Waiting for the pop by Ayswarya Murthy

WAITING

FOR THE POP

In our cover story this issue, we talk to energy, environmental and financial experts in order to decipher the carbon bubble. Is it real? How serious is it? And does Qatar’s gas economy make it immune to a certain degree? BY AYSWARYA MURTHY

Total carbon potential of the Earth’s known fossil fuel reserves.

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2,795 GtCO₂

To reduce the chance of global temperatures exceeding 2C between 2000 and 2050 to 20% or less , no more than 886 GtCOâ&#x201A;&#x201A; could be released into the atmosphere

20%

The 200 biggest coal and oil and gas companies make up 7% of the S&P500 index today

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he logic behind weaning ourselves off fossil fuels is globally accepted; there are enough reasons – the carbon-dioxide (CO₂) emissions, the finite nature of hydrocarbon resources, price volatility, complicated geopolitics. But today we are farther than ever from that goal thanks to increasing population, better technology in oil and gas exploration and extraction, and the unrelenting march of progress. And it is because of the latter that the world is hurtling towards disastrous and irreversible climate change. History doesn’t reflect kindly on our attempts so far to address the issue: the Kyoto Protocol and the infamous COP 15 at Copenhagen are just two examples of weak regulations and intent with no action. While the hand-wringing and attempts to apportion blame and responsibility continued, by 2009 world powers had agreed that they needed to start working towards limiting the increase of global surface temperatures to less than

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Comparison of the global 2°C carbon budget with CO₂ emissions potential of fossil fuel reserves

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2° C if we were to avoid dangerous climate change. Many consider even this an arbitrary political target, with climate scientists predicting a narrower safe zone that limits raising the temperature up to 1°C. So far, the average temperature of the planet has increased by just under 0.8° C, and that has caused far more damage than most scientists expected. However the 2C target is what governments are (optimistically) expected to work towards and that is what will (theoretically) pop the bubble. Back in 2011 the Carbon Tracker Initiative (CTI) released its first report, Unburnable Carbon, that introduced the term "carbon bubble" to the world. The non-profit think tank made up of financial, energy and legal experts set out to highlight the discord between efforts to reduce 44 > QATAR TODAY > AUGUST 2015

greenhouse gas emissions and growing investment in coal and oil and gas companies. According to the report, to reduce the chance of global temperatures exceeding 2° C between 2000 and 2050 to 20% or less, no more than 886 GtCO₂ (billion tonnes of CO₂) should be released into the atmosphere. During the first decade of the 21st century, we already used up a significant portion of that carbon budget. As of 2011, we only had 565 GtCO₂ in our carbon kitty which had to last us for the next 40 years and this budget will shrink further in the latter half of the century. But the total carbon potential of the Earth’s known fossil fuel reserves comes to 2795 GtCO₂, predominantly as coal, followed by oil and then gas. These are reserves that are being treated as assets and are expected to be brought to the market sooner or later, irrespective of whether they are still underground or already in the pipeline. But 2C dictates that only 20% of all this carbon can be burnt. Global stock exchanges list some of the biggest energy companies that transfer a significant amount of this carbon risk to investors. The fossil fuel reserves held by the top 100 listed coal companies and the top 100 listed oil and gas companies represent potential emissions of 745 out of the 2795 GtCO₂ (with smaller companies and state-owned entities making up the rest). And these companies – called the Carbon 200 – make up 7% of the S&P500 index today. More recently, the rapidly developing economies of China, Brazil, India and Russia have also been bringing their state enterprises to the markets. Shenhua Energy, Petrobras, Coal India and Gazprom are examples of this trend. Applying the 20% rule uniformly, we see that only 149 GtCO₂ of the listed carbon can be used, implying that investors have bought five times more carbon than they would be allowed to sell. This represents trillions of dollars in wasted capital and stranded assets. “Exchanges with above average investment in fossil fuel assets expose their domestic and international investors to as yet unquantified risks of stranded carbon. These risks increase in direct proportion to their absolute exposure to fossil fuels. Where exchanges have a high proportion of listed fossil fuel companies owning unburnable carbon, the knock-on effects to others within the financial markets risks are worth noting,” the report notes. By the time CTI released another report in 2013, this total fossil fuel reserve had increased to 2860 GtCO₂. Companies are continually exploring new fields, spending billions of dollars to bring more reserves online. The level of listed reserves could double to 1541 GtCO₂ if all of the prospective reserves are developed, the report says. Their analysis showed that the capital expenditure spend (adjusted proportionally to revenues from coal, oil and gas) over 12 months in 2012-13 by the 200 listed hydrocarbon companies totalled $674 billion (QR2.475 trillion). The higher capital costs of the oil and gas sector mean that the majority – $593 billion (QR2.180 trillion) – was related to this sector, with $81billion (QR295 billion) related to coal operations. Will investors ever see returns

