The underlying reason is the contraction of Russian gas supply which will push the long-term gas price up. Forward prices and model simulations suggest that gas prices in the coming 3-7 years will be significantly above pre-war averages. Some analyses suggest a lift in gas prices by a factor two to four from the pre-war levels. The lift in gas prices will also spill over to oil and coal, which serve as most direct substitutes for gas for certain types of use. Consequently, demand for oil and coal will increase, and these prices will also see a marked structural lift from their pre-war levels although less pronounced than for gas. As a result, electricity prices will go to a structurally higher level for a good period of time until renewables sources take over as the marginal and price setting technology.
The cost of renewable energy will not be affected by the shrinking gas supply and, consequently, there will be a sharp increase in the competitiveness of renewables relative to gas, oil and coal.
From a global climate change perspective, there are two counteracting effects at play. First, oil and coal, which contain more carbon than natural gas, will replace gas for certain uses (power generation and heavy industry). Global coal use increased to its highest level ever last year after having declined since 2013. This in isolation is bad for the climate and will pull global emissions upwards. Second, higher oil, gas and coal prices will improve the relative competitiveness of renewables and make more energy savings worthwhile.
Investment in renewable energy solutions will have a shorter payback time when the energy it replaces goes up in price. A typical solar plant takes less than three years to become profitable at current electricity prices against 11 years at pre-war levels. Likewise for energy savings. When gas, oil and coal become more expensive, businesses and households will take on investments in energy savings that would not pay off at pre-war price levels. This is good for the climate and will pull global emissions downwards.
As a consequence of these shifts, energy-producing and energy-using businesses are currently reassessing their investment plans in light of the new energy realities. Following where the money goes gives a clear answer with good hope for the global climate. During 2022, investment in wind and solar assets grew by almost 40 per cent coming close to the $500 billion mark – and exceeding investment in new and existing oil and gas wells for the first time. According to research by Rystad Energy, wind and solar investment will continue to rise over the next two years. Investment in green hydrogen, which can decarbonise activities that are hard to electrify, is also expected to grow significantly.
Implications for business leaders
Russia’s invasion of Ukraine will mark a new era in world history with large economic and geopolitical changes. With the energy world, we will also enter a new era. The transition to the new energy reality is abrupt, bumpy and uncertain.
Energy-producing and energy-consuming businesses should prepare for at least four things being markedly different in years to come:
- Price: The new energy reality will mean higher energy costs across the board and much more fluctuations in price than before the war. The highly fluctuating prices within the energy sector create a significant amount of uncertainty across the whole energy value chain. Electricity sellers will need to adapt strategies for how to manage energy supplies and hedge against risk associated with the volatile energy prices. They will also need to adapt more active energy strategies to secure long-term perseverance.
- Profit: The new energy reality will imply large shifts in profit pools from energy users to energy producers. Energy producers will have many opportunities to profit strongly from higher and more fluctuating prices, but this will also increase the need for risk management, including a focus on political involvement, such as taxation of abnormal profits. Investors will be seeking new opportunities in renewable energy under large amounts of uncertainty and in a rapidly evolving policy environment.
- Policy: The future will entail a much more active policy involvement in the energy market. National governments are intervening to support vulnerable consumers against high gas prices and providing subsidies for switching to heat pumps. At the European scale, policymakers are announcing new taxation and reforms of the price setting mechanisms for gas and electricity to address the large shifting of profits. This includes a new price cap on gas prices applicable from 15 February 2023. The EU is also reviewing state-aid policies and financing programmes to support the accelerated transition. The US Inflation Reduction Act from August 2022 directs nearly USD 400 billion in new federal spending toward energy and climate projects in the form of massive tax incentives, grants and loans.
- Power: Transmission system operators, distribution system operators and balance responsible parties will in the short run have to increase security requirements, prepare for more frequent brownouts and take precautions against blackouts. In addition, they will also have to future-proof the grid to support an increasing amount of intermittent renewable plants.
All actors in the energy field will have to actively choose strategies that will prepare them for the new energy era. When deciding how to proceed, the market participants must decide how to handle particularly large uncertainty regarding 2023 and 2024. The energy crisis is not over. We are amid a transition to a new energy era.
References
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