Transition risk is becoming more real for the world’s largest oil and gas (O&G) companies as they faced increasingly stronger pressure from investors, including their shareholders, to take more near-term action in addressing climate change.
Failure to do so by these companies could mean divestment by existing shareholders resulting in increased transition risk, particularly in the form of "stranded assets". These are physical assets whose investment value cannot be recouped and must be written off.
In the case of Royal Dutch Shell, the reckoning could come as early as 2023 when the Church of England Pension Board (CEPB), a major shareholder, plans to divest its stake in the company if it doesn’t meet its emissions target by that year, according to a statement by CEPB director of ethics Adam Matthews, made during Shell’s annual general meeting (AGM) on May 18.
At Shell’s AGM on May 18 and BP’s on May 13, both oil majors had to fend off separate resolutions presented by FollowThis, a climate activist group representing minority shareholders, who are demanding that the companies set tougher emission standards to address climate change.
The resolutions were the result of a general perception that both companies have effectively hedged putting in place tougher corporate policies to reduce carbon emissions, while claiming otherwise, and continuing to expand their highly pollutive carbon businesses.
In February of last year, BP announced that it had set a target of achieving a net-zero carbon target by 2050, but since then, it has not disclosed any details on how it plans to do this. In February of this year, Shell made a similar pledge while also saying it will continue to grow its gas business by more than 20% in the next few years.
Although both FollowThis resolutions were defeated, the number of shareholders voting in their favour has increased substantially from 8.4% a year earlier to 20.6% in the case of BP and from 14.4% a year earlier to nearly 30% in the case of Shell, indicating that there is growing pressure on the oil firms to take their carbon reduction pledges more seriously.
If anything, the recent BP and Shell AGMs seem to indicate that the O&G majors are still unsure of how to strike a balance between how they will transition to renewable energy while maintaining their still extremely lucrative fossil fuel businesses.
But the longer they postpone transitioning to renewable energy, the greater the risk of their fossil fuel businesses ending up with stranded assets as investors are moving swiftly away from this type of asset to those of renewable energy.
“We believe stranded asset risk will remain in focus as the energy transition moves forward, with a particular lens on more carbon-intensive fossil fuels, though the timeframe is still unclear,” says Nick Moller, head of global infrastructure investments group at J.P. Morgan Asset Management. “Valuations are a further risk for investors.”
The fact that investor interest in green infrastructure has increased and significantly boosted the stock prices for certain publicly listed infrastructure assets may also add to the risk of stranded assets for the O&G industry.
In terms of infrastructure, one thing that may work for the O&G majors is the fact that the supply of green or renewable investments has not grown as quickly as investor demand. However, given the increasingly strong investor appetite for green infrastructure, these companies may not have a lot of time to transition from their traditional carbon-based assets to renewable energy ones without the risk of ending up with stranded assets.
“Given the length of new development cycles, which could impact forward-looking returns, managing essential infrastructure in a sustainable way, with a focus on governance, is critical for risk-adjusted returns,” Moller notes.
It is not only O&G majors that are at risk of ending up with stranded assets. Even the oil-producing countries of the Middle East, also known as Gulf Cooperation Council (GCC) countries, are facing transition risk linked to a worldwide shift to renewable energy, which will impact their credit ratings.
As demand for fossil fuel declines, major exporters will face a loss of GDP, government revenue, and export receipts in the absence of offsetting trends, such as economic diversification, according to a Fitch Ratings report. “The creditworthiness of major fossil-fuel-producing sovereigns that can diversify their economies away from hydrocarbons will be less affected by stranded assets,” it states. “Many, such as those in the GCC, already have diversification plans and still have time to make changes.”