on these massive investments? Why do companies continue to sink shareholder funds into the development of additional new reserves that are incompatible with a low-carbon pathway? These are the questions CTI is asking. And now, so are many others.

Jochen Wermuth, is a passionate advocate of controlled divestment from fossil fuels. There is no more denial about the bubble, he says, and points out that owners or managers of $50 billion of assets have committed to divest from fossil fuel producing assets (an average equity portfolio holds 7% of assets in oil, gas and coal, so this commitment means divesting around

To divest or not to divest Over the last couple of years, CTI’s research has drawn the attention of many institutional investors, funds and regulators in Europe. “There has indeed been substantial progress,” says Anthony Hobley, CEO of Carbon Tracker Initiative. “Regulators, central banks like the Bank of England, pension funds particularly in Scandinavia, and Sovereign Wealth Funds (Norway’s) have taken note of and drawn our work,” he says. The Guardian called the Bank of England’s enquiry into the carbon bubble the “most significant endorsement yet from a regulator” and the discussions will involve the financial policy committee which is tasked with identifying systemic ecoEnergy Expert, Brookings Doha Center, and nomic risks. Meanwhile head of Consulting, Manaar Energy (Dubai) The Telegraph reported that the G20, encouraged by France which will be hosting the UN summit on climate change later this year, has asked the Financial $3.5 billion in assets). “Corporate leaders, for example Shell Stability Board in Basel to “convene a public-private inqui- Management, have recommended their own shareholders ry into the fallout faced by the financial sector as climate to mandate the development of a post carbon-age strategy. rules become much stricter”. The FSB did not respond to These organisations ‘get it’ and so do an increasing number a request for comment though it is expected to present its of long-term investors. The International Energy Agency findings prior to the G20 summit in November this year, (IEA) has already said that to bet on high long-term oil, gas and coal prices would be a mistake and that the energy injust two weeks before the COP 21 in Paris. The United Nations Framework Convention on Climate dustry is now shifting to more competitive renewable powChange COP to be held in Paris at the end of 2015 is only er sources.” Wermuth is also a member of the steering comthe next step in the global negotiations, CTI reports. It will mittee of the Divest-Invest Philanthropy in Europe which confirm the current country-level objectives which can be invites its network of primarily charitable foundations to further ratcheted down. Alongside this are the announce- align their giving and their investment objectives by pledgments from the G7 to aim for up to 70% decarbonisation by ing to divest from fossil fuels over three to five years and 2050. These all represent a downside for fossil fuels at the invest in renewable energies and resource efficiency, for both moral and financial reasons. “Philanthropies were high end of the cost curves and justify divestment. Meanwhile, some investors are taking matters into their finding out that they were donating to Greenpeace to fight own hands. In Germany, where already renewable ener- climate change, but their investment office was invested in gies satisfy 75% of the country’s demand for electricity in Shell. This is the basis of the Divest-Invest Philanthropy the summer, climate scientists, the Ministry for Econom- movement,” he notes. Wermuth warns that early action will make all the differic Affairs and Energy, environmental activists and several large funds and investors gathered for the first Berlin In- ence between an orderly transition vestment Forum that centered on the theme of “Climate to a low-carbon economy or a chaChange and Global Asset Allocation”. Wermuth Asset Man- otic and full-blown financial agement, a family office which formally manages its own crisis and recession. The key private assets while acting as a BaFin-regulated invest- issue for markets and invesment adviser, organised the forum and its founder and CIO, tors is that the rebalancing

