Upstream oil & gas, the Paris Agreement and climate risk

January 2021  |  SPECIAL REPORT: ENERGY & UTILITIES

Financier Worldwide Magazine

January 2021 Issue

The argument over anthropological causes for our changing climate are all but over. Whether it is the highest temperature ever recorded in Death Valley in California at over 54°C, or the town of Verkhoyansk in the Artic sweltering in 38°C, the signs of our impact on the planet are clear. Our subsuming reliance on fossil fuels has driven atmospheric carbon dioxide levels to over 409 parts per million in 2019, an increase of some 46 percent compared to pre-industrial levels.

Beyond temperature, a changing climate can result in stunted crops, an increase in wildfires caused by drought and torrential rain which can trigger floods and landslides, often in regions of the planet that are least well equipped to deal with it.

An industry in flux

Oil price volatility was born at the advent of the industry, and while there have been two dramatic crashes in the past five years, this time the downturn really does seem different. An unprecedented drop in global crude demand due to the combined forces of the coronavirus (COVID-19) pandemic and the Saudi-Russian oil price war undoubtedly led to the dramatic decline in oil prices witnessed this year. However, unlike previous downturns, investors are asking themselves searching questions about whether it makes sense to continue to invest into carbon-emitting industries, both from an ethical as well as economic perspective – the spectre of declining oil demand and stranded assets in a world which is transitioning to net-zero looms large.

Transition risks have already been acknowledged by European major oil and gas producers. Total, Repsol, Shell and BP have recognised substantial impairments, with BP writing down asset value to £17.5bn, equivalent to 17 percent of net assets, while at the same time announcing a staggering 40 percent reduction in projected oil output by 2030. Shell’s chief executive Ben Van Beurden has indicated that Shell may very well be past its own peak oil production. In terms of total industry impairments, Carbon Tracker estimates this to currently stand at some $87bn.

This reassessment of the long-term profitability, even viability, of the oil and gas sector is being borne out in market performance. The decline in the prominence of the energy sector within major market indices has been stunning, declining from the second largest component of the S&P 500 by weight in 2008 to just 2 percent today.

Equity values of major oil & gas companies have taken a hammering, with share prices down some 40 percent this year, significantly worse than index benchmark performance.

In approach, there is a clear divergence in strategic intent taken by oil majors on either side of the pond, with Shell and BP positioning their response to energy transition as an existential issue, whereas ExxonMobil indicated it does not see a fundamental shift in energy markets, and expects to continue to make strong returns as robust demand fundamentals play out.

Tellingly, Exxon has maintained its dividend payouts while the ‘transitioning’ oil majors have not. A recent Bloomberg report suggested the company’s investment strategy will see Exxon’s yearly emissions rising 17 percent over the eight years leading to 2025. So, the question is: who is on the right path, and whose strategy will win out?

Watershed post-Paris

The 2016 Paris Agreement was a watershed moment for the global movement toward a greener future. Major countries are already making significant policy announcements committing to climate change targets. The European Union (EU), China, Japan and South Korea have already made commitments to net zero carbon emissions in support of Paris, while a Biden administration-led White House, as well as Russia, have made recent announcements to support the Paris goals.

A consequence is that regulatory risks are undoubtedly increasing for banks, asset owners and corporations alike. In addition to political announcements, central banks and supervisors have become increasingly concerned about the systemic risks that climate change poses to the global economic system.

The Network for Greening the Financial System (NGFS) was established in 2017 to provide a coordinated response by regulators to ensure that the financial system is robust against the realisation of these risks. The current members account for 80 percent of global greenhouse gas emissions, with the US Federal Reserve Bank soon to join its ranks, increasing coverage to 85 percent of global emissions.

Focusing on the UK, the Prudential Regulation Authority (PRA) has set expectations for regulated firms to fully integrate climate change within their risk management by 2021. Next year these organisations will be subject to a stress-test via the ‘Biennial Exploratory Scenario’ (BES) in which their financial exposure will be evaluated under three different scenarios. The UK is not alone in this effort, with other regulators following in close pursuit; Europe is leading the way with Asia not far behind. While lagging, the US has now recognised climate as a near-term risk in its latest ‘Financial Stability Report’.

For asset owners, whereas climate change may have only previously been considered an ethical concern, pension funds will now include in their Statement of Investment Principles (SIP) an explanation of how climate change is considered in the selection, retention and realisation of investments, due to the realisation that climate considerations may pose a material financial risk. In addition to pension funds, insurers and other asset managers will need to explain how they are aligned on climate risk.

In addition to regulatory concerns, litigation and reputational risk are a real and present threat to all stakeholders. A bellwether case involving the Australian superannuation fund REST settled a climate change case on the committing to net zero by 2050 and disclosure in accordance with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations as part of properly managing its climate risks and obligations, a result that will demand attention by pension funds around the globe.

Climate exposure driving action

Recent regulatory changes have led banks, asset owners and managers to begin to aggressively manage their climate risks. Lending and investment into oil & gas is now subject to stress testing that could recognise the impact of stranded assets in the future.

