Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? Isabella Alloisio, ICCG, FEEM, CMCC Francesco Pietro Colelli, UniversitĂ degli Studi Roma Tre
Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? Isabella Alloisio, ICCG, FEEM, ICCG Francesco Pietro Colelli, UniversitĂ degli Studi Roma Tre
Abstract The Agreement reached at COP21 in December 2015 is driving a new momentum in climate policy worldwide, so that carbon intense projects and investments will likely face an increasing risk of stranding. The upstream oil industry is currently facing a dual challenge: economic restraints driven by low fossil fuel prices and expensive extraction and pressures driven by carbon concerns. At the same time, carbon intensive subcritical coal assets face important pressures coming over carbon concerns and other climate regulation. A key question is if a timely, ambitious set of reforms will establish an energy system transition coherent with the retirement of these assets. Furthermore, a framework aligning the decisions of financial institutions with long-term climate goals is taking shape, as a recent strain of literature has started to evaluate how an operator’s carbon risk is passed on to lenders and investors with a stake in these companies. The carbon exposure of investors should be evaluated and managed by a combination of different options ranging from disclosure and engagement to divestment and reallocation. The success of the divestment campaign, in particular, is signaling how it is not possible for operators to ignore changing investor sentiment.
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
Climate risk after the COP21 Agreement: towards a global energy transition Paris COP21 was able to convince 195 countries to adopt a Climate Agreement whose main objective is to hold “the increase in the global average temperature to well below 2°C above preindustrial levels”, with aspirational “efforts to limit the temperature increase to 1.5°C”.1 On top of that, the voluntary, nationally determined contributions of Parties (NDCs) account for around 90% of global energy-related GHG emissions, with many expressing specific targets or actions for the energy sector. Renewable deployment was envisaged as 40% of NDCs, while energy efficiency as more than 30%2. Measures for reducing fossil fuel subsidies and putting a price on carbon have were only partially addressed by NDCs and the Agreement, but opportunities might be considerable given the text’s provisions for a voluntary cooperative instrument to achieve “internationally transferred mitigation outcomes”, which might have a key role in developing and linking carbon price markets. Finally, requiring actions to evolve and strengthen over time has anchored future expectations for a sound commitment worldwide. If climate policy is scaled up, the most carbon intense assets may suffer face unanticipated or premature write-downs, devaluations, or conversion to liabilities, that is becoming ‘stranded’. ‘Climate risk’ can involve different drivers, usually classified3 in four categories: Government regulations’, comprising a wide range of drivers, from carbon pricing to subsidy regimes (as well as, air pollution regulation, disclosure requirements, product labelling or environmental damage liability); Energy technology innovation (through energy efficiency, disruptive technologies, falling costs, electricity storage); Evolving social norms (from divestment campaigns to changing consumer preferences and behavior); Environmental impacts (natural capital depletion and degradation induced by climate change, resource contamination and changing resource availability). These driver impacts will depend on the profile of the asset (e.g., fuel mix, location, operational lifetime, GHG emissions), on the Internal Rate of Return (IRR) and the operator earnings margin required, as well as on the vulnerability to competition from low-carbon technologies. Exposure can finally be affected by the operator’s “carbon strategy”, ranging from development and capital expenditure (capex) plans to asset reallocation and operational risk management4. The next section will consider climate risk for upstream oil industry, among more heavily carbon intense physical assets and operations. Other industries that might be facing substantial stranding risk are the coal supply industry and fossil-fuel-dependent infrastructure and operations, but for lack of space this will not be dealt with here. The risk of stranded assets for the upstream oil industry The ‘unburnable carbon’ debate has made clear that to meet a 2°C scenario with 50% probability (hence a relatively less ambitious target than the Paris Agreement’s), 35% of oil, 82% of coal and 50% of gas reserves globally should not be extracted5. Accordingly, 60-80% of listed companies’ current reserves cannot be burnt6, so that the value of ‘unburnable” fossil fuel reserves could amount to over USD 100 trillion up to 2050.7 Because of high marginal production costs and high profit margins, oil accounts for close to 75% of the fossil fuel asset value at risk in the low-carbon transition8. On the one hand, the main risk for the upstream oil industry is the cost escalation of moving to less productive acreage: upstream costs more than doubled over the 2000-2014 period. Subsequently, USD 220 billion of investment cuts were estimated only in 2014. Increasing costs are coming at a 1 (UNFCCC, 2015a). 2 (IEA, 2015b) 3 (SSEE, 2015) 4 (Cleveland S., 2015) 5 (Ekins & Mc Glade, 2015). 6 (Carbon Tracker Initiative 2013). 7 Channell et al., 2015 8 (Climate Policy Initiative, 2014).
