Originally posted 18 December 2017
Several articles, studies, and announcements over the past weeks suggest that the “international movement” seeking to “manage” the risks of global warming are gaining ascendance. More recently, the World Bank president, Jim Yong Kim, announced his institution was re-assessing the risks of fossil-fuel developments.
- World Bank move
- China’s Three Gorges floating solar panels
- Alberta renewable auction
- Moody’s analysis
The international financial institution in its release stated:
to align its support to countries to meet their Paris goals:
The World Bank Group will no longer finance upstream oil and gas, after 2019. (In exceptional circumstances, consideration will be given to financing upstream gas in the poorest countries where there is a clear benefit in terms of energy access for the poor and the project fits within the countries’ Paris Agreement commitments.)
In remarks to the One Planet Summit, Mark Carney, Governor of the Bank of England and the Chair of the Financial Stability Board, reiterated support for a recent initiative for companies to disclose more information about corporate risks involving climate change. Final Report Task Force on Climate-related Financial Disclosures
The Final Task Force Report was chaired by Michael Bloomberg, New York’s former mayor and founder of Bloomberg, the giant financial services media and information provider. The report is premised on the requirement that for financial markets to function optimally, the market must have adequate corporate information on which to base investment decisions. The target audience of the report are not only oil and gas corporations but also large institutional investors responsible to their beneficiaries for achieving suitable rates of return over the long-term to preserve and grow funds entrusted to them. The risks of climate change “on organizations, however, are not only physical and not manifest only in the long-term…. As such, long-term investors need adequate information on how organizations are preparing for a lower-carbon economy.” (emphasis added)
The report provides recommendations and guidance for financial and non-financial sectors. The recommendations are grouped under governance, strategy, risk management, and metrics and targets (Figure 4, page 14). The impact of this report is evident in Caisse Desjardins decision to withdraw lending to pipelines (reinstated in the past month), the World Bank decision, and reports that Caisse de Depot et Placement of Quebec is leading Canadian institutional investors to scrutinize investments in the energy sphere.
Closer to Home
In Alberta, there has been a build-up of almost breathless anticipation as the bids for renewable power were opened on 13 Wednesday in Calgary. (The Premier, Energy Minister and the Environment ministers were in attendance.) While there remain skepticism around the long-term cost of subsidies associated with these large-scale projects, cabinet ministers and the Premier were enthusiastic about the low prices obtained.
It was with great fanfare that the winning bids were revealed. The four winning bidders included Capital Power (the writer owns shares in this company) and the renewable source of electricity was exclusively from wind. For approximately one billion dollars of investment, 600 megawatts of energy will be added to the grid sometime in 2019. The Premier announced that the average of the winning bids were 3.7 cents per kilowatt-hour, the lowest price in the country (according to Dan Healing’s account). How these large-scale projects will be integrated with smaller-scale home and community projects remains to be seen. But this news is a good start for the NDP government.
Another news story of note was the institution of airborne monitoring in the Fort McMurray area. The report suggested that under-reporting of greenhouse gases and chemicals could be revealed. Moreover, the sensing equipment would be capable of separating out emissions from the mine faces, tailings ponds and background levels.
Moody’s April Report
On 26 April 2017 (after the new U.S. president was sworn in) the rating agency Moody’s Investors Service, released Oil and Gas Industry Faces Significant Credit Risks from Carbon Transition.
With the Paris Agreement of November 2016, “the global oil and gas industry faces significant risks from the effort to curb greenhouse gas emissions,” states Moody’s. Accordingly, the ratings agency felt it necessary to provide the oil and gas industry and investors with guidance on how Moody’s would take into account environmental risks. The report highlighted four major “challenges” to the industry. These challenges are:
- Policy and regulatory uncertainty and its impact on the demand for oil and gas;
- Direct financial impacts including pressures on cash flow and profitability;
- Demand substitution and changes to consumer preferences; and
- Disruptive technological shocks, involving alternative and renewable fuels.
While those in the Canadian energy industry may be hoping that the Trump administration will weaken the Canadian government’s case for pushing an “aggressive” environmental agenda, Moody’s believes that U.S. policy actions will not have the expected global influence to forestall the inter-governmental agenda.
While future policies of the Trump administration have added to the uncertainty, we do not believe that the pathway to lower global emissions will be materially derailed over the coming decade were the US to pursue a less ambitious climate policy, all else being equal. Powerful forces are at play, including robust institutional and private sector momentum, that will continue to drive global sustainable and climate agendas regardless of the direction of US federal climate policy. Additionally, a number of US states have confirmed their commitment to pursue carbon reduction policies that are more stringent than the federal government’s. As such, the effects of carbon transition will continue to have material credit implications for rated entities in a number of industrial sectors globally. (emphasis added)
Specific initiatives that Moody’s points to that will limit, and then ultimately reduce the demand for fossil fuels, include new standards for fuel emissions used in transportation and the use of carbon taxes as a policy tool. The alternative fuel vehicle (AFV) adoption rate remains low but several studies cited by Moody’s put AFV production at 15 to over 20 per cent by 2025. Natural gas production is “better positioned” than oil as it emits considerably less CO2 than coal and 16 to 27 per cent less than other fuels such as diesel and gasoline.
Lower demand for fuels will negatively impact commodity prices dissipating the economics of exploration.
As the need for exploration dissipates, the industry could shift into “cash harvesting” mode, with greater emphasis on dividends in light of falling capital spending requirements. Companies with short-cycle investment profiles will have greater flexibility around capital allocation, allowing them to generate better returns.
