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This section discusses some of the topics that frequently come up when we are discussing our research with investors:

• What does the Paris Agreement mean for the fossil fuel industry?

  The Paris Agreement marked an unprecedented united effort to combat climate change from the world’s governments. It reaffirms the objective of holding global warming to no more than 2°C above pre-industrial levels. The ‘carbon budget’ for delivering this outcome, i.e. the cumulative amount of carbon dioxide (CO2) emissions permitted over a period of time to keep within a certain temperature threshold, is shrinking with each year that passes. As Carbon Tracker demonstrated with its seminal unburnable carbon and stranded assets reports, the smaller the carbon budget then the greater the scale of fossil fuel assets that must stay in the ground. The total CO2 budget remaining from 2017-2100 is 775GtCO2 to have a 66% chance of keeping to 2°C. This budget would be far exceeded if known fossil fuels were burnt, meaning that some fossil fuels will need to be left undeveloped if it is to be achieved.

  The Paris Agreement also included ambitions to limit global warming to ‘well below’ 2°C. As one might imagine, if developments in technology and government policies result in emissions complying with this tighter carbon budget, this renders even more coal, oil and gas unburnable. The exact size of the ‘well below 2°C’ carbon budget is dependent on the likelihood one attributes to delivering the desired temperature outcome. What remains constant across all calculations, however, is that immediate and widespread decarbonisation is required to achieve this more ambitious target.

• What is the role of technology and policy in achieving the 2°C carbon budget?

  Both government policy and low-carbon technological innovations are going to be critical to keeping within 2C. Obviously policy and technology interact and cannot be seen in isolation – which policy stimulating technological deployment, and rapid roll-out reducing the future level of policy required. Both can impact the relative financial attractiveness of future energy options. Arguably the cost of capital is also critical, especially for projects with capital costs loaded up front.

  Policy comes in many forms, from explicit carbon pricing options to fossil fuel subsidies to air quality standards. The momentum is to constrain carbon emissions, although the Trump administration appears to be going against the tide. This appears to have only galvanised other major economies, multinational corporations and US state administrations to maintain the momentum. This effort towards regulating carbon will undoubtedly shift CO2 emissions some way towards a 2°C pathway. However, current climate policy proposals, (Nationally Determined Contributions), are not sufficient to deliver this outcome. Conversely there are a number of policy measures designed to address different issues, such as air quality, which also have benefits in terms of reducing greenhouse gas emissions. Alongside policy, low-carbon technological solutions are equally important to provide viable alternatives to CO2-intense equivalents, and the two often go hand in hand.

  Recent years have seen the dramatic emergence and increased growth of low-carbon power solutions such as wind and solar PV and electric vehicles in the road transport sector. Developing low-carbon technologies in the aviation, shipping and heavy industries will now be critical to achieving the 2°C carbon budget. Technological advances have been outpacing expectations in some areas, but are still disappointing in others.

  Natural gas emerges as the most favoured fossil fuel in most modelling exercises, for example the IEA’s 450 (2C-compliant) scenario sees demand growth to 2030. The degree to which gas demand is expected to grow is largely dependent on the degree to which one believes natural gas will continue to be used in the power sector, or whether it will be leapfrogged by more competitive low-carbon solutions.

• How do you determine which coal, oil and gas may not be burnt?

  Reserves and resources are technical definitions, which indicate the economic viability and certainty of what is discovered in the ground. These numbers do not however give an indication of when the coal, oil or gas will be produced, which obviously determines when the revenues will be realised. For example National Oil Companies such as Saudi Aramco may have decades of proven reserves, but could never produce them all within the next 15-20 years. US shale producers may have proven reserves of only a few years’ production, but analysts are increasingly including probable and possible reserves in their calculations.

  Investors need to understand who might be the winners and losers in a carbon-constrained future. To supply this information, Carbon Tracker developed its carbon supply cost curve approach. This analysis compares potential future coal, oil and gas production out to 2035 by their break-even cost and overlays the level of demand needed in a 2°C scenario according to the IEA. To go out to 2035 requires going beyond proven reserves – and this is where the majority of the risk probably lies – in developing the projects which current revenues are being reinvested in.

  In essence, this demonstrates, applying economic logic, which coal, oil and gas projects are within and outside the 2°C budget. Companies left with high-cost projects that are unneeded in this future may have to curtail growth plans, while those with low-cost projects that may still be needed to satisfy demand are the relative winners. Because state owned oil companies tend to have low cost production, they tend to be well positioned on the cost curve, meaning that listed and private companies have greater exposure to high cost, high risk assets.

• Which supply sectors are most exposed to demand downside risk?

  A number of factors determine the level of exposure of fossil fuel assets to weakening demand, including carbon-intensity, level of substitution risk etc. The relative prospects of the three fuels are not equal but the hierarchy is clear. Coal is the most exposed to a low-carbon future given its highly CO2-intense nature and readily available alternatives in the power sector. For example, the IEA see coal demand as flat over the next five years, which will likely be followed by a steady decline as CO2 emissions continue to decouple from economic growth.

  Much more attention has been brought to the possibility of peak oil demand over the past few years. The use of oil is deeply entrenched in modern society, but the emergence of electric vehicles threatens to substitute for oil products in the transport sector, with improved efficiency also eroding demand, particularly for road-based transport. Other petroleum products may take longer to displace, and not all are combusted in use, eg chemicals. As such, many research institutions and even some oil and gas companies see oil demand peaking as early as the 2020s.

