Horizon | Edition 8

The oil and gas sector is on notice. Stakeholders are demanding greater accountability for carbon emissions along the value chain. Net zero Scope 1 and 2 emissions by 2050 are now the industry standard. Scope 3 emission reductions are coming – with significant implications for corporate strategies and capital allocation. The pressure is rising from stakeholders in large part because the pressure is rising for stakeholders. Investors and lenders are under increasing pressure to decarbonise their own portfolios. This is nothing new, but the momentum is inexorable, driven by the underlying facts of climate change. The sobering 9 August Intergovernmental Panel on Climate Change report only adds to the sense of urgency. Signatories to the Net Zero Asset Managers initiative, for instance, have quadrupled this year and now account for half of global assets under management, while members of the new Net Zero Banking Alliance already account for a quarter of global banking assets. Carbon-related investment criteria and policies are still inconsistent and unevenly applied. However, standards will mature and converge – perhaps soon. The pool of investors that will agnostically invest in the oil and gas sector, indifferent to the energy transition, will continue to shrink. And ahead of the United Nations Climate Change Conference (COP26) later this year, governments are setting increasingly ambitious national emission reduction targets. Stricter, mandatory corporate climate reporting will follow. It’s incredibly rare for an industry to get decades-long notice that its business is under threat. Firms cannot ignore the inevitable; the only strategic dilemma is timing and pace. Not only has the oil and gas industry been afforded the luxury of a warning, but it has received it when a wall of cash is coming its way. Now is the time to reinvest cash flows from higher oil prices into building a sustainable business for future decades.

HORIZONS

CO₂mmit and CO₂llaborate:

Squaring the carbon circle for oil and gas

August 2021

Erik Mielke SVP Global Head of Corporate Research Tom Ellacott Senior Vice President, Corporate Research David Clark Vice President, Corporate Research Greig Aitken Director, Corporate Research Zoe Sutherland Principal Analyst, Corporate Research

Contents

Squaring the carbon circle for oil and gas The Scope 3 divestment dilemma Commit Collaborate Carpe diem Commit, collaborate, succeed

1. 2. 3. 4. 5. 6.

Erik Mielke

SVP Global Head of Corporate Research

Erik manages our corporate service, leading data-driven analysis and insight into companies’ strategies, performance and outlook. While upstream oil and gas is his primary focus, he also leads growing corporate research into additional sectors and commodities. Erik brings 25 years of energy industry research and corporate management experience to his role. Prior to joining Wood Mackenzie, he was VP Business Development and Commercial at Buried Hill Energy. He was also previously a managing director at Bank of America Merrill Lynch, leading emerging markets energy and US oil and gas research, and a research fellow with Belfer Center’s Energy Technology Innovation Policy research group.

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The Scope 3 divestment dilemma

It’s not just about capital markets, however. There is also growing pressure from other stakeholders, from customers to environmental groups. And the ‘mandate’ on Scope 3 value-chain emissions has started to shift from long- to medium-term reduction targets. A recent court verdict in the Netherlands placed a “significant best-efforts obligation” on Shell to reduce its absolute Scope 3 emissions by 45% from 2019 levels by the end of the decade. Though Shell is appealing the ruling, the Dutch verdict may yet be a harbinger of things to come for other companies in other jurisdictions. The only plausible way for an individual firm to comply with a 45% reduction in Scope 3 emissions by 2030 is massive divestment. But disposals will only result in a reshuffling of asset ownership and have little true impact on net emissions. Divestment may have other negative consequences, too, such as:

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Commit

Forced divestiture is not the answer to Scope 3 reductions, but the penalties for doing nothing could be severe. Financial institutions will demand a reduction in Scope 3 emissions intensity over time. Carbon free-certified oil and liquified natural gas could also be a significant and rapidly growing part of the global supply mix by 2030, potentially freezing out ‘dirty’ oil and gas from key markets. Oil and gas firms can’t solve the Scope 3 emissions problem alone. They will need to engage with governments on policy and with customers to decarbonise supply and shift demand. Investing in more aggressive Scope 1 and 2 emission reductions today will also help with Scope 3 reductions tomorrow. There are several ways to manage Scope 3 risk. Intensity can be reduced by increasing the denominator (renewables, for example) or reducing the numerator (shrinking hydrocarbon output, shifting the production mix to gas, carbon as a business).

