The changing risk landscape in the global energy sector

The energy industry has faced significant challenges over the past five years. The collapse of oil prices, more stringent environmental regulations, reduced fossil fuel demands and the growth in renewable energy alternatives, pandemic disruption and divestment of upstream projects are all under the spotlight of investors.

This article highlights five trends in the changing risk landscape facing the oil and gas sector. Given the degree of scrutiny that oil and gas businesses are facing, it is important for companies to understand these dynamics. If they are left unexamined, companies may be exposed to additional risk and scrutiny, both from regulators and the investment community, who now have a laser-like focus on the challenges facing the industry.

Trend 1 – Emerging ESG risks

Political risks remain a factor in the oil and gas sector, but new environmental, social and governance (ESG) dynamics are changing the risk landscape. The industry has been using the lenses of economics and politics to assess risks for over two decades. However, as responsible investing gathers pace, asset managers and owners are seeking to integrate ESG criteria into their risk assessments. More decision-makers are using an ESG framework to scan the risks and opportunities in their investment portfolios.

Emerging ESG issues, such as energy transition and labour rights, have influenced government decisions and have therefore impacted on the regulatory business environment. Meanwhile, companies and investors have also begun to pay more attention to ESG risks that could disrupt their operations, such as civil unrest, and to search for ways to mitigate ESG risks and integrate ESG factors into their sovereign analysis. A common strategy is to conduct a negative or positive screening of a business or supply chain using a set of ESG metrics to identify any parts of the business or supply chain that are performing below or above a certain ESG threshold. A further step would be for companies to integrate ESG factors into a regular review of their business portfolios and engage with sovereigns based on ESG. Eventually, investment managers could also use country data to integrate political and ESG risks into global macro strategies.

Trend 2 – Increasing stakeholder pressure for disclosure and reporting

The pressure to engage in more robust climate action is not only increasing for countries but also for international energy companies, which are facing increasing disclosure pressure from shareholders, regulators and civil societies. In particular, the demand for robust and transparent environmental data on water, deforestation and biodiversity is increasing. Data from the Carbon Disclosure Project, an international NGO, show that the number of companies disclosing their sustainability metrics has increased rapidly over the last two decades. Companies are also placing more weight on metrics other than climate metrics, such as water and forest metrics.

Although these disclosure pressures from governments in some cases, they are mainly from stakeholders such as institutional investors, communities in areas of operations and NGOs. Energy businesses have faced supply chain challenges due to labour issues with migrant workers, environmental impacts linked to the production of materials and equipment and tariff-related impacts on procured goods related to political turmoil. Indeed, limited oversight of direct supply chains servicing the oil and gas industry has resulted in businesses being exposed to ESG issues. This means that energy companies have to reassess their strategies to avoid regulatory violations or even potential climate litigation.

Trend 3 – Global division regarding energy transition

Amid the global ambition to limit global warming to 1.5 degrees, a significant gap has formed between developed and developing countries regarding how fast the energy transition of their economies should be. The last-minute intervention from China and India at COP26 to weaken the language on fossil fuels in the Glasgow Climate Pact reaffirmed this deepening global division. The energy crisis in 2021 also showed that some developing countries are not well prepared for an accelerated phasing out of fossil fuels, particularly coal, when alternative cleaner options are not ready. Many of these countries have to limit the disruption that decarbonisation could have on their supply chains and prioritise pressing development agendas and poverty eradication at home.

This significant gap between climate leaders and major emitters exposes international firms and investors to at least two emerging risks. First, it will likely place their investments in emitting countries, especially investments in carbon-intensive projects, under tightened scrutiny due to increasing stakeholder and regulatory pressure for ESG reporting at home. Second, delayed climate action from emitting countries also exposes businesses in these regions to regulatory disruption in the future, as these economies will come under pressure to enact sudden policy change to meet climate targets.

Trend 4 – Decarbonising investment

The global call for energy transition has also affected investment trends in the energy sector. For instance, the market has seen rapidly expanding investment in projects that promote decarbonisation, such as renewables, CCUS, hydrogen and critical materials. Regarding the upstream sector, while increasing stakeholder and regulatory pressure for ESG reporting has discouraged new investment in fossil fuel projects, major oil and gas producers will be well adapted to the shifting market preference for cleaner options, such as low-carbon LNG. Major producers will likely benefit from the growing demand for LNG from Asia, as gas is expected to play an increasingly important role in the region’s energy transition.

The changing landscape has also injected momentum into products that could mitigate ESG risks or compliance costs, such as carbon credit and green bonds. In a carbon market, companies can offset their unavoidable emissions by purchasing carbon credits from certified projects targeted at reducing emissions. Similarly, investing in green bonds can help make an investor’s portfolio greener. These opportunities can lower the cost of reducing emissions and enable businesses to commit to more sustainable behaviour.

Trend 5 – More geopolitical flashpoints

Geopolitical risks, while not new, continue to be a factor in the global energy business. Major powers are locked in a cycle of tit-for-tat targeted measures, with only a remote chance of normalisation in 2022. Great power competition between the US (and its allies) and China has accelerated and is now a defining characteristic of the international arena. How the Biden administration squares up to the challenge posed by China will shape the geopolitical risk landscape for corporates and investors over the coming years.

Over the past decade, bilateral tensions between the world’s two largest economies have been on the rise, and unsurprisingly, the trajectory of their relations is the geopolitical trend that is likely to have the greatest impact on global markets. Increasing geopolitical tension will likely trigger more retaliatory measures, including sanctions and trade and investment restrictions, and companies and investors will have to navigate the fallout from the rising geopolitical tension between the US and China. The corporate sector is increasingly viewed by sparring strategic rivals as a legitimate target, and the unwary risk of getting caught in the crossfire at one of the world’s geopolitical flashpoints.

Conclusion: The need for ESG+P risk assessment

With the above challenges facing the energy industry, conducting high-level screenings by location and industry is a cost-effective way of finding a starting point to tackle risk and ensure compliance in direct supply chains. Using quantitative ESG insights to measure risk exposure by geographical area and industry could help companies identify potential hotspots, and a well-designed risk mitigation plan could minimise the associated costs of reacting to violations should they arise. These are the crucial steps in navigating a year that is likely to be defined by ESG and political jostling.

Dr Kaho Yu
Dr Kaho Yu is a Principal Analyst at Verisk Maplecroft, specialising in politics, ESG risks, and energy industry in the Asia Pacific region. He was an associate of the Energy Geopolitics Program at Harvard Kennedy School and holds affiliated research positions at the European Centre for Climate, Energy and Resource Security (EUCERS) at King’s College London, London Asia-Pacific Centre for Social Science, and the Asian Energy Studies Centre at Hong Kong Baptist University.

Jan 2022