Industry Trend Analysis - 2?C Transition Series: Environmental Risk To Drive Up Cost Of Capital - OCT 2017

BMI View : O&G companies face a rising cost of capital as debt and equity markets progressively price-in environmental risk facto rs. However, cost increases will be incremental and will vary widely across companies in the sector.

In our 2degC Transition (2CT) Series we explore the risks and opportunities arising in the global oil and gas sector in light of the continued push towards a low-carbon economy and to limit climate change to two degrees.

The 2degC transition (2CT) poses significant risks to the oil and gas (O&G) sector. Unless companies can divorce their revenue growth from emissions growth, a low-carbon economy will erode their profitability and degrade their balance sheets. However, these impacts will be slow to accrue, playing out over a multi-decade horizon. They will also be highly uneven, depending on how different companies adapt their asset base and business model. A shorter term impact may be felt in a rising cost of capital, as debt and equity investors price-in the longer-term trends. This would add to financial pressures, in a sector heavily reliant on external financing.

Revenues, Emissions Remain In Lock Step
Oil Majors* Cumulative GHG Scope One Emissions, '000mt, & Revenues, USDmn
*ExxonMobil, Royal Dutch Shell, BP, Chevron. Excludes Total due to lack of data availability. Source: Bloomberg, BMI

Stranded Assets Pose Little Risk

On the equity side, increased attention is being paid to the implications for O&G company valuations. Central to this is the discussion around stranded assets - the risk that discovered resources will not be produced in a 2degC economy. If assets are not monetised, the net present value (NPV) of the resource base will fall, in theory reducing the value of the company. In practice, we believe these concerns are overblown.

On the one hand, the link between NPVs and company valuation is by no means clear. Regressing equity price performance onto asset PVs across a basket of around 40 of the largest listed companies over the past 10 years, we found no statistically significant relation between the two. Asset value is subject to a range of other factors, not least commodity prices, services costs, tax regimes and project execution. Reflecting some of these uncertainties, a study by Morgan Stanley found that the oil majors typically trade at significant discounts to the NPV of their proved and probable reserves, typically in the range of 20.0-30.0%.

More importantly, for most companies their reserves life is comparatively short. Based on a basket of 55 of the largest companies for which data is available, the weighted average reserves life is 12.2yrs. Furthermore, only 30.0% of these reserves were undeveloped at the start of 2017. A large chunk of global hydrocarbons must remain below the ground, if we are to transition to the 2degC economy. However, O&G reserves are unlikely to become stranded to any significant degree within the next 10 years. As such, the impact of the 2CT on asset valuations will largely depend on how companies shift their resource base - from oil, to gas and alternative energies - over the coming investment cycle.

Current Reserves At Little Risk
Global Oil & Gas Companies* Reserves To Production Ratio & % Reserves Developed
*based on a basket of the 55 largest companies for which data was available; weighted on reserves. Source: Bloomberg, BMI

Carbon Discounts A Dawning Reality

Despite the limited threat to existing reserves or production, it is probable that some form of 'carbon discount' will begin to be applied at the company level over the coming years. This would amount to a risk premium on carbon-intensive equities, reflecting continued green policy evolution and the associated shift in investment mandates. In developed markets (DMs), the greening of investments is already a major trend and is likely to gain traction, as more focus is given to the role of capital allocation in driving forward a low-carbon economy. This is playing out most visibly through the growing inclusion of environmental, social and governance (ESG) metrics, alongside traditional investment analyses.

Majors Turning Focus On ESG
Oil Majors* Average ESG Disclosure Score
* ExxonMobil, Royal Dutch Shell, Total, BP & Chevron. Score out of 100; higher score = higher disclosure. Source: Bloomberg, BMI

Again, though, the issue is somewhat clouded. Gauging an appropriate risk factor (or, in the case of assets, discount rate) will depend on both the view of the 2degC economy and of the company's place within it. On a global level, there is considerable uncertainty around how the 2CT will unfold and what emissions targets are achievable over what timeframe. Carbon budgeting at the sector or company-specific level brings added complexity, as does attempts to quantify the resulting transition risks. Nevertheless, increasing data availability and efforts to standardise analytical approaches to the impacts of the 2CT should help investors to better approximate a carbon discount moving forward.

Lending Conditions To Remain Broadly Favourable

In debt capital markets the main focus has surrounded green bonds. The green bond market is growing rapidly: based on Bloomberg data, corporate issuance rose by more than 100.0%, globally, in 2016. This has led to speculation that the greening of capital may ultimately drive more carbon-intensive borrowers to the fringes of the market. For O&G companies this would imply less favourable lending conditions and, in particular, higher interest rates.

From a multi-decade perspective, this view seems valid. However, green bonds account for less than 1.0% of the corporate bond universe by both volume and value and green capital is unlikely to take any dominant share of the market in the coming years. Other factors pose greater risks to bond yields in the O&G sector, such as the subdued commodity price outlook for 2018 or the continued rate-hiking cycle in the US.

Issuance Booming
Corporate Green Bond Issuance By Sector, USDmn
Source: Bloomberg, BMI

There are signs that green financing is becoming more attractive. We have compiled a basket of 123 green bonds and an equal-size basket of non-green bonds, matched for their credit ratings, maturity profiles, sectors, currencies and basic bond features. Across 2015 and 2016, coupon rates were consistently higher for the green basket on a weighted average basis. However, the spread has been trending downwards and over H117, the weighted average coupon for green bonds was lower by 0.3%. This likely reflects the surge in demand for this type of bond, which has outstripped supply. Importantly, though, it does reflect a higher cost of capital for O&G or other carbon-intensive companies.

Spreads Trending From Red To Green
Corporate Bonds* Weighted Average Coupon By Issue Date & Green - Non-Green Coupon Spread
* based on a basket of 123 green bonds and 123 comparable non-green bonds, matched for credit rating, maturity, currency and basic bond features. Spread = premium of green bond coupons over non-green bonds. Source: BMI, Bloomberg

As with equity markets, cost of debt capital will rise more markedly once longer-term exposure to climate change can be accurately captured. Again, this will be an incremental and uneven process. Companies that can identify their exposures (and the investment metrics by which these will be measured) and can adapt their asset base, operations and financial reporting accordingly will face, in our view, relatively minimal risks.