This article was first published in the September 2017 edition of Accounting and Business magazine.

Energy companies must manage huge uncertainties in the course of their activities. Among other things, they have to make provision for decommissioning costs on major assets such as power stations (nuclear and conventional) and oil and gas rigs that may operate for 20, 30 or perhaps even 50 years into the future. 

Decommissioning costs are themselves subject to a range of different variables, including the cost of equipment and labour, changes in environmental regulations and the future impact of climate change. There is also doubt over assets’ likely end-of-life date, which will change according to technological developments and future wholesale energy prices.

Jimmy Daboo, a KPMG energy audit partner, explains: ‘There are multiple variations, which can produce different outcomes. When you start to provision you are potentially decades before decommissioning actually happens. Accounting people are in the business of making estimates all the time. Usually these are for a shorter-term period and with fewer variables. 

‘Essentially it is a matter of engineering. Then it is a matter of costing those engineering outcomes. Next you take into account the time value of money. Then you factor in something which takes into account the risk.’ 

In other words, the provisions are calculated according to what the cost would be today, plus 20% or so as contingency to cover the risk of things going wrong, with the total discounted to reflect the future value of money. 

Inexact science

Jamie Drummond, a PwC director for assurance, warns: ‘A significant uncertainty is the scope of the work itself, particularly with old oil and gas platforms. For many companies, getting precise and complete information about the original construction is a challenge. Many installations date back to the 1970s and 1980s, since which time they may have been subject to M&A activities, personnel changes and ongoing redevelopment, so the inventory of what needs to be taken out on abandonment is not always clear.

‘The relevant legal and regulatory frameworks can change over time too, often in response to environmental concerns, affecting what may or may not be left on the sea bed at the end of the field’s production life. Some exploration and production companies have their own standards, which may be in excess of the legal obligations.’ 

Current efficiencies only

Under the accounting standards, decommissioning has to take account of risk – weather, unexpected complications, the discovery of environmental issues, etc. But calculations that assume improved technology in the future are not allowed. ‘You can only provision for proven technology,’ Drummond says. ‘However, it may be possible to assume efficiencies – for example, where there are cost benefits from decommissioning a wider area of connected facilities at the same time rather than costing the work at an individual asset level in isolation.’

Another complication is working out the likely date when production will cease. This will vary according to any improvements in extraction technologies and also wholesale energy prices as the end of life nears. ‘The date has to be re-assessed every year,’ says Drummond.

Kevin Weston is an EY assurance partner and an energy market lead for the firm. He says his clients are constantly working on updating costs and improving efficiencies. With some rigs and platforms built in the 1970s now being decommissioned, provisions can increasingly be based on experience. ‘This gives them a data point,’ he explains. 

Economies of efficiency and learning

Experience of decommissioning generates economies of efficiency and learning, as many rigs and wells are similar in terms of design and location. Weston says: ‘Companies are looking at technology – for example, drones that survey the rig – and using analytic and robotic processes.’

Operators in Europe’s North Sea have been dealing with an additional challenge over the past year. ‘Costs have been in pound sterling, but they report in US dollars,’ explains Weston. The fall in the value of the pound affects dollar-based provisioning estimates.

Risk is one of the big concerns, with the possibility of many things going wrong during decommissioning. In some instances energy majors have offloaded assets near their end of life to smaller energy companies that specialise in operating assets at lower volumes over a longer period. Those end-of-life operators take on the responsibility for decommissioning. In other instances, an energy company will pay a specialist decommissioning company to take over the liability.

Shared responsibility

In M&A negotiations, some sellers have had to underwrite decommissioning costs or retain the liability. Oil and gas extraction facilities are often owned by joint ventures, with all partners jointly responsible for decommissioning. Each partner must continually monitor its partners’ financial capacity to meet their decommissioning liabilities.

Corporations also have to do tax planning for the decommissioning. Mairi Massey, a PwC tax director, explains: ‘You don’t get any tax relief from the provisions, only when paying the actual costs incurred.’ Until then, an element of the expected costs can be accounted for as a deferred tax asset. But the value of the potential tax relief is based on tax rates applicable during the life of the asset – a complex calculation given that these rates may have changed several times.

Decommissioning arrangements vary according to location. In some African and Asian countries, operators pay an annual charge, with the government taking over responsibility for execution. The end result is similar, whether states provide tax relief to assist with costs or take direct responsibility for the decommissioning. Daboo says: ‘One way or another, the government underwrites the process.’ 

Paul Gosling, journalist