The next wave: energy transition projects to expand dramatically

 
Governments will need to use a balance of levers to both compel and impel such a dramatic level of activity.

Energy transition—a generational mandate

As part of its 2015 Paris Accord obligations, Canada has committed to achieve a net-zero economy by 2050. Domestic plans and guidelines provide interim targets between 2030 and 2035, which may be even more challenging to attain.

Energy use contributes 70%-80% of global carbon emissions, while transport accounts for about 30% of energy use. Globally, many commentators predict that the first wave of energy transition projects will focus on the decarbonization of the energy supply mix, while the second wave will focus on the decarbonization of transport energy consumption, at least in part relying on a greener energy system. In Canada, the greening of the electricity grid is already well underway in many parts of the country, and initiatives for greener transport are already advancing. For example, the 1,000 km intercity High Frequency Rail project is planned to operate with electrified technology. 

There is broad Canadian acceptance of the imperative to move towards net zero, and not just from governments. Pathways Alliance is a notable initiative of Canada’s largest oil sands companies, with a goal of net-zero emissions from operations. The required cadence of the transition isn’t universally agreed upon, though. The on-the-ground realities of accelerating change are leading to some concern about whether this might become a “disorderly” transition (with claims that there will be implications for power system reliability and costs) and concerns about the economic inefficiency of stranding reliable power systems well before the expiry of their useful lifecycle. We are seeing this friction show up in, for example, the Alberta moratorium on renewable energy projects, and the recently successful challenge to the constitutionality of the federal Impact Assessment Act. On the horizon, we may well see a range of opinions regarding interim milestones before 2050, including in response to the draft Clean Electricity Regulations, calling for a net-zero electricity grid by 2035, and the proposed oil and gas emissions cap.

Canadian policy imperatives of the day tend to drive infrastructure and energy sectoral activity. In the 1990s and 2000s, we saw a significant build-out of social infrastructure (municipal, universities, schools and hospitals). In the 2010s and 2020s, civil and economic infrastructure (power, water, telecom, and transport infrastructure) came to the fore to impel economic activity, getting goods, people and ideas to market. This also reflected a trend towards favouring revenue-producing projects which are, at least in part, self-financing. Energy transition infrastructure has been on the rise for at least the last decade, and now appears set to accelerate and overtake other infrastructure sectors as the highest priority for the next few decades.

Governments have been seeking, for some time, to balance economic prosperity and adaptation to environmental and climate change pressures. The country’s fiscal capacity has been greatly strained by the costs of COVID-19, rising interest rates and inflation, geopolitical conflicts and supply chain disruptions, challenging the ability of both governments and the private sector to invest in energy transition projects unless they are economically viable, or at least have an obvious path to economic viability. 

As net zero and energy transition imperatives rise to the top of the policy priorities, governments will struggle with the temptation to make palatable trade-offs between a robust economy and energy transition. Yet only with a healthy economy will the costs of energy transition be affordable, and so smart approaches to economic infrastructure that support energy transition likely won’t be squeezed out. For example, despite the recent moratorium, Alberta’s deal-friendly market positions the province to become an attractive environment for renewable projects.

This will be (very) expensive

We have seen and tackled massive capital program requirements, more than once. The market initially balked at the gravity of the 2014 McKinsey estimate that $57 trillion would be needed (over 10 years) to build new essential global infrastructure. It turns out that was only the opening act, which now will be dwarfed by the cost of the energy transition.

The energy transition capital need, estimated by McKinsey at $275 trillion by 2050, is a multiple of the already daunting infrastructure challenge. Estimates vary but generally assume 4-9% of national (and global) GDP would need to be dedicated annually through 2050, while only roughly one-third to one-half of that amount has already been committed. For Canada, the capital need is estimated at $2-$4 trillion, as compared to GDP of around $2.2 trillion and total federal government expenditure estimates of around $400 billion annually.  

Capital programs at that scale greatly exceed current energy capital spend, potentially cannibalizing other capital and operational program spending, and have seeded some hard discussions of how (and how quickly) to proceed with energy transition and how to balance competing priorities. The pursuit of scarce mineral, technological, human and capital resources, both within and between nations, is quite likely to create inflationary pressures and/or challenge time-sensitive policy timelines.

There is ample private capital available for investment in income-generating assets, but the current returns on many energy transition projects are insufficient to overcome project risk and yield an economic return sufficient to unlock that capital. Policymakers are disinclined to solve for the investment thesis by dramatically raising energy prices, for fear of losing public support. But somebody will need to pay for a capital deployment of this scale.

What needs to be done?

If net zero is accepted as today’s highest public policy priority, a few lines of activity present as high-leverage opportunities to move the dial.

First, our domestic energy mix must become less carbon intensive. This will require displacing some carbon intensive energy with less carbon intensive energy sources, including renewable power, hydro, nuclear power, and other green energy. For example, small modular reactors and other nuclear projects are gaining traction with more policy and financing support.

The inherent intermittent power challenges of renewable power generation would be addressed in part by energy storage projects, which are being incentivized by the federal government and individual provinces. In addition, CCUS, reforestation and other carbon-offsetting technologies will be essential to achieving a net-zero outcome.

Second, attention must turn to making Canadians more carbon-efficient energy consumers. Consumer EV vehicle incentives will assist, as will harnessing domestic supply chain security through EV manufacturing, EV battery manufacturing and harnessing our domestic critical minerals resources. Hydrogen and other low-carbon fuels are a highly promising component of the energy storage and transportation mix, particularly for heavy transport and commercial applications, although some early market adoption challenges must still be overcome. Nevertheless, hydrogen projects are seeing increased support from policymakers, which can help progress some of these early challenges.

