Quadrupling Energy Transition Financing and the Quest for Net Zero

Hart Energy Senior Editor Patrick McGee spoke with McKinsey & Co. Partner Kassia Yanosek, who recently co-authored a piece in the journal Foreign Affairs about private finance’s role in the energy transition. As everyone from energy executives to climate activists awaits word on how 2023 spending on the energy transition compares to the $1.1 trillion spent globally in 2022, Yanosek took note of private sources of finance that are taking the initiative.

"…Renewable energy is really only impacting our overall carbon emissions by a couple of percentage points." Kassia Yanosek, Mckinsey & Co. 

The work of private equity has been an encouraging sign and can provide long-term financing other markets cannot. But she noted that this is just the beginning, and to meet climate goals, energy transition funding will need to quadruple.

Patrick McGee: Why are investors increasingly willing to spend on the transition to cleaner energy?

Kassia Yanosek: Investors look for major growth trends, and the energy transition is one of them. There are clear drivers that are going to back this massive amount of capital that’s needed to go into this transition energy system. McKinsey research recently showed that by 2050, we’re going need to more than double the amount of electricity demand in the world today. That’s going to require an incredible amount of capital. Investors see that opportunity. They also see this opportunity to invest in decarbonization because we are going to be decarbonizing our energy system. That was certainly one of the things that came out of COP28.

The transport industry is going to decarbonize. That means new fuels, new ways of creating new, cleaner molecules. That is why investors are putting money into the transition. Our numbers say that we need about $4 trillion a year to meet net zero by 2050. Some figures are even higher than that. When you see those kinds of dollars, that’s when investors start to line up.

PM: Energy transition investment has increased dramatically. It’s enough to make headlines. Will it be enough to reach zero emissions?

KY: Whether it’s $4 trillion or $5 trillion, the number is massive, and that’s the amount of capital that needed per year between now and 2050 to reach a decarbonized energy system. Today, a quarter of that is being spent. We’re going to need a lot more than we’re putting in today, and we’re at the beginning stages of that. Not only is investment going up, but we’re also seeing capital being formed in private capital pools and that is also going up. Last year, $160 billion was raised globally by private equity and infrastructure funds from the sovereign wealth funds and the pension funds, etc., for transition. Just to put it in perspective, that is about eight times the amount that was raised last year for oil and gas funds. Clearly, we’re seeing the owners of capital allocate capital [for] the transition, and we’re starting to see it play out, but there’s still a lot more that needs to be done.

PM: Can you say how much is going into which technologies and what does that say about the investors’ faith in a lot of these solutions, many of which are still unproven?

KY: The majority of that $1 trillion, 80% to 85% went to proven technologies, wind, solar and batteries and related technologies for electric vehicles. In our Foreign Affairs article, we call that shallow decarbonization because renewable energy is really only impacting our overall carbon emissions by a couple of percentage points. What’s really needed is more investment in what we call deep decarbonization. Deep decarbonization is some of the game changers that can transition significantly. Green hydrogen, for example, carbon capture and storage at scale, direct air capture, which is the ability to take carbon out of the atmosphere and capture it, much cleaner fuels getting down to like a zero-carbon fuel. Those are the types of technologies that we still are not yet seeing as attractive to investors at scale because they’re still new; because the markets don’t exist yet. They’re too expensive for investors to really see a return on their capital. That’s why investors are not yet going there, but they’re trying.

PM: There are so-called “brown” firms investing in green technologies. Are they serious, or are they just investing as a way to keep tabs on new technology and on the competition?

KY: My honest answer is that it’s an all of the above. There are some brown firms that are out way ahead of their peers. They’re typically the ones that are really well performing in their core business and have the ability to convince their investors to allocate some capital to transition. Occidental Petroleum is a great example. They’ve made a big splash with their low carbon ventures group and just announced a partnership with BlackRock to invest $500 million into their first direct air capture plant in the Permian Basin. Some of the equipment companies also are [investing] because they see that getting ahead of the market will position them very well. Baker Hughes is an example. They’re very much involved in transition businesses, whether that be gas related or hydrogen electrolyzers. Then you have companies like Exxon Mobil who have made big bets that they are mostly funding themselves. CO₂ carbon capture is one of Exxon’s big focus areas, and they just acquired Denbury, which happens to have one of the most critical CO₂ infrastructure assets, the CO₂ pipeline in the Texas region. Those are a couple of examples, but there are certainly others that are saying, “I’m going to wait. I’m not going be a first mover,” and there’s many of those. It really runs the gamut.

PM: There are some oil and gas companies who have pulled back from their green investments. Can we take that as a sign that the technologies’ promise might be overblown?

KY: There is definitely a clear message that the public shareholders are telling energy companies when you look at the difference in value [and] valuation between the U.S. energy companies who have been a bit muted in their movements into the energy transition — at least in terms of big moves into, say, electric power and renewable power — versus the European firms which have made big forays into renewable energy and renewable power. There’s a huge valuation gap in between those. BP and Shell trade at a 45% to 50% discount, as of about a month ago, to their to their U.S. peers. If you look at the data of the U.S. versus the European firms, you see an inflection point where values start to diverge around 2019 when the European firms started to make these big bigger moves into cleaner energy. These energy companies that have decided to move very quickly in the transition, invested hard into power technologies which is not their competitive advantage — they’re oil and gas companies with oil and gas capabilities — and many of those assets also have much, much lower returns than their oil and gas business. Just by nature of the math, they’re going to be creating less value than their peers if they’re shifting all that capital into the transition businesses. So, I wouldn’t say that’s a sign that the promise of technology is overblown because they were actually investing in proven technologies, wind and solar proven technologies. It’s just that they weren’t the right owners of those assets.

