Oil, gas, coal and utility firms may be hugely overvalued and debt misrated if CO2 production is restrained argues new report

19th April 2013

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Oil firms and coal mining companies may prove to be hugely overvalued and their debt misrated if measures to mitigate climate change by reducing CO2 are implemented globally. The report from the Carbon Tracker Initiative and the Grantham Research Institute on Climate Change and the Environment at London School of Economics and Political Science questions whether coal, oil and utilities stocks are currently being valued at the correct share price and whether their corporate debt is being rated accurately.

Among other possible scenarios, the report suggests that dividends may be cut back and some firms may struggle to roll over debt. (we include some of the relevant sections from the report at the foot of this article).

The research says the oil, coal and gas firms are spending $674 billion on what the researchers say are potentially stranded assets because current reserves are already far above current targets for restricting CO2. It suggests that economies could be wasting capital of amounting to $6 trillion if this trend continues for the next decade.

The analysis shows that between 60 to 80 per cent of coal, oil and gas reserves of publicly listed companies could be classified ‘unburnable’ if the world is to achieve emissions reductions that represent an 80% probability of not exceeding global warming of 2°C.  The report argues that company valuation and credit ratings methodologies do not typically inform investors whether they have exposure to these stranded assets. It says that markets continue to reward reserves replacement, rather than considering reserves redundancy.

The research highlights that the 200 listed companies analysed in the study own 762 billion tonnes of carbon dioxide (CO2) through their reserves of coal, oil and gas which supports share value of $4trillion and services $1.5trillion in outstanding corporate debt.

To achieve emissions reductions consistent with an 80% chance of achieving the 2°C target, the fossil fuel reserves of these listed companies would likely have to comply with a budget of about 125 – 275 billion tonnes of CO2 – this budget is proportional to the quarter share of reserves which they own.

An optimistic scenario was applied to stress-test the carbon budgets. This assumed that more effort was applied to non-CO2 emissions, (e.g. methane from waste and agriculture), which resulted in freeing up more CO2 budget for fossil fuels.  This approach indicates a carbon budget for an 80% chance of avoiding global warming of more than 2°C is about 900 billion tonnes up to 2050, and about 1,075 billion tonnes for a 50% chance. However under a more precautionary scenario, the carbon budget could be around half this amount – 500 billion tonnes. This results in the range of 60-80% of total reserves being in excess of the 2°C budget.

The report argues that even with carbon capture is deployed in line with an optimistic scenario by 2050, fossil fuel carbon budgets would only be extended by 125GtCO2, allowing the equivalent to 4% of current global reserves to be burned as long as their emissions are captured and stored.

Beyond 2050, the total carbon budget is very small for a 2°C target, which means that reserves will remain un-burnable during the second half of the century unless there is a dramatic development of CCS after 2050.

The analysis says that even a less ambitious climate goal, like a 3°C rise in average global temperature or more, which would pose significantly greater risks for our society and economy, would still imply significant constraints on our use of fossil fuel reserves between now and 2050.

Yet companies in the oil, gas and coal sectors are seeking to develop further resources which could double the level of potential CO2 emissions on the world’s stock exchanges to 1,541 billion tonnes. Current extractives sector business models are based on assumptions that there are no limits to emissions. The report argues that this strategy is not compatible with a carbon-constrained economy.

 Analysing absolute levels of exposure, in terms of market, New York is identified as the oil financial centre having increased its level of embedded carbon through reserves by 37% since 2011. London comes out as the coal capital, having increased embedded carbon by 7% over the same period.

The study makes a number of recommendations to help governments, regulators and investors to manage these substantial carbon valuation risks. It says financial regulators should require companies to disclose the potential CO2 emissions that are embedded in fossil fuel reserves. Finance ministers should initiate an international process to incorporate climate change into the assessment and management of systemic risk in capital markets and investors should challenge the strategies of companies which are using shareholder funds to develop high-cost fossil fuel projects.

Professor Lord Stern of Brentford, Chair of the Grantham Research Institute on Climate Change and the Environment, said: “Smart investors can already see that most fossil fuel reserves are essentially unburnable because of the need to reduce emissions in line with the global agreement by governments to avoid global warming of more than 2°C. They can see that investing in companies that rely solely or heavily on constantly replenishing reserves of fossil fuels is becoming a very risky decision.

“But I hope this report will mean that regulators also take note, because much of the embedded risk from these potentially toxic carbon assets is not openly recognized through current reporting requirements.”

The report is concerned about the ability of the financial system to act on industry-wide long term risk, since currently the only measure of risk is performance against industry benchmarks.

