Carbon Tracker Initiative

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www.carbontracker.org Carbon Tracker submission to the Norwegian Ministry of Finance’s public hearing on investments in coal and petroleum companies Effective engagement leading to redirected capital expenditure

Overall Recommendations:

 The current troubles of the fossil fuel sectors should serve as a stark warning for investors to effectively build resilience to future changes in market conditions.  With approximately NOK300 billion invested in fossil fuel companies, the GPFG is in a powerful position to effectively engage with the fossil fuel industry about the risks of investing capital into future high-cost, high-carbon projects.  In parallel, a strict exclusions policy should be implemented to identify those who fail to respond to the concerns of the GPFG and remain the worst offenders on criteria of contribution to climate change and capital discipline.  The GPFG should develop indicators which demonstrate how it is driving investment to be compatible with a carbon budget which avoids dangerous levels of climate change.

Introduction

Carbon Tracker welcomes the opportunity to submit to the Ministry of Finance on the Norwegian Government Pension Fund Global’s (GPFG) investments in coal and petroleum companies. As a major global investment institution, the GPFG has significant exposure to these sectors. Carbon Tracker’s research forms part of a growing body of work highlighting the future financial risks associated with fossil fuel assets. Consequently, Carbon Tracker recommend the GPFG begins to manage their holdings in fossil fuel companies in light of stranded asset risk by developing an effective engagement framework in tandem with an exclusions policy that can remove the most high-risk, high-carbon holdings from their portfolio.

Energy transition risks and opportunities

Carbon Tracker has been a front-runner in developing the concept of ‘stranded assets’ in the fossil fuel sector. We define a stranded asset as part of a company that will lose or destroy shareholder value, in response to changing market conditions. For example, the current low coal and oil prices are a perfect example the vulnerability of the value of investments into fossil fuel companies to market changes.

In debating the energy transition, we see plenty of signs that the direction of travel is towards a more carbon constrained world – due to policy developments (not all of which are labelled carbon) and technological advances. These risks and factors are no easier to predict than the commodity prices themselves. This is why we believe investors have to understand a range of scenarios, not just the industry’s business as usual approach. Challenging the fundamental assumptions of supply and demand is one way of understanding the implications of emissions staying within a carbon budget which can reduce the dangerous impacts of climate change. Carbon Tracker Initiative

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www.carbontracker.org Capital flows need adjusting

Carbon Tracker’s analysis has shown that average returns on upstream oil projects have fallen from 21% to 12% between 2008 and 2013; similarly the Bloomberg Coal Index of 32 publicly-listed coal miners has lost half of its value over the past three years. Across the world, coal and oil and gas companies are cutting dividends, reducing capital expenditure, defaulting on debt repayments and even going bankrupt.

Simultaneously, investment in clean energy technologies has continued apace and renewable energy supply costs have plummeted, helping low-carbon indices outperform those that include fossil fuel equities over the short-term. The recent announcement from E.ON that it would split its business into separate renewables and fossil fuel power divisions is a wake-up call that the old energy sector business models need to be challenged because the future outlook looks no less risky.

For instance, Carbon Tracker’s research has shown that in the oil sector, $1.1 trillion could be spent on future projects up to 2025 that require an oil price of at least $95 per barrel to deliver a minimum return including contingencies. Going out to 2050 means this figure increases to $21 trillion. Goldman Sachs and Wood Mackenzie have come to similar conclusions in their analyses of future capital expenditures. In the coal sector, $112 billion could be invested in future projects to 2035 requiring $75 a tonne to break-even. Prices in both sectors are currently well below these risk thresholds, highlighting the trouble companies, and their investors, will run in to if they maintain these investment strategies.

The management of fossil fuel companies are not maximising shareholder value

The excesses of recent years in the oil sector have been exposed by a live stress test applied through a drop in the oil price during the second half of 2014. This rebalancing of the oil market shows that the increasing cost base of the oil sector has been supported by historically high prices, and the sums indicated for capital expenditure and dividends are no longer covered by revenue projections. Despite previous oil price shocks, the sector continues to be surprised by big movements. We believe that, as demand continues to underperform due to policy and technology improvements, there will be increasing volatility in fossil fuel pricing.

It is clear that the management of the oil sector cannot be relied upon to exercise sufficient capital discipline to align with a low demand, low carbon scenario. GPFG therefore needs to have effective means of applying influence or reducing exposure to capital being wasted on high cost, high carbon assets. There is a need to distinguish between the oil majors who have a portfolio of projects along the cost curve, and smaller specialists who are mainly betting on high cost options.

The coal sector is already considered to be experiencing structural decline in some markets, especially the seaborne trade most listed companies are exposed to. Here is further evidence that most companies did not accept the negative trends for their business model. And it is key to recognise that it is the fundamentals of the business model that are at stake here. This is not just about good housekeeping or green initiatives – it is how resilient the corporate strategy is to a low price / low demand / low carbon scenario.

