Global climate action is changing the growth prospects for fossil fuel producing countries. This paper considers what global climate policy and decarbonization trends mean for lower-income countries that plan to develop their oil and gas reserves to drive economic development, or are already doing so. There are clear evolving market trends and uncertainties around fossil fuels as export commodities, as well as risks that increased domestic production (and use) may present for the delivery of country green growth ambitions and NDC targets and long-term emissions reduction strategies.
Greater competition between fossil fuel producing countries for market share of fossil fuel supply to the transport and power sectors of key markets over the next two decades is inevitable. Many lower-income countries are higher cost producers and lack infrastructure and capacity, putting them at a disadvantage as late entrants to these markets in which the lowest cost producers aim to maintain or increase their market share. At the same time, those developing countries that have yet to begin fossil fuel production or develop dependencies on export revenues, or fossil fuel-fed power systems or industries are at an advantage compared with more established producers, where incumbent interests and the much higher ‘social costs’ of radical reform may present major barriers to transition.
For donors and financiers, there remains some conflict between the commitment to the ‘well below 2°C pathway’ in terms of climate change mitigation and their development assistance to the fossil fuel sectors of developing countries.
For donors and financiers, there remains a conflict between the commitment to the ‘well below 2°C pathway’ in terms of climate change mitigation and development assistance to the fossil fuel sectors of developing countries. To deliver the long-term goal of the Paris Agreement in the least disruptive and least expensive way, fossil fuel use has to fall quickly – coal almost immediately, oil by 2030 and gas by around 2045. This does not mean fossil fuel supply ‘quotas’, but it does require a more nuanced approach to the ways in which development assistance can help identify carbon risk and the barriers to transition at the national economy level, promote economic stability and green diversification, and act as a counterbalance to the influence of political interests, which may override shared national interests in low carbon, sustainable development.
How MDBs and donors engage in this conversation needs to be considered against changing patterns in international investment. Commitment to the disclosure of climate-related financial risks (including carbon risk) and interest in green finance and sustainable investment is rapidly growing among investors, central banks and regulators. At the same time, MDBs and donors are accelerating their climate finance commitments, and moving to de-risk private sector investment in climate resilient green growth areas. Yet reforming development assistance to the fossil fuel sector has proven challenging, and where donors have taken clear policy positions, on coal for instance, other actors have quickly filled the investment gap. This highlights the need for coordination within MDBs and donor agencies, and between them.
New approaches to managing carbon risk
The sustainable investment needs of the global energy transition and its impacts on global financial stability are commanding increasing attention at the international level. Yet the economy-wide implications for countries that are counting on their fossil fuels for development remain poorly understood and largely unprepared for. In order to address these issues, country decision-makers should:
- Build 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. While such scenarios will always be imperfect, the process of developing them can help identify the nature of carbon linkages between the fossil fuel sector and the wider economy, including the potential range of revenues a country might expect. They can also help ‘carbon stress test’ plans and policies, and ensure resilience to a ‘worst-case’ scenario for fossil fuel investment and demand. MDBs and development agencies should work with governments to develop replicable, analytical approaches to carbon risk, and build capacity to utilize them.
- Develop economy-wide approaches to carbon-related risks and opportunities, alongside the development of NDCs and long-term emissions reduction plans to 2050 under the United Nations Framework Convention on Climate Change (UNFCCC) process. Countries at an earlier stage of exploration or production have the opportunity to avoid entrenching high carbon dependence through their decisions over fossil fuels development, infrastructure and energy. Where fossil fuel production is 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, establish 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 should 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. Such discussions could also foster consultative processes that proactively manage societal expectations.
Building country-level capacities and institutions for 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. Developing effective responses will require interventions and capacity-building in those institutions that play a leading role in these areas of policy, which should:
Develop ‘carbon risk competencies’ in key areas of economic governance. Central banks, ministries of finance and those managing SWFs should begin to develop ‘carbon stress-tests’ in key areas of fiscal governance by:
- Assessing the implications of carbon linkages on domestic (and global) fiscal stability, including budgetary dependence on fossil fuel revenues. The current account impacts of growing local fossil fuel consumption (including rising import dependence, often including on fossil fuel products) and linked infrastructure investments, and risks from borrowing against future fossil fuel production should be considered in light of the full potential range of fossil fuel revenue outcomes (and therefore foreign exchange earnings or needs) and time frames for production (and thus diversification) under different climate scenarios, including the ‘worst-case’ scenario for fossil fuel demand.
- Reviewing revenue management frameworks in light of carbon risks and low-carbon opportunities, including regulations and mechanisms that allocate revenues to the national budget, stabilization and SWFs. The processes that distribute revenues through the national budget warrant special attention. Key considerations include how best to distribute revenues between short-term needs, the build out of physical and social infrastructure and long-term wealth creation, and how revenues might be used to drive clean energy and green growth and finance NDC implementation (where they are likely to arrive in time for this). The development of carbon pricing capacities can also support broader fiscal reforms.