Full implementation of new regulatory obligations will likely lead to the implementation of measures to mitigate these effects. Debt and equity providers alike are challenging themselves about the warming impact of their portfolios and credit books and are increasingly looking for ways to scientifically quantify the impact of investment decisions in terms of their warming impact, as well as traditional financial metrics.

As a result, when measuring against a net zero target, there is real risk that companies which are not compliant with Paris will effectively be barred from lending and investment portfolios. In order to manage risks by regulated firms, and in the absence of clear and transparent data quantifying how climate risk may impact the business, asset managers and owners will begin to screen firms without robust climate risk processes out of their investment portfolios. 

Investors are starting their journey on climate change risk management. They have already begun to implement measures to reduce their exposure, such as excluding thermal coal and investments in certain types of oil and gas projects. The Institute for Energy Economics and Financial Analysis (IEEFA) recently reported that some 50 global financial institutions have introduced policies restricting oil sands and oil and gas drilling in the Arctic in response to concerns around climate risk.

Mandatory disclosures and the data gap

The main hurdle in the implementation of regulations is a lack of quantification and the existence of glaring data gaps as climate change disclosures from corporates are on the whole not robust. This lack of disclosure has led to greater demand for information on climate change risks produced by companies.

The TCFD has become the leading framework under which to report these risks. TCFD reporting provides the most adequate framework for companies to manage their climate-related risks, because the information provided is forward looking. In fact, it allows companies to develop scenario analysis which will be reflected in their price assumptions and projects, allowing them to avoid stranded assets. The recommendations also contribute to a governance structure and risk management which will help them to meet their emissions reduction targets. We believe if well implemented, it could be considered as a de-facto management system which can facilitate the transition of oil and gas companies.

These recommendations have been supported by several governments and are on the way to becoming mandatory. In the UK, premium listed companies will be required to disclose on a ‘comply or explain’ basis in accordance with TCFD reporting, and it is expected that by 2022, UK-listed commercial companies and, by 2023, UK-registered large private companies, will have implemented TCFD disclosures. Pension funds will also be required to report against TCFD and improve their climate governance, and the PRA will be introducing new TCFD requirements to asset managers and life insurers. Consequently, there is a clear trajectory in which climate change will be mandatory for the vast majority of UK companies much sooner than most people expected.

Conclusion

We live in a world where views about our impact on the planet have been transformed. Civil society, political institutions and capital markets have joined forces to demand change in the way business is conducted, and to align with a more sustainable world.

Debt and equity providers alike are challenging themselves about the warming impact of their portfolios and are increasingly looking for ways to scientifically quantify the impact of investment decisions in terms of warming impact, as well as traditional financial metrics. To manage risks by regulated firms, asset managers and owners will, over a short time frame, decide to exclude companies which are not Paris aligned.

The message being given to all corporates, and especially carbon emitting companies, is clear: either quantify and disclose the impact of your activities or become increasingly estranged from the world of investment and finance. This, combined with transitional risks to net zero, is already negatively affecting asset values, even before any substantial climate policies have been enacted. This has resulted in investment into carbon-intensive industries becoming increasingly challenged. This is a world that executives and boards at oil and gas companies simply cannot ignore.

When comparing the equity performance of BP, Shell and ExxonMobil, there is no divergence despite radically different approaches to the energy transition debate. However, when thinking about their own portfolio construction, funds and regulated companies will need to consider what approaches are most likely to retain and create value in a world beset by a changing climate. Beyond divestment and engagement, in-sector reallocation will become an increasingly important consideration for decision makers in this space.

There is no doubt the world will continue to need substantial volumes of oil and gas to 2050 and beyond. The question of where oil production in particular will emanate from in a capital-constrained environment is an interesting question to address. Leaving aside the issue of reserve replacement in light of capital constraints, will oil producing power revert back to major oil producing countries such as Saudi Arabia and Venezuela? Will oil and gas producing assets be subject to a merit order of production, akin to power generation in the electricity market? These are fascinating areas to investigate.

Nonetheless, while there will be bumps on the road, the direction of travel is clear – business-as-usual for oil and gas companies is no longer viable. Without clear, science-based disclosures, capital providers cannot accurately judge the impact of carbon-emitting company activities on their portfolio, in terms of warming potential, with the only viable outcomes being to divest, blacklist or ignore.

As such, oil and gas companies need to not only incorporate robust, science-based climate reporting into financial projections, but also carry out a root and branch review of operating structure, risk matrix and strategy in order to be fit for this new, rapidly evolving economic environment.

Mohammed Chunara is a senior adviser, climate risk & ESG and Alba Fuentes Delpon is a climate risk & ESG analyst at Gneiss Energy. Mr Chunara can be contacted on +44 (0)20 3983 9263 or by email: mohammed.chunara@gneissenergy.com. Ms Delpon can be contacted on +44 (0)20 3983 9263 or by email: alba.fuentesdelpon@gneissenergy.com.

© Financier Worldwide

BY

Mohammed Chunara and Alba Fuentes Delpon

Gneiss Energy

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