Going forward, I think you’re going see energy companies focus much more on new energies that are much more aligned with their core business and their core understanding. Carbon capture, for example, you need to understand the geology in order to store that carbon. They’ve got that capability. Some are looking at geothermal, drilling into the earth. That requires geologic expertise and understanding. Hydrogen and other related new fuels require engineering capability and systems technologies that many of the downstream and upstream producers have. I think there’s going to be a shift to technologies where they’re the better owners of those technologies, and right now, those many of those technologies are still too nascent.

PM: Why do you see optimism for the transition in private capital markets?

KY: If you look at the capital that’s coming from pension funds and sovereign wealth funds, they are looking for long-dated assets to meet their liabilities. Many of the pension funds have been eyeing infrastructure assets in that particular asset class has certainly grown over the past 20 years. The energy transition fits very well into meeting those goals. So they’ve become very interested in investing in funds that are deploying into, say, the electrification trend, which is going to be long term. Solar and wind, for example, already are proven technologies and should throw off long-dated cash flows. So, I think that part of the optimism is just the long-term nature of this transition and how it’s going to match the liabilities that these funds need to address.

I also would say, and this is more on the riskier front, private equity is known historically to be at the epicenter of disruptions. Whenever an industry is disrupting, private equity is often there and can really create value because they can create growth in areas where they see an opportunity to pick out a technology or company and make it more efficient.

PM: Private equity is often vilified on Main Street and in the mainstream media, but you believe it can play a positive role in the energy transition. Can you describe that?

KY: Private equity, at least in the energy sector, is much more attuned to either just buying a company outright or backing a developer and that developer on Main Street is developing assets. What is changing is that private equity is now going to be starting to partner directly with corporates. That is a new role for private equity to play. Many corporates don’t trust private equity, [but] private equity is starting to partner in joint ventures or off-balance-sheet vehicles to work with corporates and scale their businesses. There is going to be a new mindset that private equity needs to take on so they can be great partners. I do think there will be some transition as we start to see these new innovative financial models.

PM: What size corporates do you think they will partner with?

KY: They’re going to be partnering with the Fortune 500. We already see some examples of that with Brookfield partnering with California Resources Corp. for a $500 million investment in carbon capture and storage development. Occidental and BlackRock also announced a joint venture. They are starting to spread. I think we’re going to see many more of them.

PM: Your Foreign Affairs article says private investments are not enough, at least not at the moment. We’re going to need government subsidies. How can we have confidence these subsidies will be allocated to the right places?

KY: About 25% of the capital that was invested last year came from public sector and public subsidies. The private sector is really going to be driving the transition, but the public sector has a really important role to play to enable capital to come off the sidelines in areas where we aren’t seeing the markets work. The public sector needs to be very thoughtful about the right types of subsidies and supports to bring more capital into the space. One thing that is apparent, for example, is that historically governments tend to support technologies. There are tax credits for certain technologies, certainly the Investment Reduction Act funded a lot of technologies. You’ve seen a lot of investment go into these new technologies, but in order to really see that those numbers scale we need to see a market. There needs to be more of a systems approach that governments take when they start to say, “How can we actually make this entire market get off the ground? If there is no market for green hydrogen, how do we fill the gap between the buyer and the seller in order to create long-term contracts for green hydrogen or green ammonia or green LNG?” There needs to be more of a systems approach that governments take to enable these entire markets to get off the ground.

PM: What do you mean by government taking a systems approach?

KY: You can say, “I’m going to support a subsidy on the supply side. I’m going provide a tax credit for hydrogen.” But if there is no market for that green hydrogen, then, even though it has government money coming into it, the numbers won’t allow it to get developed because there’s no nobody that’s going to buy the green hydrogen. You both need supply and demand to be balanced, and we need the government to play a bigger role in helping to create the markets, particularly for new molecules where there is no price point for them. A large hydrogen project that costs $5 billion is going to need long term contracts to pay for the capital investment up front, but today there’s no 20-year contract for green hydrogen that they can get in the market. That’s where government can help come in to potentially subsidize that price of green hydrogen or to play a role in between a buyer and seller and pay the difference between what the buyer of that green hydrogen and the seller that hydrogen needs in order to backstop the investment of their project.

PM: You were at COP28. What do you think about the agreement that they came to?

KY: I’m a practical person, and I have to say, I think it’s an amazing opportunity for all of us that want to see the world transition. The fact that there was an agreement to begin reduction of the consumption of fossil fuels is, in my view, a huge success. The work behind the scenes shows real leadership, and I was not surprised that we got to the agreement that we did. I think that we’re on track for more progress and to do it in a way that’s bringing industry in to help solve the problem.