The energy transition requires reduced use of oil, gas and coal…

If the world is going to be successful in its aim of avoiding the worst effects of climate change, demand and supply of all three of the fossil fuels – each of oil, gas and coal – will need to slow, plateau and then fall in absolute terms as soon as possible. For fossil fuel companies to navigate the energy transition will require them to focus exclusively on extracting value from a smaller opportunity set rather than expansion for its own sake. Recent commodity price volatility has already pointed investor demands in this direction.

… yet fossil fuel executives are rewarded for increasing output

Despite this, the vast majority of oil and gas companies incentivise their executives to pursue continued growth. Some incentive metrics are obvious, for example targets relating to production or reserve replacement, which have been shown to have a poor or negative historic correlation with shareholder returns. We believe these metrics incentivise potentially value-destroying behaviour given uncertainty over future demand.

Most companies also include other growth metrics which are more subtle, and incorporate other factors, for example metrics relating to earnings or cash flow. While these do include an element of value, they still incentivise production growth – for example, the easiest way to boost earnings might be to increase leverage and acquire more assets. These metrics should be considered in light of the rest of the company’s remuneration structure, and alternatives considered.

• In 2017, 92% of oil and gas companies in our universe included measures that directly incentivise growth in fossil fuel development, relating to either production, reserves,
  or both.
• Companies with the highest weightings on production and reserves/resources growth include Anadarko, Cabot Oil & Gas, CNRL and Oil Search.
• We highlight Diamondback Energy as the only company to have no growth metrics in its incentive structure for 2018, with its executives incentivised entirely on returns and cost metrics. Equinor is next closest, with only a minor inclusion of cash flow from operations.
• In the 2 years following the 2014 oil market crash, US Exploration & Production companies with a lower proportion of reserves or production incentive in their annual bonuses outperformed more growth-oriented companies by 7% CAGR (although the gap has subsequently closed). Shareholder returns exhibited a negative correlation with production and reserves-related annual bonus metrics, but a positive correlation with financial returns metrics.
• Shareholder pressure to focus on value has had an effect – 10 companies (26% of those giving full disclosure) introduced or increased emphasis on returns measures in 2018 over 2017. For example, BP removed a reserves replacement metric from its long term incentive plan and introduced return on capital employed.
• 9 companies have performance metrics that relate in some way to mitigating climate change. This includes half of the European companies reviewed, such as Equinor and Shell, but only one US company out of 20 (ExxonMobil, relating to its algae, CCS and methane reduction initiatives). However, where they are included, these metrics tend to affect a small minority of compensation, and most of these companies simultaneously encourage fossil fuel growth.

Remuneration should incentivise good management without requiring continued growth

From a value perspective, metrics that are growth neutral are preferable in our view – particularly in the context of uncertain future demand. Financial metrics should promote a focus on returns or value, for example return on capital employed. Returns metrics have a positive correlation with shareholder value (see later). Non-financial metrics such as safety are also clearly relevant.

We commend the handful of companies that have included metrics relating directly to climate change, but note the somewhat perverse situation that they are often still accompanied by incentives to increase fossil fuel production and/or reserves/resources. Shareholders have the ability to influence corporate pay structures and have done so successfully in recent years, with a notable shift in the direction from growth to value. However, there is a lot more improvement to be made.