- Investing SWFs in a way that avoids ‘double’ exposure to high-carbon international assets and helps hedge the overall national balance sheet from shocks. Emerging and early stage producers should consider following the lead of the world’s largest SWFs and pension funds, and develop ‘best in class’ investment strategies that take advantage of the opportunities presented by lower-carbon portfolios, and reduce exposure to carbon through international investments by diversifying away from or divesting fossil fuel and other high-carbon assets. Clearer guidance from established SWFs and pension funds on how they are assessing risk could help support this.
- Design energy and industrial policy for transition. Well-designed policies can help support the delivery of access to energy and industrialization goals, while incentivizing energy transition and green growth. Getting policy, regulation and pricing right is crucial to a country’s attractiveness for climate finance and technology transfer, and will be aided by:
- Taking an integrated, whole-system approach to energy planning. This should factor in investment needs, energy security considerations (supply disruption, rising import dependency), demand-side management options (energy efficiency, ‘smart’ systems), and the cost of externalities (e.g. carbon emissions, poor air quality, water stress) over time. Such tools can support policymakers in identifying the ‘lowest-cost’ means of delivering national sustainable access to energy and industrialization goals, and the ideal balance between on- and off-grid power supplies. These approaches must be dynamic, and able to respond to new prices and inputs.
- Using energy policy levers to incentivize efficiency and RE integration. Policymakers could begin by examining the policy and practical (finance, technology, pricing) requirements for the most sustainable infrastructure, which will facilitate the scale-up of RE over time. Developing and empowering proficient, independent regulators with a long-term mandate and the authority to ensure value for money for the government and quality of energy services for the consumer is key to getting the incentives right for the required public and private investment over time.
- Seizing the opportunities presented by urbanization and industrialization trends to help ‘shape’ future energy demand, through smart urban planning and the procurement of the most efficient, low-carbon designs and materials. MDBs and donors should consider how concessional finance might be used to incentivize infrastructure with the potential to be zero-carbon, and explore ways of facilitating South–South learning around the procurement, financing and delivery of urban and industrial energy systems and related infrastructure. Such an emphasis can also help shift the focus of energy discussion in fossil fuel producing countries from a supply-led approach to a demand-side, energy services perspective.
Prepare the fossil fuel sector for transition. Where fossil fuel development proceeds, or is already in place, the institutions that manage and operate upstream – including ministries of energy, ministries of power, upstream regulators and state-owned extractives companies e.g. NOCs – can all develop in ways that either help or hinder carbon risk management and energy transition. To help prepare these institutions, governments could work, potentially with assistance from development partners, to:
- Carefully consider the establishment and appropriate mandate of an NOC, given the likely time frame for transition. The distribution of risk between the state and private sector should minimize risk to public finance. Evolution of the NOC as a ‘manager of carbon’ may be appropriate for some, including sharing lessons learned about carbon markets (see below). Where there are ambitions to transition from an NOC to an NEC (national energy company), this should be underpinned by an open and practical conversation about the most appropriate institutions and processes to promote the integration and scale-up of RE and other clean technologies.
- Build capacity within the ministry, regulator and/or NOC to play a role in emissions and carbon management. Energy efficiency and emissions capacities should include the procurement and utilization of RE and efficiency technologies to help reduce sector emissions, and the monitoring and mitigation of methane leakage across the supply chain. Carbon management capacities should include the application of shadow carbon pricing to upstream and power sector decision-making, where fuel supply is to be allocated to domestic energy systems. This necessitates effective coordination with power sector stakeholders and national planners, among others.
- Share experiences and accelerate learning through the establishment of peer-to-peer learning networks. There is clear demand for peer-to-peer learning between emerging and early-stage producers and more established NOCs, petroleum sector regulators and ministries on technical issues, and on the reform of long-term business strategies and national mandates, in line with the risks and opportunities that the global energy transition presents. MDBs, donors and NGOs have an important role to play in facilitating such discussions.
Aligning development assistance with climate and country needs
Developing-country governments anticipate support for climate mitigation and adaptation. Those with fossil fuels will face unique challenges and opportunities as global energy systems are decarbonized. Without greater policy coherence within and between the providers of development assistance, the cost of transition will only grow, as dual, conflicting pathways are funded. There is urgent need for better alignment in three broad areas. To achieve this governments should:
- Align 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 NDC commitments and 2050 plans, allowing scope for rising climate ambition. Where development assistance 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 or LPG to substitute biomass in cooking – development partners must be prepared to support the wider investment and capacity to effectively deliver this outcome. Where fossil fuel development conflicts with a country’s NDC and wider green growth objectives, development assistance for alternative energy systems and economic activities should be coordinated.
- Develop 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 ECAs, do not conflict with their development agency objectives.
- Enhance 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.