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ESG Perspective - The risks of climate change in the oil and gas sector

ESG Perspective - The risks of climate change in the oil and gas sector
05/11/18

Investors and asset managers are progressively incorporating the risks of climate change into investment decisions, as it is becoming increasingly clear that those companies that fail to address the issue may be exposed as the world transitions to a low carbon future. As a leading contributor to climate change through its operations, services and use of its products, the oil and gas sector is particularly exposed to the associated risks of climate change. It will require significant changes in the short, medium and long term to mitigate this exposure.

In this report, we highlight the diversity and complexity of the oil and gas sector and the lack of consistency in terms of how seriously each company approaches climate-related risks. This makes it difficult for investor to illustrate a consistent stance when developing an engagement strategy, with some companies far more receptive to our concerns over climate risks than others. In addition, we recognise that a transition of the sector will not happen overnight and that policy-makers need to play a role, but we can implement measures that will increase the speed of transition.

NN Investment Partners (NN IP) takes climate-related risks in the oil and gas sector seriously and we acknowledge our role as an investor as the world move towards a low carbon future. We therefore developed engagement targets and we aim for consistency, expecting that all oil and gas companies that we engage with implement similar strategies. We believe that this will ensure the momentum of the energy transition and increase the speed of progress.

Climate change and the role of the oil and gas sector

Climate change, interchangeable with the term global warming, refers to the rise in the average temperature of the Earth and the resulting effects. This is largely driven by an increase in Greenhouse Gases (GHGs) entering the Earth’s atmosphere. The most prominent gases contributing to this are: Carbon Dioxide (CO2), Methane (CH4) and Nitrous Oxide (N2O) which trap heat and prevent it from escaping the Earth’s atmosphere. Therefore, the greater the amount of these gases in the atmosphere, the less heat that can escape, thereby raising the Earth’s temperature.

In its Fifth Assessment Report[1], the Intergovernmental Panel on Climate Change (IPCC), a group of 1,300 independent scientific experts from around the world under the auspices of the United Nations, concluded there is a more than 95 percent probability that human activities over the past 50 years have ‘warmed’ our planet due to an increase in GHGs.

Human activities that contribute to climate change include: deforestation, transportation, land-use changes and burning fossil fuels.

Burning fossil fuels for energy purposes, which include coal, oil and gas, is by far the biggest contributor to the rise of CO2 in the atmosphere. This is the result of the fossil fuel burning process, which combines carbon with oxygen in the air to form/create CO2 and other GHGs are released due to incomplete combustion.

In this report, we focus on the Oil & Gas sector. An important note to make is that transportation accounts for roughly 70% of global oil consumption, ranging from powering cars to airplanes. Other applications include construction activities and agriculture. We will analyse these sectors at a later stage.

Figure 1: Greenhouse gas emissions by economic sectors

The inner circle show direct GHG emission shares (% of total anthropogenic GHG emissions) of five different economic sectors during 2010. The pull-out to the right shows how indirect CO2 emission shares from electricity and heat production are attributed to sectors of final energy use.
Source: UN Sustainable Development Goals, 2018

Climate-related risks for the sector

In financial circles, discussions are increasingly about the possible risks climate change would have on the Oil and Gas sector should the world actively pursue a path towards a low carbon economy. In 2015 Mark Carney, Governor of the Bank of England and Chair of the G20’s Financial Stability Board, stated that a carbon budget consistent with a ‘2 degrees world’ (see next section) ‘‘would render the vast majority of [oil and gas] reserves stranded’’.

Because oil and gas companies’ values are partly determined by their fossil fuel reserves, the transition risk poses a significant threat to the sector’s overall value. The time frame for “peak oil demand” is being widely discussed by industry and financial analysts, with larger oil and gas companies predicting a peak in the late 2030s, while the earliest NGO projections call for as soon as 2020. The most impactful variable in this equation is the potential disruption caused by new technologies on the energy supply side (renewables like solar and wind) and demand for electric vehicles and other uses of energy. While the timeframe is debatable, it is highly probable that the rate of growth for oil is decelerating, and companies in the sector are exposed to the risks associated with this if they do not adapt their business models. Moreover, there is also a risk in relation to a change in consumer behaviour, as increased awareness of the climate impact of oil and gas may motivate individuals to reduce energy consumption.

