1 – Introduction

By the end of 2021, sovereign wealth funds (SWFs) managed more than USD 10 trillion globally. When you include public pensions funds, the total assets managed by state-controlled investment vehicles amounts to nearly USD 32trn. This pool of capital represents about a third of total global assets under management that in 2020 surpassed the USD 100trn mark. 

SWFs and other state-controlled investment vehicles funds are relevant not only because of their large and rising size in global capital markets. The public nature of their stakeholders means their goals are not merely financial, i.e. to generate a positive return on accumulated wealth. Specifically, these institutions often have strategic and socio-economic goals which are aligned to those of their sponsoring governments. For instance, the mandate of some SWFs is to support their governments during periods of falling revenues, to balance the fiscal budget. Some SWFs are mandated to catalyze domestic investments in infrastructure or in certain industries which are deemed strategic for the national economy. 

One area where the financial objective of generating a return needs to be matched with a strategic objective is sustainability and the fight against climate change. Similarly, to other institutional investors such as private pension funds, insurance funds and asset managers, SWFs have been increasingly under pressure to take an active approach in investing against climate change, and on other sustainable objectives. As discussed in this report, SWFs have started addressing this issue, and momentum is building. However, these institutions are sometimes labeled as “sustainability laggards” as they appear to have been slower than other investors – for instance public pension funds and insurance funds – to incorporate sustainability into their investment framework. As argued here, this might well be due to the fact that SWFs stick to a narrow interpretation of their fiduciary duty and tend to avoid investments that would make them appear politically motivated. 

The question of sustainability, in particular with regards to the fight against climate change and the energy transition from fossil fuels to renewables, is relevant for commodity-based SWFs. These funds represent nearly half of the assets managed by SWFs globally and of the largest 10 SWFs in the world, five of them – Norges Bank Investment Management (NBIM), Abu Dhabi Investment Authority (ADIA), Kuwait Investment Authority (KIA), Public Investment Fund (PIF) and Qatar Investment Authority (QIA) – are from oil-exporting economies. As their main source of wealth is fossil fuels, commodity-based SWFs face a double challenge: on one hand, as any other investor with a long-term investment horizon, they need to integrate sustainability into their investment framework to minimize the impact of this secular trend on future returns and to take advantage of the alpha generation opportunities that it can provide. On the other hand, given their additional responsibilities as state-owned entities, they need to consider that the wealth they manage is and will increasingly become instrumental in the future to diversify away their economies from fossil fuels. 

Navigating the energy transition is, however, a real challenge for SWFs and their political sponsors: diversifying too fast could quickly turn the commodity into a stranded asset, impacting future revenues and ultimately SWF funding. But a slower exit from hydrocarbons could generate even greater risks in the long run, given the current projections on fossil fuel demand. 

This article aims to discuss the implications of the transition in the global energy sector as the world accelerates towards a Net Zero world, with a particular focus on commodity-based SWFs. It intends to address what the energy transition means; what the investment implications are, where SWFs stand in terms of adaptation and which strategic actions they should consider to ensure that they respond to their fiduciary duty of maximizing returns, whilst at the same responding to the strategic goals of their sponsoring governments. 

Net Zero and the Global Energy Transition 

At the COP26 in Glasgow, 82 countries and regions, representing three quarters of global carbon emissions, pledged to drive their net emissions to zero by 2050. The global energy sector is the source of about three-quarters of greenhouse gas emissions, so the fight against climate change and the achievement of Net Zero by the middle of this century would mean a substantial reduction in the emissions generated by the energy sector. 

In a recent report by the International Energy Agency, the Paris-based international institution has developed a detailed roadmap for the Global Energy Sector to reach net-zero CO2 emissions by 2050 (IEA, 2021). The Net Zero Emissions (NZE) scenario elaborated by the IEA requires a massive transformation of the global energy sector. Total energy supply has to fall by 7% between 2020 and 2030 and does not grow any more until 2050. Given population and economic growth, this would imply a significant drop in energy consumption per capita. Solar PV and wind become the leading sources of electricity globally before 2030 in this scenario, and together they would have to provide nearly 70% of global energy generation in 2050. Coal demand will decline by 90% by 2050, oil demand by 75% to 24 mb/d and natural gas by 55% to 1750 bcm. Fossil fuel consumption that remains in 2050 will be used for the production of plastics or in plants with carbon-capture, or in sectors where they cannot be replaced. 

