“A forecast is a prediction; we’re saying what we think will happen. A scenario is different . . . it generally looks much further out and is trying to build a picture of the future in extreme uncertainty.” — Seb Henbest
Predicting the future is impossible without taking into account the level of uncertainty that exists. When making investment decisions for assets with long-term horizons, it is inevitable that our forecasts will eventually break down. However, while we cannot know exactly what the future holds in the 2050s, we can conceptualize different pathways that provide reasonable variations of what the future may look like. For investment managers, choosing one scenario over others can have significant consequences.
This is particularly true when it comes to the transition to net-zero energy.
There are multiple pathways through this transition, each with its own technology mix and timeframe. As a result, simply discounting cash flows based on a somewhat predictable “economic” scenario, where rational actors react to techno-economic considerations and likely policies, may not be feasible. Energy investors need to consider multiple outcomes given the various possibilities.
Research providers, think tanks, sell-side analysts, and industry groups are all vying for investors’ attention. Their objective is either to win our business or to influence our decision-making process. Often, their base case scenario is influenced by their own background.
Individuals with a history in oil price assessment or renewable energy modeling may be prone to availability or anchoring bias. Many major energy players with significant exposure to a sudden net-zero transition create their own scenarios, often guided by their own agendas. Gas transmission system operators (TSOs) and industry groups envision a bright future for their stakeholders, either through extended use of natural gas or rapid shifts to hydrogen. For example, Shell’s “Energy Transformation Scenarios” — Sky 1.5, Waves and Islands — have gained attention. The Sky 1.5 pathway assumes a larger role for oil and gas than forecasts issued by the Intergovernmental Panel on Climate Change (IPCC) and other such bodies. How hydrogen will fit into the energy mix of a climate-neutral Germany is also a topic of much discussion, but there is no consensus on its exact role or source.
Given the multitude of organizations promoting their own scenarios, investors must approach them with caution. We recommend a three-step assessment process:
- Apply filters to screen out forecasters with obvious conflicts of interest.
- Review the scenarios of target forecasters and determine the ones most applicable to your investment philosophies.
- Consider the performance of the investment target and how plausible pathways could deviate from their presumed base case, which is typically the “economic” scenario. Evaluating environmental, social, and governance (ESG) factors and the resulting risks can help assess deviations from the anticipated path.
There are other factors to keep in mind as well. Social factors may drive higher emissions scenarios, and rising energy costs may impact spending on heating, transportation, and food. Such “greenflation” could burden the low- to middle-income population and potentially lead to political and social unrest. Policymakers may face pressure to subsidize fossil fuel consumption, as has already occurred in Latin America, Africa, and Southeast Asia. This could pose a headwind in our ultimate goal of exiting fossil fuels.
However, the tailwinds pushing us away from traditional fuel sources may be even stronger. Shock events have already strained supply chains, and volatile fuel prices are contributing to calls for a renewable energy path to achieve independence. The risks associated with climate change are at the forefront of public consciousness, and as climate-related crises become more severe, popular support for sustainability should translate into public policies that push towards a net-zero scenario by 2050.
In addition to policy developments, transformative technological innovations are also possible. Small modular nuclear reactors may deploy faster than expected, or the costs of hydrogen from electrolysis may decrease earlier than anticipated, falling below $2 per kilogram.
Choosing Our Path
Some investors may be inclined to allocate based on their economic case and assume no significant technological or policy shifts. However, they must consider the possibility that these investments could become stranded and prepare accordingly — either accepting the consequences or extracting sufficient value beforehand.
Alternatively, some investments may undergo their own transition. Carbon assets, for example, may have potential in a hydrogen-based fuel scenario or can be retrofitted for carbon capture and storage (CCS). Both paths could contribute to achieving net-zero by 2050, but it is uncertain whether they will. There are too many uncertainties surrounding the cost and effectiveness of transitioning such assets, especially when they could be displaced by lower-cost technologies.
Thus, the most prudent approach may be to focus on no-regret assets. These assets are likely to perform well across all viable pathways of the energy transition, including more renewables, short-term and long-term storage solutions, a stronger grid, heat pumps, and district heating, all of which are central to a carbon-free future.
When faced with critical decisions, it is important to explore scenarios beyond the economic base case. Rationality cannot be assumed among all actors, and the transition to net-zero will not be smooth. There will be slow periods of progress followed by abrupt changes due to extreme weather events, technological advancements, political upheaval, pandemics, or other developments.
Planning for the future requires intelligence, caution, and a deliberate choice of which future to pursue.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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