The piece originally was posted to LGIM Future World Blog on February 26, 2020.  It is reprinted with permission.

Companies facing structural disruption to their business models generally have two choices. The first is to diversify. Diversification into other new businesses is always a tempting option for management teams. But it is, in our view, rarely successful.

The second is sticking to their knitting and adapting to the new reality of a declining end market. Think of the companies that made fax machines: they could have tried embracing the internet and struggled against the technology pioneers unencumbered by increasingly obsolete core businesses, or they could have doubled down on fax machines to consolidate that market and returned growing amounts of capital to their investors – a strategy of ‘managed decline’.

Is oil well?

We often get asked by clients and the public if we, as a large investor, are pushing oil and gas companies to invest more in renewables. Our answer is: ‘Not as much as you might think’. This is not because we are in any way complacent about the scale of the climate challenge. We’ve warned publicly that planning for ever-growing oil demand may hurt the industry’s profits sooner than expected, as the costs of clean tech fall and the costs of emitting carbon rise.

Capital discipline remains key, as oil and gas companies will have to maintain a balancing act between those areas where their expertise and skills can add value in the low-carbon economy (e.g. hydrogen, biofuels, etc.), and those areas where it is investors who are best placed to allocate capital to green solutions.

So what do we want? And aren’t we really just calling for business as usual? Far from it. First, companies must recognise that oil and gas production must eventually decline, if the world is to meet its climate goals. Yes, this might take place over decades, and might even be compatible with some new investments (e.g. in existing, but depleting, fields) – but climate concerns need to be incorporated into planning now. Companies need to show that they are rigorous in allocating money towards the lowest-cost, lowest-carbon production compatible with a shrinking carbon budget.

Second, the direct emissions from oil and gas production must decline to zero – not eventually, but rapidly. Putting the two together, saying “we only supply a product, it is our consumers who burn it” is no longer acceptable evidence of downside risk management – and actively lobbying against climate policies even less so. Indeed, we are starting to see companies increasing their ambition. Recently, oil major BP announced that it will become a ‘net zero’ company by 2050.

BP plans to:

• have net zero emissions across operations;
• ‘reduce and neutralise the carbon in the oil and gas we dig out of the ground’; and
• halve the emissions intensity of all sold energy (not all of which comes from BP’s own production).

To meet these goals, BP has suggested that it will:

1. gradually reduce its oil and gas extraction (with the remaining emissions to be reduced by switching to lower-carbon products, offset or captured);
2. return some of the cash from existing projects back to investors; and
3. gradually ramp up investment in low-carbon ventures.

As the company notes, “If this were to happen to every barrel of oil and gas produced, the emissions problem for our sector would be solved.”

The first point, on the gradual reduction, is the key issue. To focus, as much of the media and activist reaction has, on the third – in particular, how much BP currently invests in renewables – misses the point, in our view.

Tightening the scrutiny

To be sure, there are important details that still need to be answered, and setting an ambitious target is only the first (but very important) step. It is our role as investors to scrutinise the plans of oil and gas companies and to make sure that our views on the relative merits of the three points above align.

Indeed, as described in this blog, the need for ongoing details – particularly around new capex decisions – was what prompted LGIM to co-file a successful shareholder proposal at BP last year, and we look forward to supporting the company in taking further positive steps. Lobbying, too, will remain an area of focus, and we welcome BP’s decision to stop brand-focused advertising, quit three lobbying groups, and redirect this budget towards more positive lobbying for net zero policies.

In sum, for the oil sector to ‘go green’ it must first and foremost align its production with gradually declining demand, and set ambitious – absolute – net zero targets for its own emissions. There may well be individual companies that are successfully placed to build new low-carbon businesses: the move into renewables by Ørsted, formerly known as Danish Oil and Natural Gas, is one oft-cited example; Reliance Industries’ shift into telecoms is another.

Overall, though, the oil and gas sector is too varied (from small shale explorers to state-owned giants) and the business models too different (high-return mega-projects versus lower-return power retail) for investors to expect or desire its wholesale reinvention.

To go green, oil and gas companies should think seriously about going ex-growth.

 

This article is intended for an investment professional audience.