1 – The ESG finance is necessary for the sustainable energy transition
Financing the sustainable energy transition continues to be a global challenge given the massive associated investment needs.
According to projections provided by different institutions (e.g., OECD, World Bank, and UN Environment, 2018), several trillions of dollars in investment are needed annually to meet the 2030 Sustainable Development Goals (SDGs) and to fulfill the Paris Agreement ambitions. These figures are beyond the current public finance capabilities and show the critical need for private finance to reach the required levels.
A further challenge is that traditional financial instruments do not incorporate many of the risks and opportunities associated with energy transitions, as they focus on short-term financial return maximization. Different from the traditional investment approach, sustainable finance puts more emphasis on long-term returns with a focus on environmental, social, and governance (ESG) issues in financing decisions. Accordingly, it promises lower financing costs and greater investment and asset allocation towards projects that are compatible with the global energy transition ambitions. Particularly, the E pillar of the ESG finance has captured significant attention in recent years from various institutional investors, such as pension funds, hedge funds, and sovereign wealth funds (SWFs) worldwide. There is a growing consensus that scaling up ESG finance is key to raising sufficient funds for the investment needs of the sustainable energy transition (OECD, 2021).
Parallel to these trends, the Gulf region, as a hydrocarbon energy hub, has been going through major economic transformations. These have included an increasing degree of diversification of the local economies from natural resource-centered economic activity toward new sectors and services. More recently, Gulf countries have also begun laying out ambitious plans to deploy new climate change mitigation technologies, such as carbon capture, utilization and storage (CCUS), and hydrogen, in addition to reforming energy pricing, improving energy efficiency across sectors, and developing renewable energy power generation infrastructures. In other words, the region has been embarking on a structural change in adapting to the global transition that will in many ways be more substantial than the change elsewhere in the world.
However, several issues continue to create bottlenecks to scaling up ESG finance in the Gulf. One relates to the evolution of ESG norms and practices at the global level. In the absence of globally and regionally aligned ESG guidelines, varying ESG definitions, classifications, and reporting systems have emerged. Efforts to harmonize ESG guidelines and concepts globally are accelerating, which is a positive development, but this could pose constraints for Gulf Cooperation Council (GCC) economies, as many current guidelines do not include in their scope technologies that the region sees as crucial for managing the energy transition, such as CCUS.
National oil companies (NOCs) and the GCC countries’ giant SWFs will continue to play a major role in financing the regional transition using the wealth accumulated from oil and gas revenues. However, like many other emerging markets, the ability to also attract global ESG funding will arguably be crucial to achieving the Gulf’s long-term development goals. The past years have seen a number of major sustainable financing announcements, and by the end of 2021, three GCC countries (Bahrain, Saudi Arabia and UAE) and one NOC (Saudi Aramco) had announced mid-century net-zero emissions targets. Some local financial authorities have also published local ESG guidelines. In order to scale up ESG finance, however, the region still needs to further develop policies and regulatory frameworks to support the scaling up of transition finance, especially ESG funds, to meet its net-zero emission targets.
In this short article, we present an overview of the challenges associated with current global definitions of ESG finance for the GCC and highlight some of the emerging ESG developments in the region with a focus on the case of Saudi Arabia. We also identify factors that could help unlock further ESG financing to the GCC region with a focus on the E pillar of the ESG given its direct relevance for the energy transition.
2 – Issues and opportunities with ESG
ESG is a lens that can be used for various purposes. Companies use ESG frameworks to inform their potential investors and other stakeholders about how they are incorporating environmental, social, and governance considerations in their strategies and operations. Besides various private independent initiatives, many financial regulators also have their own ESG disclosure rules for companies operating under their jurisdictions. Rating agencies then use the available information to provide ESG scores that aim to identify materiality risks associated with respective companies or projects.
