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Atmospheric pressure

Pressure on oil and gas firms to comply with climate-change legislation is growing and the ability to respond may soon mark the difference between success and failure. Kirsty Hamilton reports

SCRUTINY FROM investors into long-term risks associated with climate change has risen to unprecedented levels. The European carbon-emissions trading market will open for business in 2005 and a series of lawsuits related to climate change has started to emerge in the US. Individually these trends may not ring alarm bells, but their cumulative effect is almost certain to produce material impacts in the short term, forcing climate change squarely onto the business agenda of oil and gas firms.

On 1 November, institutional investors with assets of over $9 trillion under management wrote to the largest listed oil and gas majors in a survey of the climate strategies of the FT Global 500 companies.

The aim was to improve our understanding of possible material impacts on investment value driven by climate change. Taxation and regulation, technological innovation, shifts in consumer attitude and demand, and changes in weather patterns are seen as primary factors driving changes in value.

This is the second investor survey under the Carbon Disclosure Project. Its 2002 survey highlighted differences between oil and gas majors, including the greenhouse gas (GHG) intensity of operations and the sizeable spreads in the costs of cutting emissions—from under 0.5% to over 2% of annual cashflow for a 10% cut in GHG emissions from 2001 levels, at $20 per tonne of carbon dioxide (CO2).

An unconnected November research publication by ABN Amro says climate change is the biggest environmental challenge faced by business, describing it as a key long-term investment theme, posing significant risks and opportunities for companies and markets. These are direct impacts from changes to the physical environment and indirect impacts from changes in regulation, consumer and investor pressures.

A shift from oil

Ed Westlake, senior pan-European oil analyst at ABN Amro, points out that climate change will slow the growth of oil demand with a faster rate of growth in gas. A strong gas portfolio is already becoming a differential reason to choose one company over another in terms of investment. There is also a shift from coal to gas in the power sector.

Investment in renewables may emerge as a differential between companies in the future. Another factor is brand—reputation and innovation will be important for addressing consumer and regulatory pressures.

Among the most significant public-policy and regulatory interventions are the Kyoto Protocol, and the European Union's (EU) Emissions Trading Scheme (ETS). Both establish binding constraints on emissions and raise costs associated with fossil fuels.

The 1997 Kyoto Protocol, an offshoot of the 1992 Framework Convention on Climate Change, is the key intergovernmental climate-change agreement, setting binding differentiated targets on industrialised countries. The looming first deadline, 2008-2012, is focusing increased policy attention on the issue, particularly in Europe and Japan, which is considering a carbon tax. The protocol also defines rules for the Kyoto mechanisms that allow three types of emissions-reduction credit to be traded between countries, creating new commodity markets in carbon.

Despite the US withdrawal from the protocol (it remains in the overarching convention), Kyoto compliance will change the regulatory environment around the US over the next decade. And US multinationals still face compliance requirements for operations in the industrial (over 30) or developing countries (nearly 90) that have ratified the treaty.

(Russian ratification is required for the protocol to meet entry-into-force requirements, now that the US has withdrawn. Baker&McKenzie, the international law firm, advises this may not occur until late 2004.)

Regional caps

However, public policy is tightening in the US—the Senate voted by only a tight margin against the bi-partisan McCain-Lieberman Climate Stewardship Act in October, which would have set a mandatory cap on industry emissions. There has also been a swathe of regulatory action at state level on CO2 or renewables, including a 10-state initiative to develop a regional cap and trade system for power plant emissions and requirements to supply renewable energy in at least 13 states.

In 2005, international talks must start formally on the post-2012 second commitment period—a second round of governmental agreements on emissions reductions. This will probably involve incipient commitments of some nature from developing countries and will inevitably tighten emissions constraints on the industrialised world.

The ETS, a central plank of EU/Kyoto compliance, will start in 2005 and covers large sources of CO2 emissions, including power generation and oil refining. National governments will define the emissions cap and allocation plan for emissions permits.

Installations must then hold enough permits or face a Euro40/t ($47/t) of CO2 non-compliance payment in the initial three-year period, rising to Euro100/t between 2008 and 2012. The ETS is mandatory, whatever the status of Kyoto ratification.

Chris Mottershead, an adviser to BP, says ETS is the most significant piece of climate legislation so far and claims it fundamentally changes the position of whoever deals with climate change within a company—putting a value on carbon transforms it into a financial issue. In early November, carbon was trading at around Euro11-12/t of CO2.

Financial impact

ETS will have a financial impact on a barrel of oil, but whether it makes it cheaper or more expensive will only become clear as governments work out their allocation plans—the method used to distribute the first round of emissions permits—says Garth Edward, Shell's international trading manager for environmental products.

The deadline for allocation plans is March 2004.
Oil companies will be directly affected at the refining end in two main areas, emissions from refineries and emissions from on-site generation of electricity, and indirectly from fuel-switching towards gas. Many balance-sheet questions are outstanding, including how assets and liabilities will appear and what the tax implications are.

The most fundamental implication of ETS, says Mottershead, is that it is finally hitting home that climate change is at the heart of the business and it is clear there are limitations on the consumption of oil. BP, he says, is the first oil firm to support the need to stabilise atmospheric concentrations of carbon.

As costs rise for carbon-intensive fuel provision, the sustainable-energy technology sector is booming. Wind energy alone has achieved a 22% global average annual growth in 1990-2001, and 38% in the EU. And, since 1980, there has been a four-fold fall in costs.

Ambitious targets, such as the UK's aim of cutting global CO2 emissions by 60% by 2050, can be successful only if sustainable energy is given a much larger role. And signs of the investor interest that will be required are starting to emerge, encouraged by policy aims and improvements in technology.

However, the greatest unknown is the climate itself. Successive rounds of serious climate-related disasters, particularly in the Western world, could significantly change public tolerance of climate risks and increase pressure on governments for a rapid, far stronger response.

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