In order to make this scenario possible, annual energy sector investments estimated to average USD 2.3trn globally in the last few years, should more than double to USD 5.3trn by 2030. By 2050, as a share of global GDP annual energy sector investments would be 1% higher than in recent years. . Most of the investments would be directed at renewable and other non-fossil energy sources (e.g. hydrogen) and this would imply that no new oil and gas fields would be required in addition to those already approved to date. Oil prices would fall to 35 USD/bbl in 2030 and 24 USD/bbl in 2050. Also, the price of natural gas would gradually fall and would more than halve in the next two decades. 

In the NZE scenario, the massive public and private investments on clean energy technologies will have a positive impact on global growth, forecasted to be nearly 0.5% higher on an annual basis when compared to a “business-as-usual” scenario of no change in current policies. But the impact is very uneven across regions with fossil fuel producer economies experiencing a dramatic drop in income from oil and gas from nearly USD 1,000 bn between 2011-20 to less than USD 200bn in 2041-50. Income per head in oil producing economies would substantially drop with a substantial reduction in standards of living. 

The scenario elaborated by the IEA has been widely debated since its release in the middle of 2021. In fact, some of its assumptions are quite controversial. For instance, it appears very unrealistic to assume that energy consumption would fall by 7% in the current decade as this has never happened in the last two hundred years. Given the fact that energy consumption in lower-income fast-growing economies such as China, India, and other emerging markets are set to increase, such an assumption implies a sharp reduction in energy consumption per capita in developed economies. This appears to be very difficult to achieve as in advanced economies energy demand is quite inelastic, as witnessed by the political backlash against soaring gas and other energy prices in 2021. 

Another far-fetched assumption is the scale of investments required to facilitate the energy transition away from fossil fuels. Indeed, the increase foreseen in Glasgow is unparalleled and the mobilization of such an amount of investment appears to be the major obstacle to the achievement of Net Zero in the global energy sector, also in light of the fact that a large part of these investments should take place in emerging markets, which lack adequate capital markets to support such a massive investment program. 

The implications for resource-rich economies are also very uncertain. The impact on prices and consequently oil and gas revenues depends on producing nations’ reaction to falling demand for fossil fuels. The recent rise in oil and gas prices and the supply cut being undertaken by oil producers shows that the trend outlined in the IEA scenario is not a straight line, but a more uncertain process where falling investments in fossils fuels can lead to higher prices for a prolonged period of time. Furthermore, the impact is likely to be very different across producer economies, with countries with lower extraction costs less impacted than others. The fall in oil demand and prices – at least for some of these economies – may appear to be in the quite distant future, thus reducing the incentives to accelerate on the diversification away from fossil fuels. 

The NZE scenario elaborated by the IEA has the merit of quantifying the magnitude of the transformation that the global energy sector will have to go through over the next three decades. Ultimately, the timing of the transformation might be longer given the uncertainty surrounding the roles played by biotechnology, carbon capture and behavioral changes, and the final mix of energy sources might well be different from what is currently envisaged also, as a result of technological developments. But what appears almost certain is that policies and regulations are gradually shifting towards incorporating Net Zero and phasing out of fossil fuels as the primary source of energy. Following COP21 in Paris in 2015, there has been an acceleration in political action to fight climate change with more and more countries committing to Net Zero. Ultimately, it appears very difficult to envisage a scenario where fossil fuels continue playing an important role in the global energy sector over the long-term as the fight against climate change accelerates across the world.  

2 – The investment implications of the Energy Transition 

The NZE scenario for the global energy sector developed by the IEA involves a massive level of capital expenditure to transform the energy supply mix from fossil fuels to renewable power. Global capital markets will play an important role in determining the pace of the energy transition, as it is unsustainable for the public sector to provide the funding required via taxation or further increasing already stretched public debt levels. The reallocation of capital has already begun as shown by the falling levels of investments experienced in the fossil fuel sectors and the rising flow of investment into renewable and green technologies.

Global capital markets play a crucial role in the allocation of capital across countries, industries and companies. Asset owners concerned about the impact of climate change and the rapidly evolving political and regulatory environment, and aiming to facilitate the energy transition are increasingly considering fossil fuel dis-investments. In public markets, by switching from traditional equity market cap-based traditional benchmarks to Paris Aligned Benchmarks, investors decrease the carbon footprint of their portfolios. Such a shift of assets to low carbon emission assets often involves a reduction of exposure to the oil and gas sector and/or to utilities companies that are relying on fossil fuels for the production of energy. At the same time, allocation to renewables or to energy companies relying more on renewables for energy production increases. 

