Rusting oil barrels against blue sky. Photo: iznashih/Getty Images.
Rusting oil barrels against blue sky. Photo: iznashih/Getty Images.

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Executive Summary

International climate commitments and the global shift towards a decarbonized economy are challenging tried and tested models of development. This presents serious risks and opportunities for countries like Ghana, Tanzania, Guyana and Mozambique, where there are hopes that fossil fuel discoveries will transform their economies. Drawing on discussions with national governments, multilateral development banks (MDBs) and donor agencies, and a series of modelled scenarios, this paper sets out how carbon risk – defined in this paper as the economic risks associated with dependence on or exposure to high-carbon sectors – will affect developing countries with fossil fuels in the coming decades. It also makes recommendations for governments and their development partners that should enhance economic resilience and competitiveness throughout their transition.

Meeting the long-term goal of the Paris Agreement – limiting the increase in the global average temperature to ‘well below 2°C above pre-industrial levels’ and pursuing efforts to limit the temperature increase to 1.5°C – will have profound implications for fossil fuel markets. Even where optimistic assumptions regarding the deployment of carbon capture and storage (CCS) and negative emissions technologies (NETs) are made, a rapid decline in global fossil fuel demand is needed in order to remain within a 2°C scenario. The least-cost pathway to this goal would be for coal demand to fall immediately, oil demand to slow from the mid to late 2020s, and natural gas to decline from the mid-2040s. This, in turn, would leave over 80 per cent of global coal reserves, half of gas and one-third of oil undeveloped.

The global context for fossil fuel investment is already changing rapidly. The investment and finance communities are watching for signals of the trends that will affect the speed and shape of the global energy transition – from reforms to fossil fuel subsidies and the introduction of carbon pricing, to the falling cost of renewable energy (RE) and storage technologies, and rising electric vehicle (EV) uptake. They are increasingly looking to reduce their exposure to high-carbon assets and investments that will decline in value throughout the transition, and anticipate policy shifts at country-level that might alter the relative competitiveness of low-carbon technologies and services. Central banks and regulators are considering how these trends might pose a risk to financial stability, while the G20 has raised these issues on the international agenda via the Task Force on Climate-related Financial Disclosures (TCFD).

These dynamics fundamentally change the prospects for developing countries that hope to use fossil fuels as a ‘leading sector’ for growth. Tightening climate policies, fossil fuel investment and RE trends suggest that the cost curves for commercially viable oil and gas projects are changing, and that the time frame for profitable production will be limited. This raises the potential for ‘stranded’ upstream investments and undeveloped fossil fuel resources, which could impose high opportunity costs on lower-income countries. At the same time, over half of the world’s least developed and lowest income countries are currently planning to explore for fossil fuels or expand their existing production, and use the associated revenues and fuel supply to help drive their economic development. Their strategic choices will affect the lives of over 1.6 billion people, as well as the chances of staying within a 2°C carbon budget.

Making long-term decisions on fossil fuel development and associated energy and industrial infrastructure amid such uncertainty presents a huge challenge for these governments, and one in which international development assistance plays an influential role. MDBs and donors have committed at least $28 billion in finance and guarantees to upstream fossil fuels and thermal power generation between 2010 and 2015. By providing concessional finance and investment guarantees, they help de-risk and lower the cost of capital, encouraging much larger sums of private capital into the sector. Now they are shifting their focus to climate finance and green growth in line with the Paris Agreement, which committed richer countries to mobilize $100 billion a year in climate finance for developing countries from 2020. As MDBs scale up their climate finance commitments – which reached a combined $32 billion in 2017 – they are also beginning to reform their policies towards fossil fuels. The World Bank Group has announced that it will stop financing upstream oil and gas by 2019.

Tightening climate policies, fossil fuel investment and RE trends suggest that the cost curves for commercially viable oil and gas projects are changing, and that the time frame for profitable production will be limited.