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
time of low oil prices: with oil prices in the USD 50-60/bbl range, investment cuts have recently been forecasted to reach USD 1 trillion from 2015 to 20209. As for the impact of COP21-driven climate regulation on exposure to stranded assets, most of the magnitude will likely depend on how policies will affect global demand for oil in the long-run: according to IEA estimates10, the four climate risk factors presented above could account for a 2030 MBPD change in oil demand11, equivalent to as much as two thirds of the gap between optimistic oil company projections (demand peaking in 2040 at 100-120 MBPD) and a consistent COP21 scenario12 (oil demand peaking in 2020 and declining to 74 MBPD in 2030). Oil production and consumption subsidies are among the factors that will play a key role in the sector’s risk: a decrease in consumption subsidies13 would increase stranding risk by bringing demand closer to a 2°C consistent path, while delaying reform to cut production subsidies might cause a higher number of risky and expensive assets to reach financial closure. It is important to point out that even a level consistent with IEA14 central projections, and with optimistic forecasts by oil companies, could be met by supplies having a marginal cost not above USD 80-90/bbl15. If demand is further cut to respect the 2°C carbon-budget of 360GtC16, reserves with a production cost below USD 60/bbl would be sufficient. Hence, projects with marginal supply cost in the 60-90/bbl range are expected to face mainly climate risk, while those beyond the higher threshold are exposed to both economic and climate risk. Deep and ultra-deep water and arctic oil are among the conventional sources at highest risk, together with unconventional oil sands, since for these categories break-even prices of extraction can easily reach an 80-110/bbl range: USD 1.1 trillion of capex is currently earmarked for projects needing over USD 95/bbl17. In focusing on these higher-cost projects, it becomes evident that private listed companies are the most exposed to carbon risk, as their current and potential production is positioned upward in the cost curve, and they own 65% of reserves needing more than USD 100/bbl18. For the 20 largest private companies 20-25% of capex to 2025, totaling 540 billion, is not needed when a 450ppm emission limit is assumed. Fig. 1 shows a production and capex share of potential future (mostly undeveloped) projects requiring USD 95/bbl to break even in seven major oil companies. The highest potential exposure to climate risk is faced by Shell, both in terms of production and capex. Almost 70% of this high cost production is concentrated in the 10 largest projects, while for the other majors the risk is more evenly spread out.
9 (Mackenzie 2015, 2016). 10 (IEA, 2015) The New Policy Scenario serves as the IEA baseline or central scenario and takes into account broad policy commitments and plans announced by countries, including pledges at the domestic level to reduce greenhouse-gas emissions and plans to phase out fossil-energy subsidies. 11 For instance, electric vehicles and advanced biofuels in non-OECD could reduce oil consumption by 13.8 MBPD in 2040 and energy-related CO2 emissions by 11.5 Gt over 2040. Further demand cuts would derive from road-transport efficiency and air pollution control measures (IEA, 2015). 12 450 Scenario limits concentration of greenhouse gases in the atmosphere to around 450 parts per million of CO2, consistent with the goal of limiting the global increase in temperature to 2°C. 13 Subsidies to fossil fuels consumed by end-users and subsidies to the consumption of electricity generated by fossil fuels. ODI (2015) 14 (IEA, 2015), (Energy Transition Advisors, 2014). 15 (Energy Transition Advisors, 2014). 16 (CTI, 2014a) . 17 (CTI, 2014b). 18 Which embed roughly 90GtCO2 and could satisfy 15-18 MBPD (CTI, 2014a). Citigroup (2015).
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
Figure 1: Future production of Oil Majors at risk
Source: Own elaboration, data from CTI (2014b)
Larger companies, such as the majors, having a diversified portfolio, may be partially vulnerable to risk in their more expensive projects, whereas smaller players concentrated in high cost activities are notably more challenged. When funding has been committed (sanctioned projects) companies will seek cost deflation, while expensive non-sanctioned projects are likely to be delayed or cancelled to maintain acceptable shareholder returns. Assessing stranding risk for investors Investors and financial intermediaries with stakes in fossil fuel companies should take actions on the eve of stricter climate regulation: in fact, a framework is taking shape that will align the decisions of financial institutions with the long-term climate goals: the portfolio-level “carbon asset risk� (CAR) has recently been analyzed by different institutions19, whose results focus on three main actions: assessing exposure, evaluating the impacts of this exposure and managing material risk (Fig. 2). Fig 2: Carbon Asset Risk
Source: UNEP, 2015
Exposure is dependent on the financial relationship (corporate loan, project finance, equity, bond) and the tenor, which together determine how the specific operator risk materializes on the CAR. Stress-testing of portfolios is the main option for evaluating risk, carried out by both companies and investors20. In 2014, for instance, around 60 institutional investors pledged to footprint their portfolios 19 (HSBC, 2015), (Citigroup, 2015), (Mercier, 2015), (Cleveland S., 2015), (UNEP, 2015) 20 For instance by introducing rupture scenarios or carrying impact analysis of key variables (2° Investig Initiative, 2015).