As well as monetary risks associated with adapting to a low carbon world, the physical damage that can be caused as a result of climate change also poses a risk. Climate change alters water cycles and exacerbates extreme weather events such as storms, tsunamis and cyclones. Consequently, this may potentially result in greater physical damage to energy infrastructure, food and water systems, populations and the global economy. While all countries will be affected by climate change in one shape or another, some regions of the world are more exposed than others.

Guidelines, regulation and statements

The potential risks associated with climate change have prompted action at national and international level in the form of stricter regulations and frameworks for reducing their emissions and overall contribution to climate change. As major emitters of carbon emissions and producers of fossils fuels, oil and gas companies are amongst those most exposed to these new regulations.

The most notable of these was the Paris Agreement[2] of December 2015 which, as of February 2018, has been signed by 195 UNFCCC members, of which 175 have become party to it. The Paris Agreement’s central aim is to strengthen the global response to the threat of climate change by keeping a global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius. While the agreement does not enforce strict regulatory laws and offers only guidelines, the accords represented the world’s first comprehensive climate agreement and have been described as an incentive for, and driver of, fossil fuel divestment.

This prompted the EU to reduce GHG by at least 40% domestically by 2030 compared to 1990 levels, including the use of carbon EU credits. At the same time, there is a clear ambition among global leaders to phase out the use of oil and gas at a national level. President Macron of France announced that the country will ban sales of petrol and diesel cars by 2040 to align with the Paris Agreement. The same commitment was made by the UK government one month later.

Furthermore, climate change is not just on the agenda of high-income countries, with emerging markets also setting frameworks for reducing greenhouse gas emissions. The world’s number one polluter, China, has aimed to have CO2 emissions peak by 2030, with efforts to pull this forward by pledging to source 20% of energy from low carbon sources by 2030 and to cut emissions per unit of GDP by 60 – 65% of 2005 by 2030. Both of these commitments are in line with China’s emissions trading system, which comes into force in 2018. India has also set a target to reduce emissions intensity by 33% - 35% by 2030 compared to 2005 levels, with Mexico aiming for an unconditional 25% reduction in GHG and short-lived climate pollutants emissions by 2030.

A notable omission from these examples is the USA, the second largest polluter of GHG emissions. The Trump administration has made it clear that it does not seek to expand environmental regulations and has made comments suggesting that the Administration doubts the science of climate change completely, underpinned by its withdrawal from the Paris Agreement and rolling back Obama-era climate policies.

In terms of self-regulation, the Task Force on Climate – Related Financial Disclosure (TCFD)[3] offers a framework for the Oil and Gas sector to disclose climate-related information consistently in its mainstream financial filings. The framework encourages firms to voluntarily provide information about climate risks to their investors and other stakeholders to illustrate their preparedness and the impact of climate change on their businesses. However, with reporting commencing in the first quarter of 2018, only four companies NN IP is invested in have announced they are supporters of the guidelines.

Sector exposure

NN IP is exposed to the climate change-related risks through its investments in the Oil and Gas sector. We have therefore analysed several companies in the sector on different topics to understand the different risks that we face as an investor.

We have analysed 49 companies within the sector, which have been categorized into the following groups:

  • We categorise nine companies within ‘Oil and Gas Equipment  & Services’ (companies that focus on providing the necessary equipment for oil and gas businesses to operate and subsequent services for doing so).
  • Eight are considered in ‘Oil and Gas Exploration and Production’ (companies that focus primarily on the exploration of oil and gas reserves in the ground and their eventual extraction, usually referred to as ‘upstream activities’).
  • Six are within the ‘Oil and Gas Refining and Marketing’ grouping (also referred to those involved with ‘downstream activities’; these companies focus upon processing the oil and gas collected during the upstream stage and transforming this into a finished product).
  • Five in the ‘Oil and Gas Storage & Transportation’ (known as ‘midstream activities’ within the sector; businesses at this stage in the production process focus upon storing and transporting the oil and gas collected during the upstream process and delivering it to a destination where it will be refined and marketed into a final product during the downstream phase).
  • 21 in ‘Integrated Oil and Gas’ (companies that engage in multiple stages of production process, including exploration, production, refinement and distribution of oil and gas – these companies are usually the largest in terms of market value due to the size and scope of their operations).

