Context – The Blueprint Series
(Apr. 2015) Carbon Tracker is developing a transition road map for the fossil fuel industry (the “Blueprint Series”). This will outline the steps we believe that the industry and individual companies will need to take to adapt their business practices and models to move down a trajectory consistent with an energy transition that delivers a climate secure global energy system.
Blueprint For Fossil Fuel Companies:
In our view, fossil fuel companies and their shareholders are exposed to the following key risks associated with climate change.
- Commodity Price risk: What is the risk to the value of existing company reserves in a ‘low carbon’ scenario for demand where commodity prices are likely to be lower but certainly more volatile?
- Demand/Volume risk: What is the relative exposure to future high cost, high carbon developments that may prove unnecessary and hence sub-commercial in a ‘lower carbon’ scenario?
- Capital allocation risk: Is there sufficient flexibility within existing capital budgets to avoid pressure on shareholder dividends and employee levels in a ‘lower carbon’, low price scenario?
- Management risk: Are management and shareholder interests aligned correctly for a ‘low carbon’ scenario, which would likely require a low/no growth investment strategy?
Carbon Tracker believes that fossil fuel management are overly focused on demand and price scenarios that assume business as usual and so there may be a risk assessment ‘gap’ between a management’s view of the future and that which would result from action on climate change, technology developments and changing economic assumptions. Critically, the greatest impact will likely be felt not in reduced volumes in the short term, but in the consequent pressure on commodity prices caused by lower-than-anticipated demand.
The major fossil fuel companies need a risk assessment approach that encompasses the risks from an energy transition. This should include:
- Scenarios that look at demand pathways that differ from Business As Usual, including the IEA New Policies Scenario and 450PPM/2Degrees Scenario.
- Planning assumptions including commodity price assumptions/scenarios and hurdle rates. These can differ from IEA price assumptions even if based upon the IEA’s demand scenarios, depending on supply assumptions.
- Key indicators for the future project portfolio such as net present value (NPV), internal rates of return (IRR) and breakeven price curves.
- An indication of cash flow at risk from commodity price changes, expressed as an NPV for example.
- A discussion of the degree of flexibility within the group’s committed and uncommitted capital investment program over the next five years.
Providing disclosure of these elements would then allow investors to determine whether they were comfortable with the company’s energy transition risk assessment.
Bringing these aspects together, we set out a “checklist” to consider when evaluating whether a company can respond well to an energy transition:
- Does management accept climate science?
- Has management assessed the probability and scale of risks?
- Is the company strategy able to cope with an energy transition?
- Are company hurdle rates commensurate with the risks faced?
- Is the board’s compensation policy aligned with shareholder value?
- Is the company planning process and governance structure fit for purpose?
- Are energy transition risks considered by all relevant committees and business units?
- Does the company’s risk management approach flow from the board through the investment planning process?
Shareholders will only be protected from the business effects of an energy transition if management address the risks from climate change and take action to mitigate them. In this respect, climate change should be treated no differently from other industry risks including such as safety, cost overruns, project delays, potential political change and fiscal uncertainty.
Two key Strategies:
Capital Management: Capital Management is a crucial function. By being more disciplined, group returns should be improved and capital is freed up. Forgone capital expenditure can be used to increase shareholder cash returns – buybacks if management believes that the company is undervalued, dividends if not. One further advantage of buybacks is that they can be “turned off” should an “unlikely” oil price scenario arise. This gives companies financial flexibility and hence helps protect ordinary dividends, reduces the need for panic asset sales and major reductions in staff numbers.
Diversification: Another strategic route that has been and is being tried by many companies is to diversify towards other industries in their comfort zone. For Carbon Tracker, the issue with diversification to lower carbon sources is whether it is clearly articulated, believable, planned out, has metrics that can be measured, and generates acceptable returns to investors.