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Investors should seek ‘risk premium’ from firms pursuing high-cost projects LONDON/NEW YORK, January...Read More
Andrew Grant, senior oil & gas analyst and author said: “We do not know when or how an Inevitable Policy Response will come, which makes it hard for companies to plan. However, they risk being left with stranded assets if they assume governments will not take forceful action to limit climate change. Preparing in advance and aligning their investment with climate targets will deliver the highest returns for the lowest risk under any outcome."
The cost of failing to anticipate an Inevitable Policy Response to climate change
In this report, we look at the Inevitable Policy Response (IPR), which models the potential impacts of delayed tough policy action by the world’s governments to mitigate climate change, driven by acute societal pressures, extreme weather events and increasingly cost-competitive renewable/low carbon technologies. The IPR has been commissioned by the UN Principles for Responsible Investment (PRI).
The IPR FPS assumes that policy makers act forcefully to contain the climate threat by 2025 – it is similar to the International Energy Agency’s 2.7ºC central Stated Policies Scenario to 2025, but moves towards alignment with the below 2 degree Sustainable Development Scenario (SDS) over 2025-2040.
Earlier policy action makes planning easier, preventing stranding. The SDS assumes early policy action resulting in a relatively smooth transition, implying fairly stable oil prices and predictable valuations. Conversely, the sharp shift resulting from delayed, forced action under the FPS results in a significant and rapid fall in oil prices post-2025. For oil, we model marginal prices as being c.20% lower post-IPR.
Oil projects developed pre-2025 may never generate the value expected at sanction if this policy response is not anticipated. As an illustrative measure, oil assets that enter production in 2019-2025 are modelled as having an aggregate NPV 50% lower if calculated based on a flat oil price from start-up equal to the maximum that results post-IPR, rather than the one we model as prevailing beforehand. Impacts will likely be greatest for projects coming onstream shortly before the IPR. If producers were to plan conservatively in advance of such an outcome this would naturally reduce the impact.
Our estimate of price impact may well be conservative. History suggests that much less severe market shifts have led to much greater falls in price. Further, industry sanction decisions and impairment testing are currently often based on higher price assumptions than we model here. Compared to oil fields considered commercial under Rystad Energy’s base case oil assumption and entering production in 2019-2025, illustratively applying the post-IPR maximum price from start-up results in NPVs that are 95% lower than base case. Many projects fail to deliver a commercial return.
The FPS implies that virtually no new oil fields are needed post-2030. Despite the rate of decline in oil demand being less than the rate of decline in oil field production, high levels of liquids associated with more resilient gas demand fill in the gap.
Some oil companies are far more sensitive to oil prices than others. Higher sensitivity means higher risk which means a higher discount rate should be used in valuations. Put simply, investors demand a higher return from higher risk assets. We provide indicative outcomes for a universe of the largest listed oil and gas producers, showing greatest leverage to demand for oil sands and shale liquids producers.