More systematic corporate disclosures about climate-related risks are needed to improve investment capital allocation and speed up the shift to a low-carbon economy
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This article was first published in the October 2017 international edition of Accounting and Business magazine.
Had Exxon Mobil reported its reserves differently in 2016, investors might have taken a different view of its future trajectory. The company had stated that its Kearl oil sands were reserves, but was subsequently ordered to debook them by the US Securities and Exchange Commission (SEC), the country’s financial regulator. A major shift in the company’s disclosures ensued in March 2017, with proved reserves cut by 3.3 billion oil-equivalent barrels. ‘Under the SEC definition of proved reserves, certain quantities of oil, such as those associated with the Kearl oil sands operations in Canada, will not qualify as proved reserves at year-end 2016,’ Exxon admitted in October 2016.
According to Tarek Soliman, senior analyst at CDP, a not-for-profit charity that campaigns for global carbon disclosure, the systematic consideration of climate-related risk would have resulted in a different figure. It would transform investor perceptions if replicated across the whole oil and gas sector. ‘If the company were to integrate climate risk into its assessments, it would highlight that these assets show a high propensity to become impaired,’ he says. ‘They would have been downgraded to a resource rather than a reserve, and this problem would have been foreseen.’
A redirection of energy pathway, not just for Exxon but all its competitors, might follow if they acted this way, as recommended by the Task Force on Climate-Related Financial Disclosures (TCFD), set up by the Financial Stability Board (FSB). TCFD’s final report was presented to the G20 group of major economies in July by Bank of England governor Mark Carney.
Classifying assets, liabilities and acquisitions under the lens of climate-related risk would, according to TCFD, lead to more appropriate pricing of risks and allocation of capital in the context of climate change. This would work as a voluntary initiative, helping speed the transition to a low-carbon economy, and shift the corporate perspective beyond immediate concerns. In Exxon’s case, it might identify a potential stranded asset.
TCFD divides climate risk into two categories: transitional and physical. Policy, legal, technology and market changes are all classified as transition risks. Examples include policy actions that promote adaptation to climate change, such as governments’ carbon pricing mechanisms. Technology transition risk includes, for example, the development of batteries that could affect the competitiveness of industries such as the automotive sector. Market risk is another transition risk, in which supply and demand for certain commodities change once suppliers start taking climate change into account.
The second major type of risk is physical risk due to changing weather patterns. These may have financial implications for organisations, such as direct damage to assets and the indirect effect of supply chain disruption. Organisations’ financial performance may also be affected by changes in water availability and quality, and food security, while extreme temperature changes can affect premises, operations, supply chain, transport needs and employee safety. However, TCFD also identifies market opportunities, such as resource efficiency and cost savings, new products, diversification and better resilience. Examples include shifting consumer preferences, low-emission goods and services and reduced water usage and consumption in agribusinesses.
But as Soliman observes, most industries are not reporting in depth on these values-based assumptions. Oil and gas companies are understandably among the least likely to want to report through a channel that undermines their very existence. But improvements have been made over the past decade as they have responded to demands for data on historic greenhouse gas emissions. These disclosures have usually appeared in corporate responsibility statements. The pressure, as expressed by TCFD, is now to disclose consistently for the first time in financial filings, and to look much further into the future.
TCFD’s recommendations require more in-depth information rather than any innovative accounting. ‘It would change what the directors are telling us in the strategic report but wouldn’t change [the structure of] the balance sheet and profit and loss account,’ explains Russell Picot, special adviser to TCFD and former chief accounting officer at HSBC. In the case of hydrocarbons, categories such as reserves and resources in strategic reports would be the numbers most likely to alter.
