Energy Transition, Uncertainty, and the Implications of Change in the Risk Preferences of Fossil Fuels Investors

This paper uses data from a survey of investors and publicly available information to assess how the energy transition has affected investors’ risk preferences in relation to the fossil fuel market, looking at the discount rate investors assign a company based on the level of risk that investors believe a company is exposed to.  

The paper finds that investors are concerned over the energy transition and have begun altering their risk preferences for long-cycle fossil fuel projects by demanding higher discount rates for oil and gas projects. For coal, survey results indicate that no returns would be adequate to make investors comfortable with investing in coal projects.  

The paper suggests that these risk preferences raise highly important implications for fossil fuel markets.  

These preferences disincentivise investment in long-cycle oil and gas projects. It can take decades before these long-cycle projects repay investment costs. The prospect of long timeframes for long-cycle projects during a growing threat of climate policies leads to “higher capital costs and investment paralysis”. This perception of energy risk means companies may redirect investment towards short-term projects. This investment gap in long-term projects is unlikely to be filled by private equity investors whose business models discourage long-term investments, or by national oil companies who do not have the capacity or know-how to expand and unlock new supply. It also means publicly listed oil and gas companies may over-concentrate on harvesting their fields relative to conducting exploration and appraisals of fields, moving towards low-risk activities. Finally, it affects how fossil fuel assets are valued, as higher discount rates affect valuations of firms, their assets, and their future profits. 

With respect to coal, lack of investment in coal could increase coal prices (and therefore gas prices). However, the paper suggests price increases will improve “the economics of alternative energy sources, energy efficiency and storage”, as the price increases make alternative energy sources more competitive, boosting the rate of transition. 

The article can be used to show the wider benefits of supply-side policies in contributing to raising the risk profile of investment in long-cycle fossil fuels, raising prices for fossil fuels and thereby accelerating the transition to alternative sources of energy. The study also shows how the energy transition can affect capital markets (and therefore investment decisions), indicating the importance of looking at the wider consequences of decisions on fossil fuel projects.