Stranded-cost risks to address on road to net-zero

Emily Wu-Associate partner Bain & Company (Jakarta) (left), Grant Dougans-Partner Bain & Company (Washington)

Until fairly recently, energy companies and their investors could assume that their fossil-fuel assets – such as power plants, refineries, oil wells, and pipelines – would operate for as long as possible, serving steadily rising demand.

But this is no more. The energy transition is bringing broad changes in the amounts and types of energy that homes and businesses use. As energy companies make commitments to reach net zero in the years ahead, power generation will shift from fossil fuels to more electrification and energy from renewables. Some existing energy infrastructure may have to shut down sooner than expected, leaving companies and investors to manage the risks and costs of stranded assets.

This is no small change, but rather a major disruption in the way that energy companies have allocated capital. It comes in the midst of a larger conversation about the role of fossil fuels: whether they are vital to prosperity or unacceptable given climate change.

While that debate continues, energy executives need to keep making decisions about when and how to invest in the energy assets that are keeping economies running. And while the uncertainty around the long-term future of fossil fuels is only likely to increase, there are things that energy executives can begin to do today to make investment decisions more confidently.

l Build shorter-term projects. Deploy capital in chunks rather than everything upfront, and adopt shorter depreciation schedules. Where possible, companies should design assets in ways that anticipate their conversion to lower carbon use, such as gas-powered generating stations that can be converted to run on hydrogen.

Companies should also look for ways to accelerate returns on investments – for example, selling electricity or natural gas in a mix of long-term guaranteed contracts and some spot sales based on market movements.

l Quantify the “uninvestable” moment. Determine how much value the asset will create, how long it needs to operate to deliver the required returns, and what its real option value might be in stranding scenarios. This helps executives decide when it makes sense to continue investing.

For example, a natural gas power plant designed to run for 30 years would probably not be worth building if it seemed likely to be stranded after only 15 years. The owners would have to write off too much of its value. However, it could be a promising investment if the plant can be converted to a low-carbon use and the life could be extended to 25 years since it would be more likely to deliver the return on equity that investors expected.

l Consider an evolving portfolio. For most companies, managing the risk of any individual asset is part of a broader strategy to evolve the business via the energy transition, while maintaining a compelling proposition for investors.

Executives will need a clear strategy for navigating their transformation and will need to allocate capital in ways that support the strategy, including consideration of carbon and environmental, social, and corporate governance (ESG) project risks, shorter payback periods, lower cost-of-capital assumptions, and ongoing reviews of performance.

In addition, energy companies will need to pay particular attention to both “green capital” and “grey capital” investors. Green capital investors look to management for signals that the company is serious about the energy transition, even if they continue to make some investments in fossil-fuel assets that may become stranded.

Grey capital investors are more comfortable taking risks on fossil-fuel assets. This capital could become an important source of potential value when considering the value of fossil-fuel infrastructure since they are purchasing some fossil-fuel assets that public companies want to shed.

All investors, whether grey, green, or somewhere in between, will pay more attention to ESG metrics and rely on data to identify companies that are best situated to generate returns from the energy transition. Scrutiny on management teams is sure to increase, particularly on their decisions about investing in assets with a risk of stranding.

This is a relatively new issue, but one that management teams at energy companies will have to contend with for the rest of their careers. Developing the skills to make these assessments and the flexibility to adapt based on shifts in policy, investor sentiment, or other conditions will be critical for success.