Oil & Gas ease into Energy Transition

Now is the time for oil and gas companies to get involved in renewable energy. Fossil fuels provide the bulk of energy consumed in the U.S., but oil and gas (O&G) companies saw declining energy consumption in recent years and face a negative, long-term economic outlook.

A shift from “oil and gas” to “energy” take companies out of their comfort zone, but provides a way to manage transition risks. Some large oil and gas companies are set to make a switch to “energy” companies that supply a diverse range of fuels, electricity and other energy services to consumers. This means moving into sectors, notably electricity, where there is already a large range of specialised actors and where the financial characteristics and scale of most low-carbon investment opportunities are (with the partial exception of offshore wind) a long way from traditional oil and gas projects.

According to Wood Mackenzie, wind and solar will make up 50% or more of new electricity generating capacity additions in the U.S. through 2050. With revenues from carbon-emitting sources declining, the best path forward for oil and gas companies is to participate in the energy transition.

Over the next decade, the pivot away from carbon-emitting resources will take many forms, and different companies will adopt different strategies as they begin their foray into renewable energy. While company size, geography, risk tolerance, and several other factors will determine initial strategy, several strategies are particularly well-suited for O&G companies looking to begin their transition: power purchase agreements (PPAs), land leases, developing or acquiring renewable energy projects, or investing in renewables through a structured equity product called “tax equity.”

Power Purchase Agreements: One of the simplest strategies is to procure electric power by signing PPAs with renewable energy project owners. PPAs with corporate buyers are increasingly common among wind and solar projects, with more than 24 GW of renewable energy procured via PPA globally in 2020. PPAs allow O&G companies to directly encourage the development of new renewable energy projects while reaping the economic benefit of locking in a low cost of power for periods of up to 20 years. With some projects, companies can also purchase the associated renewable energy credits (RECs) that can provide additional revenue streams through trading on secondary markets, or be used to meet said company’s ESG (environmental, social, governance) goals.

Land Lease: Leasing of land is often easy for both O&G companies and project developers. Since the land is often considered a brownfield, it should be easy to permit and attractive to project developers. Often these brownfield sites have an easy point of interconnection to local transmission lines as well. Site leases may be structured with a fixed rent schedule or as a royalty payment based on the revenue the project earns. With terms of 35 years or more, site leases can provide lessors with a long-term revenue stream with little to no associated expense.

Project Development and Acquisition: Already many of the largest oil and gas companies in the world, including the UK’s BP and Italy’s Eni, invest directly in renewable energy by establishing operating divisions that seek to develop or acquire renewable energy projects. Renewable energy projects generate a stream of cash distributions, which are often contracted to protect against cash flow volatility for a significant portion of the project’s 30-plus-year useful life. Project owners also earn tax benefits, such as accelerated depreciation and federal tax credits. Companies with large tax liabilities from other operations can recognize these tax benefits directly. Companies without significant tax liabilities may still monetize the benefits through a partnership with a tax-efficient investor. Owners may also benefit from the appreciation in the value of their assets caused by movements in energy prices or discount rates.

Tax Equity Investment: O&G companies that don’t want to develop or own renewable energy projects can invest using a structured equity product commonly termed “tax equity.” As a tax equity investor, an oil and gas company will provide capital that helps projects get a built-in exchange for a share of the project’s tax benefits and cash. While the structure is considered equity, it has protective characteristics that result in a risk profile that is more like debt. The limited supply of tax equity in the market allows investors to earn returns that are higher than might otherwise be earned based on the risk profile; therefore, tax equity investment plug-in hybrid attractive option for investors who have sufficient tax liabilities to efficiently monetize the tax benefits.

These are by no means the only methods by which oil and gas will pivot into a carbon-free economy. We have seen companies like Shell announce plans to invest in EV charging stations, but most will begin their energy transition with smaller steps. These four strategies provide a low barrier to entry for most O&G firms, especially those with project development or project finance expertise in house. In addition, these four pivots will help them quickly build a more resilient business that is not exposed to rising capital costs and lower global demand for oil and gas. It will help O&G groups capture the revenue found in the transition to a carbon-neutral economy.