"The idea that energy companies are oblivious to a 'bubble' that has only been spotted by environmentalists is impossible. Climate policies go into long-term forecast of oil and gas prices and companies watch it carefully. So calling it a bubble is kind of misleading." Robin Mills

of the energy eco-system takes place with as little damage to investment values as possible. “While for certain investors it is possible simply to sell these assets in the market when they are listed assets, or to instruct funds they are invested in to sell within three years or to sell real assets gradually, for the world’s largest pension funds such as Calpers (US) or AP4 (Sweden), the approach is that not everyone can divest because someone has to buy. Instead, owners of around $43 trillion worth of assets who are committed to the UN Principles for Responsible Investment, have decided to cooperate to halt further

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these concerns and is shifting away either because of grassroot constituents pressure or speculative gains based on an early mover advantage,” says Raphael. “I doubt that a large divestment from carbon assets and stock price drops would occur immediately unless there is a concrete accounting rule that would force revaluation of corporate energy assets or globally enforceable monetary fines on corporate carbon emitting offenders. In my opinion, change will be slow and gradual, say over 10 years. In all cases, if and when such scenario happens, countries would be affected more than corporations, because I would assume that corporations do not own large reserves but countries do. Also, energy corporations and other polluting industries will do their best to adapt and shift their investments and activities to lower carbon footprint activities.” And oil companies and energy analysts continue to present a compelling, if distressing, case for why fossil fuels aren’t going away all that soon and the carbon bubble is unnecessarily alarmist.

"We can highlight a number of examples where there are already stranded assets for a range of reasons, without a global deal or carbon price. With low-risk and low-cost, renewables are becoming increasingly important for investors when risks and costs for hydrocarbons are increasing. If everyone just sits around waiting for a global deal, then they will miss these fundamental developments which are already creating stranded assets."

Reality bites It isn’t surprising that with all the buzz around the carbon bubble and heightened expectation from the upcoming COP 21 to agree on tough climate change policies, shareholders are starting to question whether the profits from their investment should be used more towards capital management and diChief Executive Officer, Carbon Tracker Initiative versification rather than exploration. Over the last few months, energy majors like ExxonMobil investment in oil, gas and coal exploration on the basis that, and Shell have had to respond to the threat of the carbon due to low future prices, they are economically senseless. bubble to quell the fears of their investors. Their aim is to use their shares in oil, gas and coal compaIt is important to note at this point that much of the ponies to vote for distribution of profits in the form of divitential emissions from the listed carbon reserves comes dends or share buy-backs instead of investing them in new from coal, one of the dirtier sources of energy available toexploration projects,” he says. day. In fact, 65% of emissions are from coal, with oil providBut not everyone shares these views. Camille Raphael, ing 22% and gas 13%. Dr Keith Crane, Director of the RAND General Manager at ALSHALL Economic Services, doesn’t Environment, Energy, and Economic Development Probelieve that investors are treating the matter seriously gram says this differentiation is important while discussing enough to take corrective action. “I believe that listed eqthe carbon bubble. “In the United States, China, Austrauity investors would tend to be more concerned by shortlia, and Indonesia, coal companies are being hit hard by term profits than potential medium-term or long-term reductions in demand. The EU, risks of an investment. In the absence of enforceable formal the United States, legislation, changes in accounting rules on the valuation and Canada are on of energy reserves or a drop in demand for carbon assets, a path to phase I do not see the majority of investors divesting away their out a very large carbon assets if they are still generating good returns in the share, if not all, of short term. A small minority seems to be responding to

Anthony Hobley

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coal-fired electric power capacity. China has also reduced consumption. Coal mining companies are going bankrupt and employment in the industry is dropping. So this is already happening,” he says. And this trend might as well give the oil and gas industry some decent breathing space in terms of potential carbon emissions. “Given the longer time scale, every oil and gas investment project will come on line when demand is still solid,” he says. This concurs with what Shell has said about its SEC-proved reserves having a life of 11.5 years.

to meeting growing energy demand worldwide. Robin Mills, Energy Expert at Brookings Doha Center, is also the Head of Consulting at Manaar Energy (Dubai) which “provides strategic and commercial advice on Exploration and Production, oil service and in-