  Natural gas emerges as the most favoured fossil fuel in most modelling exercises, for example the IEA’s 450 (2°C-compliant) scenario sees demand growth to 2030. The degree to which gas demand is expected to grow is largely dependent on the degree to which one believes natural gas will continue to be used in the power sector, or whether it will be leapfrogged by more competitive low-carbon solutions.

• What evidence is there that the transition is happening?

  The transition to a low-carbon economy is occurring faster than most expected. This is most clearly demonstrated by the fact that global CO2 emissions have now been flat for three years , which is greatly at odds with every emissions trajectory from the fossil fuel industry or major modelling institutions like the IEA or US EIA. This plateau has largely been down to a fall in coal consumption globally. In turn this can be attributed in part to climate policy progress and increased penetration of renewables, which have undergone deep and persistent cost reductions almost in line with Moore’s law.

  The differences between the announcements on the demand side sectors, (around renewables in power and electric vehicles in transport), make an ever diverging contrast to the limited expectations of the incumbents in these areas. In terms of selecting new capacity, low or zero carbon options are increasingly competitive in some markets today. Depending on market structures or policy interventions there are also stranded assets appearing amongst existing capacity and infrastructure which is being retired in advance of previous expectations.

  Few observers expected the decoupling of economic growth and emissions that has continued following the financial crisis. The difference between established OECD markets and infrastructure and nascent non-OECD energy and transport systems is of huge significance. The choices made in China and India will decide the demand for many energy products going forward.

• Why is it important to challenge assumptions about the future energy system?

  No one will be exactly right when attempting to forecast the future energy system, but it is important to try and consider the full range of potential outcomes. This is why Carbon Tracker has reviewed the modelling assumptions of institutions to ensure scenario inputs are as accurate as possible. Even fundamentals such as the range of commodity prices are important, with many companies not considering a range of oil prices which covered the sustained lower levels seen since 2014 in the years preceding.

  Carbon Tracker conducted a wholesale review of energy scenario assumptions in Lost in Transition and found that the low-carbon transition could be faster-than-expected due to economic shifts in key growth regions such as China and India, and even lower overall energy demand due to lower economic growth, as per the OECD’s latest long-term forecast.

  Considering a broad range of scenarios is a valuable process as part of good risk management – resilience can only be tested by higher impact, lower probability outcomes, rather than minor incremental changes. Having all companies report against at least one standardised 2D scenario is very useful for comparison by investors or financial regulators. Otherwise it is impossible to understand relative exposure against a consistent benchmark.

• What does this mean for energy company strategies today?

  Scenarios are used to justify levels of continued development and production of fossil fuel resources. This is obviously counter-intuitive given the structural decline of seaborne thermal coal demand, but even as these signs emerged, US coal producers cited a growing export market as a reason to continue with business as usual. After a few years of decreasing annual capital expenditure (CAPEX) during the oil price crash of 2014-15, most major oil and gas companies now forecast annual increases in CAPEX. It is said this is required to fill the ‘supply gap’ left by: i) increasing demand for oil; and ii) natural decline rates of currently producing wells/fields.

  Carbon Tracker has released a number of reports that question the level of demand projected by oil and gas majors in published energy outlooks. Currently, however, only ExxonMobil publicly disclose its ‘business case’ scenario in such energy outlooks. This means that for the rest, one cannot be certain of the demand expectations companies are presenting to investors.

• Why are investors paying attention to this?

  These issues are fundamental to the future of energy businesses. The uncertainty around demand for products and the (in)consistency across supply and demand sectors is becoming more obvious for those managing portfolios. For two reasons: i) they have seen negative performance in the past; and ii) the stars are aligning for the low-carbon economy. The low-carbon transition is underway and has already claimed some casualties. Most prominent examples are those of value destruction in the US coal sector and the EU utilities . The coal sector in the US was brought to its knees between 2008-13 due to a combination of the emergence of cheap shale gas, increasingly competitive renewables and ever growing environmental regulations. As almost all US coal producers went bankrupt, investors lost money. Fast forward to today, the narrative around US coal prospects has changed, but very little has improved on the ground – production is still rock-bottom and company valuations remain low. In the EU utilities sector in the same time period, the largest 5 power generators lost over 100 billion euros in value due to higher than expected penetration of renewables.

  If these previous examples of under-estimating the low-carbon transition woke up a number of investors, recent developments have certainly got them fully engaged. Climate policy has never been in a stronger position with the Paris Agreement and similar regional efforts, while renewables continue to fall in cost and emerging technologies such as energy storage and EVs are progressing faster than expected. In response to these developments, investors are launching climate/carbon shareholder resolutions to fossil fuel companies, asking for greater integration of these risks into governance and corporate strategies. The 62% support received at the 2017 Exxon AGM for a climate change disclosure resolution demonstrates that the majority of major shareholders back this effort, and have integrated it into their governance approach.

• How are financial regulators responding to this issue?

  Climate change is firmly on the agenda of many financial regulators around the world. The efforts so far can broadly be categorised to either be an assessment of financial stability risk from climate change or recommendations to improve disclosure of climate risk information to investors.

  The international Financial Stability Board (FSB) launched a Task Force on Climate-related Financial Disclosures (TCFD) to allow markets to better assess, The final version of this was presented in July 2017 at the G20 meeting in Bonn. FSB Chairman Mark Carney stated that investors face ‘huge’ climate change losses and that lower demand could leave some fossil fuel assets ‘stranded’.

  Various national banks have also published initial reports, including the Dutch National Bank , Bank of Finland , Bank of England and the French Treasury . With regards to enhanced transparency, a lot of support has focused on the need for scenario analyses to manage future climate risk, as declared by the Hong Kong SFC and Australian PRA.