Source: Wood Mackenzie Emissions Benchmarking Tool and Corporate Service for 38 of the world’s largest IOCs

Conclusion: commit, collaborate, succeed

Despite growing decarbonisation pressure from stakeholders, the market has continued to apply a premium rating to companies with strategies focused on oil and gas. As the climate-related risk ratchets up, this is simply not sustainable. Financial institutions’ understanding of climate risk is evolving rapidly and risk-adjusted valuations of oil and gas companies will evolve with it. The day of reckoning is approaching. Stakeholders need to recognise the dilemma facing oil and gas companies. Rapid and large-scale divestment to reduce Scope 3 emissions is counterproductive folly. Scope 3 reductions are fundamentally a shared responsibility between suppliers, governments and consumers. For the industry to defend that position, however, it needs to produce a credible alternative. Companies have started to take many of the right steps. They should now double down on their commitments and collaborate to find carbon solutions. This oil-price upcycle presents a golden opportunity to accelerate targets, with a clear financial framework. A disunited, dismissive industry runs the risk of an accelerated wind-down and derating long before oil and gas demand disappears. A committed and collaborative response, in contrast, could transform IOCs into a credible part of the solution.

Most public companies have already announced some targets for Scope 1 and 2 direct and indirect emissions, but they need to be more ambitious. Decarbonisation timetables should be pulled forward, with industry leaders setting the pace. Companies should establish a strategic plan that includes a robust pipeline of material decarbonisation projects. The elimination of flaring and methane leakage are essential steps, along with the comprehensive electrification of field operations. Targeting net zero Scope 1 and 2 emissions by 2050 is now the industry standard. Is there a reason, though, that net zero couldn’t be achieved by 2035? Or by 2030? Some companies have ventured down this path, but are using carbon offsets to achieve more ambitious goals. Relying on voluntary offsets as the primary means of getting to net zero raises numerous questions, both quantitative and qualitative (additionality, baseline, permanence and verification). But at least these companies have shown they understand the need to get ahead of the investor and customer curve. And so they should. The stakes are high. Wood Mackenzie estimates its international oil company (IOC) peer group to have US$465 billion of value at risk from Scope 1 and 2 emissions, alone, under a US$150/tonne carbon price scenario – equivalent to 27% of their current value.

Value at risk (Scope 1 and 2) under different carbon price scenarios

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Squaring the carbon circle for oil and gas

Develop a realistic Scope 3 reduction strategy

Collaborate

Collaboration is the de-risking linchpin. So much of what needs to be done is industry- or economy-wide, so many sector initiatives would benefit from scale. Successful decarbonisation would help the whole industry and preserve greater asset value. The good news is that most of the global industry has a long history of cooperating on key issues and engaging on policy. Indeed, companies are already actively involved in numerous coordinated energy transition initiatives (such as CCUS and hydrogen hubs). Many of these new efforts don’t get the broader recognition they deserve, perhaps reflecting the credibility mountain the industry has yet to climb. The Oil & Gas Climate Initiative (OGCI), a CEO-led consortium of 12 of the largest oil and gas companies aimed at accelerating the industry’s response to climate change, could play a role here. Its membership list and Paris alignment tick all the right boxes, but its actions have yet to match its ambition and its collective targets for emission reductions are underwhelming. The urgency of meeting rapidly evolving stakeholder objectives requires more extensive, timely and creative collaboration. Companies need to lay the groundwork as quickly as possible for decades-long industrial cooperation and constructive engagement with governments.

August 2021

Squaring the carbon circle for oil and gas

The oil and gas sector is on notice. Stakeholders are demanding greater accountability when it comes to reducing carbon emissions along the value chain. Net zero Scope 1 and 2 emissions by 2050 are now the industry standard. Scope 3 emission reductions are coming – with significant implications for corporate strategies and capital allocation. The pressure is rising from stakeholders in large part because the pressure is rising for stakeholders to decarbonise their own portfolios. This is nothing new, but the momentum is inexorable, driven by the underlying facts of climate change. Signatories to the Net Zero Asset Managers initiative, for instance, now account for almost half of global assets under management, while members of the new Net Zero Banking Alliance already account for a quarter of global banking assets in 27 countries. Carbon-related investment criteria and policies are still inconsistent and unevenly applied. However, standards will mature and converge – perhaps soon. The pool of investors that will agnostically invest in the oil and gas sector status quo will continue to shrink. And ahead of the United Nations Climate Change Conference (COP26) later this year, governments are setting increasingly ambitious national emission reduction targets. Stricter, mandatory corporate climate reporting will follow. It’s incredibly rare for an industry to get decades-long notice that its business is under threat. Firms cannot ignore the inevitable; the only strategic dilemma here pertains to time and pace. Not only has the oil and gas industry been afforded that luxury of a warning, but it has received it when a wall of cash is about to come its way. Now is the time to reinvest cash flows from higher oil prices into building a sustainable business for future decades.

