Regardless of where you stand on the “Trump–Thunberg scale” in terms of your attitude to the issue of climate change and the viability of a swift transition to a “zero-carbon” future, there can be no doubt that the energy industry risk landscape is now on the cusp of a major transformation. That’s because there is a long running topic that has risen to strategic, board level importance and is now significantly affecting major business decisions across the globe – Environmental Social Governance (ESG)1.
In the past, business decisions taken by energy companies, their stakeholders and other corporates around the world used to be based purely on profit. Indeed, the financial meltdown of 2008 has been blamed by many on both corporate greed and government incompetence; both government officials and Wall Street executives are said to have ignored warning sides and failed to manage the risk properly. Now in 2020, it is becoming increasingly apparent that, as well as profit, ESG ratings are also going to be an important driver for energy industry stakeholders - lenders, insurers, shareholders, regulators – and even consumers. Indeed, it’s likely that the money will increasingly follow those energy companies with the highest proven ESG credentials. Fundamentally, don’t forget that sustainability is about efficiency – words any board will be happy to hear – and the transition to a low carbon economy is a financial opportunity to ensure your business is aligned with the new landscape. That means a fundamental re-appraisal of energy company climate risk, to achieve (or maintain) an ESG rating that will enable them to attract and maintain the support of the stakeholders critical to their business. In short, today’s successful energy businesses have to have a significant ESG footprint.
Luck is what happens when preparation meets opportunity, said Seneca. The world needs some luck right now because to me it feels like governments, policy makers and businesses – including some from the energy industry -are gambling with it in their response to the issue of climate risk.
I would suggest that the climate crisis today – and the lack of preparation for it across the globe - smacks of the incompetence of managing the risks that led up to the 2008 financial crisis. Back then it was up close and personal, as I traded credit default swaps for the number one rated interdealer broker at the time. The gap between the science of climate change and the underwhelming policy and business response grows larger as the world heats up. It’s a gamble - I grew up in Las Vegas, so I know that the house always wins.
However, it’s my view that “Lady Luck” is showing up - in the form of the increasing profile of ESG criteria. It’s gaining impact, traction and momentum. Increasingly, ESG criteria and investment are becoming business imperatives as well as decision-making tools. You can’t manage what you can’t measure, and you should see this as the first ripple from the stone that has been dropped into the water. The financial markets don’t want a repeat of 2008 and want to know you’re managing your risks effectively. Today, the climate crisis is close to me as I consult with various businesses, governments and organisations on climate policy, finance and investment. This article is my personal view on the changing risk landscape facing the energy industry. For some businesses, it’s easy enough to transition; however for the energy industry, with such a heavy carbon-intensive footprint, it’s going to be a whole lot harder, despite the huge opportunities being created in clean energy. Already, investors are now challenging companies’ spending on new fossil fuel production more frequently and are increasingly using their voting power to demand action. It follows that prudent risk management is at the heart of managing this transition – both now and in the long-term future. But to what extent has the energy industry begun to quantify its exposure to climate risk? The purpose of this article is to provide an overview of developments that will impact the energy industry across the globe. It will discuss the gap between the science and policy response to climate change; it will examine the response of regulators, lenders and investors. Finally, it will provide a high-level summary of the consequences for the energy industry as the world shoehorns ESG into strategy, business and investment decisions.
Set up in 1988, the Intergovernmental Panel on Climate Change is an intergovernmental body of the United Nations. They provide the world with objective, scientific information that is relevant to understand the risks of human induced climate change. They produce reports that cover the scientific, technical and socio-economic information of climate change, it’s potential impacts and options for adaptation and mitigation. The IPCC does not carry out original research; rather thousands of scientists and other experts across the globe contribute on a voluntary basis to writing and reviewing reports. These reports are then shared with governments, which includes a ‘Summary for Policymakers’, for them to use in their decision making. Their job is to put the facts on the table, and to use the analogy of the changes to the car industry since the move from horse and cart to the engine; it is then up to policy makers to decide if they want to put seatbelts and fire-retardant materials in, and think about setting national limits to negate the speed.
