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Paris climate deal highlights long-term risk for oil and gas

COP21 served as a reminder that the energy paradigm is changing, and fossil fuel producers would be wise to stay ahead of the curve

December's United Nations climate summit surprised even the most ardent environmentalists by producing an accord that binds all nations in an effort to keep global temperature increases to less than 1.5 degrees Celsius above pre-industrial levels.

The unexpectedly ambitious goal - nations had been expected to agree an upper limit of two degrees - highlights the long-term vulnerability of fossil fuels in the world's energy supply, and drives a wedge between oil and gas industries, which believe they can fulfil a role well into the second half of the century, and the coal sector, whose medium-term future as a large-scale energy source has already been called into question.

Oil and natural gas producers are unlikely to feel a short-term impact from the UN accord, as transportation and power generation are sectors with much growth still to come. However, they need to be aware of the groundswell of activism that is reaching critical mass and is now starting to affect investment decisions at all levels of the economy, from university endowments and pension funds to multilateral development banks.

The implication of the decisions in Paris, that emissions must decrease significantly and quickly, is not new. It could be argued that the 196-nation accord merely sets a political seal of approval on actions that are already being taken at national level. Climate pledges to the UN before the talks by nations such as the US, the European Union and China encompass political decisions already being implemented.

However, in order to keep global warming in check, the agreement sets a specific and very ambitious goal of achieving "net carbon neutrality", in which the carbon emissions produced by human activity are cut to the point where they are matched by the earth's ability to absorb them by the second half of this century. Human activity currently creates almost twice as many greenhouse-gas emissions as can be absorbed by carbon sinks such as forests.

All this points to a gradual decarbonisation of the global economy that will inevitably affect the oil and gas industries, and the current experience of the coal sector may provide an object lesson in what to expect.

Stranded assets

Coal is already feeling the pressure of increased climate ambition. The advent of a price on carbon emissions in Europe has helped make coal uncompetitive as a power generation fuel, to the extent that German utilities RWE and EON have hived off their coal-based power generation assets into separate companies.

In the US, the advent of cheap shale gas and the promise of tighter pollution regulation have had the same effect. Even China, the world's largest coal producer and consumer, announced in December it will not approve any new coal mines for the next three years. France's Total completed its exit from the coal sector last summer, with CEO Patrick Pouyanne pointing out that "We cannot claim to be providing solutions to climate change while continuing to produce or market coal, the fossil fuel that emits more greenhouse gas than any other."

More and more major international lenders are declining to finance new coal-fired power plants, investors of all kinds are shying away from coal assets, and the industry is the first to experience the phenomenon of stranded assets. Numerous mining companies in the US have declared bankruptcy as the cost of extracting the mineral is no longer covered by its price, while the industry in Poland, Europe's largest, is staggering under the weight of debt and low prices.

From a demand perspective, there's unlikely to be much impact in the short term on oil and natural gas markets, and in fact there may be some good news for gas producers.

The two main consumers of primary fossil energy are electricity generation and transport, and it's clear that cutting climate pollution from static sources such as power and industrial plants is a more attainable goal in the short term than is shifting the global transportation network away from fossil fuels. It's perhaps for this reason that the Paris agreement shied away from making any reference to the international aviation and maritime transport sectors.

Emissions-cutting efforts are focusing on the lowest-hanging fruit, which at this early stage is still coal-fired power. Wealthier economies are deploying large amounts of renewable energy generation, which will need to be backed up by the cleanest fossil-fuel plants available. The IEA estimates that two-thirds of all net new power capacity between now and 2020 will come from renewable sources.

Emerging economies like China and India will still power their economies mainly with coal for many years to come due to low operating costs, but they too are looking to develop cleaner alternatives and have announced ambitious building programs for wind and solar, as well as nuclear in China's case.

The advent of significant liquefied natural gas exports from producers such as the US and Australia may also eventually eat into coal's market in Asia, though the costs of logistics and infrastructure remain an obstacle. Relatively few countries in the region have built import terminals or distribution networks, and it may be some time before LNG can displace other more carbon-intensive fuels.

Reconsidering market structure

With the lifespan of a power plant ranging from 30 to 50 years depending on technology, we may now be entering the last decade in which new fossil-based power plants may be investable. After mid-century the vast majority of new capacity will have to be low- or zero-carbon if nations are to meet the UN's agreed goals and wide-scale use of natural gas together with carbon capture technology may be the next step for many countries.

Oil's outlook will depend largely on the pace of low- or zero-carbon innovation in transportation. With as much as 70% of each barrel of oil producing gasoline or diesel, policies affecting transport and fuels will be critically important.

At present there are few other sources that can offer the same energy content as gasoline or diesel at a competitive price. Compare this situation to electricity generation, where onshore wind and solar are often competitive with both coal and natural gas. Battery-electric vehicles, while offering substantial carbon reductions on the road, lack comparable performance and fuelling infrastructure and are still too expensive for the average motorist in a wealthy country, let alone an emerging economy.

Most forecasts agree that transportation emissions are likely to continue to grow well into the century, as more and more private cars join the road and demand for freight continues to swell. Oil could still be vulnerable to initiatives and policies that target consumption at sub-national level, and this was highlighted on the fringes of the Paris summit. Local governments, private sector actors and civil society groups are all working to develop low-carbon mass transit solutions that can avoid "locking-in" the emissions implicit in growing private ownership of cars.

Contribution of technologies

Deploying infrastructure for zero-emissions vehicles, such as charging points or hydrogen fuelling stations, to meet a specific deadline would require massive investments in a very short term. It's far more likely that gradual growth and development of zero-carbon alternatives will take place over a period of decades, and it's this more likely outcome that dictates a role for oil stretching out past the middle of the century.

The upshot is that when it comes to making energy investments, both private and publicly-owned lenders should pay increased attention not only to the regulatory outlook throughout the lifetime of their assets, but also to the public acceptance of their activities.

A growing variety of non-governmental actors are now bringing influence to bear on political and financial decision makers. The NGO community now includes respected financial and scientific analysts and practitioners, such as the Carbon Tracker Initiative and the Climate Tracker Project, who are questioning the long-term economic viability of fossil fuels, based on rigorous interpretation of the greenhouse-gas policies that nations have set.

What Paris has shown is that there is now political will to set out a trajectory towards decarbonisation. The pace of progress will vary around the globe, but fossil fuel producers need to stay ahead of the climate squeeze and develop a pivot strategy to embrace a low-carbon future.

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