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Business Risks from Emissions Limits

The clear link between rising global temperatures and the emissions from the combustion of fossil fuels is established. Limiting the warming effect means limiting Carbon Dioxide (CO2) emissions from the combustion of fossil fuels.

In 2009 the Copenhagen accord, drafted by the US for the UN, acknowledged that rising global temperatures should be kept to within two degrees Celsius of their pre-industrial levels. This means limiting emissions from 2010 onwards to a budget of no more than 886 GT of CO2 (www.carbontracker.org).  More than 886 GT and the two degree threshold set by the UN will be broken and the world will be faced with significant and potentially dangerous climate change.  The International Energy Agency (IEA) and others forecast that current portfolio of national policies are driving the world towards a disastrous four degree warming.  So what does a two degree limit really mean for energy supply and what new strategies are required to meet the business challenges that will result?

The above plot shows cumulative global emissions against time from 2010 through to 2050.  It shows a series of scenarios based upon different views of future global fossil fuel consumption.  These scenarios are drawn from two key sources.   The solid lines are International Panel on Climate Change (IPCC) and IEA scenarios from the work presented by Carbontracker.  The dotted lines are scenarios developed from the 2013 BP Statistical Review of World Energy.

Carbontracker Scenarios

IPCC RCP8.5 Business as usual and as likely as not to exceed 4 degrees Celsius of warming
IPCC RCP2.6 Best Case assuming emissions are halved by 2050
IEA Current Policies No implementation of new climate change policies after mid 2012
IEA 450 Best Case assuming policy action consistent with limiting global warming to 2 degrees Celsius

Scenarios developed from 2013  BP Statistical Review of World Energy

Carbon Budget – BP Conversion of consumption scenario from BP Statistical Review
Carbon Budget – BP + Full Gas Switch As above but full fuel switch from coal and oil to gas only from 2012 – IMMEDIATE FUEL SWITCH TO GAS
Carbon Budget – 2010 BAU Business as usual from 2010 consumption rates and fuel mix
Carbon Budget – 2.5% pa Reduction As above including an annual reduction in consumption of 2.5% pa

Clearly, without significant and sustained global policies to limit emissions then the world will reach and then exceed the UN agreed 2 degree Celsius warming threshold, perhaps as early as 2031 in just over 17 years.  With an early global agreement on emissions control, perhaps in 2015 at the UN Framework on Climate Change conference in Paris, then the threshold might be deferred to beyond 2045 allowing a controlled and effective transition to a low carbon economy.  This would minimise adaptation costs and their negative impact on the global economy and potentially also on international relations.  In the UK and elsewhere, government policies are built around another “dash for gas” and going “all out” for shale gas.  Even if the technical, environmental and planning challenges can be overcome and a complete switch to “clean gas” was made with immediate effect across the whole world then this would only buy an additional ten years of carbon budget.  So fuel switching to fossil gas on its own, which might take more time than it will save and require a huge global capital investment will not provide the solution.  Describing natural gas as a clean low emission energy source is misrepresentation.  In practice, a portfolio of measures will be required, and governments should consider very carefully how to guide the energy industry to invest now in areas that deliver the most effective blend of energy supply and emissions reduction.  Now consider the reserves of coal, oil and gas.  According to the Society of Petroleum Engineers, “Proved reserves are those quantities of petroleum which, by analysis of geological and engineering data, can be estimated with reasonable certainty to be commercially recoverable, from a given date forward, from known reservoirs and under current economic conditions, operating methods, and government regulations.”  For 62 years now, the BP Statistical Review of World Energy has provided high-quality and globally consistent data on world energy markets, and so whilst building accurate estimations of reserves in some nations is particularly problematic, it represents a reasonable basis for a simple analysis.

The diagram here is the same plot of global emissions, but with a rescaled vertical axis to accommodate the tall single column at 2012.  This represents the emissions embedded within the proven reserves from coal, oil and gas in the 2013 BP Statistical Review.  These total around 3500 GT of CO2 emissions.  This is almost four times more than the 886 GT budget limit.  It is this type of analysis which suggests that a significant proportion (here 75%) of current proven reserves of gas, oil and coal might not be monetized conventionally without breaching the two degree Celsius warming threshold.  Of course any reserves in the more uncertain “probable” and “possible” categories simply make the balance worse.  It is notable that the potential of shale gas being pursued by UK government policy are not even classified as reserves yet, being constrained to their even more uncertain cousin called “resources”.  This analysis was first developed back in 2007, but highlighted in July 2012 by Bill McKibben in Rolling Stone Magazine and has been refined more recently by Carbontracker and even the International Energy Agency.  As a combination of drivers including poor air quality, extreme weather events, and concern about climate change adaptation drive the evolution of new climate policies around the world, businesses must start to consider the risks and potential impacts of these new policies.  In the same way that prudent corporate boards carefully consider risk exposure for future commodity prices, exchange rates, and changes in fiscal policy, they also have a responsibility to consider the potential impacts on the operations, cash flow, and asset value of their business with potential changing climate policies.  Whilst there is no global emissions agreement in place today, an agreement in 2015 in Paris might effectively start to set limits on fossil fuel production as well as the associated emissions.  This raises a huge number of important questions for fossil fuel owning corporates such as:-

