There is a clear consensus on mankind’s activities being the main source of climate change. Yet the energy industry – particularly oil companies – remains largely stubborn in its pursuit of ever less accessible and more costly fossil fuel reserves. For investors, ‘carbon risk’ is the growing certainty that many such reserves will never be extracted.
The anthropogenic source of climate change is widely accepted1. The current rate of greenhouse gas (GHG) emissions is seen as unsustainable and the measures taken so far to limit it are considered insufficient2. Thus if nothing changes, global average temperatures look set to rise by around 6°C, yet climate change would already have catastrophic consequences even if the temperatures rose by just over 2°C3.
The scientific community broadly agrees that 450 ppm4 is the maximum concentration of GHG in the atmosphere if we are to contain the rise in temperatures to below 2°C5. Burning the world’s entire proven reserves of oil, gas and coal would take GHGs in the atmosphere far beyond this maximum. Thus, humanity has a carbon budget, meaning that some fossil fuel assets might never be extracted due to lower demand or tighter regulation aimed at reducing GHG emissions. Think-tank Carbon Tracker Initiative (CTI) labels these “stranded assets”. Such assets, particularly oil reserves, have a debased valuation and constitute a potential ‘carbon risk’ for investors, especially those with a long-term approach.
Responsible investors are rightly seeking evidence that oil companies have integrated carbon risk into their strategy. Our own ESG/SRI research team has sought more clarity and welcomes the industry’s largest companies’ willingness to engage in dialogue. So how do they justify the absence of carbon risk in the valuation of their reserves?
Hiding behind the smoke
Many oil companies say coal reserves, which account for two-thirds of the world’s carbon stock, represent a much higher risk than oil reserves. Some say they have reduced their exposure to the potential carbon risk of oil by also positioning themselves in natural gas, which contains 20% less carbon than oil and has a positive demand outlook. The companies also claim they are reducing their carbon footprint by reducing flaring6, improving the efficiency of their processes and offering biofuels and renewable energies.
We remain unconvinced. The industry places all energy sources on an equal footing, yet they are not necessarily substitutable. Oil is mainly used for transport, coal and gas mainly for generating electricity. The oil companies’ efforts to produce lower carbon content products remain marginal, in our view. And talking of the greater carbon content of coal reserves deflects from the fact that oil alone will attract 56% of total energy investment by 20307, so we believe it is logical that the debate on carbon risk should focus primarily on the oil sector.
Unproductive reserves already a reality
Importantly, many shareholders are concerned by the industry’s tendency to ignore carbon risk and destroy value by sinking money into unproductive oil projects. For example, Shell’s Arctic projects have consumed more than USD 5 billion without a single drop of oil being extracted. Total recently announced the abandonment of its Jocelyn tar sands project in Canada. In 2009, the company said that with oil at USD 95/bbl, the project was viable and that it wanted to invest EUR 7 billion.8 Now– and even before Brent and WTI having plummeted to below USD 50/bbl – the project did not see the light of day.
Over the past 20 years, during which oil prices rose fivefold, ROCE9 in the oil industry has remained at around 10%10 due to increasing operational complexity resulting in mushrooming costs. The average cost of an upstream oil project has risen from USD 1 billion in the early 1990s to over USD 5 billion.
Should this trend persist while oil prices stagnate or fall, ROCE could collapse. Without the desired profitability, highly complex and costly oil projects would be abandoned. This destruction of value would clearly impact oil shares. Noting that, in its June 2014 report11, the IEA underlined that the scenario of 450 ppm threatens about USD 300 billion of investment in fossil fuels, we feel it legitimate to ask oil companies to prove the carbon risk resilience of their projects.
Despite political lethargy, policy will make its way
The 450 ppm ceiling requires a strong international political consensus to combat climate change or oil companies will remain convinced there will be no decarbonisation of the economy and therefore no fall in demand. The industry seems unanimous in its scepticism that such political agreement can be reached.
It seems unlikely to us – even given the recent US/China climate change accord – that consensus will be reached on binding global measures to combat climate change at the next COP11 in Paris in December 2015. Piecemeal measures to restrict Co2 emissions or improve energy efficiency look more plausible. These could still limit projected energy demand and threaten the oil sector.
The industry seems to be playing down the influence public opinion has on policymakers. The social acceptability of risky, costly and/or highly polluting projects such as the tar sands or Arctic projects could plummet and the sensitivity of public opinion to the issue of climate change could increase drastically. This could push policymakers to react more seriously to the wishes of voters and pass legislation to mount a credible fight against climate change.
Given the current state of oil companies’ communication, investors cannot accurately assess their resilience should credible measures to mitigate climate change be implemented. This is at the heart of carbon risk, yet the industry appears not to be giving it serious consideration.
Calling for greater openness
Oil companies appear to have blind faith in their growth model, ignoring the probability that a global and effective agreement to combat climate change will be implemented. Yet credible measures to mitigate climate change are inevitable, in our view. As the impact of climate change worsens, the likelihood of restrictive regulations increases. The question is at what moment certain reserves will be deemed obsolete.
As a long-term investor, we cannot afford to remain passive. We have a duty to protect our clients’ capital. We favour any initiative seeking to obtain information from the companies in which we invest that enables us to refine our analysis and to better assess risk. The sustainability and profitability of our investments depend on it. We encourage other investors to get onside, governments to combat climate change effectively and the oil industry to take stock of carbon risk.