Leaders have already emerged in this space, and the picture is mixed. CDP finds Norwegian company Statoil the best performer on carbon disclosure for the longer-term horizon in its 2016 study of the sector, In the Pipeline. Canadian company Suncor is listed as the worst of 11 major global oil and gas companies, and Exxon last but one. ‘Statoil is the only company that quantifies what a world with a two-degree Celsius temperature increase would do to its worth,’ says Soliman. Indeed, in its 2016 annual report, Statoil states that the International Energy Agency’s ‘450ppm scenario’, compatible with that temperature rise, ‘could have a positive impact of approximately 6% on Statoil’s net present value [NPV] compared to Statoil’s internal planning assumptions as of December 2016’.
While most companies employ conventional economic metrics to justify decisions in financial filings, CDP finds they also increasingly publish carbon pricing. This can be seen as another way to express or at least accept the risk of regulation on carbon emissions, and to test the company’s resilience in that light. Eight out of the 11 companies use an internal carbon price, which ranges from US$22 to US$57 a tonne, while three (Chevron, Occidental and Petrobras) are silent on the matter. As Soliman suggests, internal carbon pricing may have affected Royal Dutch Shell’s announcement that it had ceased exploring the Burger prospect in Alaska. However, this is not explicit. Clarifying its decision, the company in 2015 said it was due to ‘high costs associated with the project, and the challenging and unpredictable federal regulatory environment in offshore Alaska’.
Hence, some companies apply a carbon price to projects under assessment, but there is no evidence they screen out projects on this basis. ‘I have not seen a case where the company has said: the project makes sense, but we are going to veto it because the carbon price is too high,’ says Soliman.
The TCFD report comes at a time of transition. Some of the major players in oil and gas are talking about climate risk, others are not. Some are acting accordingly, others are paying lip service. An obvious example of directional shift is Italian company Eni, which is increasing the share of gas in its portfolio. In its 2015 annual report, it states: ‘Companies operating in energy business have to face challenges…such as climate change and a gradual decarbonisation process. In this context, natural gas represents an opportunity for a strategic repositioning, thanks to gas low-carbon intensity.’
But the task force wants more. If the corporate community systematically adopted its recommendations, balance sheet, income statements and strategic reports would most likely need modifications, as Picot points out: ‘Including climate risk would sharpen disclosures on the impairment of cashflows arising from assets.’
Investors would be able to access a scenario analysis for each major sector. This would relate to a 2°C temperature rise scenario as well as, for instance, a scenario based on nationally determined contributions or a business-as-usual (greater than 2°C) temperature increase. But the actual frameworks have yet to be shaped. ‘We need to see a period of experimentation. Three or four years down the road we could potentially be assessing what is useful in the voluntary disclosures, and see it codified by institutions through, for example, stock exchange guidelines,’ says Picot.
However, he suggests that the most significant progression will be found in strategic discussions in financial statements. ‘This is not going to result in a huge data drop by companies but rather a thoughtful narrative description from board directors. It will hopefully be used as an engagement tool as well as a divestment tool,’ he says. A move towards less carbon-intensive business models could result. However, Picot declares: ‘We’re not saying they should alter their business model, but that the information needs to get out there so that the market can decide.’
Disclosures on climate-related risk have been improving, but, as the Statoil case demonstrates, the view of risk is always subjective. ‘The company had the previous year assessed a 5% loss in NPV, so the 6% improvement estimated in 2016 was an interesting flip,’ Soliman points out. Arguably, the risks to financial performance are considerable if a company moves away from its traditional business model or abandons its store of expertise. Shell’s announcement that it is to move into the electricity market is an example of such a risk, and has been attributed to its acceptance of the move towards a low-carbon economy. This could mean that power demand in the transport, industry and services sector will rise as oil and coal are displaced.
In the very different international political environment since last year, opinion on climate risk might change. Clearly, there is more to this movement than a shift in reporting standards. It is about using investor activism and peer group pressure to nudge big carbon emitters away from fossil fuels. However, given the new US administration and the US withdrawal from the Paris Accord, the full-scale international adoption of TCFD suggestions may well be delayed.
Elisabeth Jeffries, journalist
"If climate risk were integrated into risk assessments, it would highlight that oil sands assets show a high propensity to become impaired"