Here again there is differentiation between diversified mining companies who can focus on other commodities and pure coal producers who have limited alternatives. As indicated by the expert panel, there have already been cases where the coal companies’ business models are so poor that Carbon Tracker Initiative

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www.carbontracker.org they are no longer an attractive holding for the fund. This demonstrates that the financial argument for having active management is already hitting home. As a universal long term investor, we would recommend the GPFG considers how it can ensure it is ahead of this curve through more stringent requirements for the fossil fuel sector.

This does not need to be a negative story. If more cash is returned to shareholders, rather than spent on projects with poor or zero rates of return, this will provide a transition route for companies and the climate, whilst maintaining investor returns.

Engagement needs to be effective

Carbon Tracker does not believe blanket divestment of fossil fuel stocks is an effective risk management strategy for investors – the world will need fossil fuel even in a 2°C future after all. Furthermore, we acknowledge selling out of entire sectors is not a viable option for many funds that track indices. Effective engagement therefore, will be central to how best the GPFG can avoid stranded assets. As such, we support the Expert Panel’s finding that ‘active ownership and engagement are appropriate primary tools for the GPFG to use to address climate-related issues’.

However, in light of the scale of stranded asset risk Carbon Tracker has highlighted, this practice must carry sufficient teeth to drive fundamental changes in where capital is spent and the emissions that will ultimately result. Carbon Tracker believes the GPFG needs to implement a new level of active engagement that can demonstrate the following:

• A clear focus on capital discipline in the form of challenges to high cost, high carbon capital expenditure inconsistent with future low demand / low price / low carbon scenarios;

• A review of the business models of fossil fuel-based corporations to assess financial resilience to low demand / low price / low carbon scenarios;

• A commitment to creating a portfolio that drives decarbonisation rather than follows it once the market eventually responds;

• Actions to change the financial frameworks of financial regulators and ratings agencies to redirect capital away from activities based on excess carbon emissions; and

• Effective sanction mechanisms for companies which fail to respond within a reasonable timeframe, including ultimately selling out of companies that fail to take concrete steps.

Strict exclusions criteria must identify those who fail to engage and respond

An effective engagement strategy does not guarantee that companies in which GPFG have holdings adapt and align their project portfolios to lower demand, carbon constrained scenarios. Alternative options are required for such an eventuality. Carbon Tracker believe this should come in the form of effective sanction mechanisms for companies which fail to respond within a reasonable timeframe including a strict exclusions policy. As the Expert Panel reported, using both exclusion and active ownership in combination ‘can be larger than the sum of their parts’.

It is clear GPFG have identified the poor performance of the fossil fuel sector, and the coal sector in particular, by selling out of 14 coal companies last year based on the likelihood that their business model was no longer sustainable. The GPFG also sold out of 5 oil sands companies last year. These Carbon Tracker Initiative

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www.carbontracker.org totals seem small, however, in light of the 9,000 companies in the GPFG’s portfolio in spite of the extent of stranded asset risk as shown by Carbon Tracker, thus suggesting this exclusion policy needs to be tighter.

Currently, GPFG’s current criteria states a company qualifies for exclusion “if there is an unacceptable risk that the company contributes to, or is itself responsible for”, among other things, “severe environmental damage” or “other particularly serious violations of fundamental ethical norms.” Carbon Tracker believe it is imperative the GPFG’s exclusions policy is expanded to also consider the direct causal relationship between the business models of fossil fuel corporations and carbon dioxide emissions, i.e. by introducing strict standards along this supply chain.

Capex and carbon indicators

With this in mind, we support the Expert Panel in their recommendation that the most extreme companies should be excluded based on their ‘contribution to climate change’ criterion that identifies company contributions that are ‘severely harmful to the climate’. Our carbon supply cost curve analysis shows that high cost production is clearly in excess of the world’s requirements to prevent dangerous levels of climate change. GPFG therefore needs a policy which can restrict exposure to the upper end of the cost curve, through engagement or exclusion. Given the global approach of the fund, this can act as a proxy to align the fund with a lower carbon future. The policy may also distinguish between different types of fossil fuel and further sub-categories. Coal has the greatest contribution of the fossil fuels in terms of carbon emissions and is easily substitutable. In oil many of the highest cost options are also high carbon due to the nature of the reserves (eg bitumen in the Canadian oil sands). The highest cost options also relate to the physical frontiers of production (e.g. deep water and Arctic). Beyond the climate argument, these activities also raise flags with regard to physical environmental impacts.

Carbon Tracker recommend that in addition to an indicator of contribution to climate change from fossil fuel companies, a criterion identifying those companies heavily focusing on future fossil fuel projects that are very capital-intensive, such as LNG, is also included as a reason for possible exclusion. This would apply pressure on companies to implement greater discipline with shareholder capital and allow the GPFG retain greater flexibility to future changes in market conditions. The fund should also consider producing capex and carbon indicators to demonstrate to stakeholders how its investment strategy is aligned with a carbon constrained world.

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For further information on Carbon Tracker’s submission and wider research on stranded assets and at risk capital expenditures, contact:

James Leaton, Research Director

Email: [email protected]

Tel: +44 20 3700 0977