Big cuts to output could make fossil fuels producers “more profitable”

Companies that cut output of oil, gas and coal could deliver better returns than those pursuing growth, says a new report

A huge cut in fossil fuels output as recommended by climate scientists might actually make producers more profitable than the traditional model of“drill-drill-drill”, a strategy that has saddled hydrocarbon companies with a string of high-cost, loss-making assets in an era of weak prices

So says a report by London-based Carbon Tracker, which has blazed a trail in communicating the risks of carbon-intensive investments to boardrooms and governments at a time when governments are required to deliver on what they promised in last year’s landmark Paris Agreement.

Among banks and pension funds there is a growing acceptance that many reserves of coal, oil and gas may need to “stay in the ground” for economic as well as environmental reasons. But few have so far made a public stand by refusing to fund oil projects.

Communicating the view that the exploitation of new fossil fuels reserves is inherently risky has evolved into a new front in the battle to convince financial institutions to back lower carbon alternatives to the fuels blamed most for causing climate change.

The report is pitched mainly at institutional investors, but has relevance to a general audience as many people who have company pensions are indirect investors in fossil fuel producers.

The report, which was authored jointly with the Local Authority Pension Fund Forum, compared the fortunes of two hypothetical companies that exploit fossil fuels reserves in different ways.

A company that cuts back output in line with emissions reductions required to meet the 2C warming threshold outlined in the Paris Agreement, would be relying on lower cost projects in an era of tight carbon constraints, low demand and low prices. They would still be making profits, and this “managed decline” approach would be more economical than companies that continue risky expansion of reserves and production.

Increased output, or failure to cut output from currently high levels, would increase the economic risks for companies and their shareholders as carbon-cutting policies, and a shift from combustion engines to battery-powered electric vehicles, eat further into demand.

“Many industries have had to make such a transition in the past. Some, such as the tobacco industry, did so more successfully than others, such as coal. The winners tended to be those that had proactive rather than reactive business models,” the Carbon Tracker report said.

Companies following the “growth” path by exploiting new reserves (many of which would be high cost) are more greatly exposed to convulsions in global oil prices (the global market has been particularly volatile in the past two years). In a low price environment, high cost projects, such as deep-water rigs and tar sands-related projects, quickly become uneconomical.

The report poses some questions to shareholders and investors in fossil fuel production, such as the extent to which companies have planned for a further fall in commodities prices; the carbon content of the project portfolio (such as the share of tar sands and liquefied natural gas, both of which are highly carbon-intensive and expensive to build and operate); and the capital costs of their projects.

A partial recovery in oil prices from 12-year lows seen earlier this year, and doubts that a shift to electric motoring is happening anywhere fast enough in Europe, may dissuade some major producers from heeding warnings of a structural decline.

But with the world continuing to experience its hottest months on record, chronic urban pollution from vehicles, a “global stocktake” of countries’ carbon emissions coming in 2018, and forecasts of long term weakness in prices, the fossil fuel sector may have its hand forced sooner than it might care to admit.