2022 in review: Goodbye normality, hello volatility

It is hard to overstate the significance of global events in 2022 on commodity markets and the energy transition. Russia’s full invasion of Ukraine was a seismic event that propelled geopolitics and energy security concerns to the top of the policy agenda. The shockwaves sent through the energy system were felt first and strongest in European gas prices, with powerful secondary effects quickly rippling around the world and across all fuel sources. The resultant inflationary price pain now being felt by consumers sparked a ‘cost of living crisis’ that is still in its early stages.

Russia sowed the seeds of the 2022 energy crisis in mid-2021 by curtailing the availability of ‘top-up’ flows of pipeline gas into Europe. This depleted European gas stocks well below seasonal norms, leaving wholesale energy markets febrile and vulnerable to further supply shocks. The full-scale invasion on 24th February and subsequent disruption of flows on the Nord Stream pipeline triggered a series of wild gas price spikes in Q1 2022.

These actions stunned many observers who saw the invasion and weaponisation of energy as contrary to Russia’s strategic interests. The costs to Moscow are now being borne out in real time. If these events were ‘ground zero’ then the policy response could be seen as the aftershocks – just as powerful as the initial blast but spread across hundreds or thousands of detectable ‘tremors’.

The world was given a taster of the sea-change in European political thinking in May when the EU unveiled its REPowerEU package of reforms designed to super-charge renewable energy deployment and energy efficiency measures (read more in our blog ‘6 Ways The REPowerEU Plan Supports Energy Affordability’). The Inflation Reduction Act of 2022, which makes the single largest investment in climate and energy in American history ($369 billion), gave another strong signal of the direction of travel in the US.

With this in mind, we have reviewed the five predictions made by TransitionZero at the start of this tumultuous year and scored them with the benefit of hindsight. We also cast our minds forwards to anticipate how each of these trends will evolve, with predictions for 2023.

1. “Energy crisis could be a multi-year event without policy reform”

Hindsight score: 9/10

Unwittingly, this part of our January 2022 forecast turned out to be an understatement. Particularly pertinent was this line: “EU gas prices dropped precipitously late last year… [but] these price declines are likely to be short-lived.” 

War in Europe has guaranteed a prolonged energy crisis and quashed any hopes of an orderly transition. Policy reform is coming thick and fast but cannot prevent a messy, chaotic and more expensive shift towards cleaner energy sources that will have both positive and negative consequences.

For example, TransitionZero’s Coal to Clean Carbon Price Index (C3PI) reveals how precipitous cost reductions over the last decade have allowed dispatchable clean power to undercut the cost of running as much as 60% of the world’s existing conventional generation capacity. The world crossed the Rubicon in 2021 when the average cost of new wind and solar power plus storage installations fell below that of existing gas generators, and the gulf widened into a structural discount as the events of 2022 unfolded. We expect the discount to endure the post-Covid inflationary blip in renewable energy costs.

On the downside, a hyper-accelerated chaotic energy transition means a widening disconnect between short- and long-term policy objectives. Gas-to-coal switching is a necessary but fleeting measure to guarantee power supplies. It is not a signal of weakening climate resolve. More concerning is the rush to lock capital into new natural gas infrastructure that will outlive Europe’s need to replace Russian molecules with liquefied natural gas (LNG).

Prediction for 2023:
The economic consequences of an enduring energy crisis will bite hard in 2023, defining fiscal and legislative agendas. Corporate and country insolvencies are now inevitable, as the depth of the financial crisis will crimp the ability of nation states to support all at-risk sectors of their economies. Expect an overly-apocalyptic news cycle centred on demand destruction, deindustrialisation and economic contraction. The noise will mask the signal of European political resolve around the national security imperatives of decarbonisation.

Emerging markets are struggling to adapt to the new higher energy price environment, with most priced out of the market. Existing LNG buyers must bite the bullet on import costs, with governments using subsidies to keep energy affordable for consumers. The cost burden of subsidising gas consumption will crimp LNG demand growth in the coming years, posing a risk of state utilities in regulated markets falling back on coal to ensure security of supply. This could quell appetite for coal phase-downs without concerted international support to remove barriers in local markets.

2. “Price formation in the EU ETS could exacerbate CBAM politics”

Hindsight score: 5/10

The European carbon price was a rare beacon of stability during an otherwise tumultuous year for commodity markets. The cost of emissions allowances (EUAs) on the EU-ETS finished 2021 at the equivalent of €80/tonne in December, and essentially stayed at that level throughout 2022. EUAs averaged €82/t throughout the year, and traded within a relatively narrow range of €58/t and €97/t.

We were right to presage the possibility of EU carbon prices remaining “stubbornly high”, and in other circumstances these might have “exacerbate[d] the politics associated with the EU’s carbon border adjustment mechanism” (CBAM). Trade tensions were sidelined by war and whipsawing wholesale energy prices.

EU lawmakers last week finalised a landmark deal to implement CBAM in October 2023, but under a toothless test phase that will last as long as European industries enjoy free allowances under the ETS. A provisional deal on the ETS was agreed on 18th December, agreeing that free allowances for industrial sectors would be phased out between 2026 and 2034. CBAM was hastily passed in response to the Inflation Reduction Act, which is luring EU industries to boost their US production capacity with billions of dollars of tax credits.

In parallel, US officials are proposing to levy carbon tariffs on steel and aluminium. Together with CBAM, this could create the basis for a global ‘club’ of tariff-exempt trade that will put major industrial exporters such as China and India on the back foot. But so far, the biggest impact has been to raise the prospect of ‘green protectionism’ (see Bonus Prediction below).