In brief, the science is telling us that the earth is getting hotter. Figure 1 above shows that the trend of the global surface temperature of the earth; twenty of the warmest years on record were in the past 22 years. The grey line shows the rising concentration of CO2 levels. In my view, the scientific body of evidence from the Intergovernmental Panel on Climate Change (IPCC) is overwhelming. The IPCC interprets the science and summarises it to governments; it’s then up to governments what actions to take, based on the scientific data.
In 2018, the IPCC produced a special report on Global Warming of 1.5°C2. This set alarm bells ringing about the risks of climate change impacts, not only with policy makers but also with businesses and corporates, because it showed that the differences in outcomes between 1.5°C and 2°C are considerable. What’s terrifying is that, without changes, we are likely to blow through the carbon budget during the next decade.
Figure 2 left shows where global current policies are versus where we need to be for a 1.5°C or 2°C scenario. IEA is the International Energy Agency and NDCs are Nationally Determined Contributions, which are countries’ material climate commitments.
Companies determine their risk appetite by analysing their exposure to a variety of segments, such as market movements, geopolitical events and changes in counter-party risk. There is now a sharper focus on environmental threats over the next ten years, and energy industry leaders know it. For the first time in the history of the World Economic Forum’s Global Risk Report 2020, environmental threats dominate issues on senior leaders’ agendas, as evidenced by the position of the green diamonds in Figure 3 left – remember this is a survey asking them what issues are crossing their desks. In summary: business and finance leaders know that the likelihood and impact of environmental threats to the energy industry are high. The science is clear - high carbon intensive industries are particularly exposed to three primary risks: physical, transitional and liability, all of which have significant financial consequences for the energy industry. Let’s discuss each in turn.
As many readers will already appreciate, climate change is not just about temperature rise - there may also be unpredictable changes to the weather. Chronic changes to temperature and sea level rise will accompany changes to acute extreme weather events such as tropical cyclones, wildfires or droughts. Indeed, climate change affects virtually every aspect of the energy system, with specific challenges varying by geography and intensity. A Texas oil company is worried about hurricanes; an energy company in California has to manage droughts; permafrost melting and potential methane releases are concerns if you are conducting Exploration & Production operations in the Arctic. The concept of prudent expenditure is relevant to forecast normal operating conditions but it’s difficult to create an expenditure forecast assessment for extreme weather events; for example, Australia’s recent bushfires have been unprecedented in their frequency, severity and geographic spread. The region you’re in might not be impacted by water stress or flooding right now, but that could change and seasonal tolerances might be further stressed. This is where the use of those IPCC scenarios is incredibly useful because they give an evidence-based frame to consider possible futures.
Business Interruption The energy industry will also face an increasing number of Business Interruption (BI) scenarios and environmental issues such as pollution or pipeline spills, are often overlooked according to the Allianz Risk Barometer 2019.3
What’s it going to cost? The potential costs of insuring assets against the impact of climate change is higher for the energy industry than any other line of business. According to an analysis from Schroders as part of a physical risk assessment for the oil & gas industry, it could equate to more than 3% of their market values, as outlined in Figure 4 on the previous page.4
Transition risks occur as societies move toward a zero-carbon economy. 49% of annual global GDP – more than $39 trillion – is now covered by regions of net zero targets, according to the latest analysis from the Energy and Climate Intelligence Unit (ECIU).5 Investors have a growing concern over the viability of high carbon business models in an increasingly carbon-constrained world. For example, it’s been estimated that fossil fuel companies risk wasting $1.6 trillion of expenditure by 2025 if they base their business on emissions policies already announced by governments instead of basing it on international climate goals.6 Creating an effective climate risk mitigation plan is proving difficult for the energy industry, but it is not impossible.