Consequently, there are currently countless ESG frameworks being applied worldwide. Definitions and classifications used by different actors in different countries are highly non-standardized and fragmented (OECD, 2020). Some of the globally recognized independent ESG reporting frameworks include the Responsible Investment (RI), the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and Integrated Reporting (IR) framework. Major rating providers include MSCI, Sustainalytics, and Bloomberg. In addition to these independent parties, government agencies, such as capital boards, also provide frameworks for voluntary or obligatory ESG reporting.
Across these major reporting frameworks, there is also significant variation in their metrics’ coverage, scaling criteria, and methodologies, which leads to inconsistent scores or rankings that complicate their utilization among investors.
There is a general recognition that harmonization is needed, and various attempts are ongoing towards this aim, including sustainability reporting standards developed by the European Commission. The International Financial Reporting Standards Foundation is working to develop a baseline global reporting standard building on the Task Force on Climate-related Financial Disclosures (TCFD) framework, which was welcomed by G20 leaders in 2021 (G20 Italy, 2021).
An issue that has emerged on the radar in the Gulf is that most ESG frameworks do not directly account for the application of a number of emission management technologies, including CCUS, that the region sees as important. According to a recent study by the Global CCS Institute (2020), out of 27 ESG initiatives examined, only a few of them directly incorporate CCUS technologies. The vast majority of these initiatives only indirectly account for companies’ CCUS activities through their reduction of the final carbon emissions. In other words, the capital allocated to CCUS technologies does not explicitly contribute to the ESG ratings of companies.
The absence of CCUS technologies from most ESG frameworks arguably reflects a general focus in the global energy transition discourse on energy sources rather than the source of emissions. This is understandable from the point of view that fossil fuels and industry account for 89% of global carbon dioxide emissions (Hausfather, 2018). Rating providers also offer for exclusions of specific industries, including fossil fuels and nuclear, and for thematic focuses that rebalance scores towards for example a specific aspect of E (Boffo and Patalano, 2020).
At the same time, as the global discussion has strongly shifted to a focus on achieving net-zero (rather than zero) emissions mid-century, there has been a growing recognition that both CCUS and negative emissions technologies – along with other emission reduction approaches, including fuel switching and even nuclear energy – are needed to achieve cost-effective and equitable emissions pathways.
There is also a global recognition that both many fossil fuel revenue-reliant countries and hard-to-abate sectors (including industries and heavy transport) will require technologies that either rely on decarbonizing fossil fuels (such as blue hydrogen, which is produced from natural gas or another fossil fuel, with carbon removed through CCS) or technologies that are yet to be brought to the market. Strategies including fuel switching and industrial energy efficiency, therefore, also have significant potential to reduce emissions.
While CCUS technologies are not yet utilized at a large scale, they are cited as one of the key technologies to achieve net zero targets by the International Energy Agency. According to a recent IEA report (IEA, 2021), it is estimated that nearly US$1.3 trillion capital investment will be needed to scale the technology to 5600 Mtpa by 2050 from its current level of 40 Mtpa. Similarly, newly emerging technologies, such as hydrogen, are also not included in the current ESG guidelines, despite some analysis suggesting it could meet up to 30% of the final global energy demand in 2050 (BNEF 2020).
Many oil and gas companies are currently expecting to invest in CCUS and hydrogen technology development projects to exploit this potential and some are already reflecting this in their long-term business strategies. Having ESG methodologies that are flexible enough to incorporate the application of these and other emerging technologies that help reduce emissions could therefore be beneficial for these companies, with an eye on their ESG ratings. Alternatively, turning the focus from fixed listings of specific energy sources and technologies to activities and outcomes that prevent atmospheric emissions could also be beneficial from the perspective of countries and companies that expect to rely on a variety of mitigation technologies going beyond renewable energy and energy efficiency.
