John Teahan

Portfolio manager

August 12, 2020
9:00 am

Ready or not

European oil & gas majors and the energy transition

Over the last few months, we conducted a deep dive into our portfolio energy holdings, reassessing their plans for the transition to a low carbon economy and meeting their obligations under the Paris Agreement. This transition holds a lot of risk, as well as potential reward, for shareholders like us. Recently, we have seen risk materialise in dividend cuts, impairment to equity and share price declines; driven by the Covid-19 demand shock and the oil price war supply shock, but also due to divestment motivated by climate change, accelerated by environmental and social issues taking centre stage during the pandemic. What we are looking for are companies that can navigate the transition and be in a strong position to supply what will be a growing demand for energy through and beyond the transition period. Population growth and the quest for rising standards of living will drive demand; the landscape on the supply side will change radically.

Across our different mandates we own shares in Total, Royal Dutch Shell, bp and Eni. First the good news; in our opinion the European majors ‘get it’ – they get that climate change is happening, that regulation is coming down the track, that carbon pricing and carbon tax is very much on the horizon in a meaningful way and that they have to communicate the fact that they ‘get it’ to retain their social licence to operate. This contrasts with their American peers, particularly Exxon Mobil, who are well behind on these issues.

However, while they now acknowledge the issues, publish lots of reports and set lots of long-term targets, there is an amount of work still to do. Here are ten takeaways from our analysis and communications with the four companies mentioned:

All four have aligned themselves to the Paris Agreement (COP21) target to restrict global temperature rises well below 2° Celsius. Royal Dutch Shell points out that in many parts of the world the tougher Paris Aim of 1.5° Celsius is now being adopted.
Gas is the focus across all four, it is the only way to replace coal quickly and delivers a complementary source of energy to renewables, which are less reliable. Post 2040, the prospects for gas and gas assets becomes less certain.
All four believe their assets are safe from becoming ‘stranded assets’, think tank Carbon Tracker believes it is not possible for all energy companies to realise the value of their hydrocarbon assets. The four above say they are focused on the lowest cost barrels.
Scope 1 and 2 emissions will be hard to eliminate in order to achieve net zero, particularly for some majors. After very positive developments in efficiencies, there will remain a large amount of emissions to offset via carbon sinks or carbon capture, utilisation and storage (CCUS). Carbon sink offset targets may imply an unrealistic acreage of tree planting, otherwise it may purely be an exercise in transferring legal ownership without a net addition of carbon removal for the planet. Eni say they aim to conserve mangroves that would otherwise be under threat. Eni also has a concrete plan for CCUS via flow reversal into depleted gas fields. Other majors rely on future technological developments.
Scope 3 emission reductions are dependent more on government action, than action by the energy companies themselves. As governments move economies to net zero, each sector of an economy moves towards net zero. These individual sector Scope 1 and 2 emissions are the energy companies’ Scope 3 emissions, hence the Scope 3 reduction. Energy company targets thus mainly reflect government targets and that is why Total, for example, limits Scope 3 net zero target to the EU, Norway and the UK.
All four companies use carbon pricing or carbon tax assumptions within their capital expenditure decisions. As a rule of thumb $40 per tonne of carbon dioxide equivalent (tCO2e) adds $2 to the cost of a barrel of oil. Carbon Tracker says “By 2050, Shell estimates that some countries will increase carbon prices to $85/ton of GHG emissions, which translates into roughly a $3-4 additional cost per barrel of oil and therefore does not appear to pose a robust test of company projects in a low-carbon transition”.
Carbon intensity hides the fact that some of the majors will increase carbon emissions in absolute terms by 2050. If their renewables and power generation businesses grow faster than hydrocarbons, then intensity decreases, alongside higher emissions. This is a criticism of the Transition Pathway Initiative approach; they do not look at absolute emission levels and thus their view on a company differs from Carbon Tracker; Shell and bp reverse in rankings between the two organisations.
Long reserve life used to be a positive attribute. Now investors consider long reserve life (especially for oil assets) increases the risk of ‘stranded assets’. Shell made the point that 80% of their reserves would be produced by 2030, what they don’t highlight is that each year they add to reserves so 2030 becomes 2031 and 2032.
Comparisons between companies is highly problematic. Boundaries vary, estimation methodologies vary. Issues include how to attribute the equity share within operating and non-operating joint ventures, whether equity stakes are included (bp/Rosneft), how they estimate Scope 1 and 2 emissions for third party products, whether to include energy trading.
The Covid-19 pandemic has materially shifted the debate on climate change. The energy companies have come out with updated, more ambitious targets. The language is about ‘building back better’. The European Recovery Fund, with the Commission’s ability to raise funds independently, increases the prospect of increased carbon pricing and carbon taxes, the current company assumptions may not reflect this risk.

With any transition, particularly with one as important and large as the transition to a low carbon economy, the risks are very high. What we see is that the large European energy companies understand the transition is happening and understand that they must move with it. While Eni has detailed plans on how they will make the transition, the other three under review are short on detail (albeit bp is moving fast) and place the burden of transition, the real heavy lifting, on future management. They are due to hold investor days in the coming months to set out more detail. We will then have a chance to assess whether they are making meaningful plans to meet their obligations and targets because, ready or not, climate change is happening, more regulation is coming, and society is becoming increasingly impatient.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the names shown above are for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

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