In a new report out today, Carbon Tracker Initiative (CTI), the NGO that invented the concept of “stranded assets”, blasts Shell’s “climate letter” of 16 May, in which Shell argues that “we do not believe that any of our proven reserves will become stranded”. According to CTI, Shell’s focus on proven reserves is “too narrow” and “understates the risk that its business faces from changes in climate policy”. EP editor Karel Beckman takes stock of the debate – and concludes that the value of Shell’s stocks will become very dependent on the weather.
Carbon Tracker Initiative (CTI), which grew out of a non-profit UK company called Investor Watch (established in 2009 “to align capital markets with efforts to tackle climate change”), is surely one of the most influential climate campaign groups active today. Financed by a number of philanthropic funds, including The Rockefeller Brothers Fund and the European Climate Foundation, it got its start on 15 July 2011, when it produced a landmark report under the title Unburnable Carbon.
This report argued, very simply, that if the world takes measures to move to a low-carbon economy, the world’s major oil companies will be left with hundreds of billions in “stranded” oil and gas assets that could not be produced anymore.
This was just the right message that made money men sit up and take notice. With good reason. As the report pointed out, “the stock exchanges of London, Sao Paulo, Moscow, Australia and Toronto all have an estimated 20-30% of their market capitalisation connected to fossil fuels”. Not to mention the world’s pension funds of course, which rely to a large extent on investment in oil and gas shares (in the Netherlands, Shell stock has traditionally been called “the widows-and orphans-fund”). Or the world’s governments, which almost all rely heavily on oil and gas taxes for their state budgets.
It took a while, however, for the oil companies to respond. After CTI followed up with another report in 2013, “the findings reverberated around the world”, as energy expert Chris Nelder puts it in an excellent review of “the Carbon Bubble”, published on 16 June on the website Smart Planet. As Nelder notes, financial institutions like Standard & Poor’s, Moody’s, HSBC and Citi all showed themselves receptive to CTI’s thesis – and they were very concerned.
In May of this year, CTI came out with a third report, Carbon Supply Cost Curves, in which the NGO pinpointed which companies and projects were most at risk (Petrobras, ExxonMobil, Rosneft and Shell topped the list). But even before then, in March, ExxonMobil had come out with a message for its shareholders, which provided for the first time an official response to CTI’s warnings. Shell then followed on 16 May with a letter to its shareholders (incidentally, very difficult to find on the Shell website, for one thing because it does not have a name).
Both ExxonMobil and Shell in their responses dismissed the idea that their assets are at risk from climate policies, at least for the foreseeable future. CTI has now responded to Shell’s “climate letter” in detail, taking it apart piece by piece and showing why, in its view, Shell is misleading its investors about the risks involved in the company’s activities.
Before turning to CTI’s latest report – “Responding to Shell, an analytical perspective” – it is worth taking a closer look at Shell’s Climate Letter. Shell writes that it believes “that the risks from climate change will continue to rise up the public and political agenda … and we are preparing the company for when legislation and markets will support more significant action to mitigate CO2.”
Shell does not elaborate on how it is “preparing the company” to do so, apart from noting that it is “actively managing its CO2 footprint through: growing our natural gas business, investing in low-carbon biofuels, investing in CCS, and investing in the energy efficiency of our own operations”.
The Letter goes on to note that “any transformation [of the energy system] will inevitably take decades” because of the “long-lived nature of the infrastructure and many assets” in the system. In addition, Shell points out that the world will see “growth in energy demand” until the middle of the century “and possibly beyond”. From this it infers that “the world will continue to need oil and gas for many decades to come, supporting both demand, and oil and gas prices.” For this reason, Shell notes, “we do not believe that any of our proven reserves will become ‘stranded’.”
Note that Shell assumes here that “energy demand” will automatically translate in “oil and gas” demand. It also assumes apparently that society will care enough about the company’s “long-lived assets” that it will not take measures that might hurt their value.
Next, Shell’s Letter argues that the “stranded asset” notion has “some fundamental flaws”: “the methodology has significant gaps, not least a failure to acknowledge the significant projected growth in energy demand, the role of CCS [carbon capture and storage], natural gas, bioenergy and energy efficiency measures.”
In addition, according to Shell, “energy demand growth” will ensure that fossil fuels will continue to play “a major role in the energy system – accounting for 40-60% of energy supply in 2050 and beyond” – and the “huge investment required to provide energy is expected to require high energy prices, and not the drastic price drop envisaged for hydrocarbons in the carbon buble concept.”
The Letter points out that Shell’s own future energy (so-called “New Lens”) scenarios “show that the world can tackle and resolve the climate issue over the course of this century but not in less time than that.” It also notes that the “debate on addressing CO2 emissions” needs to recognise “the possible” and pay heed “to the reality of the world today”, and requires a “frank acknowledgement of the cost to society inherent in large scale shifts of the energy system”. It speaks of “alarmist interpretations of the unburnable carbon issue”.
As to Shell’s own assets, the company argues that they run little risk of becoming stranded, because they will be produced long before any climate measures really start to bite. “Some 60% of our disclosed resource base is either under construction or in operation meaning that it is potentially less exposed to regulatory changes in 10, 20 or 30 years.” It says that the lifetime of the proved reserves on its balance sheet (proved reserves divided by production) is some 11.5 years. Including the broader concept of “resources” takes the life to “some 25 years”. From this the Letter concludes that at least the proved reserves are not “at risk from any potential change in regulation from climate change”. In other words, no need for investors to get worried – for the time being.