The reduction in exposure to high emissions sectors by asset owners is not only pursued on ethical grounds, i.e. to reduce the impact of climate change on the well-being of future generations, but also in order to mitigate risks associated with energy transition, such as a) declining returns on high-emission assets and b) potential value impairments on so-called stranded assets.

With regards to declining returns, for many years there was a belief that the incorporation of sustainability into an equity portfolio would lead to underperformance versus a traditional portfolio. This prevented many investors from taking more decisive action on this front, as performance is the primary objective for most investment policies. The performance of a portfolio manager is often measured in terms of its ability to generate returns equal to or above a selected benchmark. Over the last few years as more investors have shifted towards investment strategies that are increasingly aligned to low emission scenarios, performance has actually been better or at equivalent to traditional investment policies. In the future, more and more investors will switch towards these indexes, so stocks associated with high emissions are likely to be penalized, whilst those more “green” will be rewarded. The positive performance of ESG indexes during the pandemic has also helped to reduce the perception that sustainable investing involves a “sacrifice” in terms of performance. 

More broadly, a recent UBS AM publication provides a detailed academic literature review, as well as original data analysis, finding that conventional levels of ESG (meaning the use of well-known indexes as benchmarks) causes little difference in risk and return compared to traditional, non-ESG indexes. However, a too strict ESG criteria, such as, excluding all firms not yet ready for NZE would reduce diversification materially, likely causing a higher tracking error and lower risk-adjusted returns over the long-term.

However, the paper also shows that it is reasonable to expect firms that have high ESG ratings to have lower risk of one-off catastrophic losses. An example of this is the issue of stranded assets. The stranded assets hypothesis has its roots in a paper published in 2009 in Nature, a scientific journal. In that paper there was the first estimation of the maximum amount of carbon emissions that could be permitted to ensure a high probability that global warming would remain within 2 degrees by 2100. Based on those estimates, Carbon Tracker estimated that about 80 per cent of total fossil fuel reserves would never be burnt. In a more recent study, it was estimated that to achieve the Paris Agreement and stay within the 1.5 degree warming relative to pre-industrial levels, the results would be similar (C-EENRG, 2020): 79 percent of fossil fuel reserves would be stranded with losses of nearly USD 30trn in revenues in the next twenty years for oil, gas and coal companies. This is a decline of more than 20 per cent in sales for the fossil fuel industry and the risk of stranding for several upstream and downstream assets of international oil corporations is high. 

Adopting investment strategies aligned to carbon emission reduction scenarios is not only a question of generating good returns and/or avoiding losses linked to the exposure to stranded assets. It also concerns the opportunities of generating additional returns – alpha using the industry jargon – as the global energy sector moves away from fossil fuels towards renewables. The share of renewables, nuclear energy and natural gas with carbon capture, utilization and storage (CCUS) is set to increase sharply in the next decades, opening up investment opportunities. Investment opportunities also emerge in the technology needed for the global energy transition, for instance with regards to the production of hydrogen and biomasses and the storage of electricity produced via solar and wind plants. The financials of renewable energy sources are already competitive with fossil fuels and this trend is set to accelerate as policies and regulations incentivizing the energy transition accelerate globally. 

3 – Strategic implications for SWFs 

Compared to other institutional investors, SWFs have been rather slow to integrate climate change and sustainability in their investment framework. According to Global SWF, by the end of 2021 of the 161 existing SWFs only 34 formally incorporated climate change into their investment framework, six were supporters of the so-called Task Force for Climate-related Financial Disclosure (TFCD) framework and only two SWFs have joined the Net Zero Owner Alliance. 

However, an acceleration is definitely under way. A total of 19 SWFs – including some of the largest commodity-based SWFs such as ADIA, QIA and PIF have joined the One Planet SWF Group, the French presidency-sponsored initiative entirely focused on SWFs and climate risk. In a recent interview, the managing director of the KIA said that “the process is ongoing with the KIA currently transitioning toward 100% ESG compliance for the entire portfolio while currently focusing on the E part of ESG”. 

There is also growing evidence that SWFs are increasing direct investments into renewable energy. Over 2018-20 SWFs investments into traditional energy sectors have been larger in terms of value but there is a clear growing trends in the number of deals made in the sector of renewables. This still a small amount when compared to total assets under management but the trend is definitely on the rise.
In 2021 – according to preliminary data – green direct investments might have surpassed black investments in value for the first time indicating a positive momentum for the renewable sector among public funds.  

