production cost curve dataset to help decision-makers understand the implications of carbon pricing on non-EU facilities.

3. Beijing eases again: Economic policy easing to test China’s net-zero convictions

Due to a real estate slowdown, tech crackdown, and energy inflation, China is likely to refocus its economic policy on its 'six stabilities', which are stable employment, finance, trade, foreign investment, investment, and expectations. In short, this means China will ease economic policy to increase growth to acceptable levels. The debate is not whether China’s policymakers are easing but by how much. Loosening policy, via monetary policy, credit policy, fiscal policy, and real estate policy, will undoubtedly lead to another wave of investment projects, which have historically resulted in rising emissions from heavy industry and electricity generation. China's governance tends to be characterised by complex dynamics between the central government, state-owned enterprises (SOEs), and local governments.

If the central government is serious about its climate ambitions, it will need to avoid a recurring theme associated with China’s credit cycle: once the call goes out to local governments and SOEs to spend again, the urgency to spend typically results in limited conditionality. Failure to caveat spending to avoid coal plant investments will result in carbon lock-in and stranded assets.

For example, our previous analysis of new coal plants in Henan, Inner Mongolia, Jiangsu, and Shandong provinces found negative net present values from both a project and equity perspective. Moreover, none of the projects were able to service their debt requirements, yielding an insufficient internal rate of return.

4. Pay up to phase down: Finance to replace coal plants in the Global South takes tentative steps towards implementation

COP26 finally saw a genuine focus on replacing coal with zero-carbon alternatives. Based on our analysis, aligning global coal generation with a 1.5°C goal would require replacing nearly 3,000 coal units between now and 2030 with zero-carbon alternatives. Capital will only be scaled with climate finance and policy reform. This urgency has resulted in a number of initiatives to finance the replacement of coal plants, such as the Asian Development Bank’s energy transition mechanism (ETM). Despite the potential pitfalls - most notably making cash conditional on market reform - we believe this policy is necessary and should be implemented.

Transparency begets trust. Replacing coal needs to be informed by all stakeholders. This is unlikely to happen without transparency around economic, financial, environmental, and just transition drivers. In an effort to support the transition away from coal, we are planning to release a Coal Asset Transition (CAT) tool. CAT provides asset-level economic, financial, and environmental information to support high-level screening of coal power plants to be replaced with zero-carbon alternatives.

5. Sustainability-linked bonds boom as greenwashing looms

According to some estimates, sustainability-linked bonds (SLBs) are expected to double in issuance volume in 2022. SLBs are any kind of forward-looking performance-based bond instrument for which the financial characteristics can vary depending on whether the issuer achieves predefined objectives. These objectives are expressed as predefined Key Performance Indicators (KPIs) and Sustainability Performance Targets (SPTs).

While moving companies in the right direction, KPIs are often easily achieved and do not necessitate the changes required to align investment decisions with a 1.5°C outcome. Verification of these objectives takes the form of monitoring and reporting, performed by an independent third-party with relevant expertise and credentials. Verification increases the credibility of the bond by providing assurance on the meeting of the KPIs but is frequently performed by companies that do not have a sufficient understanding of the industry or the specific KPIs being undertaken.

To improve transparency and accountability around KPIs and SPTs, we believe verification should be made publicly available. We also believe that more aggressive KPIs and SPTs should be tied to these bonds, and factored into the pricing and the step-up mechanisms of the bond structure. We are uniquely positioned to understand and analyse steel companies, both from an emissions and cost perspective, that want to take advantage of this market. We intend to provide insight into the pricing and verification of these bonds to mitigate greenwashing and help provide sustainable capital allocation.

Put the zero back in net-zero

In 2021 the world was inundated with big net-zero promises from governments and corporations. COP26 underscored the need for policies to implement these promises. We look forward to working with decision-makers in 2022 to manage the decline of fossil fuels and support the shift to zero-carbon alternatives.

Notes:

1. Based on spot API, TTF, CAL and EUA prices from the start of January to the end of December 2021.

2. Based on a facility-level weighted average across the following countries: Czech Republic, Germany, Denmark, Spain, Finland, France, UK, Greece, Hungary, Ireland, Italy, Netherlands, Poland, Portugal, Romania, Slovakia and Slovenia. For more information on the assumptions used see here.