James Leaton, Research Director, Carbon Tracker, said: “Fossil fuel companies are currently facing a carbon budget deficit. Pretending business models reliant on more carbon emissions fit with increasing carbon constraints is the equivalent of the emperor’s new clothes. It is time investors and regulators started looking more closely at how capital is being spent.

“Institutional investors are currently driven by whether they are outperforming the market, rather than understanding the value that is at risk. More forward-looking financial indicators are required if investors are to translate climate change risk into investment decisions.”

About the research

The Grantham Research Institute on Climate Change and the Environment, LSE, provided analysis of the carbon budgets associated with various global warming targets, including the potential impact of CCS. Carbon Tracker analysed the coal, oil and gas reserves of the largest fossil fuel extractives companies listed on stock exchanges. These reserves were translated into potential CO2 emissions and linked to the relevant stock exchanges and financial data.  The full research is here – www.carbontracker.org/wastedcapital.

Below we print three excerpts of the report which investors may want to take note of.

What the report envisages happening to companies’ capital.

Companies will likely respond to falling commodity prices by delaying CAPEX and mothballing assets mines, extraction wells and power plants in the expectation that the price will rise in the future and they can be brought back into use. However a long-term low-carbon scenario will ultimately lead to closure of assets, decommissioning and if possible, sale of sites for alternative land use.

A hierarchy of factors used in identifying candidates for closure would include:

Purchased/explored but not yet developed;

Margin: inefficient plant/highest cost producers first to be mothballed or delayed;

High risk sites politically (North Africa) or technically (Arctic);

Ease of access to the market: local fuel sources may be preferable to exposure to geopolitical instability;

Low remediation costs and/or potential for land use in other purposes would maximise resale value of the decommissioned site.

New developments would be put on hold – the reserves would remain ‘on the books’ but further cash would not be spent on them. The assets could be disposed of but this assumes there is still demand for them, which is unlikely in a contracting sector.

Proposed new performance metrics

Some of the core indicators used for these sectors need updating if a better picture of the position of a company in a carbon-constrained world is to be obtained. Especially as many indicators need to be inverted from their current approach.

Reserves replacement ratio (RRR): currently companies are expected to at least replace the reserves expended through production – either through exploration or acquisition. Maintaining a RRR above 100% is rewarded as an indicator of future revenues.

Applying carbon budgets to reserves inverts the dynamic of the RRR, and could be converted into a reserves redundancy ratio.

Returns on invested capital (ROIC)

Each oil company has a track record of achieving a rate or return on capital employed. For a number of years oil majors have seen rising costs which have been hidden by the oil price ratcheting up. This has preserved margins, but leaves the oil companies vulnerable to lower prices. The peak oil demand scenario would put pressure on ROIC, exposing the weakness in assuming that future performancewill repeat the past.

Conclusions

Peak demand will lead to falling prices putting pressure on margins and projects with the highest breakeven costs. Maintaining levels of return on capital will be increasing difficult.

Traditional metrics such as the reserves replacement ratio have traditionally rewarded investment in replenishing stocks of fossil fuels. If the market switches, this will flip this indicator such that replacement is no longer desirable.

A range of factors from air quality regulation, and falling renewable costs, to water availability are changing the energy markets, without global regulation yet in place.

Utilities face uncertainty over the lifetime of generation plants with market mechanisms such as carbon prices contributing to this. As a result they are vulnerable to impaired assets.

Recommendations

Analysts need to use a range of assumptions to stress-test their valuation outputs.

The traditional metrics such as reserves replacement ratio need to be replaced or reversed to reflect a carbon-constrained world.

 What the report says about how corporate bonds are rated

Coal

Pure coal mining companies are most vulnerable to changing operating conditions, especially those  that are reliant primarily on domestic markets, eg US, South Africa.

A global deal on climate change or a carbon price are not essential to generate regulatory risk. Air quality measures are proving just as effective, eg China, US.

The cost competitiveness of different technologies is constantly evolving. The gas-coal dynamic has  been critical in the US. Renewables make it a three-way fight in an increasing number of countries eg Germany, Australia.

The speed at which the business model unravels shows coal’s vulnerability in a contracting market.•

The ability of some companies to refinance their debt when it matures in the next few years may be impinged.

In the first half of 2012, US coal demand was at its lowest for 25 years. Cheap gas prices were compounded by the US EPA’s introduction of mercury emissions regulation which the market  clearly did not believe would happen. As a result US coal mining companies saw downgrades:

Smaller companies with high exposure to oil  sands are not resilient to the price stress of a peak demand scenario. Cashflow pressure could impact dividends and result in the cancellation of projects, creating stranded assets.

