As climate change rises up the political agenda throughout the West and beyond, shareholders have an important role to play in limiting global fossil fuel consumption by pressuring oil companies to amend their strategies, argues Sora Utzinger.
5 minute read
At the oil company’s recent annual general meeting on May 21, BP shareholders voted overwhelmingly in favour of a motion that will push it to set out a business strategy aligned to the Paris Agreement’s goal to combat global warming.
Although BP is boosting investment in its renewable-energy business, it is also planning on expanding oil and gas production. The resolution, which Aviva Investors co-sponsored with Hermes and L&G, requires the company to evaluate whether each new fossil fuel project is consistent with the Paris Agreement. It aims to keep the rise in global temperature this century well below two degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius.
The BP resolution was driven by a concern the company was disclosing insufficient information to enable investors to appraise whether its strategy – particularly those planned investments in fossil fuel reserves – was consistent with the Paris goals being met. That was in turn making it difficult to weigh up the long-term investment case.
While this resolution is a step in the right direction, BP still has some way to go to catch up with European peers such as Repsol, Shell, and Total, all of which have begun to accept some responsibility for the way in which their products are used.
These three companies are aiming to reduce the amount of greenhouse gases they and the end-users of their products emit, both by boosting investment in renewable sources of energy and by shifting fossil-fuel production away from dirtier forms of energy such as tar sands and coal – which emit more carbon dioxide per unit of energy produced – towards natural gas.
Out of scope?
Although it will try to improve the energy efficiency of its operations by reducing flaring and decreasing methane emissions, BP has so far shied away from committing to cut these so-called Scope 3 emissions.
It is certainly true the company has in recent years been orientating its upstream strategy towards gas and liquefied natural gas (LNG) and away from oil. Although BP is more reliant on oil than most of its competitors – it currently accounts for more than 60 per cent of its production mix – the company intends gas to make up at least half its output by the middle of the next decade. However, while BP has said it will start to estimate the carbon intensity resulting from the use of its products, this is of limited benefit when it comes to addressing the issue of rising temperatures since this metric is framed as net emissions per unit of energy produced. The bottom line is that without an absolute limit, there is nothing to stop a company such as BP continuing to grow its hydrocarbon operations.
And while the company has also committed to spending US$500 million per year on low-carbon activities – around three per cent of total annual capital expenditure – and to invest US$100 million in projects that can help reduce emissions caused by its upstream oil and gas operations, these numbers pale in comparison to competitor activity.
For instance, Shell has committed to doubling its new-energy division's annual budget to $4 billion from 2020. Its focus on acquiring clean-energy assets seems to signal its management's acknowledgment of the long-term risks to global oil demand posed by policymakers and the accelerating electrification of the transport industry.
Companies such as BP cannot solve the climate crisis on their own. Other economic actors such as car manufacturers, aircraft makers and end consumers need to play their part. And most important of all, governments around the world need to set the right legislative framework with the necessary incentives and penalties.
Nonetheless, both capital markets and companies currently underestimate the speed and scale at which regulations could come into force to deliver the goals of the Paris Agreement. For companies like BP to remain relevant and generate long-term value, their strategy needs to change. Opening new oil and gas reserves is a multi-year commitment, both financially and strategically, and oil groups need to clearly set out their strategy in view of the long-term trend towards low-carbon energy and renewables.
While this does not mean oil companies should necessarily stop investing in fossil fuel reserves altogether, they need to recognise doing so exposes them to stranded asset risks since there is an upper limit on the number of new projects that can go ahead. As Shell chief executive Ben van Beurden put it in 2017: “This means only proceeding with those investments that are climate-competitive.” 1
Ultimately, they need to adopt one of two approaches. They could choose a ‘managed decline’, focusing on maximising returns from their existing portfolio while refraining from sanctioning new projects that failed to fit into a given carbon budget. As a result, upstream production would gradually diminish, with excess cash being returned to investors. A second option would be to use free cash flow to diversify into other sectors, especially renewables, while adopting the same climate-constrained approach to the hydrocarbon business.
Oil companies often have a competitive advantage in establishing a renewables business. Shell for instance has plenty of experience from its Gulf of Mexico oil and gas business dealing with US offshore environmental and drilling regulations.
Arguably the most aggressive shift in strategy saw Denmark’s Dong Energy divesting its entire upstream oil and gas business in 2017 and changing its name to Orsted to focus on renewables, including offshore wind, solar and biomass. Orsted in November 2018 agreed to provide 500MW of wind and solar power to ExxonMobil for the latter’s operations in the Permian Basin in Texas and New Mexico.
The value of engagement
The activities of the fossil fuel industry threaten to undermine progress towards achieving the Paris goals. If carbon emissions are not curtailed, global temperatures could rise by six degrees by the end of the century. According to an EIU estimate, the associated damage could wipe US$43 trillion, in current prices, off the value of financial markets.
Worryingly, whereas many European oil and gas companies are taking steps to articulate a climate strategy, major Asian and American peers have fallen behind. Data disclosure remains a key issue for many state-owned Asian oil and gas companies, such as Petrochina, which does not yet disclose any emissions data. Similarly, Exxon has no overall corporate emissions reduction targets and recently denied shareholders a chance to vote at its annual meeting on a proposal that it should set targets for cutting emissions. In fact, the company’s upstream emissions intensity has increased since 2013, according to research by CDP, an environmental charity. By not setting climate-related remuneration criteria, it lags European peers in terms of climate governance too. By contrast, US rival Chevron recently announced it intended to set intensity targets across its direct operations, following investor pressure. Although Chevron’s portfolio is oil heavy, with gas accounting for just 35 per cent of production, this is at least expected to rise to 41 per cent by 2022 as large LNG projects expand.
With the stakes so high, institutional shareholders have an important role to play in getting these companies to change their behaviour. After all, overinvestment in the oil and gas industry presents a considerable risk to investors, regardless of whether the world as a whole is taking decisive steps to mitigate climate change. Eventually, either oil and gas assets will be stranded as fossil fuel demand declines, or excessive carbon emissions will lead to huge financial costs that are expected to result from climate change. By investing in companies that are less exposed to the risk of stranding and taking strategic steps now to benefit from the transition to a low-carbon economy, asset managers have a role to play in safeguarding shareholder value for their clients.
As for the laggards, while divesting is sometimes viewed as a more convenient option, once investors sell their stake they effectively lose their ability to put pressure on company boards, both in terms of face-to-face engagement and voting powers. There is a risk these shares are bought by less conscientious shareholders who are not interested in holding their investee companies to account on non-financial issues, such as climate change or human rights. This is why rushing to divest could be counterproductive in the long term and unnecessarily perpetuate the status quo.
The outcome of the BP annual meeting highlights a major benefit of institutional investors engaging with the companies in which they own stakes. It shows we can push oil companies towards more sustainable low-carbon energy sources. However, the passing of this resolution merely marks the start of this process of engagement and we will be following the company closely over the next few months to see how it puts the resolution into action.