Authors
Authors
<a rel="noopener noreferrer" href="https://www.eurasiagroup.net/people/ralkadiri" target="_blank" title="Raad Alkadiri
Eurasia Group">Raad Alkadiri
Eurasia Group</a>
Read time: 6 minutes
Geopolitics have always mattered when it comes to energy. No commodity as central to the economic wellbeing of countries can ever be divorced from the tides of political events. But, with the Russian invasion of Ukraine, geopolitical factors are shaping energy flows and investment more directly than they have done for some time, cementing new trading patterns and redefining energy security concerns. In a world already undergoing seismic change because of climate concerns, the ripple effects will be material.
Geopolitics’ impact
The invasion of Ukraine is a watershed event that is destined to mark the beginning of a new era of global politics: a post-post-Cold War. The first major land war in Europe since 1945 has revived a Western security alliance that had decayed as it searched for relevance after the fall of the Soviet Union; heightened concerns about the political and economic vulnerabilities of globalized supply chains; and accelerated the regionalization of the global order as U.S.-China divisions have widened.
In the energy sector, it has prompted greater political intervention into how and where hydrocarbons are bought and sold, and at what price. Sanctions, curtailments, G7 price caps and the notion of “good” and “bad” barrels and molecules (based on the political orientation of the producer) all mean that politics, rather than markets, are increasingly determining the flow of oil and gas. That Russian Urals-grade crude, shipped from Baltic and Black Sea ports, is overwhelmingly heading to markets in Asia at heavily discounted prices is not the market at work; it is the result of overt political decisions. LNG flows into Europe are guided by a similar logic. With no immediate end to the Russo-Ukrainian War in sight, this erosion of market pressures is likely to persist, and the traditional stickiness of energy markets means that the new flow patterns will become increasingly cemented.
A muddled world
Greater political intervention is also clouding investment signals in an energy sector already ruffled by the challenges of energy transitions. Uncertainty over energy transition policy, over shareholder and stakeholder sentiment, and over the cost and availability of capital were already muddying the long-term investment picture for hydrocarbons and renewables alike. Now investors face heightened political uncertainty as well.
At the heart of the challenge is governments’ prioritization of energy security since the Russian invasion and – more importantly – the fact that the term is defined differently by different states and regions. To Europe, energy security is now about sustainability of supply, as decarbonization has become synonymous with self-sufficiency, with the shift to renewables easing the continent’s dependence on hydrocarbon imports. To the United States, the phrase is about ensuring low-cost energy supplies, whatever their nature. For India and China, the concept is defined differently still, in terms of reliability as well as cost.
These distinctions foster a “catch-is-as-catch-can” approach to energy security. Moreover, they make multilateral coordination on long-term energy and climate policy – already an onerous task given the economic, social and political disparities between the industrialized world and the global majority of developing states – virtually impossible. What remains is a patchwork global investment environment that is deterring energy companies both from making much-needed investments into the hydrocarbons needed to at least moderate the disruptions of energy transitions, and from investing sufficiently into renewables and new energy systems that will ensure that long-term climate and emissions goals are met.
Green protectionism on the rise
Adding to the complications for investors is the parallel shift toward greater industrial protectionism, which is driven in part by growing geopolitical competition between the United States and China. The U.S. Inflation Reduction Act of 2022, which included over $360 billion of financial support for energy transitions, represented a belated acknowledgment by Washington of two things that China and the EU realized long ago: Green investment can deliver economic and industrial growth, and state-directed energy policy is beneficial.
It is too early to tell whether the hype about a green-technology “arms race” has begun. Nevertheless, green investment is increasingly seen across the world as a means of improving national economic security by reviving and expanding domestic industry, creating jobs and boosting economic growth. The challenge for investors is whether the protectionism that is increasingly accompanying these policies will create more options (and clarity) for capital allocation or fewer. A world of rival markets with competing trade and investment rules will increase the costs of doing business and undermine the benefits of economies of scale. As is increasingly becoming the case with the United States and China, it will also force companies to choose where to invest based on geopolitics not returns, meaning that capital will be allocated less efficiently.
ESG on the rise
How investors respond may ultimately come down to how the financial sector sets the terms for the cost and availability of capital as energy transitions unfold. In the absence of common global rules, and with governments and corporations worldwide still largely reluctant to set the agenda for climate regulations and policy, no other sector can fill the gap. And in doing so, the financial sector will increasingly be driven by the environmental, social and governance (ESG) concerns of its own shareholders and of the stakeholders it serves.
ESG may have become part of the cultural wars that are polarizing U.S. domestic politics, but in essence it is an acknowledgement of a growing set of risk factors in a world that is being transformed by fundamental changes in climate and information. It is not just the transition and physical risk to investment associated with climate change and related policy; it is the reputational risk as a much wider set of stakeholders have access to a much larger set of information. This “risk squared” is not something any responsible investor can ignore, irrespective of the jeremiads of politicians. Indeed, as the definition of ESG broadens further, to include biodiversity impact as well, ESG is likely to guide investors more rather than less.
No love for hydrocarbons
What of hydrocarbons in this context? Similarities to the fate of big tobacco are overdone. Smoking does not fuel economic growth, but oil and gas do. Moreover, in the absence of sufficient ready alternatives to fill the energy gap, the choice will remain between using hydrocarbons and enduring economic hardship. The world’s reaction since the beginning of the Ukraine war has illustrated very clearly which option governments will choose.
However, the reputational risk associated with the sector will continue to grow as the deleterious impacts of climate change rise, the medium-term emissions targets are missed, and technology solutions fall short of expectations. Much to the chagrin of producers, governments and companies, binary solutions to climate change will increasingly be put forward, and the economic necessity of hydrocarbons will increasingly be denied by vocal critics and policy-makers, especially in the industrialized world. In short, hydrocarbons will remain unpopular in many quarters, and the sector could increasingly be shut out of investment over the longer term, or at least forced to pay a premium for capital, even as it proves profitable and economically vital.
Authors
Authors
<a rel="noopener noreferrer" href="https://www.eurasiagroup.net/people/ralkadiri" target="_blank" title="Raad Alkadiri
Eurasia Group">Raad Alkadiri
Eurasia Group</a>