Initiative No Rhyme or Reason arbon Tracker Unreasonable projections in a world confronting climate change Carbon Tracker Initiative, July 2016 About Carbon Tracker The Carbon Tracker Initiative is a team of financial specialists making climate risk real in today’s financial markets. Our research to date on unburnable carbon and stranded assets has started a new debate on how to align the financial system with the energy transition to a low carbon future. This report was authored by: Rob Schuwerk and Luke Sussams. Acknowledgements This report draws heavily on internal memoranda prepared and commissioned by John Wunderlin on behalf of Carbon Tracker. The authors would also like to acknowledge the contributions of James Leaton, Mark Fulton, Tom Drew and Stefano Ambrogi for review and edits; Margherita Gagliardi for the design. Disclaimer Carbon Tracker is a non-profit company set-up to produce new thinking on climate risk. 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Contents Executive Summary 5 Introduction 8 Part I: The Regulatory Landscape: The existing SEC regime for forward-looking disclosure and its shortcomings 14 Part II: Carbon Budgets 22 Part III: The US coal crash, revisited 31 Part IV: EIA’s Energy Model 38 Part V: Coal Company Disclosures in Context 50 Part VI: Conclusions 62 4 | www.carbontracker.org Executive Summary EIA Reference Case is not a forecast This paper discusses why the EIA Reference Case is not an appropriate basis for coal sector financial planning and strategy, The EIA produces its Annual Energy Outlook (AEO) to provide and reviews how it has been utilized in industry SEC filings. With a range of scenarios, from one reflecting existing policies (the the 2016 Reference Case now reflecting the Clean Power Plan, Reference Case) to one that assumes economic conditions we ask whether the Paris emissions constraints will prove to be which drive accelerated coal plant retirements (Accelerated Coal the correct lead indicator? Retirements). The EIA is very clear that these are projections reflecting certain factors, NOT predictions or forecasts. Known trends The Reference Case is by definition a scenario in which no announced or new policies are enacted, existing policies with Companies must analyze “known trends, events, demands, sunset provisions do become ineffective, and technology commitments and uncertainties that are reasonably likely evolves at a steady pace. This is therefore a high case for coal to have a material effect on financial condition or operating demand, and there is every likelihood of a downside from this performance.” We would argue that increasing measures to demand level. Indeed, actual results over the past several years limit emissions from power generation, and the reducing costs have departed dramatically from Reference Case projections. of alternative power generation technologies are known trends. EIA modelling of emissions reduction targets more accurate The direction of travel of both these vectors is clear. On occasion, the EIA has built projections based on specific policy proposals, including the American Power Act and Two-part test for disclosure the American Clean Energy & Security Act. These models The SEC requires issuers to apply a two-part test to determine employed emissions constraints consistent with the laws’ whether trends and uncertainties must be disclosed. First, targets (which, in turn, were largely consistent with Obama’s it must determine whether the uncertainty is “reasonably Copenhagen pledges). These projections have proven far more likely” to occur. Second, if the uncertainty cannot affirmatively accurate over the past five years than those that assumed no be deemed “unlikely,” the corporation must then determine constraints even though the laws were never enacted. This whether the uncertainty would have a material effect on the strongly suggests that policy and technology are following in registrant’s financial condition, assuming it occurred. We would the wake of the overall emissions reductions targets and that argue that since 2010, a scenario of increased policy measures those targets should be a leading indicator to be considered by on pollution, lower costs of renewables and lower natural gas issuers in providing forward-looking information. That said, coal prices was not unlikely and would have a material impact on companies have consistently emphasized the Reference Case. The Heart of the Matter | 5 the financial condition of US coal producers. Indeed with the Buying spree benefit of hindsight, it is clear that such a scenario came to A number of US coal mining companies undertook acquisitions pass and has had a material impact on the value and financial during the last peak of the market in 2011, taking on significant performance of US coal mining companies. Much of this decline debt in order to do so. This business strategy was predicated has been captured in EIA projections that incorporated climate on demand continuing to increase, and a strong market for targets. coal products. This misread of demand, and the failure of management to acknowledge that the reality was deviating Forward projections materially from its chosen projections saw an industry in denial. The SEC encourages the disclosure of “management’s The implications, however, were clear from sources, such as the projections of future economic performance that have a EIA, that were being cited in corporate reports. reasonable basis and are presented in an appropriate format.” It is also expected that the assumptions underlying these Too late projections should be transparent. This calls into question The 2015 10Ks1 filed in 2016 started to bring in references whether presenting a scenario where nothing changes as the to some of this information – but by this time it was too late most likely forecast to inform investors is reasonable. If it is not as many of the companies were already filing for bankruptcy made clear that this scenario also goes against the direction of protection. Arch Coal included a wider range of IEA and EIA travel indicated by government policy and market trends, then scenarios. Peabody has acknowledged examining the impact of this failure to disclose assumptions is significant. A business a range of policies that might impact coal and found that the strategy for a growth market with rising prices is very different financial impact could be material. However, in Peabody’s view, to one that is shrinking with falling prices. such analyses were too fraught with assumptions and therefore could not reasonably quantify potential future impact. All Range of scenarios scenarios contain assumptions to address future uncertainties, When selecting projections of future financial performance, including those that assume nothing changes. In the context of management is also advised it “should take care to assure that risk disclosures, the fact that there is uncertainty strengthens the choice of items projected is not susceptible to misleading the case for using assumptions that convey the extent of the inferences through selective projection of only favourable risk. items.” This would suggest that presenting a range of scenarios, rather than just the one that justified a BAU strategy would be an appropriate approach to disclosure. Reviews of the accuracy of previous projections would also inform whether an informative basis for the projections is being used. 1 A Form 10-K is an annual report required by the U.S. Securities and Exchange Commission (SEC), that gives a comprehensive summary of a company’s financial performance. 6 | www.carbontracker.org Dealing with uncertainty While companies often expressed uncertainty 1800.0 in forecasting the impact of climate policy, they readily provided third-party scenario 1600.0 information suggesting decades of continued demand for US coal—even though those 1400.0 projections discounted the aforementioned policy uncertainties to zero. From the 1200.0 point of view of a company managing risk, this seems a flawed approach; if an impact 1000.0 cannot be predicted precisely, it should not be assumed there is no impact at all. A more 800.0 reasonable approach would be to conduct a sensitivity analysis of a range of impacts 600.0 to demonstrate resilience under a number of scenarios. This does not require the 400.0 probability of the outcome to be determined.