Better alignment between development assistance to fossil fuel sectors and climate finance and support for low-carbon development and green growth is critical to supporting inclusive and resilient growth. The development of fossil fuels and related power and industrial infrastructure is a multi-decade undertaking, which will heavily influence a country’s future economic development and energy systems. As international investment and development assistance move away from fossil fuels and towards clean energy, developing countries with fossil fuels will need timely information and new approaches to managing risk. This paper explores some of the challenges that developing countries with fossil fuels face, and how their governments and development partners can respond, through the following questions:

  • How might decarbonization affect developing countries with fossil fuels and change the nature of traditional ‘resource curse’ risks, and how can scenarios help explore the impacts of this (drawing on modelled examples for Ghana and Tanzania)?
  • At the country level, what policy measures and practical responses can help governments assess carbon risks and align fossil fuel sector decision-making with long-term climate and green growth goals?
  • At the international level, how are MDBs and donors responding to these trends, and where are there opportunties to improve policy coherence and coordination around carbon risks and better support transition in fossil fuel driven economies?

Key findings and recommendations

Developing new approaches to carbon risk

Companies, investors, central banks and regulators are increasingly testing their long-term resilience against 2°C scenarios. Compared to current Nationally Determined Contributions (NDCs) under the Paris Agreement, 2°C scenarios suggest a much smaller role for fossil fuels. However, major uncertainties regarding the expansion of CCS and the evolution of clean technologies mean they cannot be taken as a reliable guide to the future. Long-term investors (including pension funds and sovereign wealth funds) are responding to this, increasingly limiting or excluding fossil fuels from their portfolios and using their shareholder votes to influence company behaviour. These trends are already having an impact on the direction of international oil companies (IOCs) and publicly-traded national oil companies (NOCs) such as Equinor in Norway and (soon-to-be-listed) Saudi Aramco in Saudi Arabia, and may in time affect sovereign debt.

For developing countries that are considering exploring for oil and gas or expanding existing production, multi-decade scenario analysis that considers the interaction between production, revenues and demand under different climate outcomes can help improve decision-making and reduce exposure to carbon risks. The country scenarios to 2045 developed for this paper show a wide range of revenues under different climate constraints. Ghana’s oil revenues could vary by around 50 per cent between an NDC and a 2°C No CCS scenario, while Tanzania’s gas revenues could vary by around 80 per cent, reflecting the greater impact of accelerating RE and lower than anticipated levels of CCS in the power sector. Lower than anticipated or sharply declining revenues may compound many traditional fiscal challenges that fossil fuel producers tend to face, particularly the strain that rising domestic fuel demand places on foreign exchange. ‘Greening’ domestic demand could help mitigate this stress, as well as support the delivery of NDCs.

Changing patterns of demand for fossil fuels would also affect the window of opportunity for economic diversification away from the sector – widely considered the litmus test for ‘successful’ fossil fuel-led growth. Compared to the traditional lifespan of an oil or gas resource, which may span several decades and offer the opportunity to re-invest and extend the ‘plateau’ in production, the most constrained climate scenarios suggest a much tighter time frame for diversification. While the NDC and 2°C scenarios show Tanzania’s gas exports continuing for over two decades, the ‘No CCS’ 2°C scenario shows it declining from 2030 and potentially leaving infrastructure stranded and fossil fuel resources undeveloped, assuming development proceeds at all. This highlights the dependence of national plans on fossil fuel supply and the level of infrastructure development and investment (or debt) required to deliver this as key contributors to carbon risk at the country-level.

Carbon-related shifts in energy investment and demand patterns are likely to act as risk multipliers for many well-known resource curse risks.

