Can big oil transition to a low-carbon economy?

Photo by Istoica

Please, PUT a global price on carbon.

That’s pretty much what six of Europe’s biggest oil and gas companies said in a joint letter sent in May to Christiana Figueres, the United Nations’ top climate bureaucrat.

“We stand ready to play our part,” Shell, BP, Total, Statoil, Eni and BG Group wrote, pointing to a number of actions they are already taking to limit emissions, from greater investment in lower-carbon natural gas and operational efficiency to supplying more renewable energy and exploring the use of carbon capture and storage.

“For us to do more, we need governments across the world to provide us with clear, stable, long-term, ambitious policy frameworks,” they said. “We believe that a price on carbon should be a key element of these frameworks.”

Figueres, being a diplomat, was diplomatic in her formal response. She’s been around the climate negotiations block more than a few times, and has heard the big fossil fuel companies talk a good game before. Her message back: give the world a reason to believe you.

For starters, she said, tell us how your company would transition over the next 80 years to successfully operate in a decarbonized global economy, which is a long-term goal the G7 leaders – including, to the surprise of many, Canadian Prime Minister Stephen Harper – agreed to in June.

“I hope you can understand,” she added, governments and civil society “need to be reassured of your sincere commitment.”

The hint of skepticism in Figueres’ response is no surprise. For years, the fossil-fuel industry has talked about the need to cooperatively solve the climate challenge, and many of the world’s largest oil and gas companies have for more than a decade privately backed, if not publicly called for, a global price on carbon.

Yet, as former U.K. climate negotiator John Ashton regularly points out, these same companies continue to invest in the oil sands, call for the construction of more petroleum pipelines and lobby governments to open up environmentally sensitive territories for exploration. They promote natural gas over renewable energy, and they push for carbon capture and storage without actually building it at a scale that matters.

They no longer deny the existence of man-made climate change and the need to do something about it, but they’re unwilling to map out what their transition to a low-carbon economy might look like. Indeed, they refuse to recognize any need to fundamentally transform their business model.

Ashton made this contradiction clear in an open letter to Shell chief executive Ben van Beurden in March.

The industry’s position, he wrote, is “a manifesto for the oil and gas status quo.” One need only point to Shell’s recent decision to restart its deep drilling efforts (since cancelled) in the Arctic. It equates to “psychopathic” behaviour, Ashton added, and reveals a cognitive dissonance that persists throughout the industry. “Commitment, to a transition that ends where it began.”

Jules Kortenhorst, CEO of the Boulder, Colorado-based Rocky Mountain Institute, who spent nearly a decade working for Shell, shares that observation. “I do not believe that any of these companies have yet come to grips with the brutal facts that they have to address,” said Kortenhorst in an interview with Corporate Knights.


Dangerous gamble

Those facts are piling up quickly, from Pope Francis’s encyclical on climate change, to the crackdowns on coal in China and the United States, to an expanding global divestment campaign that – if nothing else – has alerted investors to the growing risks of banking on oil and coal stocks, for both the planet and their portfolios.

“Investors will look for company strategies that are attuned to the new game rather than the rhetoric of the old,” according to Chatham House, the respected policy think tank.

The oil industry is vulnerable, and the speed at which their value can be erased is already starting to grab headlines. California’s two biggest pension funds lost more than $5 billion (U.S.) since June 2014 because of the declining value of their fossil fuel holdings, while Norway’s massive sovereign fund, which has already divested many of its fossil fuel assets, still lost $40 billion between July and August, partly because of falling oil prices.

In Canada, the oil sands are arguably suffering the worst. Since hitting its peak in March 2011, the BlackRock iShares Oil Sands Index Fund, which tracks the biggest energy companies operating in Alberta’s oil sands, has lost more than two-thirds of its value – and roughly half its value since oil prices began plunging last August.

There’s no question falling oil prices have played a big role in recent value declines, but as climate policy gathers momentum and new technologies, such as solar and energy storage, continue their trend of becoming more affordable and ubiquitous the medium- and long-term outlook, especially for coal and oil, looks grim.

“For oil, the Kodak moment will be when somebody produces a low-cost battery, as that will change the transport market profoundly,” said John Mitchell, an associate research fellow with Chatham House. Demand for oil, he explained, will fall dramatically once electric vehicles can compete with gasoline-fuelled vehicles on both performance and price. (The “Kodak moment” refers to the demise or decline of a business that fails to see or adapt to a disruptive change in its industry, such as Kodak with digital photography).

