A number of recent reports have raised the question of how much of existing hydrocarbon reserves can be used if the world is to meet the Paris Goal of no more than 1.5 degrees of global warming. This blog examines the conclusions of the most recent of those reports, published in the journal Nature, in the light of an article written by the IEA’s Director and Iraq’s Foreign Minister about the geopolitical impact of the Energy Transition.
The 8 September Report
An 8 September Report in the journal Nature (the Report) made an important link between forcing the pace of the Energy Transition and the geopolitical impacts of tackling climate change. In doing so, the Report underlined the tension between ensuring that the Energy Transition is a Fast Transition, but also a Just Transition. The Transition must move the world as fast as possible to a low carbon future. But it must do so without destroying the value on which stock markets and pension funds rely; leaving millions in fuel poverty; or tipping regions which are heavily dependent on hydrocarbons for their economic growth into instability and unrest.
The Report concludes that global coal production peaked in 2013 and oil output is at, or near, peak demand. The Report compares its 2021 analysis with a similar analysis carried out in 2015, concluding that the proportions of un-extractable reserves are significantly higher than those in the 2015 analysis. Although that change is partly due to the reduction of the temperature target from 2C to 1.5C following the Paris Agreement, it is also driven by the falling costs of renewables and electric vehicles, which reduce demand for oil.
The Report, together with the IEA’s Report in May 2021 and the UN’s Report from last December conclude that fossil fuel production must fall rapidly to keep global temperature rises to under 1.5C and avoid severe climate disruption.
A Zero Carbon Future Means Significant Change for Hydrocarbon Companies…
Using a global energy systems model to assess the amount of fossil fuels that would need to be left unexploited, to allow for a 50% probability of limiting warming to 1.5 °C, the Nature Report argues that meeting the Paris Climate Goal of 1.5 degrees will result in significant volumes of fossil fuel assets (90% of coal and 60% of oil and gas reserves) becoming stranded – effectively making them worthless. The Report estimates that companies will be obliged to write down their reserves and should plan for a reduction in production by up to 50% over the next decade.
The Report concludes that in order to meet the Paris goal, oil, gas and coal production should already have peaked and will need to decline at 3% a year from now. Such a scenario would have a significant impact on company valuations, meaning that hydrocarbon companies should put in place strong transition plans now.
But the Impact on Hydrocarbon-reliant Countries is even starker…
This analysis leads the Report’s authors to conclude that all Arctic fossil fuels and 99% of unconventional oil and gas must remain un-extracted due to ‘their large size (as well as less-favourable economics and higher carbon intensity)’. The Report calculates that this would mean that in a 1.5 degree world, 58% of all currently known reserves of oil would remain un-extracted; 59% of proven methane reserves and 89% of coal. There are regional variations in the model – Canada, for example, would have to leave 83% of its oil untouched; Central and Southern America 73%. For Russia and FSU Countries, that figure falls to 38%, but for Middle Eastern countries the model suggests that 62% of proven oil reserves would have to remain in the ground. The picture for individual countries’ coal reserves is similarly bleak for those countries dependent on hydrocarbon revenue. The model concludes that the US, Russia and the former Soviet Union countries would need to leave 97% of their coal reserves in the ground; Australia, 95% and China and India, 76%. The Report submitted these figures to a sensitivity analysis model which included the deployment at scale of CCUS. This analysis did not have a significant impact on the headline figures, leading the Report’s authors to conclude that the results are relatively robust to uncertainties across key assumptions.
The authors of the Report state that the impact of such an abrupt change will be felt at national and individual levels. Workers in the Hydrocarbon sector will need to be re-trained and energy companies will need to aggressively shift over their portfolios to focus exclusively on renewables.
The Report does not comment on whether such a rapid (and truncated) transition could be carried out at the same time as ensuring uninterrupted supplies of energy (and transport) to consumers. But it seems clear that such a swift transition would place huge strain on the economies and social fabric of States that are heavily reliant on fossil fuel revenue. Countries in the Middle East are particularly at risk, given the centrality of global oil and gas markets to their economies – the Report notes that the MEA region will see a decline of 50% in production by 2050, relative to 2020 production levels and juxtaposes that decline with the statistic that Iraq, Bahrain, Saudi Arabia and Kuwait currently rely on fossil fuels for 65–85% of total government revenues.
This tension lies behind an article written by IEA Chairman Fatih Birol and the Iraqi Foreign Minister, Ali Allawi earlier this month, which highlighted the impact climate change is already having on the Middle East. The article quotes the example of Iraq, where temperatures are estimated to be rising up to seven times faster than the global average, exacerbating stress on the country’s water supplies. The article notes the risks of instability and unrest if the Energy Transition is not handled early and the economy is not proactively transformed in an equitable, affordable way by transferring employment and investment from hydrocarbons to renewables, creating employment for the region’s large youth population and economic growth.
The Article quotes the IEA’s forecast in its December 2020 report ‘Global Roadmap to Net Zero by 2050’ that, to reach Net Zero, the world’s demand for oil will need to decline from more than 90m barrels a day to less than 25m by 2050, noting that such a reduction would reduce net revenues for oil-producing economies (many of which rely on oil exports and revenues to pay the wages and associated costs of a large public sector) by 75%.
The article uses this statistic to underline the importance of engaging with the needs of fossil fuel-producing countries. The Article’s authors quote Iraq again where poverty rates doubled in 2020, due to the global reduction in hydrocarbon demand caused by the pandemic. The authors make a plea for this engagement, noting that failure to do so risks the Energy Transition being an Unjust Transition, with profound implications not only for regional and international security but also for the stability of global energy markets.
The Article concludes that hydrocarbon producing countries will increasingly be forced to aggressively diversify their economies before the Energy Transition strips them of their core revenue sources. If that chronology is not observed, livelihoods will be lost and poverty rates will increase – that combination of factors risks creating deepening economic hardship and increasing unemployment with the associated dangers of broader societal unrest and instability. Getting the timing right will be key to maintaining the balance between Fast and Just Transitions.
A Silver Lining?
The world will continue to need energy through the Energy Transition (indeed, with a growing world population, it will need more energy, not less), but – if climate goals are to be met – that energy will have to come increasingly from sources other than hydrocarbons. Developments in production and efficiency (as well as the impact of different subsidy regimes) have continued to drive down the costs of renewable energy, meaning that, in some parts of the world, renewable energy is competing on price with that produced by fossil-fueled plants.
The Birol Article notes that the worst potential solar sites in Iraq get up to 60% more direct energy from the sun than the best sites in Germany, underlining the advantages that the Middle East has for producing energy from solar power – that includes electricity and green hydrogen. Although effective exploitation of that potential will require significant investment in infrastructure, ports and interconnectors, all four of the interventions mentioned in this blog make the point that early and effective investment in the Energy Transition offers countries in the Middle East the opportunity to continue to play a core role in the supply of global energy markets.
Investment on this scale will create opportunities for renewable and infrastructure companies. Covington’s legal and public policy teams have considerable expertise in the energy sector and would be delighted to discuss with those companies how to manage the Energy Transition, helping them avoid the risks and seize the opportunities the changes to global energy systems offer.