3 – A holistic transition concept: the circular carbon economy
Since 2019, researchers and other climate change stakeholders from Saudi Arabia have worked on developing an energy transition concept that speaks to this interest in adopting a more holistic and technology-agnostic approach to reaching net zero. Called the circular carbon economy (CCE), the concept is focused on minimizing and, ultimately, preventing atmospheric carbon dioxide and other greenhouse gas emissions while ensuring each country can leverage its strengths in the most cost-effective way and in some cases also creating economic value while reducing emissions. The CCE is based on the concept of the circular economy and uses its three Rs – reduce, recycle and reuse, and adds a fourth, remove. Instead of materials and products, the CCE focuses on energy and emissions flows. It can be used by companies or countries to examine their mitigation options side by side, identify gaps, strengths, and weaknesses, and build technology pathways.
The CCE incorporates all major mitigation activities under its four Rs: ‘reduce’ refers to avoiding emissions in the first place through renewables, energy efficiency, fuel switching, and nuclear energy. ‘Recycle’ refers to bioenergy, which is carbon neutral when it circulates through the natural carbon cycle. ‘Reuse’ includes CCU technologies that can capture carbon dioxide over long periods of time such as certain polymers and concrete, and ‘remove’ covers natural sinks (if they increase the amount of carbon sequestered from the atmosphere) and CCS, along with carbon removal technologies like direct air capture.
Different Saudi actors have been promoting the CCE concept as an inclusive, holistic framework to reducing and managing emissions in line with globally agreed climate goals. However, as shown above, it also sheds light on a number of areas in the ESG space where oil and gas companies and heavy industries are currently in many cases not recognized for their ongoing and planned efforts to reduce emissions. Most recently, in October 2021, the Kingdom announced it would seek to achieve net-zero emissions by 2060 specifically by using the CCE approach (Saudi Green Initiative 2021). Two other GCC countries have also embraced the concept: Kuwait and Bahrain are also applying the concept to their new UN climate change commitment, announced in late 2021.
4 – ESG developments in Saudi Arabia
Saudi Arabia has in place several ambitious initiatives aimed at transforming and diversifying its economy over the next decade to ensure welfare and competitiveness in a fast-transforming world. A major impetus of the reforms is the accelerating global energy transition, which is eventually expected to lead to lower global demand for the country’s main export product, oil. The Saudi Vision 2030, along with its Vision Realization Programs, and more recently the Saudi Green Initiative, are some of the examples of ambitious initiatives that promise a historic change with several trillions of U.S. dollars of investment in various sectors, including industries, energy, and tourism. Although Saudi SWFs, led by the Public Investment Fund (PIF), actively invest in these sectors, attracting ESG finance is expected to become a key requirement to fully deliver on the targets. Below, we discuss some of the recent ESG developments and initiatives in the Kingdom.
The Saudi Stock Exchange Tadawul has a total market capitalization of more than SAR 9.1 trillion (US$ 2.42 trillion, Saudi Stock Exchange 2021). In October 2021, Tadawul issued an ESG disclosure guidelines document to encourage listed companies to engage in voluntary ESG reporting. The guidelines do not provide a fixed set of criteria, but rather explain the significance and benefits of ESG disclosure for local stakeholders and present a benchmarking of the most common “material” themes and key issues for issuers to take into account and be aware of. Under E, these themes are climate change (e.g., absolute emissions, emissions intensity, product carbon footprints, and physical climate risks), natural resources (e.g., biodiversity and land use, water stress, and material sourcing), pollution and waste (waste from operations, packaging waste, electronic waste), and “environmental opportunities” (clean tech, green buildings, renewable energy, and cleaner hydrocarbon energy, such as CCUS). This final theme is an example of the kind of disclosure guidelines that would benefit companies seeking to reduce their emissions through a broad range of technologies, as discussed above.
Beyond equity markets, the Kingdom aims to attract more global investment with a particular interest in ESG. Local media reported in 2021 that the PIF is both working on an ESG framework and planning a green sukuk (Sharia-compliant bond) issuance, and the PIF’s Governor has suggested that the fund and its portfolio companies could deliver up to 70% of Saudi Arabia’s 50% renewable energy target for the power sector by 2030 (Arab News 2021; FII Institute 2021). Further, as some have observed, the Kingdom’s long history and experience in Islamic finance, which values responsible investment principles and instruments focusing on social problems and economic development such as microfinance, provides a significant background and context to adapt ESG finance (Wilkins, 2020).