On the policy front, how the big energy companies react depends on whether they believe strict climate policy is not just inevitable but also imminent. For the scientific community, the answer is clear – if, as a society, we hope to keep the average global temperature increase from reaching dangerous levels (i.e. keeping the increase below 2 degrees C) then dramatic change is necessary, the sooner the better.

“With the oil companies it’s not whether the world is warming as much as whether the policy is going to be strong or not,” said Mitchell. “I think the companies have a way to go in acknowledging how serious the problem will be.”

This is perhaps most evident in the oil sands. When Linda McQuaig, a Toronto NDP candidate in Canada’s upcoming federal election, commented this summer on a political TV show “a lot of the oil sands oil may have to stay in the ground,” the backlash and shaming from industry and the Harper government was swift and harsh.

Bank of England Governor Mark Carney

McQuaig’s comments differed little from those of Bank of England Governor Mark Carney or the World Bank or the International Energy Agency – all have publicly acknowledged that two-thirds of the world’s known reserves of fossil fuels will have to be left undeveloped if humanity has a fighting chance against climate change. “We’re not going to be able to burn it all,” U.S. President Barack Obama bluntly said last year.

Yet talk about pace and scale of development in Canada’s oil sands is considered unspeakable – a blasphemy – in political and industry circles, even though oil sands projects are widely recognized as the highest-risk, highest-cost projects in the industry, and likely the first to be impacted as the noose of climate policy tightens. The country, in essence, is in a persistent state of denial.

“Adopting this low-carbon future will not be without pain for some,” concluded a comprehensive report released in August by Citigroup. “We estimate that the total value of stranded assets could be over $100 trillion based on current market prices.”

One would think that the potential implications of this for a Canadian economy highly dependent on the oil sands would be grounds for an open, honest discussion of how the country and the industry needs to move forward.

Making such a discussion even more critical is how the direct impacts of climate change, such as record-breaking drought and flooding, are already impacting oil sands developers. For example, Alberta’s energy regulator told many oil sands operators in July that they can’t divert water from the Athabasca, Peace and Wabasca rivers for use in their operations.

The reason? An unusually dry summer, which climate scientists say is likely to become a more common occurrence in the region.


Options for transition

To be fair, some petroleum companies are more progressive than others, and within individual companies, there are executives and younger parts of the workforce that privately express the need for the industry to change its ways. “But even if you realize that privately, it’s hard to share it with anyone internally,” said one industry consultant. “That’s because the disconnect is so strong between the corporate strategy and the public interest.”

Assuming the executive management teams of large energy companies were to sit down, roll up their sleeves and develop a transition map – one that included a low-carbon, 2-degree scenario – what options might be in their plan, and could such a plan be designed to keep investors from running for the hills?

“I do not envy the oil company CEOs,” said Kortenhorst, adding that he understands why industry leaders are so reluctant to face this new reality head on.

“It’s daunting to think through how a company – whose valuation and competencies, infrastructure, inherent skills, history is all based on large scale projects with long time horizons and massive capital investments – can shift to a new reality that’s going to be decentralized, based on more modest capital investments and shorter time horizons, and is about electrons rather than molecules.”

Below are some actions the big oil companies are likely to consider as they map out their adaptation strategies:

Surface coal mining. Photo by Stephen Codrington
Surface coal mining. Photo by Stephen Codrington

1) Throw coal under the bus. This infighting in the fossil fuel industry is happening right now. Under a 2-degree scenario, Citigroup says about one-third of oil reserves, half of natural gas reserves, and 80 per cent of coal reserves need to stay in the ground. Burning coal emits the highest amount of CO2 per unit of energy it delivers, so regulation and carbon pricing hurts the coal industry most. “Coal is first on the firing line,” said one analyst.

The oil and gas companies know this, which is why they’re speaking out in support of a global price on carbon. For them, every tonne of coal that gets left in the ground leaves more of the global carbon budget to oil and gas. From hereon in, oil and gas companies will be jockeying for a bigger piece of that fixed budget to extend the life of their traditional businesses for as long as possible.

2) Add more natural gas to the asset mix. Natural gas, generally, emits half the amount of CO2 per unit of electricity as oil does, so it makes sense for big petroleum companies to lean on this resource more as a way to position their respective asset mixes as lower carbon and secure an even larger piece of the global carbon budget. It also makes use of existing expertise in drilling, fracking, and pipeline transmission.

Where demand for oil is expected to fall in a 2-degree scenario, demand for natural gas is expected to hold steady or grow. It’s why oil giants like Exxon are investing more these days in natural gas assets. “A key point about a carbon price is that its initial effect will favour gas over coal in the power system,” says Mark Fulton, an advisor to the Carbon Tracker Initiative, which has led research on what a 2-degree carbon budget might look like.