The strategic implications of the global energy transition for SWFs are significant. Like any investor with a long-term investment horizon, SWFs will have to incorporate sustainability into their portfolios to protect their funds from the impact of this risk factor on future returns. Furthermore, as their political stakeholders accelerate on the green agenda, they will be asked to decarbonize their portfolios and increase allocations towards renewables. This is likely to happen with different intensity across regions and countries as it will remain dependent on the degree of commitment to Net Zero of their respective governments. 

The strategic implications for commodity-based SWFs is even more relevant. Oil exporting economies will have to accelerate the diversification of their economies away from fossil fuels as they prepare for the post-fossil fuel era. This will require a massive flow of domestic investments into non-oil sectors that will have to become the main engine of growth and provide the revenues required to replace those generated by oil exports. This implies that the mandate of SWFs will have to be adapted as their accumulated wealth becomes instrumental to such primary objectives. 

The mandates of commodity-based SWFs primarily have two main goals: stabilization and saving. Stabilization portfolios aim to provide funding to the government during periods of low commodity prices; they have a short-to-medium term investment horizon and often require low volatility liquid investments such as bonds. Saving portfolios aim to provide wealth to future generations; they have a long-term investment horizon and invest in more risky assets such as equities and illiquid alternative asset classes (Castelli, 2012). The global energy transition impacts both these two goals and adds another dimension: to support the strategic reduction in oil dependency. 

The stabilization mandate needs to be upgraded to reflect the challenge posed by the energy transition: from short-term management of oil price fluctuations to “structural diversification” (WEF, 2019). Over the long-term, stabilizing the economy involves funding the energy transition and the development of non-oil sectors. The saving function also needs to be upgraded from long-term return maximization to long-term sustainable performance. But the most important innovation is adding an additional goal which is of a strategic nature and involves a much higher focus on domestic investments to support the transformation of the economy. 

This innovation has actually already started back in 2014-15 when oil prices collapsed from above USD 100 dollar a barrel to less than 50 dollars. This was the end of the oil “supercycle” which started in the early 2000s and actually coincided with the finalization of the 2015 Paris Agreement. Since then, SWFs have gradually increased their domestic investments and this trend has continued over the years. A good example of the shift from “saving” fund to “ strategic” fund is the Public Investment Fund (PIF) of Saudi Arabia. It was in 2015 that the mandate of the PIF was modified to be aligned with the Vision 2030 objectives that are very much focused on developing the non-oil sector in the Kingdom to prepare the country for the post-oil era. Another example is that of Mubadala which, taking advantage of an early move in renewables (the Masdar initiative was established in 2006) and its strategic capabilities, has become a key player in the oil diversification strategy of the United Arab Emirates. As recently pointed out by Chief Strategy and Risk Officer Ahmed Saeed Al Calily: “Mubadala is looking to create the next new clusters such as supporting the energy transition. Our recent partnership with ADNOC and TAQA will propel Masdar’s renewable capacity to more than 50GW by 2030 and create a global clean energy powerhouse. This partnership will also support the UAE’s role in the energy transition and contribute to its strategic goal of achieving carbon neutrality by 2050, while becoming a global leader in green hydrogen” (Global SWF, 2022 Annual Report: State-Owned Investors 3.0”). 

The shift of the mandates of commodity-based SWFs will involve an acceleration in the allocation of investments to alternative asset classes and direct investments including venture capital and infrastructure in sectors like renewable and green technologies. Whilst investments by SWFs in venture capital have risen over the last few years, they still represent a relatively small share of their funds. SWFs could become the main channel to move funds into technologies like hydrogen or carbon capture, which are likely to grow in these economies as the demand for fossil fuel falls. The oil industry in these economies could become a major player in the development of hydrogen as it has the know-how to produce it and the infrastructure to transport it. 

In conclusion, the role of commodity-based SWFs will rapidly evolve as they become instrumental to the transformation of their economies. This evolution has already started in the middle of the last decade when the commodity prices super-cycle ended and climate change climbed to the top of the global policy agenda following the Paris Agreement. The pandemic has further reinforced this trend as policy actions to improve the quality of life including the environment have found broader support among voters. Commodity-based SWFs will be required to shift the focus of their investment towards technology, infrastructure, human capital and growth sector. The public nature SWFs coupled with the knowledge acquired through investing in global capital markets can become a powerful tool to deal with the challenge posed by the energy transition.