Stranded assets are a potential consequence of changing investment patterns and falling oil and natural gas demand. In a scenario where the amount of carbon emitted is consistent with scientific estimates of what is more likely to keep the rise in average global temperatures below 2 degrees, estimates of the amount of unburnable, currently recoverable fossil fuel resource (including coal) range as high as 60%-80%. (emphasis added)
Moody’s looks at three factors in determining ratings for oil and gas companies: financial profile; asset mix; and corporate strategy. These factors boil down to balance sheet strength (low debt vs. equity); more natural gas than oil; and more natural gas than oil.
Listed in the report were Canada’s major resource companies: Canadian Natural Resources, Suncor, and Teck belonging to Canada’s Oil Sands Innovation Alliance. Encana, Enbridge, and TransCanada are members of Natural Gas STAR Program. These corporate memberships are referred to as “material action” by the agency.
Finally, the agency also provided a “heat map” (Appendices 1 and 2) to “illustrate differences in issuer vulnerability.” The highest risk is characterized by: limited public disclosure of governance arrangements for environmental risks including scenario planning; lower profitability and high leverage; and companies with less than 25 per cent in natural gas production and reserve life greater than 15 years. Oddly, the agency’s report does not contain the word “reclamation” or the phrases “reclamation costs,” “de-commissioning,” “abandonment costs,” “restoration costs,”or “environmental liabilit(y)ies”.
As premiers, energy and environment ministers grapple with global warming issues, the financial sector is becoming a focal point for new regulatory requirements facing publicly traded oil and gas companies. Recent acquisitions of oilsands’ assets by Suncor (Murphy Oil), CNRL (Shell), and Cenovus (ConocoPhillips) have altered the financial profile (more leverage) and asset mix of these companies. As these large Canadian corporations have taken on more exposure from their international oil and gas competitors, the closer the relationship between Alberta’s environmental liabilities, writ large, and these companies individual environmental liabilities becomes. Thus, the financial fortunes of these vast oilsands organizations intertwine with the financial profile of the province.
Moody’s omission of reclamation costs and environmental liability is not only noteworthy by itself but a search of Suncor and CNRL’s recent quarterly reports generally reveals the same omission. Although, buried on page 88 of its Third Quarter report, Cenovus, in a section entitled “Forward-looking Information,” the following is divulged:
Developing forward-looking information involves reliance on a number of assumptions and consideration of certain risks and uncertainties, some of which are specific to Cenovus and others that apply to the industry generally. The factors or assumptions on which the forward-looking information is based include: forecast oil and natural gas prices and other assumptions inherent in Cenovus’s 2017 guidance, …… Cenovus’s ability to obtain necessary regulatory and partner approvals; the successful and timely implementation of capital projects or stages thereof; Cenovus’s ability to generate sufficient cash flow to meet its current and future obligations; estimated abandonment and reclamation costs, including associated levies and regulations; (emphasis added)
CNRL does disclose abandonment costs. In its latest Third quarter report, abandonments “represent expenditures to settle asset retirement obligations and have been reflected as capital expenditures in this table.” Specifically noted are abandonments in the North Sea platforms. “Asset retirement obligation accretion expense” represents “the increase in the carrying amount of the asset retirement obligation due to the passage of time.” In CNRL’s case this expense was $119 million for the nine months ending 30 September 2017. Suncor or Cenovus’s reports do not contain this expense. CNRL additionally acknowledges in its forward-looking statements
timing and success of integrating the business and operations of acquired companies and assets, including the interests in AOSP as well as additional working interests in certain other producing and non-producing oil and gas properties (the “other assets”), acquired by the Company on May 31, 2017; production levels; imprecision of reserve estimates and estimates of recoverable quantities of crude oil, natural gas and NGLs not currently classified as proved; actions by governmental authorities; government regulations and the expenditures required to comply with them (especially safety and environmental laws and regulations and the impact of climate change initiatives on capital and operating costs); asset retirement obligations; (emphasis added)
For analysts and researchers interested in understanding how much money is being set aside for reclamation work, they face considerable challenges in doing so. In the case of Suncor, “Provisions” are given at $6.485 billion. According to the relevant footnote: “An increase in the credit-adjusted risk-free interest rate to 4.00% (December 31, 2016 – 3.90%) partially offset by recognition of additional disturbances resulted in an overall decrease in the decommissioning and restoration provision of $15 million for the nine months ended September 30, 2017.” (emphasis added)
The foregoing brings several issues to the forefront of analysts assessments of the financial viability of these firms. Firstly, public issuers must provide full, plain and true disclosure. The Forward-looking information is not only legal boilerplate, it must summarize at the imponderables and unknown such to satisfy its securities lawyers that its periodic disclosures are full, plain and true so the company is insulated from lawsuits. Secondly, the value of “provisions” is determined, in part, by the “credit-adjusted risk-free interest rate” that is used to value future liabilities discounted to the present. The higher the rate, the lower the future liabilities, all things being equal. “Additional disturbance” is another term laden with ambiguity.
So as these pressure points and questions multiple, the Canadian oil and gas industry will ramp up pressure to “remain competitive”- that is, to be allowed to defer obligations in the form of environmental requirements and by demanding lower taxes (with all the Canadian corporate community) to compete against their American brethren. Meanwhile, securities regulators, financial institution regulators, rating agencies, banks, and institutional investors must remain vigilant as the climate change discussion promises to “heat up.” Also watch for terms such as stranded assets and de-commissioning costs to proliferate in stories on coal and oil and gas industries.