The climate risks associated with the sector impact all categories, albeit in different ways. For example, physical damage to infrastructure in oil rich regions from climate-related storms disproportionately affect companies involved with exploration and production activities. At the same time, the trend towards stricter climate related regulations and tougher stances on GHG emissions at a national and international level significantly affect companies involved with refining and marketing the fossil fuels.

Given the above, all activities along the supply are likely to be impacted by 1) the expected energy transition towards more sustainable energy sources and 2) more extreme weather conditions due to global warming. As the integrated companies are present across the entire chain, they will be impacted heavily. Their capital-intensive nature, with projects that cost billions to develop and are productive for a number of decades, makes them most vulnerable within the sector as the business model cannot be changed overnight (at least not without massive capital destruction). They are also the among largest GHG-emitting companies in the world. Even though this is more of a reflection of size rather than bad operational practice, their acquaintance among the general public makes a  big oil company an easy target for environmental groups, NGOs and governments in their publicity campaigns. It therefore puts them under greater scrutiny to take climate-related risks seriously. Accordingly, if the sector as a whole seeks to be less exposed to climate related risks, this will require a significant shift from business as usual by Integrated Oil and Gas companies.

Research

The Oil and Gas sector can basically be divided into two camps with regards to how it approaches climate related risks:

  1. Those who seek to remain in oil and gas and therefore focus on energy efficiency and greater social responsibility in the areas in which they operate, to reduce their contribution to climate change
  2. Those who go one step further and are investing in low carbon technologies and attempting to diversify their energy mix

After a severe down-cycle, oil companies are becoming profitable again on the back of a recovery in commodity prices. No wonder that companies are hesitant to divest from oil and gas and appetite to invest in more reserve developments is on the rise. This does not bode well for a transition to a low carbon world. As oil and gas is found in many places around the world, supply restrictions policies are extremely difficult to implement. For that reason, demand destruction will be pivotal to reduce GHG from the Energy sector.  It will take either a major technological shift, such as a rapid adoption of cheaper electrics vehicles from cheaper batteries or a significant regulation change, such as a price on carbon, to converge the sector towards a similar long-term business strategy. While we see encouraging developments on both sides, an acceleration is needed to reduce our dependency on fossil fuels as well as keeping the effects of climate change within boundaries.

Transparency

As an engaged investor, we encourage companies to be transparent about their business activities and report risks related to climate change. Through our analysis, we found that 40 out of the 49 companies had an annual climate or sustainability report that provided policies on climate change. While this is encouraging, there was significant variety in the level of detail that companies disclosed. Indeed, we found that the European oil and gas giants were far more transparent about their integration of climate-related risk into their models than their American counterparts. Oil and gas companies in emerging markets appeared even more reluctant to publish details, if any.

Targets

Targets seem to be primarily focused on companies seeking to reduce their environmental and social impact in the regions they operate. In particular, there was a clear focus on reducing GHG emissions through improved energy efficiency and intensity, research and development into new technologies such as Carbon Capture Storage (CCS) and acquisitions or investments into the renewable sector (dealt with later in this report). These varied in ambition and scope between companies, dependent on the size  of the company and where they were based, with a clear divide between Europeans and the rest of the world. We found that 32 out  of the 49 companies researched reported their SCOPE 1[4] and 2 GHG emissions, with the majority going a step further illustrating the trend of these emissions in the past five years. Very few reported their scope 3 emissions, but those who are most transparent about scope 1 & 2 show ambition to incorporate 3 into their annual reports.

Increasingly, we are seeing oil and gas companies incorporate the Science-Based Targets Initiative[5] into their business model. Targets are considered ‘science based’ if they are in line with the level of GHG reduction required for a 2 degrees world, as set out by the Paris Accords in December 2015. From a business’ perspective, it can be an effective way of developing a competitive advantage by illustrating  its commitment to a low carbon world. Within the Oil and Gas sector, the adoption of these targets has been slow but there appears to be growing interest, particularly among the majors based in Europe.

Investments in renewables

International oil and gas companies (IOCs) have had a footprint in low carbon technologies, but this trend has accelerated since the  fall in oil prices in 2014. Indeed, the collapse in the price in 2014 brought a sharper focus on the need for companies to consider  their long-term diversification and growth strategies. This is most prominent in the Integrated Oil and Gas grouping whereby there  has been a growing interest in investing in renewable sources, in particular: wind, solar and biofuel technologies.