• • •

a transfer of ownership to operators less susceptible to stakeholder pressure to engage in emission mitigation measures increased investment under new ownership that would extend the life of carbon-intensive fields greater concentration of resources in the hands of national oil companies (NOCs), raising supply and price risk.

In short, rapid and large-scale corporate divestment is not the solution to the world’s decarbonisation challenges. Many stakeholders, particularly financial institutions, recognise the undesirable distortion and would prefer a more sustainable path.

Scope 1 Direct emissions from activities

Flaring Fuel combustion Company owned vehicles

Scope 2 Indirect emissions

Purchased and consumed electricity, heat & steam

Scope 3 'All other' indirect emissions and combustion of oil and gas products. By far the biggest source of emissions

Combustion of oil & gas (main source) Emissions from marketed products Business travel

Defining Scope 1, 2 and 3 emissions

Note: CH₄ = methane; N₂O = nitrous oxide; HFCs = hydrofluorocarbons; PFCs = perfluorocarbons; SF₆ = sulphur hexafluoride; NF₃ = nitrogen trifluoride Source: Wood Mackenzie Corporate New Energy Series Carbon Primer

Emissions (in order of magnitude) CO₂, CH₄, N₂0, HFCs, PFCs, SF₆, NF₃

Only CO₂, CH₄, and N₂0 are reported by companies

There are two key components to any viable strategy for oil and gas companies: (1) commit to faster decarbonisation and (2) collaborate across the industry, with government and with other stakeholders to deliver innovative solutions that spur more rapid decarbonisation in line with the aims of the Paris Agreement.

Step up Scope 1 and 2 emission reductions

Decarbonise – core oil and gas paired with the decarbonisation of operations and carbon removal. This maintains leverage to oil and gas prices while reducing carbon risk Diversify – diversify into new energy while continuing to invest in upstream, paired with decarbonisation Divest – diversify into new energy while shrinking the oil and gas portfolio. Extract value by monetising upstream assets in the upcycle

1. 2. 3.

Decarbonisation focuses on preserving the value of the existing portfolio. It should be the minimum response for all firms. For many NOCs and the long tail of specialist E&Ps and refiners, it may be the only path. Diversification and divestment seek to open doors to new riches in the rapidly growing low-carbon energy sector. Which model companies choose will depend largely on two factors: shareholders and natural resource endowment. European pension funds have different priorities to US retail investors, for instance. NOCs act as custodians of national wealth. One size does not fit all.

Low-carbon differentiation

The potentially huge opportunity in hard-to-decarbonise sectors underpins the long-term sustainability of the decarbonisation route. Oil and gas companies will need to bring carbon capture, utilisation and storage (CCUS) into the mainstream to protect their legacy product and drive the development of a ‘carbon-as-a-service’ profit centre to de-risk this business model. Fast-tracking commercial scale-up will require regulatory support and collaboration across industries. Even in bullish scenarios, however, CCUS cannot materially reduce oil and gas industry Scope 3 emissions by 2030. Similarly, low-carbon hydrogen production, including blue hydrogen from natural gas with CCUS, offers enormous long-term low-carbon potential, but it will take time and capital to build the necessary scale and reduce costs. In contrast, wind and solar are happening at scale now, with huge growth potential. Building a portfolio this decade – either through diversification or divestment – will help reduce Scope 3 emissions intensity. Upstream electrification is another entry point into renewables, reducing Scope 1 and 2 emissions while creating long-term optionality. Varied strategic pathways for the energy transition should deliver more orderly decarbonisation. Differentiation will limit ‘crowding out’ and the risk of overheating in renewables, the primary commercial, low-carbon growth market today. It will also enable distinct strategies and technological positions to play out. Strategic differentiation also gives investors choice. Over time, they will come together on a common set of objectives for the sector to manage carbon exposure. As winning business models emerge, corporate strategies may also converge.