The elephant in the room: burning fossil fuels Furthermore, there is now a major elephant in the room: energy companies are still figuring out how their current business models, based on burning fossil fuels, can be transitioned for a more sustainable and Paris Agreement-compliant, low carbon world. Gas has been promoted as a “bridging” fuel in the transition to a zero-carbon economy; however, it is still a fossil fuel. And any advantage it might hold over more carbon intensive fuels such as coal or oil are lost with even small amounts of leakage of methane, which is a far more potent greenhouse gas than CO2. This means that oil and gas companies have a “double whammy”; they need to invest heavily in new fields while their traditional revenues and margins are under pressure. Upstream extraction is becoming more and more expensive, while renewables are becoming more price competitive due to both subsidies and technological innovation. “The advantages of speed and convenience enjoyed by the oil industry today are time-limited…and will be subject to fierce competition from a cheaper, cleaner fuel source” said BNP Paribas Mark Lewis in his Wells, Wires and Wheels report.7 Former Governor of the Bank of England Mark Carney took it a step further when he recently told the UK’s Channel 4 news: “Companies that don’t adapt, including companies in the financial system, will go bankrupt, without question.”8 Oil and gas companies cannot pivot their business models easily. Hydrogen is being presented as a potential game changer for oil and gas companies as natural gas contains methane (CH4) that can be used to produce hydrogen but the integration of it into the world’s energy systems is complicated and will require new infrastructure. Carbon capture and storage technology is not advancing quickly enough to curb emissions growth. There is no silver bullet to tackle decarbonisation; it is a complex and challenging task requiring all stakeholders, governments and society to come together to find solutions. And, as shown in Figure 5 on the previous page, the task is will only become more challenging as policy continues to tighten.
Business interruption Of course, Business Interruption risk is not just physical; it can impact a company’s reputation and has the potential for liability. As well as choosing not to insure high-carbon assets in some instances, insurers are also hedging against losses due to physical impacts by improving their risk analysis with advances in climate modelling. Premiums are being adjusted and industries with large environmental footprints are under increasing pressure to safeguard sensitive ecosystems, both on land and at sea.
Fossil fuel companies are already facing the physical and transitional risks of climate change and now they have to confront a third in the form of liability lawsuits. The Center for International Environmental Law took a comprehensive synthesis of the available evidence, then evaluated and concluded that major carbon producers can and should be held accountable for climate impacts in their 2017 report entitled Smoke and Fumes: The Legal and Evidentiary Basis for Holding Big Oli Accountable for the Climate Crisis9. There are a growing number of legal cases in the US by cities and local governments that draws attention to coastal communities who are vulnerable to extreme weather and sea level rise10. They are seeking damage from several major oil companies for damage to infrastructure, roads and rising tides.
New litigation is using science-based evidence New litigation cases are using science to quantify and show the relationship between emissions to particular place-based companies and climate change related impacts, such as sea level rise11. “The industry has profited from the manufacture of fossil fuels but has not had to absorb the economic costs of the consequences; the companies are now being called to account for their conduct and the damages from that conduct”, says Harold Koh, a professor in international law at Yale Law School12.
Global trends in climate change litigation According to a “Global Trends In Climate Change Litigation: 2019 Snapshot” policy publication at the Grantham Research Institute on Climate Change and the Environment housed at the London School of Economics, climate change litigation is expanding across jurisdictions as a mechanism to strengthen climate action13. There are over 1,800 climate laws and policies according to Climate Change Laws of the world, an open-access compilation of climate change litigation, which is increasingly viewed as a tool to influence policy outcomes and corporate behaviour14.
PG&E has been heralded at the first ‘climate change bankruptcy’ when they filed for bankruptcy in the face of liabilities from wildfires of $30 billion or more that swept across their service areas in northern California. PG&E is a regulated utility that serves approximately 5.2 million households. It’s been over a year and PG&E is trying to restructure its debt to emerge from bankruptcy. During the past year PG&E announced a $13.5 billion settlement with a committee of law firms representing about 70% of people who suffered losses from fires in recent years and reached an $11 billion settlement with insurance companies on claims related to the recent wildfires. Regulators boosted a previously agreed $1.7 billion settlement announced in December 2019 to a record $2.1 billion penalty in February 2020. PG&E still face hurdles and California Governor Gavin Newsom set a deadline for a bankruptcy exit plan to be in
place by 30 June 2020, which would allow PG&E to access a new state “wildfire fund” to pay for damages. PG&E still needs state approval of the plan to qualify for the fund.
