Fuelling change:

Companies are still responding to the challenges and opportunities of the transition but tending to their legacy cash cows for a bit longer. Financial institutions still think of climate risk as a material investment risk – and an opportunity. Crucially, governments have increased incentives and regulation to drive investment in the transition.

Stakeholders need to build on this progress to drive low-carbon technologies and new transition material supply through the investment inflection point to enable rapid scale-up. It’s a delicate balancing act. On the one hand, the transition leaders have moderated their pace, moving closer to the herd. On the other, transition laggards face rising costs of capital and will have to either improve or accept a narrowing opportunity set.

We have identified three ways for companies to manage this complex dynamic. First, shift to a transition growth mindset while nurturing legacy cash cows. Second, incorporate transition risks and rewards into differentiated investment hurdles rates. And third, use new business models to enable growth and close valuation discounts.

Oil and mining companies have the balance sheets and cash flows to finance ‘their bit’ of the energy transition. However, this is predicated on robust commodity prices to finance investment and shareholder distributions, as well as orderly capital markets and the absence of turmoil. The transition would be harder to finance in a prolonged risk-off market.

How policy evolution will impact the timing and pace of the scaling up of these technologies is the big unknown. Oil companies may still face the capital allocation dilemma of high oil and gas returns versus lower-risk, lower-return renewables for many years yet. The metals most exposed to the transition, such as lithium and rare earth elements, have garnered broader market interest than established commodities such as nickel, copper and aluminium. But it is these base metals that need to mobilise the most growth capital to achieve climate goals.

We see three key routes for corporate boardrooms to navigate this complex dynamic.

1. Tend to the legacy cash cows while shifting to a transition growth mindset

The more nuanced debate around ESG gives companies an opportunity to strike a more balanced deal with stakeholders, one that will accelerate the low-carbon pivot while ensuring an affordable supply of energy and materials today. This is likely to be accompanied by robust company valuations.

Industry-specific transition pathway frameworks – which define how different sectors will achieve Paris alignment – will contribute to a more open discussion between investors, companies and other stakeholders. Transition pathways are at the heart of the GFANZ framework adopted by major financial institutions.

Companies can influence this discussion from a position of improved strength. As Larry Fink, Chairman and CEO of BlackRock, the largest asset management company in the world, wrote in his 2023 annual letter to investors, it is “not our place to be telling companies what to do. My letters to CEOs are written with a single goal: to ensure companies are going to generate durable, long-term investment returns.”

Most mining majors exited coal before the energy crisis, missing out on bumper profits. The spin-off companies are using cashflows to expand production – not the intended result. Investors now expect companies to balance the need for returns today by tending to their legacy portfolio with transformation tomorrow. Companies have greater flexibility to harvest legacy hydrocarbon portfolios, ensuring responsible rundown.

And investors are still rewarding those companies that don’t move too far, too fast. Transition laggards in our oil and gas Corporate Resilience and Sustainability Indices (CoRSI) framework are trading at some of the biggest premium ratings in our coverage.

As the transition unfolds in the longer term, expect hurdle rates to bend with transition risk and opportunity. Part of the low ‘return’ of transitional investment is risk avoidance and optionality. And higher returns could be up for grabs in low-carbon projects with greater commercial risk, such as CCUS developments that include carbon price risk. In times of uncertainty, companies need a bigger portfolio of options to manage risk.

Building a deep and diverse low-carbon, transition-ready pipeline will be critical to remaining responsive in future. And companies will need flexible strategies to respond to an evolving risk-reward balance, monitoring the main catalysts that impact the pace of the transition and adapting capital allocation accordingly.

Already, some of the European majors are adjusting, diverting part of the capital earmarked for renewable power to other low-carbon opportunities, such as bioenergy. And mining majors are concentrating on their core commodities (like copper), opting for low-risk strategies such as brownfield projects and acquiring existing producers. Mining majors will also need to beef up their transition metals opportunity set, perhaps by diversifying into less familiar battery raw materials to capture the high returns in this sector.

Oil and gas companies will also use ever-tougher capital allocation criteria for hydrocarbon investment, even if prices stay high. We are already seeing this play out with emissions intensity, with new projects increasingly only getting the green light if their emissions intensity is lower than the portfolio average. And many companies already use lower hurdle rates for gas than oil.

3. Use M&A and new business models to enable growth and close valuation discounts

Mergers and acquisitions (M&A) are a potential backstop that will enable late movers to catch up. However, that strategic optionality may evaporate if commodity prices and margins tank in an accelerated transition, even for companies with fortress balance sheets. Buying into advantaged low-carbon assets, such as CCUS and hydrogen, could quickly become expensive.

Major oil companies are already using M&A to accelerate expansion into low-carbon businesses, such as biofuels, biogas and renewable power. However, overall capital allocated to low-carbon M&A remains limited. Mining majors also continue to take a low-risk approach to acquisitions of transition-focused commodities.

New or modified business models can help reduce the transition valuation discount and support efficient capital allocation in businesses with very different costs of capital and risk-reward profiles.

Partial spin-off subsidiaries can inject low-cost growth capital and reveal hidden value in the conglomerate structure of larger groups. Companies can tap into lower-cost capital by partly selling down de-risked renewable assets to boost cash flow and returns. New vertical integration can also support expansion in areas such as biofuels and battery-related supply chains.

Innovative approaches to accessing diverse financing partners are a means of boosting equity returns. The majors' expertise in project management makes them ideal custodians of new capital. But they must align project financing with stakeholder appetites. For instance, project finance offtake agreements would suit original equipment manufacturers’ desire for low-risk offtake, while also boosting returns for mining operators.