Tax incentives will in part mitigate the potentially uneconomic cost of projects, as well as introduce competition with other markets for scarce resources, in part in response to the incentives available in the United States under the Inflation Reduction Act.

Although energy transition projects will dominate the market, further economic infrastructure projects will continue to be important in their own right to drive productivity and GDP growth, which would help facilitate an affordable energy transition. And social infrastructure projects will continue to be essential to our social and political fabric.

What hurdles must be overcome?

Priorities for governments and the private sector are always in flux, but a few trendlines are obvious. The scale and urgency of energy transition require some upgrades and modernization of the legislative, regulatory and policy-driven factors that have historically delayed or frustrated ambitious projects. 

There is an obvious financial pressure to efficiently source and deploy massive amounts of capital. The energy transition challenge is beyond a whole-of-government challenge, extending to the whole of the public and private spheres of the economy. While government fiscal capacity is somewhat constrained, there is ample private capital available to support economically viable projects and activities that satisfy ESG objectives. The challenge will be to support economic viability through a broad industrial policy to enable revenue certainty and certainty of government financial support. 

To mobilize energy transition projects at this unprecedented pace, our regulatory landscape needs to become more nimble. Critical minerals and hydrogen projects require a faster and less complex project approval and environmental approval scheme. For example, while Ontario may be behind other provinces when it comes to carbon sequestration projects, a new regulatory framework is underway to authorize special carbon storage projects, sending promising signals to project proponents.

In addition to changes in regulations, energy projects need to consider embracing newer approaches to partnerships and contracting. Indigenous communities need to be brought into projects earlier, and with a more holistic form of Indigenous equity partnership and project participation in mind. More collaborative procurements are required to enable win-win approaches rather than win-lose principles associated with some current rigid contracting models. 

The federal government and provincial governments have demonstrated a sustained commitment to making worthwhile projects happen, even if they are not completely or immediately self-financing. Canada Infrastructure Bank (CIB) has 5 focus key areas (green infrastructure, public transit, trade and transportation, broadband and clean power), as well as Indigenous infrastructure across all 5 key areas. CIB’s trade and transportation focus area recently expanded to support transport and other enabling infrastructure for critical minerals projects. The CIB focus is a good indication of the federal government’s current policy drivers.

The scale of the challenge will require both a whole-of-government effort and a whole-of-economy effort. Neither governments nor the private sector can solve this alone, and private capital and innovation will buttress government fiscal and policy measures.

If you build it, will they really come?

A great number of major projects (including most privately financed projects) are endorsed through a business case: a reasonable estimation that there is a proven technology, and a reasonable probability of sufficient revenue, to absorb project capital and operating costs, to manage project risk, and to provide a reasonable economic return in the case of projects with private capital.

Some of the proposed energy transition projects don’t yet have such a level of certainty. CCUS and hydrogen projects currently may have unproven demand and revenue assumptions. Critical minerals projects enjoy high demand but face an uncertain regulatory landscape. In addition, the mining sector finds itself in a balancing act between market demand and mineral supply constraints. Some uncertainty on the recapture rules for the Clean Technology Investment Tax Credit may mean they are not fully valued in project financial models or throughout supply chains. Some efforts must be taken to de-risk projects and programs in order to proceed with greater certainty and at the desired pace.

Projects can be broadly categorized into the following categories: (i) those that are already self-financing (requiring only private capital); (ii) those that have little or no return (requiring purely public capital); and (iii) those that have some revenue, but at a level of certainty that is either inadequate for a project to be self-financing or that has large or not well understood risks (requiring a mix of public and private capital, at least as a bridge until project uncertainty is resolved). Half to two-thirds of the required energy transition investments fall into this latter category, requiring significant additional support from both the public and private sectors to gain the desired momentum.

CIB can be a key enabler of such projects that are in the public interest but are not yet entirely self-financing, requiring time to prove demand, revenue viability or technological merit.

A flexible and pragmatic approach for a generational investment

There are many daunting challenges before us: doubling the electricity generation and production capacity, enabling new critical minerals mines, offsetting carbon-based energy sources with green energy and green hydrogen, proving up CCUS and hydrogen technologies, improving the speed and certainty for major project approvals, and enabling project equity roles for indigenous communities. Each of these would be a significant standalone challenge. Attempting to resolve all of them in tandem requires a patient and flexible approach.

Both governments and private sector participants must take a pragmatic and collaborative approach to market supply and demand constraints, appropriate government incentives and disincentives, and the required regulatory, procurement, financing and contracting approaches. Such a level of mutual commitment will set projects up for success, rather than failure, delay and/or prolonged disputes. And we expect energy and infrastructure projects will continue to adjust their approaches to risks in order to carry on project procurement and development at the pace the transition requires.

A long and winding road to energy transition

We see vibrant infrastructure and energy markets for decades ahead. The sectors will rotate such that energy transition becomes most active, followed by economic infrastructure and then social infrastructure. The scale of the energy transition investment will require a whole-of-economy approach, in which governments and private investors together commit significant capital. Canada will also need to utilize policy, regulatory measures, fiscal support and a tax framework that enables and accelerates essential projects and unlocks significant private-sector investment. While the interim 2030 and 2035 targets may feel like a sprint, the 2050 targets will feel more like a marathon. With coordination, pragmatism and consistent determination, Canada can successfully traverse this road.