Prediction for 2023:
Carbon border taxes remain a politically charged topic that could spill into mainstream discourse at any moment, but the first political fight will be internal to the EU over ETS reforms and the end of free allowances. Until EU heavy industries relinquish free EUAs and pass through carbon costs in full to their customers, CBAM will have limited geopolitical impact. This won’t happen in 2023 but CBAM’s symbolic implementation will loom large over trade talks between the EU and its major trading partners, which are rarely straightforward even in benign periods.

3. “Economic policy easing to test China’s net-zero convictions”

Hindsight score: 6/10

‘Easing’ has been the buzzword for China watchers in 2022, albeit mainly in relation to Covid restrictions rather than economic policy. The two are linked, of course, and Beijing’s reluctant climbdown from its strict zero-Covid policy (in the face of unusually widespread civil disquiet) will re-open the world’s second largest economy. China’s strategy of localised lockdowns and forced isolation lasted longer than many commentators predicted. Reports indicate Covid easing is finally gaining pace.

The biggest surprise is that zero-Covid lasted as long as it did. The questions we raised at the start of the year thus remain unanswered: how will China achieve economic growth, and will it lock in unsustainable emissions in the process? Aside from the air pollution and carbon impacts of relying on coal, China risks further financial losses for coal-power generating companies and the potential for heightened water use stress during droughts (read more in our two China-related blogs ‘Feel the burn’ and ‘Thirst for (clean) power’).

Prediction for 2023:
China’s post-Covid reopening will trigger an ‘exit wave’ of infections that disrupt business and travel, postponing a reinvigoration of economic activity until the second half of the year. Clean and conventional energy sector investment will continue unabated, with China expected to make more big strides in offshore wind. Progress here will make China’s many electricity market inefficiencies more difficult to ignore, injecting urgency to long-overdue power sector reforms. Exploratory moves towards market-based pricing will continue, but are unlikely to be effective. The strengthening global consensus around the need to quit coal will add a geopolitical dimension to the calculus over whether to authorise new coal plants. Beijing will tread a careful line to secure its energy needs while avoiding climate pariah status.

4. “Finance to replace coal plants in the Global South takes tentative steps towards implementation”

Hindsight score: 9/10

Climate finance for coal retirements is yet to move out of the ‘pledges’ phase, but the preferred vehicle for implementation is taking shape. Just Energy Transition Partnerships (JETPs) are gaining traction, with Indonesia and V1 both announcing in late 2022 respective high-level deals that include coal refinancing at their core. South Africa will be first to road-test these mechanisms, having pioneered the JETP model at COP26.

As the drawn-out V1 negotiations attest, getting a JETP over the line is a considerable undertaking. Yet as explored in our latest blog, ‘Indonesia’s coal retirement conundrum’, that’s just the first step. There’s a lot we don’t yet know about how JETPs will be implemented on the ground. Chief among these is the incentive for commercial banks to participate with concessionary loans.

Prediction for 2023:
To mobilise private capital, international partners and host governments will coalesce around the need to issue carbon credits for coal asset refinancing and repurposing. This will raise tricky questions around the credibility of measurement, reporting, and verification (MRV) given there is currently no approved methodology for baseline-setting and accreditation.

5. “Sustainability-linked bonds boom as greenwashing looms”

Hindsight score: 3/10

War, inflation and the end of quantitative easing hammered bond markets this year, resulting in the first ever annual dip in overall global green bond sales. Issuances in 2022 sank to $635 billion, down 30% on 2021. Sustainability-linked bonds (SLBs) gained market share but this ‘boom’ occurred within a contracting sector.

SLBs are still plagued by concerns over transparency and moral hazard. Most coupons contain step up clauses of 25bps that kick in if Key Performance Indicators (KPIs) or Sustainability Performance Targets (SPTs) are missed, meaning investors benefit from issuers’ failure to meet environmental or social goals. This underscores the need for a reformed coupon structure that better aligns incentives between issuers and investors, and incorporates more aggressive KPIs and SPTs.

Prediction for 2023:
With bond markets expected to rebound from 2022 lows, demand for green bonds should return to growth in 2023. This will sustain interest in standards to ascertain the integrity of SLBs, and in the need for better data to support ESG investing more broadly. We will continue to analyse steel companies from an emissions and cost perspective through our suite of tools, such as the Global Steel Cost Tracker, and provide insight into the pricing and verification of these bonds to mitigate greenwashing and support sustainable capital allocation.

6. Bonus prediction: Carbon trade wars and green protectionism loom large in 2023

While the events of 2022 did not yield significant progress to deliver on climate pledges, they did supercharge awareness of the risks of unmitigated fossil fuel reliance and the national security benefits of transitioning to clean energy sources. Implementation remains underwhelming but new policy and financial instruments offer an opportunity to create a virtuous circle of carbon pricing, border tariffs, international climate finance and revenue repatriation.

If CBAM and JETPs go hand-in-hand, the result could be decarbonisation at home and abroad. Rather than paying the EU or US a border tariff for carbon-intensive products, global exporters will be incentivised to institute their own domestic carbon pricing and reinvest those fees in cleaning up their export industries. But repatriating the carbon fee alone won’t always be enough, which is where JETPs come in. Blended finance targeted to the lowest hanging fruit on the abatement cost curve can enable less developed economies to participate in low-carbon, tariff-free climate trade clubs that would otherwise exclude them.

Economic inclusion is key to delivering a just energy transition that spreads the benefits of decarbonisation equally around the world. The alternative is a world of ‘green protectionism’ and carbon trade wars that hinder the free flow of goods, services and capital required to rewire the global economy around clean fuels. The geopolitical events of 2022 fostered the narrative of deglobalisation, so 2023 will be a crucial year for world leaders to steer a course to a more participatory and equitable trade-based shift in energy systems. 

TransitionZero looks forward to another energetic year working with partners and stakeholders to inform business decisions with investment-grade data, tools and digital resources.