An example is Equinor[6], which has invested USD 2.3 Billion into offshore wind energy up to 2017. Again, this aspect of business models in the sector exposed the divergence between American  and European companies, with the latter far more interested in diversifying their energy mix. However, even within industry leaders’ portfolios, investments in renewables are negligible when compared with the amount continued to be invested into oil and gas.

Climate change risk and compensation

An effective way companies in the Oil and Gas sector can illustrate their commitment to a low carbon world is by correlating their performance to climate-related risks. Some companies indeed decided that this offers them a competitive advantage because it illustrates their performance in relation to their ability to survive  in a low carbon world. As with other aspects of this analysis, European-based firms were more likely to develop such models and disclose the relevant information, with American and emerging market-based companies lagging behind. However, the points of measurement and how this can be categorised by quantitative and qualitative indicators is still not universally agreed, with each company using different frameworks for each. An example of how this can be done could be to assess how companies’ activities complement the Paris Agreement’s ambition for a 2 degrees world. Shell’s recent announcement of its Sky Scenario is a good example of this.

Risk disclosure

Increasingly, companies in the sector are encouraged to stress-test their portfolio against climate risks to illustrate to investors their preparedness for possible disruptions resulting from climate change. This can be in the form of physical, technological, regulatory and social changes in the market, as outlined in the previous section under ‘climate-related risks’. We found only eight of the 49 companies in  NN IP’s portfolio had conducted one form or another of stress-testing in relation to climate-related risks, and even within this grouping some appeared as box ticking as opposed to taking the risks seriously. This underlines the general trend in the sector which is that companies have been slow to incorporate such disclosures into their models.

Engagement approach, focus on transitions

The Oil and Gas sector is very diverse and complicated, and there is a lack of consistency in terms of how seriously each company approaches climate-related risks. This makes it difficult as an investor to illustrate a consistent stance when developing an engagement strategy, with some companies far more receptive  to our concerns over climate risks than others. Nevertheless, we acknowledge our role as an investor in the transition and have set out several engagement targets that we consider to be important for the sector overall.

Focus on the climate transition

Despite all the risks and climate change agreements, we must realise that the transition of the energy sector will not happen overnight. Globally, we are still dependent on energy and because of this there will not be an imminent collapse in oil demand. What is notable is that there is a current trend in investment strategies away from finding new sources of oil and towards finding alternatives to it. If the bigger energy consumers such as the EU and China remain committed to control global warming, the fossil fuel industry will be affected. The International Energy Agency (IEA), indicated that to come close to a 2 degrees Celsius target, oil demand would have to peak in 2020 at 93 million barrels per day, which is below current levels. Oil used for transportation for instance would have to decrease over the next 25 years and be replaced by electricity, natural gas and/or biofuels. None of the signatories to the Paris Agreement has, however, pledged drastic actions yet, but as the costs of renewable energy continues to fall, such a transition appears ever more unavoidable.

The fossil fuel which will benefit the most from the transition is natural gas. It offers many benefits if it displaces more-polluting fuels. CO2 emissions (per unit of energy produced) from gas are around 40% lower than coal, and around 20% lower than oil. Many see electricity powered by gas and renewables as the first step in an overhaul of the global energy system.

Figure 3: Share of natural gas in total energy-related emissions of air pollutants & CO2

Source: International Energy Agency (IEA), Gould, McGlade, 2017

An engagement approach

The current challenge is to ensure the momentum of the energy sector transformation and increase the speed of the progress. The ratification of the Paris Agreement, but also the implementation of the United Nations Sustainable Development Goals, show strong global support to address climate change and other environmental concerns. Rapid and clear signals aligned with long-term objectives will be needed to steer the Energy sector towards sustainability. NN IP has therefore developed several engagement targets that we will monitor and evaluate on a yearly basis.

On governance issues, we expect companies to be transparent on how board members and management processes ensure there is adequate oversight of climate-related risks into decisions-making processes. This can include accountability mechanisms to ensure there is oversight of climate- related risks, setting key performance indicators related to climate performance, the way incentives are aligned with an appropriate climate risk strategy and the level of expertise among members in relation to climate-risk decisions. We believe this is achievable through NN IP’s role in voting at annual general meetings (AGMs) on the election of board members and compensation items.

