Governments’ role in the decline of fossil fuels

HITE Hedge Asset Management's James Jampel says the public will look to assign blame and extract compensation for the planet’s predicament

The debate continues as to whether 2019 was the year for peak oil demand, and whether it will ever fully recover from the Covid-19 shock. Permanent changes in travel and commuting behaviour, along with continued uncertainty regarding the need for further lockdowns, needs to be weighed against the increased likelihood of enhanced stimulus. 

However, the ‘good will’ of Mohammed Bin-Salman that restrained Saudi output, the professed reluctance of US players to ramp up production, and the temporary absence of Iran from world markets – all required for short run bullishness – are each unstable situations that theory says cannot remain indefinitely. 

In the long run, the fossil fuel industry must lag in growth and profitability if the planet is to survive. Luckily that long run growth and profitability is impaired by a unique confluence of factors, including weak demand, abundant supply, emerging substitutes, and a suboptimal industry structure.

Fossil fuels are not going away any time soon. Instead, there probably won’t be much profit, or free cash flow, for investors in the carbon value chain. Moreover, profit growth there will be dwarfed by returns in other sectors.

Government intervention will exacerbate these trends and will be driven by broad public support for addressing the existential threat of climate change. The public will look to assign blame and extract compensation for the planet’s predicament – and fairly or not, the likely targets will be fossil fuel interests.

We see five levers governments can pull to penalise fossil fuel companies and investors.

1) Removal of subsidies

The first direct lever against carbon value chain profitability is the removal of fossil fuel subsidies, and higher direct taxation, including through carbon markets. The EU is about to expand its carbon trading scheme to target a 55% reduction in carbon emissions from 1990-2030, up from today’s target of 40%.

Additionally, China will soon debut its carbon market. Carbon taxes decrease the profitability of every unit of carbon consumed creating a direct hit to profitability. A carbon tax doesn’t look on the cards in the US immediately, but the Democrats do look certain to try and end fossil fuel tax breaks. 

2) Regulations to internalise pollution costs

Adopt regulations that force market participants to internalise costs that are otherwise imposed on society. A topical example is natural gas production and transport, and the associated methane emissions and flaring. This month, three investors managing more than $2trn (AllianceBernstein, CALSTRS, and LGIM) urged the Texas Railroad Commission to eliminate flaring by 2025, arguing that “voluntary actions alone have been insufficient”. The reason voluntary actions haven’t worked, as gas producers know, is that ending flaring is costly.

3) Geographical restrictions

US president Biden has committed to a Day 1 Executive Order that would restrict further development on Federal lands and the Gulf of Mexico. Biden’s plan also includes environmental review requirements that could make the construction of new fossil fuel infrastructure (pipelines, port facilities) extremely difficult.

4) Enhanced disclosure to raise the cost of capital

Such measures centre around legal requirements for fossil fuel companies and their financiers (banks and lenders) to calculate and disclose climate-related risks in their public materials, which could even include their financial statements.

The idea is if potential investors are truly aware of the risks, they will be less likely to invest – similar to the impact of the grisly images that European cigarette manufacturers must put on their packaging.

Also, large institutions that are holders of credit could be required to carry greater reserves against fossil fuel holdings than more favoured industries. Enhanced disclosure is also on Biden’s policy list.

5) Trade barriers

There is growing awareness that ‘carbon adjustment fees’ at the border could be required to ensure home industries required to pay carbon taxes are not unfairly disadvantaged by unregulated imports. This is one way carbon policy in one country could impact fossil fuel economics elsewhere.

There are compelling moral and national security arguments that oil should not be exported from the US, nor imported from Saudi Arabia or Russia given plentiful supply in North America. True fossil fuel independence from the whims of Mohammed bin Salman and Vladimir Putin might ultimately be achieved by deglobalising oil and ending the US’s participation in the market for its products.

Pressure will continue to mount on the fossil fuel industry as climate change accelerates, putting the social license to operate the carbon value change at risk. In turn, this is likely to negatively affect companies deemed to be part of the problem, not part of the solution.


Natasha Turner

Natasha is global editor at ESG Clarity, part of Mark Allen Financial, and has been a financial journalist for seven years. She has been shortlisted for Story of the Year and Investment Journalist of the...