Carbon risk debate: heating up fast

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Despite growing consensus on mankind’s activities being the main source of climate change, most oil companies remain stubborn in their pursuit of ever less accessible and more costly fossil fuel reserves. For investors, ‘carbon risk’ is the growing inevitability that many such reserves will never be extracted.

Stranded assets = carbon risk

The scientific community broadly agrees that 450 parts per million (ppm) is the maximum concentration of greenhouse gases (GHG) the atmosphere can hold if we are to contain the rise in global average temperatures to below 2°C. Burning the world’s entire proven reserves of oil, gas and coal would take GHGs in the atmosphere far beyond the 450 ppm limit.

So humanity has a carbon budget, meaning some fossil fuel assets might never be extracted. They become stranded assets. The debased valuation of such assets, particularly oil reserves, constitutes a potential ‘carbon risk’ for investors.

Responsible investors are thus rightly seeking evidence that oil companies have integrated carbon risk into their strategy. Our own ESG/SRI research team has sought more clarity on how the industry’s largest companies’ justify the absence of carbon risk in the valuation of their reserves.

Oil companies unconvincing

Many oil companies 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. They claim they are reducing their carbon footprint by reducing flaring, improving their processes and offering ‘greener’ alternatives.

We remain unconvinced. The industry sees all energy sources as being on an equal footing, yet they are not necessarily substitutable. Oil is mainly used for transport, coal and gas mainly for generating electricity. And the fact is that oil alone will attract 56% of total energy investment by 2030, so we believe the debate on carbon risk should focus primarily on the oil sector.

Unproductive reserves: carbon risk already a reality

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 USD 5 billion without a drop of oil being extracted. And Total recently abandoned its Jocelyn tar sands project in Canada. In 2009, Total had said that with oil at USD 95/bbl, the project was viable and that it wanted to invest EUR 7 billion. Now – not least with Brent and WTI having plummeted to around USD 63-66/bbl – the project will not see the light of day.

Destruction of value could impact on oil shares

Over the past 20 years oil prices have risen fivefold, but ROCE of oil companies have remained at around 10%*. Greater operational complexity has meant mushrooming costs. Average upstream oil project costs have 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, projects would be abandoned. This destruction of value would clearly impact on oil shares. In its June 2014 report, the IEA underlined that the scenario of 450 ppm threatens about USD 300 billion of investment in fossil fuels.

Public opinion on climate change likely to harden

The oil companies seem to underplay 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, drastically heightening the sensitivity of public opinion to the issue of climate change. This could push policymakers to react more vigorously to voters’ wishes and pass legislation to mount a credible fight against climate change.
Judging by what we hear from oil companies, 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 giving it serious consideration.

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 seek fuller information from the companies in which we invest so that we can refine our analysis and better assess exposure to 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.

* Kepler Cheuvreux: ‘Delivery matters’, January 2014, p.11
Thibaud Clisson

Senior Analyst, ESG

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