Hard choices for low-carbon transition

The Ukraine crisis, energy prices and supply shortages will have serious consequences for the net zero transition, explain David McNeil, head of climate risk, and Aurelia Britch, director, Sustainable Fitch.

Energy policy responses to the Russia-Ukraine crisis are starting to emerge, as western countries try to rapidly decouple their economies from dependence on Russian fossil fuels. These shifts are set to be costly and technologically complex, with supply chain and inflationary pressures acting as headwinds. Trade-offs between sustainable, secure and affordable energy are likely to become acute.

The European Union’s REPowerEU policy package announced in March 2022 aims to reduce European dependence on Russian fossil fuels and diversify energy supplies across liquified natural gas and renewable energy, introduce energy efficiency measures and develop local biogas production. Nonetheless, wider inflationary pressures could limit the viability of some goals. Price regulations and other market interventions to support households and small businesses could be widely deployed in the coming months. The package suggests measures such as temporary relaxation of state aid rules, windfall taxes on energy companies and wider recycling of revenues from the EU Emissions Trading Scheme to assist households.

These market interventions could pose credit risks to utilities companies, particularly if inflationary pressures persist.

Increased LNG imports represent the bulk of the short-term target but may involve significant costs given globally traded LNG cargoes typically ship wherever prices are highest, while demand from Asia is strong and spot prices are extremely high. Moreover, the climate impact of key LNG sources is high in the form of methane leakage (Figure 1).

Besides energy security implications, the Ukraine conflict has exacerbated metal market tightness and sent prices for a number of metals key to energy transition technologies soaring to all-time highs. This could pose challenges to the development and adoption of transition technologies.

Russia is the largest exporter of nickel, accounting for 21% of global refined nickel exports in 2021, a commodity which is central to many types of lithium-ion batteries. It also accounted for 7% of global refined copper exports last year, a cornerstone for all electricity-related technologies (including batteries, renewables and wind technology). The country is the second largest exporter of refined aluminium (9% of global exports in 2021), which is used in batteries and also important for electricity networks. Russia also accounted for 10% of global platinum production in 2021, used in hydrogen fuel cell vehicles.

Sanctions imposed on Russia will most likely disrupt mineral and metal production and trade in the country. Buyers have reportedly started to shun Russian metal supply as the threat of further sanctions directly impacting metals mounts, exacerbating supply chain pressures at a time of already tight commodity markets. With prices of most metals including copper, nickel, aluminium and zinc now close to or reaching new all-time highs, battery and renewables equipment manufacturers will face escalating production costs and significant supply chain challenges to secure supply from elsewhere.

Raw materials account for up to 80% of the cost of batteries. As a result, the magnitude of the price rally could reverse in 2022 the long-term trend of falling batteries costs, which are the most expensive component of electric vehicles. Climbing manufacturing costs, coupled with the lingering chip shortage could curb EV production capacity this year. They could also dampen the strong momentum of EV sales, as elevated costs for new EVs relative to internal combustion engine vehicles remains one of the biggest barriers for EV adoption according to consumer surveys.

Renewable equipment manufacturing could also be impacted, given most components for renewables include copper, and some also require large quantities of zinc (wind) and polysilicon (solar). This could delay installation for new renewable projects – nearly a quarter of planned solar projects in Europe were cancelled in 2021 because of rising raw material costs (Figure 2).

While European producers are most at risk of lower physical supply given their high reliance on Russian metal exports, the rally in low-carbon technology materials prices will impact most producers around the world. These acute supply challenges could add impetus to the trend of low-carbon technology manufacturers securing supply for strategic minerals by signing long-term agreements with upstream players located in stable markets with better sustainability records, such as Australia.

Skyrocketing prices of materials will also incentivise public support and private investment for the circular economy and recycling of batteries. Investment in battery recycling capacity has picked up since 2020, with automobile companies looking to take an active part in the process. Supply chain challenges will add impetus to that trend. Private sector and investor measures in support of the circular economy are likely to accelerate.

Figure 1. Methane intensity of oil and gas production by country
t methane/ktoe

Source: International Energy Agency

Figure 2. Investment cost structure by commodity
% of total investment costs

Source: International Energy Agency