Oil and Gas Business Models - Resilient or Risky?
Posted on 24th July 2023 at 15:16
This article, co-authored by JS Global principals Paul Stuart-Smith & Jane Stevensen, was first published on Thursday 20th July 2023 on the GARP (Global Association of Risk Professionals) website
Are Oil and Gas Companies’ Climate-related Risks Adequately Captured?
Achieving the goals of the Paris Agreement, goals to which virtually all countries of the world are committed, requires demand for oil and gas to fall significantly by 2030. This irrefutable truth sits implicitly at the heart of national and corporate net-zero pledges, a point reiterated by COP28 Director-General Majid Al Suwaidi in a speech to mark the start of London Climate Action Week in the last week of June.
By contrast, soaring profits at fossil fuel companies over the past year and heightened energy security concerns, both driven by the conflict in Ukraine, have given renewed impetus to oil and gas production and provided a pretext for some of the oil majors, including BP, Shell and ExxonMobil, to dial back on climate goals. Where only recently they were vying to outdo each other with much publicized carbon cutting pledges and net-zero targets, we’ve seen a major shift in strategy.
BP has pared back its goal of at least 35% emissions reduction by the end of this decade – once lauded as the most ambitious in the industry – to a more modest 20-30% cut instead. Shell has announced it will not increase spending on renewables this year, in direct contrast to previously stated plans, while Exxon has decided to withdraw from its decade-long algae biofuel initiative.
But despite remaining overwhelmingly committed to producing fossil fuels, energy companies continue to assert in their annual reports and other public pronouncements that their business models are ‘Paris-aligned’ and their portfolios ‘remain resilient’ even under a net-zero scenario. Which makes one wonder, are the models underpinning the scenarios used by oil and gas companies to stress test their portfolios really able to adequately capture climate-related risk?
In fact, there is a growing body of research which suggests that scenario planning carried out by energy companies is flawed. A McKinsey article, published as long ago as 2017, highlighted the “particularly acute” problem that, “when business leaders consider a range of scenarios, they tend to “chop the tails off the distribution” and zero in on those that most resemble their current experience. Extreme scenarios are deemed a waste of time.”
“This approach,” the authors argue, “leaves companies dangerously exposed to dramatic changes. It is extreme risks, not everyday ones that should most concern energy companies. Likewise, it is the prospect of chaotic change, not gradual shifts that should keep energy executives awake at night.”
Shortcomings in Underlying Models
A more detailed analysis of the “flawed foundations” of Integrated Assessment Models (IAMs) is provided in an influential 2022 research paper The Economics of Immense Risk, co-authored by renowned economists Nicholas Stern and Joseph Stiglitz, in collaboration with Charlotte Taylor.
IAMs underpin the development of climate scenarios by organisations such as the International Energy Agency (IEA), the Intergovernmental Panel on Climate Change (IPCC), and the Network for Greening the Financial System (NGFS). These scenarios are then widely used in analysis of climate risks, not just by fossil fuel companies, but by companies across sectors as well as by governments, central banks and other policy makers.
In their paper, Stern, Stiglitz and Taylor set out the “serious shortcomings” in the methodology used in IAMs to integrate economic and environmental analysis. These shortcomings are particularly acute given “the realities of the immense risks of climate change and of the radical changes in our economies that a sound and effective response requires.” IAMs, the paper concludes, are: “inadequate to capture deep uncertainty and extreme risk, involving potential loss of lives and livelihoods on immense scale … where we know that we do not know how things may unfold, but we do know that there are scenarios, with not insignificant plausibility or probabilities, that have enormous consequences.”
By smoothing away the more extreme possible outcomes facing the economy and society from physical and transition risks, and by assuming, for example, that financial and commodity markets continue to work efficiently under most climate scenarios, IAMs are prone to giving the users of scenarios a false sense of confidence.
Scenarios Ignore Volatility and Market Dislocations
Take for example the IEA’s Net Zero Emissions by 2050 Scenario (NZE), used by many energy companies to test the resilience of their portfolios. This scenario which, in the IEA’s words, “maps out a way to achieve a 1.5°C stabilisation in the rise in global average temperatures, alongside universal access to modern energy by 2030,” requires annual energy-related greenhouse gas emissions to fall by approximately 40% to 23 gigatonnes by 2030 (and to net zero by 2050).
