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How Markets Address

Climate Risk

Sustainable finance is booming, but energy transitions require new economic models and a new view of risk.

Around the world, investors and governments have declared the importance of reducing carbon with a loud voice. Consider California Governor Gavin Newsome’s pledge to ban sales of new gasoline-powered cars starting in 2035.

That doesn’t, however, mean electric vehicles will fill the Golden State’s freeways on January 1 of that year. In explaining the complexities of moving to more sustainable energy, Charles F. Mason, a professor of petroleum and natural gas economics at the University of Wyoming, points to “the law of unintended consequences.”

As the California deadline approaches, Mason expects many people to buy gas-powered cars, while others will keep their vehicles longer if battery lives and lack of charging stations are still a concern. “The plan won’t operate as advertised,” Mason says, “but that doesn’t mean it will bust. Just take the projected gains with a grain of salt. The bright side is, by promulgating this idea, the governor has expanded the market for electric so you will see the market for electric vehicles expand in the medium term, say in the five years preceding the deadline.”

Read More: “The Role of Markets in the Energy Transition”

As this suggests, the market forces that underpin the energy transition are a complex balancing act. From asset managers to pension funds, investors are pressing companies in all industries to reduce their carbon footprints. Billions of dollars have been shifted to sustainable investments over the past few years.

However new economic models, new investments and a new view of market risk will be needed to support the growing call to reduce energy-related carbon dioxide emissions. “The main reason the U.S. has moved away from coal-fired power plants isn’t because of wind power or environmental regulations, but because the economics of retrofitting coal-fired plants didn’t make sense,” Mason says. “When looking at sustainable energy, you can’t skirt the basic economic issues.”

Changing the merit order

Energy transitions have occurred throughout human history. For example, fossil fuels gained prominence in the United Kingdom because so many trees had been harvested for fuel. It was cheaper to dig for coal than ship in wood from elsewhere.

The current energy transition differs from earlier ones in that it does not factor in only the cost and efficiency of energy sources. The cost of pollution from burning fossil fuels is a new part of the equation. “Carbonomics”—the interaction of economics and sustainability—requires applying new techniques and assumptions to the valuation of energy to help reduce risk.

Any energy transition requires a shift in the fuel mix, or the “merit order” of different energy sources used for electricity generation, heating, transportation and industrial processes. For electricity generation, coal needs to move down the merit order and carbon-free renewables need to move up.

Because renewable fuels remain intermittent in nature, and many are not yet cost-competitive with fossil fuels, change takes time—which raises some thorny debates.

When looking at sustainable energy, you can’t skirt the basic economic issues. Charles F. Mason, Professor, University of Wyoming

In many countries in Asia, for example, natural gas is viewed as sustainable compared to coal. “Some people believe natural gas isn’t sustainable enough because it’s still based on hydrocarbons,” says Gordon Bennett, managing director of utility markets for Intercontinental Exchange (ICE) futures market. “They also rule out the utilization of offsets and carbon capture to reduce the carbon footprint of hydrocarbons. However, right now in developing countries, more than 1 billion people are living in energy poverty. Do they have to wait to come out of energy poverty because they are only allowed energy from renewable sources? That’s a difficult balance.”

Looking beyond ‘good’ and ‘bad’ energy

Sometimes people talk in terms of “good” and “bad” sources of energy. Energy transitions are all about balance. The best example of carbonomics in action is in electricity generation, which hinges on a subtle interplay between coal, gas and renewables. In the future, other relationships between competing fuels will come into play. Achieving net-zero carbon will require trillions of dollars in investment. Fossil fuels are also needed in the manufacturing and deployment of windmills, solar panels and other alternative sources.

In any energy transition, the current energy mix funds the energy that will replace it. Large energy companies have taken their existing technologies and spun them into variants, like offshore wind turbines.

“They have made a bet on renewable energy,” Mason says. “While that bet isn’t great, it isn’t horrible—they have a stable full of smart engineers.”

New technology to capture and store the carbon emissions from gas-powered plants could change the equation. “That’s the card up our sleeve—right now we don’t know if it’s an ace or seven of clubs,” he says. “Carbon capture is still pretty expensive, but it could be a moneymaker in the next 10 years.”

For now, the liberalization of markets—where price is set by the market as opposed to governments—is a key step toward addressing climate change. Financial markets provide price transparency for the present and future value of energy, giving companies the ability to access funding, allocate capital and manage risk.

“The role of financial markets is to allocate capital and manage risk, and the core to both of those is valuation,” Bennett says. “Companies with volatile earnings are hard to value, and so they require access to risk management and hedging to smooth their earnings. In that fact, they can access the capital they need to finance their growth. So valuation is at the center of a complex system that will help move the world to more sustainable sources of energy.

This content was produced in partnership with Wall Street Journal Custom Content. The Wall Street Journal News organization was not involved in the creation of this content.


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