The PIF plays a key role in the financing of Vision 2030. The government has set a goal to expand the fund’s total assets to SAR 4 trillion (US$1 trillion) by 2025, which includes a significant focus on ESG projects in and out of the Kingdom (Public Investment Fund Program 2021). For instance, the PIF manages the investment of multi-billion US$ megaprojects in the Kingdom, which are currently under the development phase, such as the planned city NEOM, the Red Sea tourism development, the Qiddiya entertainment project, and the Roshn real estate development. The common theme across these projects is sustainability and thus, a large part of the PIF portfolio has a strong ESG focus. For instance, the Red Sea project raised a US$3.8 billion green loan in 2021 from domestic banks, which included the ones with foreign ownership, such as Banque Saudi Fransi and Saudi British Bank.
Saudi Arabia’s NOC, Saudi Aramco, has also been pursuing an increasingly active ESG-
related agenda. The company’s 2020 annual report includes an ESG overview section and mentions plans to publish the company’s first standalone sustainability report in a year’s time (Saudi Aramco 2021). The company is also a founding member in the CEO-led Oil and Gas Climate Initiative (OGCI), which launched a new strategy in September 2021 that includes the aims of reducing upstream methane intensity to well below 0.20% by 2025, reducing upstream carbon intensity to 17.0 kg of carbon dioxide equivalent/barrel of oil, and achieving zero routine flaring by 2030. OGCI members also set a net-zero greenhouse gas emissions target for operational (scope 1 and 2) emissions, with Saudi Aramco announcing an ambition to reach this target by 2050. This goal is a decade earlier than the Saudi government’s net-zero target, which also only applies to carbon dioxide emissions. (Saudi Aramco 2021b.)
5 – Conclusions
Financing the sustainable energy transition continues to be a challenging task for the world. With its long-term focus, ESG has become the new norm and a necessity, rather than an option or a luxury, for delivering the financing needs of the transition. However, diverging views on its definition and classification creates bottlenecks for the mainstreaming of ESG finance.
Despite global efforts to harmonize the definition of ESG, including by the EU, SASB, and TCFD, a globally agreed ESG taxonomy can still take some time to emerge, given the widely varying interests, preferences, and priorities among companies and countries worldwide. How one defines the transition significantly matters for the definition of the ESG guidelines, and this issue will become increasingly important as actors worldwide seek to harmonize related frameworks. Of relevance for Gulf countries is that most current ESG taxonomies largely fail to explicitly include many emission management technologies that are important for the region and other major hydrocarbon exporters and for cost-effective net-zero pathways worldwide, including CCUS and hydrogen. A more inclusive definition of the transition that can address country- and sector-specific issues could help deliver more inclusive ESG frameworks, which in turn could benefit countries that are currently seen as incumbents in the energy transition, as well as sectors that are hard to abate worldwide, including heavy transport and industry.
Many of the countries in the region have already set ambitious long-term targets in the form of mid-century carbon neutrality targets. As the first steps towards achieving these goals, they have begun investing in sizable projects that will result in emissions reductions, including in the areas of renewable and nuclear energy, CCUS and blue and green hydrogen. Saudi Arabia, which still generates more than 40% of its electricity from oil (IEA 2021b), has set a target of reaching a 50-50% mix of renewables and natural gas by 2030. Consequently, switching from oil to natural gas, along with energy efficiency, will play a significant role in realizing the Kingdom’s energy transition and CCE ambitions, alongside renewables, CCUS and hydrogen. While local SWFs and NOCs take a significant role in the financing of many of these projects, attracting global ESG funds will continue to be critical to delivering on the long-term goals. Recognition of all the different ways in which Saudi Arabia and the Gulf region will be reducing their carbon footprint, including in ESG frameworks, will be important to unlock many of these investments.