According to the most recent iteration of the scenario, oil demand would need to decline gently from around 95 million barrels per day (mb/d) to 75 mb/d between now and 2030, and then to 23 mb/d in 2050. Oil prices would also decline gradually, to US$35 per barrel (bbl) in 2030 and US$24/bbl in 2050, while natural gas production would fall – again steadily – from today’s level of 4.2 trillion cubic metres per year (tcm/y) to 3.3 tcm/y in 2030 and 1.2 tcm/y by 2050.
The scenario assumes no investment in new oil and gas projects but allows for continued investment in existing fields “to ensure that supply does not fall faster than the decline in demand.” Together with investment in clean energy technologies, this is “calibrated to minimise stranded assets and avoid energy market volatility,” thus justifying the smooth declines in fossil fuel volumes and prices.
The problem with this approach is that it ignores the extreme volatility and market dislocations that are likely to occur in the real world from “the radical changes in our economies” that limiting global warming to 1.5°C will require. Or as Mark Cliffe, visiting Professor at the London Institute of Banking and Finance, pithily asks in a recent article published in The Actuary, “What planet are we on?”
Cliffe argues that “we need scenarios that embrace the fact that we are living on Planet VUCA: one characterised by Volatility, Uncertainty, Complexity and Ambiguity,” rather than standard climate models that “are missing crucial risks, tipping points, and feedback loops, thereby understating the risks and opportunities.”
Ways to Improve Scenario Analysis
Fortunately, help is on the way. A major research project run by the University of Exeter, funded in part by the UK government, is evaluating a new generation of economic models that are better able to “simulate the processes of change” in the real economy. These can then be used to inform more “successful policymaking on the energy transition” and, it is hoped, will in time allow a more sophisticated approach to corporate scenario planning to emerge.
In the meantime, an energy company may elect to test the resilience of its portfolio under a net-zero scenario, at least in part, by simply recalculating the Net Present Value (NPV) of its existing producing assets using the smooth fossil fuel price curves derived in the IEA’s NZE. For the first two or three years, these prices may be no lower than the price assumptions already used on the company’s balance sheet. Further out, projected production levels from proven reserves are likely to have fallen and, in any case, the associated cash flow will be heavily discounted, typically by 10% per year, meaning that the impact of lower oil and gas prices in, say, 2030, on today’s NPV is unlikely to be very significant. It is this approach that allows energy companies to claim that their portfolios remain resilient in a net-zero scenario, even though the scenario itself is based on unrealistic assumptions.
One way the process could perhaps be made more rigorous until such time as a Planet VUCA-type model is developed could be to increase the discount rate used when recalculating the NPV under the net-zero scenario. Although simplistic, the rationale for this approach would be that a higher discount rate reflects the far greater transition risks, including a far higher Weighted Average Cost of Capital, facing the energy company under a net-zero scenario compared with the business-as-usual case. Doubling the discount rate to, say 20%, when recalculating the NPV under the net-zero scenario could more than double the negative impact on NPV and thus steer energy companies and their stakeholders to weigh transition risks far more carefully.
In fact, taking a more holistic approach to identifying and assessing climate-related risk and opportunity is something all responsible companies should already be doing as part of their transition planning and in order to report in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). Transition planning has gained new impetus over the past 18 months as policy makers across the globe, including the Securities and Exchange Commission (SEC) in the United States, have emphasized the importance for companies, particularly financial institutions, to demonstrate that their business models are prepared for a rapid global transition towards a low carbon economy. Transition planning is currently a major focus for the Glasgow Alliance for Net Zero (GFANZ) and forms an integral part of the sustainability and climate standards newly released by the International Sustainability Standards Board (ISSB).
The clock is ticking down to 2030. This was brought into sharp focus at London Climate Action Week where, in the presence of King Charles III, a countdown clock was unveiled showing the short time remaining before the catastrophic effects of global warming become irreversible. The unveiling triggered the launch of 150 similar clocks across London and other major cities in the UK. For energy companies, operating on the front line of the energy transition, credible contingency planning based on realistic assessment of the potential extreme risks to their existing business models has never been more important. 2030 is only six financial statements away.
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