Emission potential of listed hydrocarbon reserves (in GtCO₂)

Although an oil project may run for decades, the payback period, the company says, is concentrated in its early years, so it will have paid its way long before tough laws come in. Then there is the question of demand. While the percentage of fossil fuels in the future energy makeup is expected to fall, in absolute terms oil and gas companies still anticipate a need to step up, or at the very least, continue production levels in light of the increase in global consumption. Both ExxonMobil and Shell have provided data supported by the IEA that show how a natural decline in production of liquids will have to be replaced. ExxonMobil told its shareholders that based on this analysis, they are confident that none of their hydrocarbon reserves will become “stranded” and they believed that producing these assets is essential

frastructure projects.” He has no doubt that these new projects are commercially viable and will yield returns. “The argument here is that there is much more resources than we can ever use. There is some truth in it, especially when it comes to coal. And not all oil reserves can be used because, like the heavy oil found in Venezuela, some are expensive to extract and use. That is why exploration is important – to discover cheaper, easier alternatives. Also, a large part of the global resources are held by national oil companies which are producing them very slowly. If you believe the use of oil

IEA new policies scenario showing natural decline and need to replace production

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IEA new policies scenario showing natural decline and need to replace production Souce: IEA world energy outlook 2012

and gas will decline over the next 100 years, doesn’t it make sense to look for resources we can use today?” he asks. This is why he believes that the expensive projects that have stalled or been cancelled because of the low oil prices will be revived in the next two or three years, irrespective of whether the price picks up. “Companies will cut costs, squeeze suppliers and look for better, efficient ways till

Shell energy demand outlook million boe/d 400

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these projects are economically viable again. We are at $56 (QR205) a barrel now which is still a very high oil price, historically speaking (for a long period of time the price has been around $20-30 (QR75-110) per barrel in today’s terms),” Mills says. So the viability of these projects is not in question. He also points out that the fall in oil prices was not because of new climate policy or the emergence of renewable energy but because of volatile market forces that the energy industry is more than familiar with and knows how to handle. “Oil prices might fall again, for whatever reason, and companies might fail, but that’s the risk investors take. Energy companies are not banks. If they make losses, or even go bankrupt, that’s normal workings of the market and won’t affect the economy more broadly,” he says matter of factly.

Born with the carbon risk Climate change and energy companies have had a tumultuous history. Like the albatross around the mariner’s neck, oil and gas companies have always had to anticipate and factor in the risks of stringent climate change policies. According to Mills, “The idea that energy companies are oblivious to a bubble that has only been spotted by environmentalists is impossible. Climate policies go into long-term forecast of oil and gas prices, companies watch it carefully, try to lobby on it like any other interested party and, as climate policy continues to get tougher and renewables grow, they will continue react to that appropriately. None of this is sudden or unexpected. There have been no dramatic changes that have caught the industry unawares. So calling it a bubble is kind of misleading,” he says. ExxonMobil explains to its 2040 2050 shareholders how it incorporates carbon risk into its investment deCoal cisions. “We address Nuclear Other Renewables the potential for future climateSolar

Source: ExxonMobil

COVER STORY

related controls, including the potential for restriction the industry and on emissions, through the use of a proxy cost of carbon its investors into and which is embedded in our current Outlook for Energy. bankruptcy It is simply our effort to quantify what we believe gov- ruin, he dismisses. ernment policies could cost to our investment opportu- To him, the carbon nities,” the statement says. So while these energy com- bubble is just another panies are still calling for a carbon price, they are also new approach by envibasing their economies on their own internal price (For ronmental campaigners to example. Shell budgets for future capital investment on the assumption it will pay $40 a metric ton for carbon emissions. That’s almost six times the current price for pollution rights in the European Union’s carbon market, the world’s biggest). The companies may boost their shadow carbon price if climate policies get tougher and, according to Shell, “if the regulatory environment doesn’t evolve quickly, we actually have a carbon upside in our projects today”. Of course no one denies, least of all the companies themselves, that they have to think very hard about their long-term future in a world of tough action against climate change. “Do they want to get into renewables, invest General Manager, ALSHALL Economic Services in energy efficiency, will carbon capture and storage technologies come to their rescue? There is no easy answer to that, of course,” Mills admits. “For ener- persuade investors not to put money in fossil fuel companies. gy companies these considerations are at least 30-40 years “In the next two to three years they might have a different away.” That a sudden crisis will occur which will plunge angle,” he says.