All of the claims in Shell’s Letter are addressed in some detail in the new report from CTI. To start with the last point, regarding the lifetime of Shell’s proved reserves, CTI argues that indeed reserves that are being produced now or in the near future will not be “stranded” in the sense of being left in the ground, but they might well destroy shareholder value, if their costs exceed their revenues. This could happen if CO2 prices are drastically increased or if oil prices decrease as a result of climate policy measures that lead to lower demand for oil. CTI notes that over a quarter of Shell’s potential future production through 2050 requires an oil price of $95 per barrel to earn a commercial rate of return.
In addition, CTI points out that investors will be able to profit from the production of current assets, but only if the cash flow from them is withdrawn – and given back to the shareholders in the form of dividend or re-invested in other activities. If, however, Shell re-invests the money in future oil and gas production, “the non-carbon bet is merely rolled forward”.
CTI also disputes the idea that Shell’s assets are protected for the next “10, 20, or 30 years”, because projects take much longer to be realised than Shell assumes in its Letter. CTI cites a number of examples, such as the Kashagan field in Kazakhstan, certain oil sands projects and Shell’s ventures in the Arctic, to argue that “lead times from discovery to production” are often 15 to 20 years, so “exploration investments affecting production from 2030 onwards are being taken today”.
CTI also addresses the other main point that Shell makes, namely that oil and gas will inevitably continue to play a large role in the future energy system. It notes that “energy demand growth” will not necessarily translate into “oil and gas demand growth”. It argues that “slower-than expected economic growth in China and other Asian economies, rapid deployment of more fuel-efficient cars/trucks and electric vehicles, substitution of natural gas and renewable energy sources for oil, limits on vehicular air pollution in developing countries, and curtailment of subsidies for oil consumption (which totaled $200+ billion globally in 2012)” could well change the picture drastically. Again, an important point here is that such developments could lead to lower demand for oil, which would lead to a price decline that would leave Shell’s assets economically (rather than physcially) “stranded”.
According to CTI, the “2-degrees scenario” from the IEA (International Energy Agency) – i.e. that assumes that policy measures are taken which limit CO2 concentrations to 450 ppm, which according to the IPCC (UN panel on climate change) would keep global temperature rise within 2 degrees Celsius – projects oil demand in 2050 to be 50 million barrels per day, slightly more than half of today’s production. Clearly that would have a disastrous effect on Shell’s business.
CTI also notes that Shell’s own “New Lens” scenarios, which according to Shell show that the world needs till the end of the century to tackle the climate change challenge, result “in a pathway for global CO2 emissions” that is “more consistent with a 6 degrees scenario rather than a 2 degrees scenario”. Needless to say, a 6 degrees temperature rise is not something the world is likley to accept.
This last point ties in with “the cost to society inherent in large scale shifts of the energy system”, which Shell says the stranded-asset advocates do not take into account. CTI counters that the costs to society of Shell’s energy scenario as a result of global warming will be many times higher.
CTI also denies Shell’s claim that it has insufficiently taken into account the possible role of CCS. It argues that even under the most optimistic assumptions, CCS will only “extend the carbon budget by 12-14%”. It will certainly not provide a solution for CO2 emissions from transport which are the main application of oil today.
What CTI does not address in its new report is the role natural gas could play in an energy system confined by stringent climate change measures – and how this would affect Shell’s position. The report is limited to oil.
Future Energies Team
How should an outside observer – or investor – interpret the stranded-asset debate? Certainly from a broad perspective, CTI is right that Shell and the other oil companies are caught in a contradiction. Most oil companies, certainly Shell, do not dispute the prevailing climate change theory. But that means that they cannot continue with business-as-usual. They have to change and rather quickly at that.
In fact, this turns on its head Shell’s argument that its assets and infrastructure are so long-lived as to make short-term changes impossible . On the contrary, the very fact that its assets and infrastructure have such a long investment life, puts them at risk. The very fact that Shell is engaged in a business that makes investments looking forward over decades – as the company often stresses – makes it necessary that it at the very least presents a convincing vision how it could survive and prosper in a low-carbon world.
That vision has not been forthcoming. Shell’s Letter makes that clear: it is in every respect defensive. Shell does refer to three alternatives that it is pursuing: CCS, biofuels and gas. But certainly CCS is at most a stopgap measure. Natural gas is a fossil fuel. And if Shell intends to become a biofuels business, investors surely will want to know a lot more about how this could ever replace the value of its current oil and gas activities.
Shell of course will argue that there still is time for the company to develop alternative strategies. The company’s new CEO Ben van Beurden has said publicly that the company is not in a strong position to become an important player in solar or wind power. In an interview in the most recent edition of the in-house (Dutch-language) Shell magazine “Venster”, Van Beurden says that “we tried solar and wind, but it did not work for a company with our capabilities and expertise”.
However, he adds that “this does not mean we have given up. Our Future Energies Team, which regularly reports directly to me, looks at a wide range of different sustainable energy sources.”
This indicates a direction, but not yet an answer. For the foreseeable future, the value of Shell stocks may become very dependent on the weather.