The longer term climate policy, technology and  impact risks are not included in the typical three year rating horizon.

Financial models that only rely on past performance  and creditworthiness are an insufficient guide  for investors.

Utilities

The uncertainty around the future of fossil fuels is greater in some markets than it is for renewables.

Decentralisation of power generation can reduce the available market for traditional utilities.

Traditional business models are no longer viable in energy markets which encourage decarbonisation – companies need to adapt to survive.

Non-carbon factors such as water availability add to the complexity of understanding the viability of future large-scale generation, eg China, India.

Germany is already experiencing the pressure that competition of distributed solar power and subsidised wind power is putting on centralised fossil power stations. With renewable energy meeting 26% of demand in 2012, and targets of 35% by 2020 on track to be exceeded, coal and gas power stations are struggling to maintain load factors of baseload plant (~75%) and are at times pushed to act as back up capacity to the renewable generators. Large increases in renewable energy have had a profound negative impact on power prices and the competitiveness of thermal generation in Europe. What were once considered stable companies have seen their business models severely disrupted. Given that further increases in renewables are expected, these negative pressures will continue to erode the credit quality of thermal based utilities in the near to medium term.

Updated methodologies

Ratings agencies need to review and evolve their methodologies to reflect emerging issues. We consider climate change to be the equivalent of corporate pension fund liabilities. Previously it was just assumed that funds had sufficient assets to cover defined benefit liabilities. Then it emerged that there were some shortfalls, so analysts started adding this in. Now these figures are included on the balance sheet so that the complete picture is available.

Recent work with credit ratings agencies has shown that the fundamentals of their methodologies relating to the financial strength of companies and the soundness of their business models can be impacted by climate risk. This makes a case for a more systematic stress-testing of credit ratings and an adjustment of approach to factor in the likelihood of alternative outcomes. Over time this should result in systematic coverage of the issue.

Looking forward

It is also clear that in order to avoid systemic risks in the future, investors will need information which looks forward. The nature of climate change means that the future is very unlikely to repeat the past, whichever pathway the world follows. Ratings agencies are realising that using historic performance to forecast future creditworthiness is becoming increasingly inadequate. It is time for investors to push for improved analysis and ratings agencies to respond to the challenge.

Improved oversight

The influence which credit ratings agencies have on the availability of capital is clear. With that power comes responsibility. Following the financial crisis, new regulations are being introduced to improve the quality of credit ratings. In the US, the Dodd-Frank Act established an office at the Securities & Exchange Commission which was set up to monitor the credit ratings agencies. In Europe, the European Securities and Markets Association (ESMA) has responsibility for supervision. But, to date, these new rules have not included the imperative of climate and wider sustainability risk.

Conclusions

Traditional business models are no longer viable in energy markets which encourage decarbonisation – companies need to adapt to survive.

The ability of some companies to refinance their debt when it matures in the next few years may be impinged.

The speed at which the business model unravels shows coal’s vulnerability in a contracting market.

Cashflow pressure could impact dividends and result in the cancellation of projects, creating stranded assets.

Financial models that only rely on past performance and creditworthiness are an insufficient guide for investors.

Recommendations

Investors need to exercise influence as ratings users to ensure the routine integration of climate  factors in the assessment of business models and creditworthiness.

Regulators should ensure credit ratings agencies are addressing climate change as part of their  efforts to tackle systemic risk.

 Value at risk

Institutional investors are rightly concerned about managing risks to their portfolios. Sometimes the narrow definition of the risk can prevent investors taking forward-looking action based on future risks. Instead risk is usually defined as deviation from the benchmark rather than the probability of an absolute loss in value. Either directly or indirectly this results in funds reflecting the composition of the market in order to reduce the risk of significantly deviating from the trajectory of the market.

This leaves fund managers some license to overweight or underweight specific companies within a sector, but is likely to result in the sectoral composition mirroring the benchmark. This is one reason why it is difficult for investors to respond to demands to divest wholesale from a sector. Institutional investors would have to issue a specific mandate which chose to override the market norms with a policy decision to avoid certain activities. The analysis in the earlier chapters shows there is still large amounts of fossil fuels tied up in the benchmarks.

Given the divergence between the different levels of emissions going forward, different tools may be needed. It is perfectly feasible to produce valuations based on different assumptions around future emissions levels, which can then produce a range of potential stock prices.

Probabilities can then be assigned to these outcomes dependent on the investor’s beliefs on the trajectory we are heading. A simplified example of this approach is presented in the box in the next page.

As most valuation models are based on a repeat of historical performance and business as usual, it seems safe to assume that any such adjustment would be downward for most fossil fuel-based companies.

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