  • How might my share price be affected?
  • How will my ability to service existing debt be affected?
  • How will I be able to maintain shareholder support for exploration programmes to prove up reserves I may not be able to fully monetize?
  • If the changes impact future production and cashflow, does the business still have the capability of servicing its debts?  Is the business still solvent?

Those corporates who consider this to be a risk so remote that it is not worthy of consideration should remind themselves about the introduction of the “carbon price floor” in the UK on 1st April 2013 less than three years from its origination in 2010.  This sets a minimum floor price for CO2 emissions from electricity generation in 2015 of £18.08 per tonne rising steadily to £24.62 per tonne in 2018.  The EU Allowance price in January 2014 for one tonne of CO2 is less than £4.50.  This change, driven by a policy objective of encouraging low carbon investment, significantly raised future operating costs of some UK power generation assets and contributed to decisions to shut down production early on some assets.  What might be the equivalent in the oil and gas industry?  At government level, whilst there is a deep understanding of, and commitment to deficit reduction through earning more and spending less, DECC continue to maintain an untenable objective of producing more fossil fuel and emitting less CO2.  Surely governments must now seriously consider the logic and sense of seeking to maximise both hydrocarbon resource recovery whilst at the same time meeting commitments on emissions and climate change?  In early 2014, much of the world of business remains either unaware of these matters or chooses to ignore them.  Right now there are no national policy connections between the 2009 agreed temperature limit and the deployment of the proven reserves of fossil fuel, and as the world emerges from the financial crisis fossil fuel energy production is seen by many as as the fuel for economic growth.

A Change in Atmosphere?

Even without global climate protection agreements, some change is beginning to happen.  Some of it is being driven by a growing realization in the commercial world that something has to change and at some point, national governments will collectively or unilaterally grasp the nettle of serious climate change legislation.  Already, this is resulting in a some major investors questioning or even divesting their position in coal, oil and gas reserve holders to reduce their exposure to the risks associated with the “Carbon Bubble”.  Perhaps most notably, the worlds largest Sovereign Wealth fund in Norway has just embarked upon a study to consider its position regarding its fossil fuel investments, whilst one of Norway’s largest private investors Storebrand has already excluded many fossil fuel related companies from its funds on sustainability grounds.  The oil and gas and coal industries have endured many financial shocks over history, but the re-adjustments to asset values that might happen once the climate saving policies start to be embedded around the world would be amongst the biggest of business challenges.  We are in the early stages of a significant change period for oil, gas and coal companies where those who look up to the horizon have some time to adjust their strategies to manage this very real risk and respond early creating new opportunities for growth.

What strategy options are available for Fossil Fuel reserve holders?

For those corporates who do look forward, there are strategies available to mitigate some of the potential risk.  Starting to account for the realistic “social cost” of carbon emissions in project economics should be considered.  This will encourage the steady and progressive switch of investment into low carbon energy technologies such as renewables and Carbon Capture and Storage (CCS).  For some, CCS may enable continued monetization of fossil fuel reserves in a low carbon way compliant with emerging stringent climate policies.  In all fossil fuel corporates, the value of exploration and development of high carbon intensity fuel reserves such as coal and oil (especially oil sands) must surely be questionable without full CCS in place.  Nations and companies with shale gas aspirations must also consider the practicality and time it would take to bring these unproven resources to market such that large amounts of capital are not expended to bring more reserves into play that simply cannot be monetized.  In the fossil fuel world, asset trading will become an even more complex space with sellers seeking to de-risk their portfolio by monetizing some assets before any devaluation trend begins.  There may be be a flush of transactions between sellers who perceive risk and buyers that don’t or who have mitigated the risk on other ways.  Of course corporates with CCS experience in place will be in a strong position to buy assets at possibly reduced prices at this stage.  As for what happens to oil and gas prices in this scenario – that is for another post.  The low carbon transition is on its way and fortune will favour those prepared for it.

This article was written by Alan James.

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