Getting the collaborative essentials right

When it comes to coordination, there are four near-term imperatives: Apples to apples Industry credibility depends on the standardisation of emissions measurement and reporting. Right now, it is almost impossible to compare self-reported company metrics and there is far too much scope for firms to report in a flattering light. This is basic stuff, but getting it right is essential for investors, lenders and companies to properly gauge risk, assess performance and set targets. The challenge echoes the reserves classification issue of the early 2000s. The industry had a serious metric-related credibility crisis, engaged with regulators to solve it and eventually re-established its standing. It wasn’t pretty or quick, but it worked. Build a big tent IOCs need to team up with other oil and gas companies and adjacent industries to support the development of emissions-reducing technology and its implementation at scale. Regional consortia to address industrial CCUS and hydrogen are good examples, with several proposals already under consideration. One emerging collaborative model is Canada’s oil sands, where industry members have a long history of cooperating with both federal and provincial government for industry-wide benefit. In 2021, this spirit of cooperation yielded the Pathways to Net Zero Alliance, a collaborative CCUS effort between the top five oil-sands companies, accounting for 90% of production, to support their collective 2050 net-zero ambitions. Carrots, sticks and carbon pricing Proactive engagement with governments to create supportive regulatory and policy frameworks will be vital to scaling up investment in technologies such as CCUS and green and blue hydrogen. Larger players will have to take the lead, communicating the incentives needed to make nascent technologies sufficiently economic for investment. It remains to be seen whether national emissions reduction ambitions can translate into industry and corporate targets through collaboration. Comprehensive carbon pricing in key jurisdictions, especially in the United States, is the most obvious answer to such challenges, but the politics are difficult. Many companies officially support a price on carbon. But that needs to be converted into clear proposals and government-industry engagement, otherwise it is just window-dressing. COP26 could be the catalyst for momentum on this front. Wash away the ‘greenwash’ Carbon offsets are a key element in achieving decarbonisation targets. The low credibility of underlying offsets at present, however, casts a ‘green-washing’ pall over the entire market. IOCs should help develop and support current initiatives leading up to COP26 to establish a credible, liquid, global offset market that accurately reflects the cost of carbon abatement. Offsets should not be a substitute for hard work to decarbonise operations and products, but they can help bridge technological gaps.

Oil & gas companies must expand their collaboration across a wide range of energy transition issues

Source: Wood Mackenzie

Carpe diem

Current prices are leading to record free cash flow, so companies should seize the moment. A sustained oil-price upcycle presents a golden opportunity for the sector to ‘do it all’ – return cash to shareholders, fortify balance sheets and accelerate corporate transformation. Many oil and gas companies willingly accept hedging costs in order to de-risk near-term cash flows. It’s time to start hedging longer-term carbon risk with rising low-carbon investment. To build credibility, companies should lay out a financial framework for their energy transition. It should cover capital allocation between dividends, financing and investment in the legacy oil and gas businesses and low-carbon businesses. Some companies have already started doing this to some degree; we think most will follow. Frameworks will vary by company, circumstances and Scope 3 business model, but they should all have one thing in common: a quantified, credible, material and rising capital allocation to decarbonisation and low-carbon solutions. Qualifying low-carbon solutions would include investments in new low-carbon assets or technology that help decarbonise existing assets.

Carpe diem: the oil-price windfall

The trillion-dollar opportunity

15% of their 2021 investment budget to renewables (US$15 billion, split evenly between mergers and acquisitions and organic capital expenditure). That’s a start, but clearly too little to move the needle – and other IOCs are barely scratching the surface on decarbonisation spending. Our universe of 45 IOCs will generate a US$1 trillion cash windfall if current prices are sustained to 2030. Allocating 30% of operating cash flow to shareholder distributions would boost collective 2020 distributions by more than 80%. That would still leave room to expand capital budgets by one-third relative to current planning and our base case. Upstream budgets will creep up. The big question is by how much, and whether gas will be prioritised to boost upstream sustainability and help reduce Scope 3 emission intensity. If the ‘windfall’ capex is channelled 2:1 into low-carbon spending versus oil and gas, the IOCs could have US$660 billion of decarbonisation investment firepower this decade, a near threefold increase. This level of investment would fund more than 10% of global low-carbon energy investment by 2030, compared with less than 2% today. A commitment of this magnitude could be transformative.