On March 16 2020 PG&E won court approval to raise $23 billion to help pay its bills over destructive California wildfires after Governor Gavin Newsom dropped his opposition to a financing package designed to help the nation’s largest utility get out of bankruptcy.
Sources:
https://www.mercurynews.com/2020/01/23/confused-about-pges-bankruptcy-heres-what-you-need-to-know/ https://www.cnbc.com/2019/09/13/pge-reaches-11-billion-settlement-relating-to-wildfire-claims.html https://www.nbcbayarea.com/news/california/california-wildfires/regulators-boost-pges-wildfire-fine-to-2-1b/2243860/ https://www.marketwatch.com/story/pge-wins-court-approval-of-23-billion-bankruptcy-financing-package-2020-03-16
The push for climate disclosure Michael Bloomberg tweeted in 2014: “if you can’t measure it, you can’t manage it.”15 The truth of the matter is that climate risk is hard to measure. Much of this is due to a lack of data - how do you take decisions when faced with the uncertainty of climate change, knowing that your data is incomplete? Work is being done across governments and industry that addresses those data gaps. For example, the private sector led Task Force on Climate-related Financial Disclosure (TCFD), is now widely endorsed by more than 1,000 companies, financial firms, governments and other organisations. It sets out recommendations designed to help companies disclose decision-useful information about their exposure to climate change.
The TCFD is generally voluntary, although climate disclosure has become mandatory in France, and financial regulators around the world have it on their agendas and are considering their options. The EU taxonomy for sustainable activities released last year provides guidance to around 6,000 EU-listed companies, banks and insurance companies that have to disclose non-financial information under the Non-Financial Reporting Directive and it integrates the recommendations of the TCFD. The UK has gone a step further with their first Green Finance Strategy released in July last year that will require finance to be linked to sustainable and resilient growth and some calls for climate reporting to potentially become mandatory in the UK by 2022. But legislation for mandatory disclosure is not the only way to go to drive change; indeed, Mark Carney has discussed creating pathways to make TCFD mandatory, for example through securities regulation disclosure standards or listing requirements16.
Increasing action by investors and the banking sector During 2016 to 2018 ESG investment grew 34%, representing $30.7 trillion in assets, according to the Global Sustainable Investment Alliance.17 The growth of sustainable and ethical investing continues to rise, with new funds being developed alongside ESG products and services. The overall rational for ESG, or sustainable investing, is that those companies who are managing their risk would, in theory, perform better in the transition to a low-carbon economy. This view points to one of the reasons why the TCFD is supported by so many organisations; while it can be hard to compare and verify the claims of disclosure, agreeing a common set of global reference points on climate-related disclosures is one of the steps to helping investors allocate capital more effectively. Shareholders are increasingly aware of the influence financial institutions have in the energy transition. Investor led initiatives, such as the Principles for Responsible Investment with investors representing over $80 trillion in assets, look to hold investee companies accountable to failures in embedding ESG into investment. Investors are increasingly putting pressure on banks to end the financing of fossil fuels and some banks are responding with targets. For example, BNP Paribas is looking to phase out all financing to the outstanding loans to companies related to thermal coal by 2030 in the EU and 2040 for the rest of the world18. Boston Common Asset Management, a leader in global sustainability initiatives, says that more action needs to be taken by banks as fossil fuel producers will become worse credit risks since their business models are not fit for the future.19 Continuing to lend to fossil fuel producers puts more credit risk onto bank balance sheets; it leaves them exposed to potential stranded assets and defaults. Lenders are responding to calls for them to do more. The rise of green financial products continues, with banks creating new green instruments and implementing climate risk assessments or a 2°C scenario analysis. Alongside this there is thorough work being undertaken to consider what green is, so there will be no room to hide behind surface level efforts. The UNEP FI Principles of Responsible Banking is an example of one of the initiatives that is actively exploring this space.
