Investors are increasingly using scenario analysis to assess climate risks, in line with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD). At present, they are at risk of substantially underestimating those risks by using unreliable climate scenarios.
Investors are also increasing pressure on oil & gas companies to disclose climate risks, with BP recently conceding to demands to disclose how its spending plans and strategy align with the goals of the Paris Agreement. Yet there is far less agreement about what Paris alignment looks like in practice.
The Paris Agreement aimed to limit warming to 1.5°C and ensure warming remained well below 2°C. The scenario most widely used by investors to assess this is the International Energy Agency’s (IEA) Sustainable Development Scenario (SDS). However, this scenario only manages to be on track to achieve these goals by assuming the use of carbon dioxide removal technologies at levels considered unrealistic by both the IEA itself and the IPCC. This scenario also requires carbon capture and storage deployment to increase 135 fold from the mid-2020s to 2040.
This reliance on carbon capture and removal technologies is deeply problematic. The IPCC’s recent landmark report on limiting warming to 1.5°C highlighted the challenges. For carbon capture and storage there is significant uncertainty over its future deployment, costs have not fallen, and the technology is largely absent from governments’ plans to deliver the Paris Agreement. For carbon removal the IPCC is even more critical, saying that the technology is unproven and that relying on it is a major risk to the world’s ability to limit warming.
Scenarios like the IEA’s SDS, which place the burden of emissions reductions on these unproven technologies do not provide a credible guide to alignment with the Paris goals.
Because the IEA’s scenario places the burden of emissions reduction on vast future deployment of carbon capture and removal, it models an increase in gas demand and only a 23% reduction in oil demand by 2040.
So what would genuinely limiting warming to 1.5°C mean, without gambling on the future success of these unproven technologies?
The results are strikingly different: a reduction in production of 60% for gas and 66% for oil by 2040. As a result, none of the $4.9trn the oil & gas industry is forecast to invest in new fields is compatible with limiting warming to 1.5°C. This is the headline finding of a recent analysis by Global Witness, which compared industry production forecasts with scenarios used by the IPCC to produce its report on 1.5°C.
These findings have profound implications for the future of the oil and gas industry. Continuing investment on a business-as-usual pathway, or in line with the IEA’s SDS scenario, would substantially increase the financial risks for oil & gas companies and their investors from a transition to a 1.5°C world.The most underestimated threat that investors face is from a disorderly transition of the kind the Governor of the Bank of England, Mark Carney, has warned of. If this forecast investment in new supply goes ahead, an ever-increasing gap emerges between the current emissions pathway – where high levels of fossil fuel emissions continue on the assumption that they will be mitigated by future large-scale deployment of carbon capture and removal -– and a technically achievable pathway to 1.5°C. Closing that gap would require increasingly heavy-handed intervention.
The Principles for Responsible Investment (PRI) has suggested that such a forceful intervention would be likely to include government action such as restricting demand for fossil fuels or reducing the supply of fossil fuels through the sudden and immediate phasing out of existing fossil fuel infrastructure. This would have a significant and immediate impact on the valuation of oil & gas companies.
Investors do not just face risks if the world is successful in curbing warming; they face greater risks from the failure to limit warming. Over-investment in new oil & gas supply would lock in long-term emissions and put the world closer to a dangerous business-as-usual pathway.
The potential costs of this are vast. A study by Schroders found that the world is currently on track for around 4°C of warming,which could lead to global economic losses of up to $23trn per year – the equivalent of three or four times the losses incurred in the 2008 financial crisis, every year. This scale of loss represents a systemic threat to the global financial system.
The oil & gas industry is at a crucial turning point. Capital expenditure has fallen by over a third since 2014, largely because of a slump in oil prices. Yet it is forecast to rise by over 85% over the next decade, reaching over $1trn a year. Two thirds of that investment is set to take place in new fields where development has not yet started and investments have not yet been sanctioned. The oil & gas majors are set to lead this surge in investment, making up five of the 10 largest investors in new fields over the next decade, led by ExxonMobil, Shell and Chevron.
The risks to the sector and the systemic risk to the financial system can be minimised through avoiding overinvestment in new oil & gas fields. Investment decisions made in the short to medium term will shape the extent to which these risks materialise.
Investors hold the key to this decision. They need to keep the pressure up on the oil & gas majors, and require them to prove their capital investment plans are credibly aligned with achieving the Paris goals.
Murray Worthy is a Senior Oil and Gas Campaigner at Global Witness, which campaigns to end environmental and human rights abuses driven by the exploitation of natural resources.