Carbon-related shifts in energy investment and demand patterns are likely to act as risk multipliers for many well-known resource curse risks. However, their economy-wide implications remain poorly understood and largely unprepared for. Countries could address this by:

  • Building understanding of a country’s exposure to carbon risks and its time frame for transition through the development of multi-decade scenario analyses. These should consider the interaction between production, revenues and demand under different climate constraints, including ‘worst-case’ scenario for fossil fuel investment and demand. While such scenarios will always be imperfect, the process of developing them can help identify the nature of carbon risk between the fossil fuel sector and the wider economy, including the potential range of revenues and the time frame for production. MDBs and development agencies can help support the development of replicable, analytical approaches and build country capacity to utilize them.
  • Developing economy-wide approaches to carbon-related risks and opportunities for green growth, alongside the development of NDCs and long-term low greenhouse gas emission development strategies to 2050 under the United Nations Framework Convention on Climate Change (UNFCCC) process. Countries at an earlier stage of exploration or production may have the opportunity to avoid entrenching high-carbon dependence through their initial decisions regarding revenue and fuel deployment and infrastructure investment. Where fossil fuel production is already underway, the focus is likely to be on developing policies and mechanisms to mitigate carbon risk and support low-carbon transition as part of sustainable economic diversification.
  • Where capacity permits, establishing a cross-government ‘transition dialogue’ to scope the country-specific carbon risks and opportunities that a decarbonizing world presents. This could focus on economy-wide implications, from the energy and industrial pathways that fossil fuel development might lock-in to fiscal stability implications (including the sustainability of debt) and impacts on the wider investment environment for climate finance and for the country’s broader economy. This could be championed at cabinet level, and bring together stakeholders from government institutions related to finance, national planning, energy and power, environment and climate, and oil and gas, among others.

Building country capacities for transition

The impact of these carbon risks over time will of course vary depending on a country’s stage of fossil fuel production, the type and scale of resource, its cost of production and, crucially, the planned allocation of production to export and domestic markets. The proposed role of fossil fuel revenues and/or physical fuel flows in the national economy, and the kinds of carbon linkages these establish – through the spending and investment of revenues and through the development of energy and industrial systems – is a major variable between countries, particularly where gas is concerned. The challenges confronting Tanzania and Mozambique, where most gas production will be exported, look very different to those in Ghana, where gas production will supply the domestic power sector.

The choices that emerging and early-stage producers face differ from those of their more established peers. They include an opportunity to develop along a greener, lower-carbon path from the outset and avoid the need for expensive transition later on.

The choices that emerging and early-stage producers face differ from those of their more established peers. They include an opportunity to develop along a greener, lower-carbon path from the outset and avoid the need for expensive transition later on. For example, a small country like Guyana, which is just embarking on large-scale offshore oil production, will have options not available to populous, established oil producers with significant domestic fossil-fuel demand such as Nigeria and Angola. Countries deciding whether to explore for fossil fuels or develop their discoveries should consider how associated revenues and fuel flows – and the infrastructure they require – might support or undermine national green growth ambitions and the delivery of increasingly ambitious NDCs over time.

Developing capacities in leading institutions and policy areas – including economic governance, energy and industrial policy, and the fossil fuel sector – can enhance a country’s ability to effectively manage carbon risk and support transition. Countries and their advisers should review traditional ‘good governance’ recommendations relating to fiscal governance, upstream oil and gas, and energy and industrial planning with carbon risks in mind, for example:

  • Developing ‘carbon risk competencies’ in key areas of economic governance. Central banks and ministries of finance and those who manage revenues have an important role to play in three key areas: first, assessing the implications of the energy transition for domestic fiscal stability and the time frame for diversification; second, reviewing revenue management frameworks in light of their vulnerability to carbon risks and their potential to support domestic transition and NDC implementation; and third, investing sovereign wealth funds (SWFs) in a way that avoids ‘double’ exposure to high-carbon international assets and helps hedge the overall national balance sheet from shocks.
  • Designing energy and industrial policy to incentivize transition. Getting policy, regulation and pricing right is crucial to a country’s attractiveness for finance and technology transfer. Adopting integrated approaches to upstream, energy and climate planning can help identify the ‘lowest-cost’ pathway to delivering energy access and industrialization goals, and as well as the most flexible infrastructure options and the ideal balance between on- and off-grid power supply over time. Governments should seize the opportunities that urbanization and green industrialization trends present to ‘shape the peak’ in emissions through smart urban design and demand-side management.
  • Preparing the fossil fuel sector for transition. With the right incentives and capacities, institutions that manage and operate in the upstream – including ministries of energy and power, upstream regulators and national oil companies (NOCs) – can help manage carbon and emissions. Building capacity to procure clean technologies, monitor and manage emissions and apply carbon pricing to analysis and decision-making could contribute to this. The establishment and appropriate mandate of an NOC should be carefully considered in light of the likely time frame for transition. Peer-to-peer learning between lower-capacity and more established producers on technical issues and long-term strategy may help.

Aligning development assistance with climate and country needs

As MDBs and development agencies scale up their climate finance and support for green growth, policy and technical advice will need to engage with the unique challenges that developing countries with fossil fuels face. Effective support requires understanding of politically-viable alternative development models or support for transition pathways that account for existing fossil fuel interests and exposure to carbon risks. Sharing experience and best practice across agencies could help speed up this learning curve. For example, the European Bank for Reconstruction and Development (EBRD) supports the TCFD and is integrating ‘transition risk’ into its advice to fossil fuel-driven economies, while the African Development Bank (AfDB) is working to mainstream ‘climate-resilient growth’ and NDC implementation into its assistance to countries with fossil fuels.

These approaches must be grounded in developing country perspectives, and their anticipated support for climate mitigation and adaptation. Should developing countries focus on fossil fuel development and building large-scale, capital-intensive fossil fuel infrastructure instead of reaping the competitive advantages that clean technologies, green urbanization and industrialization and smart, circular economy systems offer, they risk being burdened with much higher costs for low-carbon transition in the coming decades, in addition to the costs of adaptation and loss and damage associated with climate impacts. The following steps will assist partner countries in making the right decisions. Key recommendations for donors and MDBs include:

  • Aligning development assistance to upstream oil and gas and linked energy and industrial infrastructure country NDCs and long-term emissions reduction plans to 2050. Where fossil fuel development is under consideration, MDBs and donors should support country studies to explore whether this is compatible with national climate ambitions, and allows scope for NDCs to become increasingly ambitious over time. Where support to fossil fuels is made on the basis of its contribution to NDC targets – for example gas-to-power in order to displace coal- and diesel-generation – development partners must be prepared to support the wider investment and capacity to effectively deliver this outcome. Where it conflicts with a country’s NDC and wider green growth objectives, development assistance for alternative energy systems and economic activities should be coordinated.
  • Developing clear and consistent policy positions on the re-alignment of development assistance in support of the Paris Agreement, alongside private sector partners. Policy should address the conditions for support to upstream fossil fuels and linked downstream energy and industrial activities under a 2°C scenario, as well as common approaches to the use of carbon pricing. MDBs can provide credit enhancements and package bankable projects to crowd-in private finance into infrastructure that enables a low-carbon, climate resilient pathway. At the national level, donor countries should ensure that the activities of other forms of public finance, including non-ODA policy banks and export credit agencies (ECAs), do not conflict with their development agency objectives.
  • Enhancing policy coherence at the international level. There is a risk that assistance from different actors will support conflicting development models, further damaging prospects for sustainable growth. This makes deepening cooperation with non-traditional donors – and particularly the Asian MDBs, policy banks and ECAs, which provide the vast majority of finance for high-carbon sectors – even more important. Given its role in furthering international cooperation on climate-related financial risk and green finance, the G20 could support dialogue between G20 members (and other key donors such as Norway), participating MDBs and international organizations, and non-participating developing countries, with the objective of coordinating development assistance around these issues. This could also help provide a framework for North–South and South–South lessons-sharing and capacity-building.