Private investment in a company or project is a combination of investors providing equity that bear more risk but expect higher returns, and lenders providing debt that expect lower risk but lower returns. The combination of the two determines the cost of capital for that company or project.
Higher cost of capital for fossil fuel can reduce new investments in fossil fuel infrastructure and ultimately lower supply. It is therefore a crucial finance indicator, revealing whether financial conditions for fossil fuels and investments are becoming economically unfeasible.
The cost of capital for fossil fuel companies has remained between 10% and 14% over the past decade. Fossil fuel companies have been able to rely on access to consistently low-cost debt financing, while the cost of equity has been more volatile.
The cost of capital for project financing has also been volatile, and has even shown signs of increasing. Offshore oil project cost of capital reached as high as 22% in 2019. Various factors may contribute to this: increasing recognition of climate transition risks, such as demand destruction from technologies like electric vehicles; public policies signaling a future with reduced fossil fuel demand and supply; investor engagement on decarbonization; and a smaller pool of capital willing to invest in the industry due to climate concerns or recent investment losses in energy.
Even with the recent surge in fossil fuel prices, Goldman Sachs estimates a 15% divergence between the cost of capital for certain oil and gas projects relative to renewable energy projects, as the cost of capital for renewable energy has declined.
The cost of capital for other high-carbon activities, including heavy industry, shipping and aviation, should rise as competing technologies enter the market and economic, social and political pressure encourages substitutions for low-carbon alternatives.