Increasingly, investors are demanding that companies outline a scenario analyses of their abilities to survive in a low carbon world. NN IP encourages such strategies, which can include: the outlook for future energy demand, what are the potential impacts of public policy measures in a 2 degrees world on the company’s business model and the impacts of new technologies (such as electrical vehicles or renewables) entering the market. Building on these issues, we encourage policies such as stress-testing portfolios against climate-related and scenario risks on a regular basis as well as developing research and development strategies, which account for these issues.

The increased use of sustainability and climate reports alongside annual reports for transparency and disclosure is welcome. However, we do encourage companies to integrate these into their annual reporting as well. We believe companies must report their Scope 1, 2 and 3 emissions, and develop targets and ambitions on all three levels. Similarly, we expect companies to disclose their views of, and responses to, their material climate-related risks and opportunities across different asset classes. In the context of these suggestions, NN IP is a supporter of self-regulatory initiatives such as the Taskforce on Climate Related Disclosure (TCFD) and supports companies that incorporate them into their business plans.

Self-regulation however will not be enough to tackle these risks. Therefore, we strongly support companies that actively engage with public policy makers and make constructive suggestions as to how policy measures can support their plans to accommodate climate- related risks in their business models. This can include developing positions on energy and climate polices, carbon pricing, energy efficiency targets and renewables, as well as trade associations in which they are members. Furthermore, there should be greater disclosure regarding a company’s lobbying and its political spending and consistency between a company’s public positioning on climate change and its lobbying activities.

Conclusion

NN IP takes climate-related risks in the Oil and Gas sector seriously and we acknowledge our role as an investor as the world moves towards a low-carbon future. We have therefore developed engagement targets and we aim to have consistency, whereby we expect that all oil and gas companies carve out a transition plan.  We do not seek to target or expose an individual company but to ensure our policy approach is universally applicable to all the companies with which we engage.

Our commitment to addressing climate-related risks is also demonstrated by our membership of the UN’s Principles for Responsible Investment (PRI), achieving an A+ rating, and we are a member of the Institutional Investors Group on Climate Change (IIGCC), which provides useful collaborative frameworks for addressing these issues. We believe that collaboration with other investors will strengthen our message, and we have therefore joined a PRIcoordinated engagement that asks companies to respond to the risks they face as a result of constraints to oil and gas use going forward. In addition, NN IP participates in IIGCC’s corporate programme, where we engage about climate-change risks and opportunities faced by companies, as well as their strategies and performance in addressing and disclosing them. We also joined the Climate Action 100+ group.

As emphasized in the report, the current challenge is to ensure  the momentum of the energy sector transformation and increase the speed of the progress. Rapid and clear signals aligned with long-term objectives will be needed to steer the energy sector towards sustainability. With an active engagement strategy,  we can contribute our share  in the broader climate transition.

Notes and sources:
[1]
Fifth assessment report, IPCC, Greenhouse Emissions by Economic Sectors
[2] UNFCCC, The Paris Agreement, October 2018
[3] TCFD, 2018
[4] Scope 1, 2 and 3 is explained in Figure 3
[5] Science-Based Target, the Science-Based Targets Initiative, 2018
[6] Company name, explanations and arguments are given as an example and do not represent any recommendation to buy, hold or sell the stock

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About the author

Faryda Lindeman

Faryda Lindeman

Senior Corporate Governance Specialist

Experience since 2006

Business Experience

2017-to date Faryda is Senior Corporate Governance Specialist in the Responsible Investment team at NN Investment Partners

2015-2017 Manager Governance Research, Sustainalytics, Netherlands

2010-2014 Advisor Responsible Investment & Governance, MN Services, Netherlands

2008-2010 Team Lead Benelux, Institutional Shareholder Services (ISS), Belgium

2006-2008 Analyst, Institutional Shareholder Services (ISS), Belgium

Qualifications

Woman Corporate Directorship Program, TIAS, 2016 to date

MSc in Sociology from the Erasmus University, Rotterdam, 2015 to date

BSc in International Business and Management from Hogeschool Rotterdam in 2007

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