The debate at Rio+20 in late June was about “natural” capital. Just days earlier, world leaders attending the G20 summit in Mexico discussed the recapitalizing of European banks. Amid all this talk, extractives companies worldwide continue to plough massive amounts of capital into “unburnable carbon” – carbon that must be left in the ground if we are to avoid the worst impacts of climate change.
The Cancun Agreement in December 2010 captured an international commitment to limit global warming to two degrees Celsius above pre-industrial levels. It also recognized the potential need to tighten this target to 1.5 degrees. Companies and investors may talk openly in support of this two-degree framework, but the capital expenditure plans of the fossil fuel sector are keeping us on the path to six degrees of global warming.
The money deployed now will be used to develop a dirty energy resource for decades to come. It can take at least five years to explore for and develop a coal, oil or gas asset before it achieves full production. In the world of quarterly reporting this is relatively long-term thinking.
Zeroing in on oil, the industry is setting new records with its capital spending budgets, allocating $728 billion (U.S.) to exploration, development and production projects in 2012. The integrated oil majors are each spending more than $30 billion this year, with levels set to rise over the next five years.
It is worth noting that for publicly-listed oil companies the era of “easy oil” is over, as recognized by Royal Dutch Shell’s chief executive in 2007. This means that a rising proportion of investment is going toward developing "unconventional" fossil fuel technologies and reserves. Unconventional production includes deep-water oil and gas, liquefied natural gas, tight gas, coal bed methane, shale oil and gas, gas-to-liquids and oil sands.
The return on investment here can only match previous levels from conventional resources if the price of oil continues to rise. The higher up-front capital costs per barrel also mean that projects can take decades to produce a positive cumulative cash flow. Yet about 35 per cent of predicted production from the three largest independent U.S. oil majors will be from unconventional sources by 2018, up from 20 per cent in 2010.
A risky path to take? There are warning signs out there if we turn attention to the North American coal sector, which appears these days to be running out of options. The combination of cheap domestic gas and more stringent emissions regulations has made coal an expensive option. Consumption of coal in the U.S. in the first quarter of 2012 was at its lowest in 25 years. Power companies have cancelled a number of planned coal plants in the last six months. Exelon, for example, may have to take a 40-per-cent haircut on the value of the coal plants it is selling off. Ratings agency Moody’s downgraded Alpha Natural Resources at the end of June due to its exposure to Central Appalachian coal.
One wonders if this is coal’s Kodak moment. There are similarities here with the sub-prime crisis – mixing in high-risk products with an assumption that property prices will continue to rise. Extractives companies are moving quickly to wrap up baskets of high-risk, carbon- and water-intensive unconventional reserves. The ongoing viability of this model assumes that demand, prices and carbon emissions all continue to increase, with no alternative technologies becoming more competitive.
The oil sands are a case in point. In Canada, accounting rules are downplaying the levels of oil sands listed on the stock exchange. Current rules date back to the days of $40 per barrel of oil. At this price it made perfect sense for companies to only report reserves that were due for “imminent production.” Higher levels of reserves have started to appear in financial reports as they become economically viable at a higher oil price. The physical existence of the oil sands reserves is not questioned, but whether the planet can afford to burn these carbon-intensive assets should be.
In other words, accounting standards are not adequately factoring in climate risk. Research is currently underway to analyze the reporting requirements in major resources markets. The aim is to identify current practice as well as possible future interpretations and amendments of risk factors that should be included in reserves reporting.
The measures to improve fuel efficiency in the United States, for example, could dampen the market for oil sands production. It’s arguably why there is intense pressure today to open up new export routes such as the Keystone pipeline, in effect locking in new infrastructure.
So what can shareholders do about risky exposure to unburnable carbon assets? Institutional investors have limited options for influencing the equities they hold when they are benchmarked against an index such as the S&P 500 or FTSE All-Share. Many are tied into holding major fossil fuel stocks to avoid underperforming the market in the short term. But they can apply an engagement approach with the individual companies they hold.
They can encourage fossil fuel companies to diversify rather than deepen their hydrocarbon asset base by moving into cleaner alternatives. Unfortunately, most companies are getting deeper into fossil fuels. After dabbling with renewables and “Beyond Petroleum,” the oil companies are investing in even more carbon-intensive unconventional technologies with only token efforts in pure renewables.
Coal companies do not have an alternative business model, only the potential of geographically shifting markets. The displacement of coal by gas in U.S. power generation has coal companies seeking new export routes to survive. Many are struggling. Patriot Coal was forced to file for bankruptcy in July 2012, sending jitters through the sector.
Investors can also engage in a strategy of debate and direct. Shareholder resolutions can pressure debate on an issue. It’s rare that such resolutions achieve the significant majority support required to direct a company to act, but just forcing public debate with a company can be enough to influence management. There have already been many shareholder resolutions on climate change at oil and coal companies, primarily in the U.S. where it is easier to file them.
One debate relates to shareholder dividends. More investors are beginning to question the capital spending strategies of coal companies. They want more cash paid out to shareholders as dividends rather than poured back into activities and assets that rely increasingly on uncertain markets.
Fund managers, focused on retaining clients and securing bonuses, tend not to rock the boat. Not wanting to risk underperforming the market, few are willing to sell out of fossil fuels and miss out on short-term returns.
The failure of markets to integrate long-term risks means that company valuations are based on short-term performance. This skews the markets to value fossil fuels, resulting in a boost in share prices and the market value of companies. Problem is, this leaves the average pension fund exposed to a carbon bubble burst, as only a few will get out before the market crashes.
Perhaps there’s a blind faith out there that high-growth developing countries such as China will save the day for a dirty fuel such as coal. But will it? Bernstein Research recently issued a note directly challenging the assumption that China will have an insatiable demand for coal.
“The stakes couldn’t be higher: from the outside looking in, the U.S. has just joined Australia, Colombia, Indonesia, Mozambique, Mongolia and South Africa on the list of coal exporters that believe Chinese coal consumption and import growth are a one-way trade,” according to Bernstein. “If that assumption is wrong, where does all the coal go?”
The answer is clear. If we are to keep the average rise in global temperature to below 2 C, all that coal goes in the unburnable carbon category.
Investor beware.
