As the world transitions towards a low-carbon economy, investors are increasingly interested in how oil and gas companies plan to address related risks. Most companies in the industry recognize that their business is exposed to risks related to carbon regulations, decreasing demand for its products, or increasing costs related to the implementation of emission reduction technologies. However, when it comes to addressing these risks, disclosure is limited (as we noted in our July 2017 blog post on the Task Force for Climate-Related Financial Disclosures [TCFD]). Oil and gas companies will have to increase and improve their disclosure if they want to convince investors of the viability of their business model in a carbon-constrained world.
To fully understand what’s behind this disclosure gap, and what companies and investors can do to close it, we will first have to understand what transition risk is and why it has become increasingly important to investors.
What is transition risk?
While fossil fuels may continue to meet the bulk of the world’s energy demand over the short run, changing patterns of energy consumption, driven in part by carbon regulation, are likely to significantly affect the profitability of oil and gas firms. The Paris Agreement has brought transition risk into focus for investors, as governments ramp up climate policies to help meet the common target of net zero carbon emissions by 2050. As major emitters of carbon emissions and producers of fossil fuels, oil and gas companies are amongst those most affected by carbon regulations. At especially high risk are companies with higher average production costs, like those involved in carbon-intensive projects, including oil sands mining, high Arctic drilling and some liquified natural gas (LNG) projects, and those that are not diversifying their product lineup.
According to a recently published Carbon Tracker report, fossil fuel companies are at risk of losing USD 1.6 trillion by 2025 if they align their business models with current government emissions policies rather than international climate goals. Not surprisingly, investors are increasingly concerned about how companies plan to remain profitable under different scenarios and regulatory regimes. However, this is exactly the area for which disclosure is nearly absent.
An oil and gas company’s exposure to transition risk is driven in part by its asset portfolio and product strategy, however, management is also a risk factor. In our 10 for 2018 report, we look at the transition risk management preparedness of the ten largest oil and gas companies and highlight Royal Dutch Shell (Shell) as one of the top performers in terms of climate-related disclosure. However, even strong reporters, like Shell, do not adequately demonstrate how their business model will evolve under different regulatory, societal, and market-based scenarios. Therefore, we need to take a closer look at the current practice of conducting scenario analysis and how it could be improved.
Scenario analysis: what could be improved?
Scenario analysis is one of the more challenging aspects of a company’s climate risk strategy. Although the exercise encourages companies to explore the physical, strategic and financial risks and opportunities driven by climate change, it is also the area where most companies are lagging.
Several scenarios about the future energy landscape exist. Most oil majors publish one or multiple scenarios. However, in nearly all scenarios, the company’s business model remains profitable, based on the assumption of continued growth in global demand for oil and gas. Moreover, the role of competing energy sources, like renewables, is systematically undervalued. In short, these scenarios are mostly aligned with the company’s strategy and do not provide investors with insights into how the company plans for situations less favorable to their current business models.
Shell’s latest Sky scenario is unique in the sense that it predicts fossil fuel consumption will drop around 2030 and fall below current levels in 2040. However, the company does not provide any insights into how it views its own role within this scenario.
Primary Energy by Source in the Three Scenarios
To gain more insights into a company’s transition risk management, investors can demand companies start reporting on how they will operate under scenarios that have a clear potential to disrupt current business models. The scenarios used should be both driven by regulatory changes and by projected market dynamics within the energy sectors. For instance, companies should conceive of:
- At least one scenario that is more ambitious than the International Energy Agency (IEA) 450 scenario, which reflects a 50-50 chance of staying below two degrees;
- At least one scenario that is two degrees compliant;
- At least one “shock scenario” that anticipates a disruption to fossil fuels’ dominance and a growing role for electric vehicles and renewables.
For every scenario companies should disclose their business strategy to remain an attractive value proposition. They should also provide materiality thresholds for specific risk drivers such as carbon price or demand fluctuations. Investors can encourage companies to engage in industry initiatives, such as the Edison Electric Institute’s reporting template, or to develop industry-specific frameworks for reporting in alignment with TCFD. This will allow for greater comparability of data and strategies.
The effects the low-carbon transition on the oil and gas sector was a featured ESG risk in our 10 for 2018 report. To learn more about the 10 ESG issues we expect to post significant risks for investors in the year ahead, please download 10 for 2018: ESG Risks on the Horizon.
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