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
by adopting a series of Principles for Responsible Investment21, but further streamlining and participation is required to effectively measure the misalignment of portfolio investments to the 2°C limit22. At the same time, operators should increasingly use the 2°C analysis to stress test their market decisions and allow investors to realize the value of this commitment: for instance, in the case of the oil and gas majors, a recent independent research found out that considerable value can be created by investing in a carbon-constrained portfolio, rather than in a BAU one23. Risk exposure can then be managed by a combination of disclosure, divestment, reallocation and engagement. Disclosure of information is a prerequisite for the effectiveness of the assessment and for the evaluation and management of climate risk: main oil companies have recently pledged24 to promote disclosure, and a pivotal step forward was taken in France with Article 17325 of the Energy Transition for Green Growth, enacted in August 2015, which strengthens mandatory climate disclosure requirements for listed companies and financial institutions26. Divestment, reallocation and engagement: momentum towards effective impacts At the climate summit in Paris it was announced that more than 500 institutions representing over $3.4 trillion in assets have made some form of commitment to divest from fossils fuel based operations. Divestment strategies can range from a 100% portfolio divestment to partial divestment (tilting) according to index classification, revenue criteria or breakeven prices27. Another alternative is a worst-in-class approach based on the carbon intensity of individual companies. Despite action form early movers, such as universities endowments, public pension funds or institutions, such as cities, have been considered more successful at raising public awareness than at impacting the targeted industries, and a further phase would take off if very large pension funds and other institutional investors joined the momentum, eventually bringing about a change in market norms. The advantages of carbon based indexes are furthermore beginning to be evidenced by the experience of some institutional investors28 as well as by academic analyses29, and some promising preliminary results show that these carbon efficient indexes could closely mimic or even outperform standard indexes. As investors realize that early action might also entail a first-mover advantage, rather than simply risk minimization, economic considerations will overtake moral or ethical incentives. According to recent research by the University of Cambridge30, slightly less than half of the returns impacted due to climate change could be hedged by investors through cross-industry and regional reallocation and divestment. Research by asset managers31 has found that positive returns are associated with retaining exposure to the energy sector, but reorienting portfolios towards low carbon energy, by replacing fossil fuel stocks with energy efficiency and renewable energy investments32. Divesting from brown assets could hence be part of a strategy leveling-off the playing field between brown and green projects, as the investment costs of the latter are much more sensitive to high interest rate environments than those of the former. Blocking off and shifting 21 http://www.unpri.org/ 22 (Hohne et al., 2015). 23 (CTI, 2016) 24 (OGCI, 2015) 25 (2° Investig Initiative, 2015) 26 Ibid. The decree requires institutional investors to disclose four types of information: Investment policies, climate-related financial risk, associated GHG emissions and contribution to the Energy Transition. This mandatory requirement go beyond the reporting on social and environmental consequences of the company’s activity, which is already mandatory in France, and reach the request for reporting on the consequences on climate change of all of the company’s activities, including the use of goods and services produced. 27 (HSBC, 2015). 28 (AP4, 2015). 29 (Andersson, 2014) 30 (Cambridge Institute for Sustainability Leadership, 2015). 31 (Monnin, 2015). 32 (Impax, 2016)
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
channels of finance will have particularly strong effects in developing countries, as these usually have lower domestic financial depth. Finally, in order to align risk and return perspectives, shareholders and lenders should engage with a company to assess and monitor over time the risk management approach adopted. Lenders could include such considerations in due diligence, while shareholders can establish ongoing discussions with company management, as well as file resolutions. For instance, a large number of shareholder resolutions were filed since 2015 to several large energy utilities and oil companies by the Investor Network on Climate Risk (INCR) participants33. Conclusions UNFCCC’s NAZCA initiative shows the extensiveness of commitments to climate action, since as of December 2015 it registered more than 10,000 actors ranging from companies, cities and regions, investors and civil society organizations. In particular, 239 utilities and companies in the energy sector committed themselves to both individual and cooperative actions. As for the upstream hydrocarbon sector, 10 of the leading oil and gas companies34, providing almost a fifth of all oil and gas production and supplying nearly 10% of the world’s energy, pledged under the Oil and Gas Climate Initiative (OGCI) to strengthen their actions to reduce the GHG intensity of the industry’s operations, explicitly targeting the reduction of flaring and methane emissions (through the Gas Methane Partnership35 and the zero Routine Flaring). Sector level commitment is important, but as the previous sections have shown, cooperation between fossil fuels asset operators and their funders is necessary for building a sound and transparent framework that can drive down ‘carbon risk’ and make it possible to exploit new value opportunities.
(Ceres, 2016) (OGCI, 2015). 35 Endorsed by only seven companies: BG-Group, Eni, Pemex, PTT, Southwestern Energy, Total and Statoil. 33 34
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
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Exposure of fossil fuel assets to carbon risk: will stranding risk increase in a post COP21 Agreement world? ICCG Reflection No. 49 /July 2016
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