How capital markets will drive the decarbonisation of oil and gas

Are oil and gas companies doing enough to tackle climate change? It’s a question we’ll address at our Global Energy Summit next week. The answer is almost certainly no, despite the earnest intentions of many companies.

COP26 in November is expected to intensify the pressure on governments and, by extension, companies to reduce emissions. The industry will need a plan if it’s to persuade stakeholders, including investors, of its sustainability. Tom Ellacott and Greig Aitken of our Corporate Analysis team talked me through their latest thinking of how things play out.

First, the industry has made progress since the Paris Agreement. Many IOCs and NOCs have set net zero targets and we’re seeing strategies start to adapt for the transition. Just this week, The Oil and Gas Climate Initiative, a group of 12 leading IOCs and NOCs that produce 30% of the world’s oil and gas, committed to accelerating Scope 1 and 2 emissions reductions from operations under their control. Yet only a handful of IOCs, mainly Majors, have presented a clear vision of how they intend to get to net zero.

We argued in our August Horizons that the industry needs to commit and collaborate. Commit is about doing more and doing it faster. That means more ambition for Scope 1 and 2 emissions, accelerating the trajectory for net zero by 2050 and building a robust pipeline of decarbonisation projects. Collaborate – with other companies, other industries and governments – because it’s essential if technologies like carbon capture and storage and green hydrogen are to be delivered at scale.

Scope 3 emissions are the elephant in the room. Oil and gas companies can’t reduce Scope 3 on their own. The industry has to engage with governments on policy, and with customers to shift consumption to low-carbon energy.

Commit and collaborate identified three strategies for Scope 3. Decarbonise, maintaining the focus on oil and gas, but establishing carbon as a business (CCUS, carbon offsets) to support oil and gas cash flow and compensate for its eventual decline – the route US Majors are pursuing. Diversify into new energy while continuing to invest in upstream, paired with decarbonisation. And divest – diversifying into new energy and shrinking the oil and gas portfolio. This is the low-carbon path of the Euro Majors, although they have different takes on how quickly they should move away from the legacy business.

Divesting though, doesn’t solve the problem but shifts it elsewhere. Shell’s US$9.5 billion Permian sale this week cuts its exposure to Scope 1, 2 and 3 emissions. ConocoPhillips, the buyer, increases its emissions exposure but reduces its portfolio carbon intensity and breakeven costs. There will be more such deals in the coming years as Big Oil rationalises, though as the world moves more rapidly to net zero the pool of buyers will dwindle.

Second, there’s an urgent need to codify net zero targets. Today, it’s extremely challenging to compare self-reported company emissions metrics and there is too much scope to report in a flattering light. The entire industry’s credibility depends on standardised emissions measurement and reporting – comparing apples with apples. Without that, investors, lenders and companies can’t properly gauge risk, assess performance and set targets.

Stakeholders, under growing pressure themselves to decarbonise their portfolios, are engaging with the industry to write the rule book. The IIGCC (Institutional Investors Group on Climate Change) has just published the Net Zero Standard for Oil and Gas (NZSOG), a framework of actions based on uniform metrics it argues oil and gas companies must adopt to get to net zero. NZSOG will enable stakeholders to compare company strategies and allocate capital accordingly.

But the IIGCC’s framework goes much further than our Commit and Collaborate thesis. It requires companies to set net zero ambitions through the entire oil and gas value chain including Scope 3, short-, medium- and long-term net zero targets aligned to a 1.5 °C pathway, a decarbonisation strategy with a commitment to ‘green revenues’, alignment of capital allocation with the net zero targets and improved, standardised disclosure. The framework also suggests executive pay should be linked to climate targets.

BP, Eni, Occidental, Repsol, Royal Dutch Shell and TotalEnergies support the NZSOG and will lead a pilot programme. These are among the most ambitious IOCs on targeting net zero, but few, if any, meet the IIGCC’s standard yet.

The IIGCC comprises mainly European-based institutional investors, though all will invest in equities globally. The pilot group, Occidental aside, are European-domiciled. But it’s not, in our view, an exercise in preaching to the converted. NZSOG has been developed in consultation with Climate Action 100+, a group of 617 global investors with more than US$55 trillion under management.

We expect the IIGCC’s NZSOG will prove to be an important step towards an industry-wide global framework and set of common metrics. It will help, not hinder, companies to explain their strategy for sustainability to stakeholders. As more companies, investors and lenders buy in, those outside the framework will feel increasingly uncomfortable and run the risk of future shareholder actions to force them to comply.

There is a risk of unintended consequences. The trajectory of oil and gas demand is highly uncertain. Stringent Scope 3 net zero targets risk a premature decline in supply.

Third, there’s big money at stake. Our analysis estimates that 38 of the world’s largest IOCs have US$465 billion, or 27% of current value, at risk just from Scope 1 and 2 emissions under a US$150/tonne carbon price scenario.

On strategy, the jury is out among investors. Our analysis shows the US Majors continue to command a premium rating over the diversifying Euro Majors, though the strong US stock market and dividend cuts muddy the water. It’s too early to say which strategy is winning.

Likewise, it’s difficult to say what influence a new rules-based net zero framework will have on strategy or market ratings. But it will have an effect. It could promote more divergence, pushing decarbonising companies to focus on a time-limited oil and gas business and eschew new profit centres. Or it might accelerate convergence – and the wind-down of the publicly listed oil and gas sector by choking off external capital.

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