Capital allocation framework* (2021-30) for IOC universe if low-carbon investment is prioritised

*Assumes 30% of ‘windfall’ cash flow is distributed to shareholders, 10% to deleveraging and 60% to investments. Source: Wood Mackenzie Corporate Benchmarking Tool

Conclusion: denial is futile

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David Clark

Vice President, Corporate Research

David is a Vice President on the corporate research team. His focus is on large- and mid-cap US independent E&Ps, providing in depth data-driven analysis and strategic corporate insight. He has played a key role in developing corporate service product offerings, including the expansion of corporate financial data. He is based in New York City. David joined Wood Mackenzie in 2020 after a 17-year career as a sell-side research analyst, most recently as a Managing Director at Mizuho Securities USA. Prior to that he worked as an analyst at Wolfe Research and Deutsche Bank, where he began his career and worked until 2014. Over the course of his energy research career he has focused on the global integrateds, US E&Ps, Canadian oil companies, US independent refiners and the oil market.

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Zoe Sutherland

Principal Analyst, Corporate Research

Zoë is a principal analyst with our Corporate Research team, who brings more than 15 years of industry experience to her role. She initially joined Wood Mackenzie in 2001 as an upstream analyst, where she contributed to the set-up and launch of the North American Frontier service. Since then, she has worked in our Gulf of Mexico Deepwater and Russian Upstream research teams, building a detailed knowledge of the sector across these regions, before joining the Corporate team in 2010.

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Tom Ellacott

Senior Vice President, Corporate Research

Tom has worked at Wood Mackenzie for more than 20 years. As senior vice president of our corporate research team, he guides the development of our corporate analysis and thought-leadership pieces. Having started his career as an upstream analyst, Tom has worked in our Southeast Asia and North Sea teams, where he developed a deep understanding of the challenges unique to those areas. He then played a leading role in founding the corporate team and managing the development and launch of its products and offering. More recently he has led the corporate research team which spans the Corporate Service, M&A Service and the Corporate Benchmarking Tool. Tom is now exclusively focused on corporate research. During his time on the team, he has led the analysis of over 40 companies in the Corporate Service, including all the Majors, leading Independents and the main Asian national oil companies. Tom is often sought out for his insights into the evolving E&P market, frequently presenting at conferences and industry events. As the focus shifts to renewables, Tom strives to continue to develop our corporate research offering and explore new areas.

will also help with Scope 3 reductions tomorrow

Investing in more aggressive Scope 1 and 2 emission reductions today

It’s incredibly rare for an industry to get

decades-long notice that its business is under threat.

The only plausible way for an individual firm to

is massive divestment

comply with a 45% reduction in Scope 3 emissions by 2030

Collaboration is the de-risking linchpin

vital to scaling up investment in technologies...

with rising low-carbon investment.

It’s time to start hedging longer-term carbon risk

Proactive engagement with governments to create supportive regulatory and policy frameworks will be

Join the debate. Get in touch with Greig

Greig Aitken

Director, Corporate Research

With 15 years of relevant experience, Greig brings a holistic view of corporate activity to the corporate research team. Greig heads up the upstream M&A Service, which harnesses the power of Wood Mackenzie's global asset research to provide an unparalleled independent view on mergers and acquisitions. Greig's responsibilities include overseeing and supporting individual deal evaluations, and analysing industry trends on themes such as valuations, corporate strategies and value creation. Greig is also the lead corporate analyst covering Italian Major Eni and runs point on the Corporate New Energies Series (CNES). CNES profiles and models Big Oil’s strategies and ambitions in new energies, as well as benchmarking these companies across core decarbonisation themes including offshore wind, solar, CCUS and hydrogen. Greig joined Wood Mackenzie in 2012 as analyst in the M&A Service. Prior to this, Greig was a sell-side equities analyst in Brewin Dolphin’s award-winning institutional broking business (now N+1 Singer). He was Extel-rated in both the Technology and Oil & Gas sectors, and was the #1 ranked stock picker in the energy sector (FT / Starmine Analyst Awards, UK & Ireland). Greig spent the early part of his career as a software developer in the pensions and life assurance industry. Greig's views on M&A and corporate strategies are regularly sought by the media and he is a frequent presenter at forums and conferences.

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Greig Aitken

Director, Corporate Research

Missed our previous editions of Horizons? Download them here.

Edition 7 | July

Edition 6 | June

Edition 5 | May

with industry leaders setting the pace.

Decarbonisation timetables should be pulled forward