Central banks are taking action Climate-related risks pose complex challenges, not just to private banks but also to central banks, regulators and supervisors. The Bank for International Settlements released a paper in January of this year of the role of central banks in relation to climate-related risks and included what they call “Green Swan” risks, defined as “potentially extremely financially disruptive events that could be behind the next systemic financial crisis”.20 Contrary to the lack of significant global policy responses from governments, the rise of central banks examining climate risk shocks to financial stability has been swift. They are becoming organised via the Network for Greening the Financial System (NGFS) which was launched in December 2017 with eight central banks and has grown to 63 members and 12 observers across five continents21. The NGFS is a group of central banks and supervisors who are developing guidance around climate risk assessment and scenario analysis. This work will provide frameworks for other regulators who are also looking to evaluate climate risks – at the end of the day what they want to know is that companies understand their risks and are taking concrete action. This is the chance to get ahead of the game.
The rise of climate stress testing Stress testing is conducted to focus on financial stability, to ensure that financial institutions are adequately capitalised for the next crisis. Regulators develop macroeconomic scenarios; firms evaluate their portfolio against these scenarios and create their own scenarios too. The Bank of England released a discussion paper in December 2019, with the objective to “test the resilience of the current business models of the largest banks, insurers and the financial system to the physical and transition risks from climate change.”23 This includes a wider scope of stress testing, broader participation, extended modelling horizon, integrated climate and macro financial variables and counterparty-level modelling expectations. Central banks tend to adopt the best market practices of their peers; it would be a logical development for other central banks to follow suit with climate stress testing in their own countries. Efforts by the NGFS are gathering momentum and numbers to create a framework, and the development of more low carbon policies is just a short matter of time.
Physical and transition risk The costs of physical impacts and business disruptions can be considerable and the transition risk of physical assets becoming stranded is a real concern. Oil and gas companies are risking $2.2 trillion in stranded assets by 2030, yet virtually every oil major is betting against a 1.5°C world and they continue to invest in projects that are contrary to the Paris Agreement, warns a 2018 report from think tank Carbon Tracker24.
If this is combined with governments taking a tougher stance on carbon emissions, it can be seen that the energy industry is faced with paying for their carbon externality while holding onto the soon to be obsolete assets that are generating them. It has been estimated that the implementation of a carbon tax, which is one of the most commonly cited potential policy responses, on the power generation and oil & gas industries with a tax level of about $50 /tCO2e could result in $50 billion to $300 billion in losses on outstanding debt across both sectors; the report extrapolated that as much as $1 trillion could be at risk in the broader economy25. What is becoming evident is that climate risk is not fully priced into the portfolios of banks, investors and pensions and this is alarming. Governments are not acting forcefully enough on climate change as their policy action is insufficient to drive significant change; fossil fuel subsidies actually increased half a trillion from 2015 to 2017, according to an International Monetary Fund report26, and the Paris Agreement’s ‘ratchet mechanism’ means that policy announcements are likely to happen, starting in 2023 with the Global Stocktake. The financial consequences on the value of oil and gas companies in the future points to them being negatively impacted by these upcoming low carbon policy measures. The global financial system and the energy industry must make a faster shift towards the alignment of climate security and sustainable development.
Physical and transition risk Climate change litigation continues to see a rise in the number of cases and geographic expansion, including in low and middle-income countries27. While establishing a causal link between a place-based source of emissions and climate damages can be difficult, new cases are using science as evidence. This growing trend of litigation cases against energy companies has just got started and the financial, plus solvency, implications could be severe. The bankruptcy of PG&E has been recognised as the first major corporate casualty of climate risk, and few people expect it to be the last.
Final thoughts: prudent risk management will be critical! Capital has to be reallocated to support the just transition to a zero-carbon economy. Such a just transition means balancing society and the economy, along with managing the transitional implications for potentially “stranded” assets, communities and workers. It also presents the energy industry with opportunities to adapt and modify their business models. Low carbon growth could deliver economic benefits of $27 trillion by 2030 compared to business as usual, according to a New Climate Economy report28; this means opportunities for the energy sector too. However, each passing year of inaction increases the risks of unabated climate change and propels us towards the subsequent economic, societal and fiscal shocks on the horizon.
