Allocating Resources between Renewables and Fossil Fuels
There was general agreement on the policy of developing renewable investments, but when specific projects came for approval, management and the Board needed criteria to decide if a particular approach was right for the company. Statoil’s leaders had to reassess their processes for choosing investments. What was the appropriate measure for risk and reward? Should they set a different hurdle rate for the renewable sector or continue with the same assumptions they used in making oil and gas investments? How should they define financial value in a market that does not yet exist? How could they match the nimbleness that renewable start-ups had used to enter new markets?
New Mindset
One of the challenges to the new renewable energy sector was the need for company decision-makers to develop a new, more entrepreneurial approach to evaluating investments. In deciding on a new investment in oil or gas fields, the company typically spent many hours of technical research in preparing for an auction in a new oil field. When the company evaluated a future business opportunity, it would have a good idea of what the project cost structure would be and could create scenarios reflecting ranges of future oil prices.
With renewables, executives would have to make decisions based on a much thinner knowledge base, without the time, data, or resources for deep research. For example, how would prices for equipment and construction change as the market developed – go up, stay the same, or continue to come down, and at what rate? On the other hand, many offshore wind projects began with offtake contracts for the energy produced and the expectations of subsidies from governmental incentive programs. Many decisions had to be based on a belief that future legislation and regulations would include incentive schemes for renewable energy projects that would allow the company to profit. The uncertainty was very challenging for a lot of Statoil’s established quality control systems and support organizations. The new business areas required acting under greater uncertainty, like a startup.
Some consultants advised them, "Since no one knows the answers yet, shouldn't you test and invest in a lot of technologies and segments?" A number of other companies had followed this approach, spreading company resources across numerous areas. However, Statoil rejected this method. They would concentrate first on areas such as offshore wind and only investigate other opportunities in the future.
Investment Decisions
A major distinction of offshore wind projects was the lower profitability of renewable investments compared to oil and gas projects. Renewable projects had an expected IRR of around 10%, but the decision-makers were used to oil and gas proposals with a projected IRR of 25 to 30%. The CEO was extremely supportive of entering this new sector, but other executives were skeptical. They asked, “How can we justify allocating capital to something that is far less profitable than oil and gas projects?”
Although measuring the risk profile for renewables was new to Statoil, the company worked to define expected risk and return. One underlying requirement for any investment in renewables was that every approved project should have an expected positive return. As Pål Eitrheim, the second head of New Energy Solutions, NES, said, “I have been very firm that I'm not running a sustainability shop. I am in the process of developing what should be a profitable business for Equinor’s shareholders.”
Rummelhoff and her group spent a lot of time within the company explaining that the risk profile for renewable projects was much lower than those for oil and gas, so you could not expect to get the same kind of return as you would in new oil investments. While the cost of developing large oil projects was somewhat predictable, the volatility of the price of oil and gas globally created one major risk factor. Also, production from oil and gas fields could turn out to be much lower than anticipated, even after high-cost exploration and drilling. In addition, oil and gas extraction required working with flammable products under high pressure and difficult settings, creating a risk of catastrophic industrial accidents, potentially resulting in employee deaths and environmental destruction. Accidents were rare. but lowering the risk required high levels of emphasis on safety operations and oversight.
Offshore wind projects had long timeframes. Equinor, like other oil companies, was used to evaluating very large projects with high risk and long development times, so this aspect of the investments would be similar. For example, Statoil's license for Dogger Bank Wind Project in the North Sea, off the East Coast of Yorkshire, England, was awarded in 2010 and the long-term power contracts with the UK government in 2019. The project was not expected to begin producing power until 13 years later. The timing. although long, was not that different from complex projects on the oil and gas side, but the causes of the long timeframe were very different. For oil and gas, the greatest time might be in the early phase. The exploration phase required getting the technical risks lined up, characterizing the reservoir, and starting test drills to appraise the reservoir. Once the decision to drill was made, the construction phase of a big project typically would take three to five years. For offshore wind projects, the construction phase was similar to new oil projects, but additional time was needed to resolve regulatory issues and gather permits and negotiate power contracts.
Although safety measures were also important in the renewable space, the risk of extreme accidents was lower and other factors made it less risky than an investment in an oil and gas project. It was true that projecting the costs of materials like turbines and windmill blades was problematic, but many observers expected the costs to come down, even though there was no certainty about how much or when the change would happen.
Equinor’s leaders believed that the company possessed a strong advantage over other entrants in the offshore wind space. It had the experience and technology to work under difficult geographical demands. The company could use its strong balance sheet generated by oil and gas to enter markets, giving them an advantage over utilities and pureplay renewables, which often did not have that depth of resources. It could use project funding to finance the work, Statoil could draw on financial resources like infrastructure funds, pension funds, and hedge funds, rather than turning to banks.
With renewable assets like offshore wind, the big expense was the initial permitting and construction. Equinor on occasion funded projects by "farming down," divesting a percentage of a project by bringing in new investment partners at various stages of the process. The new partner provided capital and shared risk and return for the project. Once the projects were built, the costs were known, and longer-term energy contracts could provide predictable future revenues, which the new partner could share.
Equinor had developed hurdle rates to rank investment possibilities by defining project risks under expected conditions and various scenarios. It applied its knowledge of addressing risks in oil investments as it evaluated renewable projects. Sven Skeie, Equinor CFO, summarized Equinor's approach, "We are in this game for value. So it's a profitable growth that we're doing and that means that you need to pass the different hurdles. We are following up as we are moving along - are we able to add value to a portfolio or is it going in the wrong direction? So we are also measuring the value creation that we are doing year by year." It's both commercial and a way to adapt to what we really need within the renewables, and not doing it exactly the same as we have been doing within oil and gas."