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(Corrects name of the the International Energy Agency)
“The Paris Agreement on climate change, which entered into force in November 2016, is at its heart an agreement about energy.” This statement by the International Energy Agency (IEA) in its 2016 World Energy Outlook leaves little doubt about the critical linkage between climate change and the energy landscape. One month after the release of the Outlook, the Task Force on Climate-Related Disclosures (TCFD) released its Recommendations Report, which offered a similar and compelling view of the critical linkage between climate change and the energy landscape, stating: “The reduction in greenhouse gas emissions implies movement away from fossil fuel energy and related physical assets. This…could have significant, near-term financial implications for organizations dependent on extracting, producing, and using coal, oil, and natural gas.”
When evaluating investments tied to fossil fuels, the consideration of climate change is critical – but what tools are available for investors to understand and analyze this risk?
The Fundamental Mismatch and Stranded Asset Risk
Per the Energy Information Administration (EIA) of the United States, in 2017 global proven reserves stood at approximately 1.6 trillion barrels of oil. If consumption were to remain at the 2017 daily average of approximately 98.16 million barrels, then current proven supplies meet demand for approximately 45 years.
The Paris Agreement, ratified on November 4th 2016, committed signatories to “[Hold] the increase in the global average temperature to well below 2 °C above pre-industrial levels…” Data from the International Panel on Climate Change (IPCC) suggests that meeting that goal will require that the atmospheric concentration of CO2 be limited below 450 parts per million. The IPCC projects that if current trends continue, global concentrations of CO2 are anticipated to reach 450 ppm in the 2030-2040 timeframe.
Put simply, there is a fundamental mismatch between carbon embedded in proven reserves and the amount that the atmosphere can accommodate if the Paris Agreement commitment will be met.
If we are to meet this commitment, some proven fossil fuel reserves may never be monetized – and hence become “stranded.” While uncertainty surrounds this risk—for example, whether governments commit to enacting policy to limit carbon emissions or the emergence of technologies to reduce or eliminate emissions associated with fossil fuels—the “fundamental mismatch” persists.
Understanding this risk is of critical importance to investors as the valuation of an oil and gas company is a function of its ability to profitably monetize its proven reserves.
Climate Change Scenario Analysis: A Case Study
To illustrate how assets might become stranded, I conducted a simple scenario analysis to analyze the impact of two climate-change scenarios on the cost of capital for four of the world’s largest integrated oil and gas companies: ExxonMobil, Royal Dutch Shell, Chevron, and BP.
I constructed a model using each company’s publicly disclosed data regarding production rates and proved reserves levels for oil and natural gas. Price projections were incorporated from the International Energy Administration’s (IEA) 2016 World Energy Outlook.The Outlook contains three scenarios – the Current Policies Scenario, the New Policies Scenario, and the 450 Scenario. The Current Policies Scenario projects a “business as usual” case, and assumes that governments are slow to enact policies to halt the progress of climate change. For the purposes of this analysis, the New Policies Scenario (NPS) and 450 Scenarios were considered, the former of which considers governmental policy announcements to reduce carbon emissions, and the latter of which models the yet more aggressive policies required to meet the 450 parts per million limitation for the atmospheric concentration of CO2. As such, the NPS Scenario forecasts higher prices for oil and gas relative to the 450 Scenario.
The intent of the analysis was to illustrate the relative magnitude of potential financial impacts that could result from a transition from the NPS forecast to the more aggressive 450 Scenario. As such, simplifying assumptions were made to emphasize the take-aways related to the value of scenario analysis.
Scenario One – Base Case
In the first case study, current production rates were projected into the future and maintained until the proved reserves for each company were exhausted. The net present value of future cash flows using the IEA price projections for the New Policies Scenario were taken as a base case, and those for the 450 Scenario were taken as a sensitivity case. Each company was then compared with respect to the percentage reduction in the present value of future cash flows between the two scenarios – i.e., how much more economically “painful” the 450 Scenario would be relative to the NPS. This gap was then analyzed across a range of discount rates.
It can be observed that, for all discount rates, Shell’s portfolio of assets experiences a smaller reduction in value when moving from the NPS to the 450 Scenario than ExxonMobil, Chevron, or BP.
The difference can largely be explained by the relative ratio of the current production rates of each company to its current reserves level.
The shorter timeframe over which Shell’s reserves will be monetized at current production rates results in the higher valuation relative to its peers. This highlights a basic yet important consideration – companies that monetize their assets sooner are more likely to be shielded from the impacts of emerging risks, such as climate change, relative to their peers.
Scenario Two – Perpetuity Case
To normalize for the differing timeframes noted in the previous section, each company’s current production rate was forecast at a constant level equal to the 2017 rate. This scenario therefore presumes that reserves replenishment will occur at a constant rate, on average. The resultant cash flows were assumed to occur in perpetuity after the final year in the IEA price forecast.
While the NPS forecasts steadily increasing prices for both oil and gas, the 450 Scenario predicts a rising natural gas price and peak oil price within the forecast period followed by a gradual decline. As such, the relative value of natural gas to crude oil increases over the latter part of the forecast. As the discount rate increases, the impact of this divergence becomes increasingly muted.
Shell, with the largest proportion of natural gas production relative to crude oil, again experiences the lowest reduction in the present value of its future cash flows relative to its peers. A discount rate of 8% for Shell corresponds with a reduction in value of approximately 14.5%; applying this same value reduction to ExxonMobil, Chevron, and BP corresponds to an implied discount rate of 8.8%, 9.9%, and 9.7% respectively.
Scenario Three – Perpetuity Case in 2023
As described in the previous section, the impacts of the diverging prices forecast in the NPS and 450 Scenario are diminished by the discount rate applied to the future cash flows. As such, the impact of this trend on the implied discount rate for each company is expected to increase over time.
To exemplify this effect, the same analysis was applied using a base year of 2023.
As anticipated, the impacts of the relative price of oil and gas between the NPS and 450 Scenario have been amplified. At a discount rate of 8%, the reduction in the present value for Shell is approximately -20.3%. Again, applying this same reduction to ExxonMobil, Chevron, and BP, this results in an implied discount rate of 9.3%, 11%, and 10.7% respectively.
The Benefits of Scenarios
The preceding analysis presents a simple framework whereby some of the impacts of climate change scenarios on the valuation of oil and gas assets can be illustrated.For investors, three key take-aways emerge:
• The increase in the implied discount rate that results from higher exposure to more carbonaceous fuels is one way to understand stranded asset risk; if prices follow the IEA forecast, the project hurdle rate for crude oil assets will increase relative to natural gas, potentially rendering some disadvantaged assets uneconomic to develop.
• Higher exposure to natural gas tends to mitigate the impacts of more aggressive climate-change policy scenarios due to its higher value as a source of energy relative to more carbonaceous fuels such as oil and coal.
• The exposure of large, long-cycle projects to these emerging risks is greater than that for shorter-cycle projects. As such, a shift towards in shorter-cycle projects is a potential mitigative strategy companies can employ to manage uncertainty associated with emerging climate risk.
As with any model, the quality of its conclusions is only as good as its underlying assumptions – there is no silver bullet with respect to analyzing climate risk. However, even the simple model presented above demonstrates the value of standardized, comparable scenarios for investors seeking to manage their exposure to the potential, “significant, near-term financial implications” cited by the TCFD.
David Parham is the Non-Renewables Sector Analyst for the Sustainability Accounting Standards Board (SASB).