"I believe that listed equity investors would tend to be more concerned by short-term profits than potential medium-term or long-term risks of an investment. In the absence of enforceable formal legislation, changes in accounting rules on the valuation of energy reserves or a drop in demand for carbon assets, I do not see the majority of investors divesting away their carbon assets if they are still generating good returns in the short term." Camille Raphael

The future as Shell sees it Shell has envisaged what might lie ahead 50 years from now through the lens of two possible scenarios - Mountains and Oceans. The first scenario, labelled “mountains”, sees a strong role for government and the introduction of firm and far-reaching policy measures. These help to develop more compact cities and transform the global transport network. New policies unlock plentiful natural gas resources - making it the largest global energy source by the 2030s - and accelerate carbon capture and storage technology, supporting a cleaner energy system. The second scenario, which we call “oceans”, describes a more prosperous and volatile world. Energy demand surges due to strong economic growth. Power is more widely distributed and governments take longer to agree major decisions. Market forces rather than policies shape the energy system: oil and coal remain part of the energy mix but renewable energy also grows. By the 2070s solar becomes the world’s largest energy source.

Global Fossil Energy Share in 2035: Shell & IEA scenarios 85% 80% 75% Shell

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The COP that could? The other sticking point between carbon bubble campaigners and sceptics is the 2C target which is also known as the 450 ppm (parts per million) scenario. The economic realities of the dominance of fossil fuels and the precedence of weak regulatory action on climate change have led energy majors to dismiss the carbon bubble. “This scenario is based on the premise of meeting 2°C and working backwards; whereas all the other scenarios on the chart are forward-looking and start with today’s realities as the starting point. When Shell plans, we plan for our businesses to be robust in a range of potential futures, not just for one potential outcome,” Angus Gillespie, Shell’s Vice President for CO₂ Strategy, told shareholders at the Royal Dutch Shell Annual

change, there doesn’t seem to be enough will or a sense of urgency to enact these tough policies. So on second look, the whole carbon bubble scare might as well be moot and it’d probably be business as usual till the bitter end. “Regulating carbon emissions is a big and global initiative. There are plenty of disagreements on measurement, impact and timing of global warming, curbs quotas, enforcement mechanisms, etc. Not that the subject is not important or threatening, but like many other global issues, it is hard to reach a consensus on how to solve the problem and implement solutions quickly, effectively and systematically across all countries unless the threat is imminent,” Raphael says, summing up the frustrating shape of things. This is why there is so much pressure on the participants of the upcoming COP 21 in Paris to deliver a strong enough framework so that governments can at least start to implement the necessary policies. Year 2015 is a self-imposed deadline. Coming on the heels of the dire warnings in the Intergovernmental Panel on Climate Change’s Fifth Assessment Report, it is hoped (feverishly) that this edition of the COP summit will pave the way for a global, legally binding treaty on reducing carbon emissions to limit the global temperature increase to 2 °C above pre-industrial levels, a historic first in over 20 years of UN climate negotiations. Enabling massive transformational shifts to low-carbon trajectories is one of the five critical results of the agreement, according to media reports. There is a spectrum of opinions on the outcome of the summit and energy companies, among Founder and CIO, Wermuth Asset Management many others, will be closely watching the proceedings. But Hobley says the outSocially Responsible Investor event last year. And Exxoncome of the deal wouldn’t affect the carbon bubble because Mobil’s statement makes it clear that, though the company it is no longer as dependent on a global deal and the 2C expects government constraints on use of carbon-based target as before. “We can highlight a number of examples energy sources and limits on greenhouse gas emissions in where there are already stranded assets for a range of reathe coming years, “the impact of these rising costs of regsons, without a global deal or carbon price. This has been ulations on the economy we expect will vary regionally accentuated by the oil price drop. US coal has also suffered throughout the world and will not rise to the level required due to cheap gas and mercury regulation, with no federal for the low-carbon scenario”. In fact, the company does not effort on carbon. Lack of water could be an issue in India even incorporate the “low-carbon scenario” in its capital and Australia which makes coal power generation unviable. allocation plans but “ensures investment selectivity under China is taking action on air quality and peaking coal use in a wide range of economic assumptions by maintaining a this five-year plan at around four billion tonnes, with major very diverse portfolio of oil and gas investment opportueffects on coal markets. And renewables are already achievnities”. This is very indicative of American companies that ing grid parity in some are hoping that if they sit tight and stay quiet, the problem markets – competition will go away. European companies, on the other hand, are is a key factor as much more active in defending the carbon bubble, talking alternatives become about addressing climate change and calling for carbon cheaper,” he says. price, according to Mills. “We should stop For all the alarming and very convincing data on climate

