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A Low-Risk Way for Oil and Gas Firms to Get in on the Energy Transition

Now is the time for oil and gas companies to get involved in renewable energy. Fossil fuels provide the bulk of energy consumed in the U.S., but oil and gas (O&G) companies saw declining energy consumption in recent years and face a negative, long-term economic outlook.

According to Wood Mackenzie, wind and solar will make up 50% or more of new electricity generating capacity additions in the U.S. through 2050. With revenues from carbon-emitting sources declining, the best path forward for oil and gas companies is to participate in the energy transition.

COMMENTARY

Over the next decade, the pivot away from carbon-emitting resources will take many forms, and different companies will adopt different strategies as they begin their foray into renewable energy. While company size, geography, risk tolerance, and several other factors will determine initial strategy, there are several strategies that are particularly well-suited for O&G companies looking to begin their transition: power purchase agreements (PPAs), land leases, developing or acquiring renewable energy projects, or investing in renewables through a structured equity product called “tax equity.”

Gary Durden

Power Purchase Agreements: One of the simplest strategies is to procure electric power by signing PPAs with renewable energy project owners. PPAs with corporate buyers are increasingly common among wind and solar projects, with more than 24 GW of renewable energy procured via PPA globally in 2020. PPAs allow O&G companies to directly encourage the development of new renewable energy projects while reaping the economic benefit of locking in a low cost of power for periods of up to 20 years. With some projects, companies can also purchase the associated renewable energy credits (RECs) that can provide additional revenue streams through trading on secondary markets, or be used to meet said company’s ESG (environmental, social, governance) goals.

Land Lease: Leasing of land is often easy for both O&G companies and project developers. Since the land is often considered brownfield, it should be easy to permit and attractive to project developers. Often these brownfield sites have an easy point of interconnection to local transmission lines as well. Site leases may be structured with a fixed rent schedule or as a royalty payment based on the revenue the project earns. With terms of 35 years or more, site leases can provide lessors with a long-term revenue stream with little to no associated expense.

Project Development and Acquisition: Already many of the largest oil and gas companies in the world, including the UK’s BP and Italy’s Eni, invest directly in renewable energy by establishing operating divisions that seek to develop or acquire renewable energy projects. Renewable energy projects generate a stream of cash distributions, which are often contracted to protect against cash flow volatility for a significant portion of the project’s 30-plus-year useful life. Project owners also earn tax benefits, such as accelerated depreciation and federal tax credits. Companies with large tax liabilities from other operations can recognize these tax benefits directly. Companies without significant tax liabilities may still monetize the benefits through a partnership with a tax-efficient investor. Owners may also benefit from the appreciation in value of their assets caused by movements in energy prices or discount rates.

Tax Equity Investment: O&G companies that don’t want to develop or own renewable energy projects can invest using a structured equity product commonly termed “tax equity.” As a tax equity investor, an oil and gas company will provide capital that helps projects get built in exchange for a share of the project’s tax benefits and cash. While the structure is considered equity, it has protective characteristics that result in a risk profile that is more like debt. The limited supply of tax equity in the market allows investors to earn returns that are higher than might otherwise be earned based on the risk profile; therefore, tax equity investing is an especially attractive option for investors who have sufficient tax liabilities to efficiently monetize the tax benefits.

These are by no means the only methods by which oil and gas will pivot into a carbon-free economy. We have seen companies like Shell announce plans to invest in EV charging stations, but most will begin their energy transition with smaller steps. These four strategies provide a low barrier to entry for most O&G firms, especially those with project development or project finance expertise in house. In addition, these four pivots will help them quickly build a more resilient business that is not exposed to rising capital costs and lower global demand for oil and gas. It will help O&G groups capture the revenue found in the transition to a carbon-neutral economy.

Gary Durden is a managing director with CohnReznick Capital, based in the New York office. He provides transaction management and advisory services for clients in the sustainable energy sector, including corporate M&A, capital raises, and structured finance solutions for wind and solar projects. Gary has closed equity investments in more than 5 GW of utility-scale and C&I wind and solar projects, including tax equity, cash equity, and sale lease-back transactions.