Relying more on natural gas is not a long-term climate solution, but it buys the big energy companies some time and will be needed to help manage the variable nature of wind and solar technologies, at least until large-scale energy storage becomes more economical.

3) Kill risky, high-cost exploration and return value to shareholders. This is where big oil is entering new territory, but big investors are increasingly asking: Why spend billions of dollars pursuing high-cost, high-risk projects when there’s a strong chance they will be stranded in a climate-constrained world?

“It costs close to 20 per cent cost of capital to drill for oil or for gas in the Arctic, so why for Pete’s sake are we still seeking energy in the Arctic?” said Kortenhorst, referring specifically to Shell’s Arctic-drilling ambitions. The same question stands for new oil sands projects. According to Carbon Tracker, the roughly $400 billion committed to Alberta oil sands projects between now and 2025 represent more than a third of high-risk projects expected to become stranded assets in a 2-degree world.

Instead of spending capital on growth, cash flow from existing operations can be returned to shareholders in the form of share buybacks and increased dividends. “Those payouts are the channels through which oil and gas companies’ profits are recycled away from fossil-fuel production,” according to Chatham House’s July 2015 research paper “Oil and Gas Mismatches,” co-authored by Mitchell.

4) Consolidate where it makes sense, shed where it doesn’t. Chatham House says a period of adjustment is expected in the transition to a low-carbon economy in which financially strong companies acquire strong assets currently belonging to weaker companies. “High-cost and high-risk projects will be abandoned or deferred,” according to its report. “Companies whose existence relies on such projects will be taken over or broken up, and countries that depend on them for future development will have to revise their strategies.”

To a certain extent, low oil prices have already sparked some rationalizing of asset mix, but merger and acquisition activity is expected to heat up over the coming years as the big players seek lower-carbon assets that keep them in the game longer. Shell’s planned $70 billion takeover of BG Group, the world’s largest liquefied natural gas supplier, may be a sign of things to come.

That deal, if it goes through, will separate Shell from its more oil-oriented peers, BP, Chevron and ExxonMobil among them. In the meantime, emphasis will be put on operational efficiency that lowers product carbon intensity.

5) Seriously pursue diversification beyond fossil fuels. It’s the trillion-dollar question: Can big oil thrive as something other than big oil under a 2-degree climate scenario? Many in the environmental community argue these deep-pocketed giants should invest in more renewable energy as they wean off fossil fuels – the fast the better.

But it’s a daunting scenario, said RMI’s Kortenhorst, comparing it to an American football veteran being told he suddenly has to play professional soccer. “Yes, it has something to do with running around the field, but it’s dramatically different.”

Many already dabble in wind and solar. The biggest move to date came in 2011, when France’s Total SA purchased 60 per cent of SunPower, the second-largest solar panel maker in the United States. But holding and bankrolling a renewable asset and letting it operate independently is much easier than transforming core competencies, which is a rare feat for an incumbent with magnetic attraction to the status quo.
“History shows that energy companies are incapable of transitioning out of their core business into a new market,” said Jigar Shah, founder of solar developer SunEdison.

Solar development, for example, couldn’t be more different than oil development, which is grounded in geology and mining. One deals with electrons, one with molecules. One is decentralized and IT-driven, the other more centralized and mechanical. Development timelines for one can be measured in months, the other in years or decades.

Not that a business makeover can’t be done. After all, Kodak competitor Fujifilm spent the past decade successfully transforming itself from a struggling photo-film manufacturer into a pharmaceutical and cosmetics company now venturing into regenerative medicine.

Shah said if big oil is to make a play for renewables, it should be in areas that leverage its core competencies, such as drilling and engineering for geothermal power development, or which better complement its existing fuel business, such as biofuels or hydrogen.

But even there, points out Chatham House, the potential pitfalls are many. “Experience of the 1980s shows that further diversifying into what are, in effect, other industries is risky both for a company’s management and for its shareholders.”

So what’s a big oil company to do to avoid the Kodak moment? Ultimately it’s up to its investors, which can ignore the issue in the short term and postpone the pain, or pressure the company to come up with a game plan designed to protect owner interests in the long term – and execute on it. “It’s a risk management situation,” said Fulton. “Simply put, they need to manage that risk.”

What’s almost certain is that 50 years from now the giants of today’s petroleum industry will look substantially different from the way they look today, if they exist at all. “They will have nowhere to hide,” John Ashton wrote in his fiery open letter to Shell. “The low-carbon economy is starting to take shape, and it works.”

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