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Carbon supply cost curves: what now for investors?


On 8 May, over one hundred investment professionals gathered in London for the launch of the new Carbon Tracker report ‘Carbon Supply Cost Curves’. It is the first study to quantify the financial risk to oil capital expenditure (CAPEX) in relation to carbon constraints and a range of demand scenarios.

The results show that over US$1.1 trillion of investor capital through 2025 – or US$21 trillion through 2050 – risks being wasted on uneconomic and high-carbon projects. That’s the sum the industry may spend on developments that rely on high market prices of at least US$95 a barrel to break even, largely made up of deepwater, Arctic, oil sands and other unconventional reserves.

This risk is material, and prudent investors should take notice. It is time for investors to step up as active stewards and re-assess their investment strategies.

The rationale is simple. Major oil and gas companies are allocating increasing amounts of shareholder capital to high-cost, long-term projects. Despite that, oil production has barely increased. In 2012, the 200 largest listed oil, gas and coal companies spent five times as much – US$674 billion – on finding and extracting new reserves as they did on returning money to shareholders – US$126 billion. The US$674 billion also dwarfs the US$281 billion in total global investment in clean energy in 2012.

Rusty oil drums © Staffan Widstrand / WWFRusty oil drums in Chukotka, Russia © Staffan Widstrand / WWF

This reflects an assumption that sustained high prices and continued high demand will justify production costs. These assumptions are likely to be tested. Oil prices have dropped to US$40 per barrel twice in the last decade. Demand could be impacted by a range of future issues including economic slowdown in China, improvements and cost reductions in renewable technologies, efficiency gains, and regulation to limit GHG emissions. Gambling on a US$95 oil price per barrel on behalf of shareholders is taking a big risk.

Carbon Tracker’s report suggests that investors should engage with companies to push for capital discipline, different compensation incentives, disclosure of stress tests to oil price and demand, and price assumptions underpinning CAPEX strategies. Focus should be on projects at the high end of the cost curve such as the Canadian oil sands and deepwater in the Gulf of Mexico and Brazil. Well-known players like Petrobras, Rosneft, Exxon, and Shell currently top the table of highest capital spending on projects needing US$95 a barrel and should therefore be on the radar of investors.

Also important is the role of regulators in making sure that companies disclose detailed information and allow investors to gauge where risk lies. Stress testing against much lower oil prices is a reasonable step in a carbon constrained future. These are important recommendations but will they be sufficient to ensure capital discipline? And – more importantly – will they be capable of steering the sector away from levels of warming far in excess of 2o C?

The high-carbon  – capital expenditures radar map

Carbon Tracker map © Energy Transition Advisors (ETA)Carbon Tracker map © Energy Transition Advisors (ETA)

In a recent letter to shareholders, Exxon dismissed the risk of asset stranding and considered any future capping of carbon-based fuels to the levels of a low carbon scenario to be “highly unlikely”. Exxon also expects a 25 percent increase in demand for oil by 2040, met primarily through high-carbon deep-water production and oil sands. This shows little commitment to change and begs the question of whether divestment is the best pathway to ensure portfolio resilience.

In January 2014, a coalition of 17 major foundations, representing almost US$1.8 billion in investment, announced plans to divest from fossil fuel companies and invest more in clean energy. In March, FTSE and Blackrock – the world’s largest asset manager – launched the first set of benchmark indices that exclude companies linked to exploration, ownership and extraction of carbon reserves. These are clear indications that investors – and increasingly mainstream ones – are taking the financial risk of climate change and potential for trapped carbon assets seriously.

In the launch event in London we were reminded that only companies willing to adapt to societal and technological changes survive in the long run. Many of today’s top 10 companies in the S&P 500 barely existed back in 1980 – Apple, Google, and Microsoft, for instance – and only three from 1980 are still in the top 10 today. The energy system transformation has already started and oil companies need to adapt or risk going the way of Kodak and others.

In April, the CEO of the German utility RWE – whose shares have fallen 78 percent since their January 2008 peak – regretted being too late to invest in renewables. Public perceptions about nuclear power have rapidly changed and a state-backed expansion of renewables has seen their market share rise to 24 percent in Germany last year. I can’t help thinking that some oil companies may find themselves in the same situation. The new Carbon Tracker report provides the data investors lacked until now to challenge proposed investments and support a low-carbon transition on the basis of financial returns and carbon content. The message is clear and if investors shout loud enough, maybe the oil majors will hear it.

Fingers crossed.

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