The energy transition is disrupting the traditional business model of oil and gas players, and many are now responding by decarbonising and diversifying their portfolios and investing in renewable power.
Oil and gas companies are perfectly positioned to lead the energy transition because of their massive resources, global reach and established customer relationships, while capital markets are placing higher valuations on companies aligned with the energy transition.
Yet the oil and gas majors with the biggest investments in low-carbon markets have yet to see this translate into a material improvement in their valuations.
The challenge is that successfully branching out into new energy requires a strategic approach to navigating the major uncertainties around where, when and how to support activities from hydrogen to EV charging. Successful investments will require new operating models based around offering customer-centric power, harnessing smart energy management and risk-exposure practices, diversifying portfolios to balance risk exposure across regions and sectors and pursuing capital excellence and project capabilities.
And while oil and gas majors currently put less than one quarter of new investments towards renewables, McKinsey analysis shows that leading firms will only start to see an upside when 40% or more of their portfolios become low carbon.
The race to net-zero emissions will see global demand for fossil fuels peak by 2025. Electricity, hydrogen and synfuels will account for a significant part of the global energy mix by 2050. This will mean a fundamental and global shift in how energy is produced and used that will require strategic responses from fossil fuel businesses.
This represents an opportunity for established oil and gas companies to diversify and play a leading role in the energy transition by investing in sustainable power.
Oil and gas majors have many transferrable capabilities that could help them lead and accelerate the energy transition. Their experience in offshore oil and gas projects could help develop integrated offshore renewable projects.
For example, bidders for the Netherlands HKW offshore wind tender provided offers that also included heat and hydrogen investments.
Oil and gas firms also often have extensive experience in hydrogen production and in natural gas storage and transportation. This could help them drive the safe production and transport of green hydrogen.
Many players across the value chain could also leverage their established brands, customer relations, real estate and roadside fuel stations to roll out EV fast-charging services.
And pressure to reduce fossil fuel emissions has meant oil and gas players have developed decarbonisation solutions from energy retail to batteries that are highly relevant to renewable industries.
Yet transforming these strengths into real returns will require companies to solve the three key equations of when, where and how to invest in sustainable power solutions.
This will involve successfully timing investments in new energy markets to achieve both carbon targets and shareholder expectations, choosing the optimal market segments to enter, and an “arm’s length” setup that ensures new energy divisions are independent and thus attract higher valuations and more ESG capital.
We have identified four strategies that would help oil and gas companies lead in the energy transition.
Four key equations
Customer-centricity: The winners in the downstream power market will be those that deliver integrated customer-centric renewable offerings tailored to individual needs. For example, while mining companies may require renewable electricity to power operations, steel manufacturers may need to use hydrogen.
Crucially, customer-centric approaches solve the questions of when, where and how to invest by ensuring oil players enter production when demand is rising, invest in projects that best suit customer needs and help define the operating model.
Energy management and risk-exposure practices: Oil and gas players will also need to adopt energy management and risk-exposure practices capable of adapting to the market volatility, constraints on geographic arbitrage opportunities, fragmented regulations and varying investment risks that characterise the power industry. For example, winter storm Uri in the United States recently caused major investment risks for power producers.
Diversification: Oil and gas majors must diversify their portfolios so that risks across different regions and markets offset each other. Geographical diversification will be essential as power prices are increasingly set by renewables and therefore subject to regional weather variations.
Our research shows that balancing risks among different types of energy assets and financial positions can remove 50-80% of commercial risks. Building smart, diversified portfolios across geographies can therefore cumulatively reduce collective risks.
Capital excellence and project capabilities: Companies must pursue capital excellence and improve their project capabilities to ensure investments are optimally timed for maximum returns. Projects should be managed on time and within budget.
They should avoid premature investments in immature markets and conversely avoid investing too late after competitors are already well established. The fossil fuel workforce should also be reskilled to understand power markets, regulatory frameworks and customer needs in the energy transition, helping to further maximise return on investment. New reporting frameworks could be developed to cover combined financial and environmental performance across Scope 1, 2 and 3 emissions.
Leading the transition
Oil and gas companies have been investing in renewable generation since the 1980s but the success of these investments has been mixed with those most invested yet to benefit from material uplifts in valuation.
However, the energy transition is accelerating and oil and gas companies are uniquely well positioned to lead it. The key to fossil fuel firms successfully investing in renewable energy is to adopt thoughtful and strategic approaches that play to the oil and gas industry’s unique strengths.