Times are turbulent—and all industries are being affected. That said, energy companies in particular face a number of disruptions from both macroeconomic and energy-specific shocks, including volatility in commodity prices, increased pressure to reduce carbon emissions, and supply chain disruptions. In fact, the majority of current energy and commodity prices are significantly higher and much more volatile than they were before the COVID-19 pandemic.
History teaches us that energy companies that create and pursue new opportunities during times of crisis are more likely to emerge as winners.1 However, shifting the mindset from merely reacting to volatility to taking the opportunity to thrive can be difficult. Doing so requires not only capturing larger trends but also understanding additional risks that can emerge as new opportunities are pursued.
This article explains how leading energy companies can thrive in this challenging environment by getting a better handle on current risk exposures and capturing opportunities to optimize portfolios for long-term, sustainable growth.
Europe’s changing energy landscape: An overview
According to a recent McKinsey report, the energy transition is creating opportunities for European countries to pivot toward domestic clean-energy production.2 However, the costs of switching to clean energy by 2050, and thus becoming less dependent on fossil fuels sourced from unreliable regions, are estimated at $5.3 trillion.3 The switch to increased renewables thus comes with a price, particularly as it relates to upgrading electric grids, the need for baseload power with hydro pump storage plants, and smarter technology in homes and offices for heating or cooling.
Further complicating matters, the energy landscape is becoming increasingly circular, complex, and volatile. For example, the power value chain has changed: consumers have become prosumers as new business models have emerged, and the addition of renewable-energy sources has increased demand and price volatility. Furthermore, the COVID-19 pandemic and the invasion of Ukraine have had a significant impact on the lives and livelihoods of millions of people and resulted in significant supply chain disruptions. Both have raised the prospect of an economic recession and amplified market volatility affecting energy companies and consumers alike.
On this point, a few recent examples of price spikes illustrate the expected increase in volatility. In early 2021, more than 4.3 million homes and businesses across the state of Texas lost power after a polar vortex brought temperatures to a 30-year low.4 Over the course of a week, power prices spiked, jumping from approximately $1,000 per megawatt-hour (MWh) to $9,000 per MWh. In another example, from 2016 to 2020, Australia experienced a significant increase in negative price events, primarily driven by distributed solar photovoltaics (PV). Finally, regional differences are becoming more apparent and will need to be managed. At one point in 2021, power cost more than £2,000 per MWh in the United Kingdom and approximately €100 per MWh in Norway.5
Moving forward, price volatility is expected to further increase because of the higher penetration of intermittent renewables, requiring companies to structure a risk management approach.
Playing defense: Structuring a risk management approach
Shifting the mindset from surviving to thriving requires companies to play defense—and structure a successful risk management approach—before playing offense. This means understanding the larger trends by collecting the right data, conducting analyses, and then using the results to inform decision making. With these points in mind, companies can take four practical steps to navigate times of uncertainty.
Step one: Create transparency around risks
Creating transparency requires companies to take a snapshot of their current risks. By building a heat map, companies can break down these risks and determine which should be prioritized (table). In addition, heat maps can illustrate how certain actions can result in additional, previously unseen risks. They can also help leadership understand risk ownership, managing where risks occur in silos. Risk data is not meant to stay in the engine room—it should be taken into the boardroom. A one-page heat map overview can help facilitate this shift by making the risk data understandable at all levels of the organization.
Step two: Engage in quantitative modeling
Heat maps essentially provide a snapshot of portfolio risk. As a next step, quantitative modeling can illustrate the entire distribution of risk, effectively creating a dynamic portrait. Risks can be quantified through a high-level outside-in analysis, and the models can help company leaders better understand the impact of investment strategies. Such methods are based on risk modeling derived from investment banking after the financial crisis of 2008, during which the industry undertook significant upskilling.
Step three: Stress test
Once the quantitative models are created, relevant scenarios can be applied to the portfolio with direct indications of how they will affect company finances, and expert projections can be supplemented with simulations to re-create real-world complexities. The results of the stress testing can help shine a light on the probability of disruption as well as possible mitigation efforts.
Step four: Ensure risk governance
For a company to benefit from sophisticated risk modeling, the results can be presented to the board in an actionable way so that decision making can be based on those results. Many energy companies already have the data and know how to manage it. However, it remains challenging to build a comprehensive view of the portfolio that can be easily communicated to top management and to the board. On this point, the results of stress testing will need to be translated in a way that makes sense—and getting the data right takes significant effort. Through simple, informative dashboards that show the evolution of the portfolio, management boards can be engaged and then decide on a road map to tackle the risks.
Playing offense: Pursuing new value chain opportunities
Once the risks are fully understood, companies can begin pursuing promising new opportunities, which often entails creating optionality through rapid capital allocation to new business areas and expanding into new value chains. Shifting from playing defense to playing offense is a matter of having the right mindset. Many companies want to weather the storm by covering their bases, but emerging as a winner requires also building on strengths.
As an example, a leading energy player in the United States recently undertook a significant write-down on its renewables construction plans because of inflation and shortages in the supply chain. The risk materialized in higher capital expenditure costs, while expected revenues were mostly fixed over a long period without indexing to inflation. As a result, the obvious defensive play would have been to move away from renewables. However, taking the offense, the company embraced this risk by forward integrating. In other words, it invested in the vessels needed to construct offshore wind parks.
Another example is in the natural-gas industry. In 2022, some German companies in the industry saw losses close to €20 billion because they ran out of gas supply but still had to meet their delivery obligations. A defensive reaction would have been to simply ramp down these activities, because sourcing gas was no longer a viable option, and to focus on other business activities. In contrast, one company built on the still-existing demand for gas, leveraged existing relationships, and doubled down on becoming a major player in supplying liquefied natural gas (LNG) to Europe. This entailed booking capacity in LNG facilities and being a part of the construction consortiums of LNG terminals, which in Germany are typically public–private partnerships. Essentially, the company was able to become a player in the LNG business by accelerating its LNG regasification plans.
As a last example, energy costs and renewables in Europe faced extremely high prices in 2022. Moving forward, the defensive play across industries will likely be to ramp down production and move to other markets that are more competitive in energy sourcing and cost. However, other markets and geographies have higher proportions of fossil-based fuels in their energy mixes, so companies may find it harder to meet sustainability goals without taking additional action. One offensive play, as made by a large chemical company in Europe, is investing in power production and taking equity in renewable power, thereby securing energy for a company’s own supply chains and processes at competitive prices.
European energy companies face a number of challenges, particularly when taking offensive action. However, making these bold moves—especially during times of crisis—can pay off and give companies a competitive edge in the long term. Companies can ultimately choose whether they want to simply shield themselves from risk or embrace it and integrate it into their strategic decision making. Pursuing the latter can make the difference between surviving and thriving in the years to come.