Transitioning to a zero-carbon economy for the energy industry is extremely complex, with lots of moving parts. ESG criteria, investing, standards and reporting just might be our “Lady Luck” to save us from the greed of the 2008 global crisis but it’s my view that ESG actions, financial flows and alignment are not happening fast enough to deliver impact at scale. Fundamental systemic change is required on a global level - change is coming, whether we like it or not. It can be embraced or delayed – but not avoided, so starting now is key. To conclude: as stated at the beginning of this article, prudent risk management is at the heart of this piece. For energy companies to remain going concerns in the future, action is required: be prepared, share information and work with other relevant stakeholders and governments to find solutions for the eventual transition to a zero-carbon economy. Only in this way will the industry respond effectively to the future transformation of the energy risk landscape.
Margaret-Ann Splawn is a climate policy, finance and investment consultant. She is a member of the Energy, Sustainability & Climate taskforce of the B20, the official G20 dialogue with business and Active Private Sector Observer for developed nations at the UN Green Climate Fund.
1 ESG has been defined by the Financial Times as “a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies. ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability” - http://markets.ft.com/research/Lexicon/Term?term=ESG
2 https://www.ipcc.ch/sr15/ 3 https://www.agcs.allianz.com/news-and-insights/expert-risk-articles/risk-barometer-2019-nat-cat.html 4 https://www.schroders.com/fr/insights/economics/how-will-physical-risks-of-climate-change-affect-companies/ 5 https://eciu.net/news-and-events/press-releases/2020/almost-half-of-global-gdp-under-actual-or-intended-net-zero-emissions-targets 6 https://www.carbontracker.org/energy-firms-risk-wasting-1-6-trillion-ignoring-low-carbon-transition/ 7 https://docfinder.bnpparibas-am.com/api/files/1094E5B9-2FAA-47A3-805D-EF65EAD09A7F 8 https://www.channel4.com/news/mark-carney-capitalism-is-part-of-the-solution-to-tackling-climate-change 9 https://www.ciel.org/reports/smoke-and-fumes/ 10 https://www.reuters.com/article/us-oil-climatechange-rhode-island/rhode-island-sues-major-oil-companies-over-climate-change-idUSKBN1JS28M 11 https://insideclimatenews.org/news/04042018/climate-change-fossil-fuel-company-lawsuits-timeline-exxon-children-california-cities-attorney-general 12 https://insideclimatenews.org/news/04042018/climate-change-fossil-fuel-company-lawsuits-timeline-exxon-children-california-cities-attorney-general 13 http://www.lse.ac.uk/GranthamInstitute/publication/global-trends-in-climate-change-litigation-2019-snapshot/ 14 https://climate-laws.org/ 15 https://twitter.com/mikebloomberg/status/425738442803511296?lang=en 16 https://uk.reuters.com/article/us-climate-change-boe-carney-interview/carney-says-business-must-come-clean-quickly-on-climate-idUKKBN2080TU
17 http://www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf 18 https://www.petroleum-economist.com/articles/corporate/sustainability/2020/financial-institutions-go-green 19 http://news.bostoncommonasset.com/wp-content/uploads/2019/11/Banking-on-a-Low-Carbon-Future-2019-11.pdf 20 https://www.bis.org/publ/othp31.pdf 21 https://www.ngfs.net/en/about-us/membership 22 https://www.ngfs.net/sites/default/files/medias/documents/ngfs-a-sustainable-and-responsible-investment-guide.pdf 23 https://www.bankofengland.co.uk/-/media/boe/files/paper/2019/the-2021-biennial-exploratory-scenario-on-the-financial-risks-from-climate-change.pdf 24 https://carbontracker.org/oil-and-gas-companies-approve-50-billion-of-major-projects-that-undermine-climate-targets-and-risk-shareholder-returns/ 25 https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2019/feb/Oliver_Wyman_Climate_Change_Managing_a_New_Financial_Risk1.pdf 26 https://www.imf.org/en/Publications/WP/Issues/2019/05/02/Global-Fossil-Fuel-Subsidies-Remain-Large-An-Update-Based-on-Country-Level-Estimates-46509 27 http://www.lse.ac.uk/GranthamInstitute/publication/global-trends-in-climate-change-litigation-2019-snapshot/ 28 https://newclimateeconomy.report/2018/wp-content/uploads/sites/6/2018/09/NCE_2018_FULL-REPORT.pdf