"While for certain investors it is possible simply to sell these assets in the market when they are listed assets, or to instruct funds they are invested in to sell within three years or to sell real assets gradually, this is not possible for the world’s largest pension funds such as Calpers (US) or AP4 (Sweden). Their approach is different because not everyone can divest when someone has to buy." Jochen Wermuth

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Carbon emissions under existing policies, new policies and 2C target policies IEA scenarios

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The current structure of the gas industry makes it less prone to wasting capital on projects that may not be needed in a lowdemand scenario. LNG plants are so capital-intensive that they are usually approved only once the majority of production has been contracted.

2°C (450 ppm)

just banging on a global deal and show how low-risk and low-cost renewables are becoming increasingly important for investors, whilst risks and costs for hydrocarbons are increasing. If everyone just sits around waiting for a global deal then they will miss these fundamental developments which are already creating stranded assets.” Wermuth concurs, elaborating on the two megatrends, independent of 2C policies, which are dampening the outlook for oil producing companies and countries. “Firstly, production continues to rise, but consumption is stagnating in Europe, North America and Japan, where half of global output is sold. Demand from China has also peaked. The recent crash in crude prices has not stimulated growth in demand. Secondly, renewable energy is getting considerably cheaper, and is challenging fossil fuels. Dubai set a new global benchmark last year, when ACWA Power and TSK successfully bid for Dubai Electricity and Water Authority (DEWA)’s 200 MW solar PV plant, offering $5.84 cents/kWh. That’s cheaper than power generated from oil at $10 per barrel,” he says. “Whether there is a binding agreement in Paris or not, the carbon bubble will burst, and the smart investor will get out before it does,” he says. A reprieve for Qatar Diversification is the only way forward for hydrocarbon nations; this is known. There are concerns that some governments in the region are not addressing this hard enough or transforming their economies fast enough. But Qatar might have a unique role to play in this shifting ecosystem. According to CTI, the current structure of the gas industry makes it less prone than oil or coal to wasting capital on projects that may not be needed in a low-demand scenario.

In particular LNG plants are so capital-intensive that they are usually approved only once the majority of production has been contracted. And the low proportion of gas listed on global exchanges reflects the concentration of reserves in Russia and the Middle East, where oligarchs and national oil companies are dominant. However, while indicating that there is room for some growth in gas supply in the next 20 years, the report warns that it won’t be as simple as expecting a coal-to-gas switch. The exact amount of growth in each region will depend on a range of factors like cheaper renewables, greater efficiency, new storage technologies, higher carbon prices, and relative commodity prices. But the gas outlook is largely optimistic. In assuring its investors, Shell highlighted how in 2013 the company for the first year produced more gas than oil and that their SEC-proven reserves are more than 50% gas. In Dr Crane’s opinion, natural gas has an even longer time horizon than oil as it is being used as a bridge fuel. “So I don’t see where climate change policies per se would affect investments in natural gas. Bottom line: climate policies are hitting coal hard, not so much oil, and natural gas has benefited from these policies and is likely to continue to do so,” he says. Not only can Qatar’s gas economy be relatively immune to the carbon bubble but Wermuth emphasises the positive potential impact that Qatar can have as a provider of the "transition fuel" for a 100% renewablepowered economy. “The potential write-off would also be less in the instance of a CO₂ emission carbon tax being effectively introduced,” he says AUGUST 2015 > 51