Improving Transparency Of Climate-related Risks In The Upstream Oil And Gas Sector

Authored By: Kate Woolerton & Rob Schuwerk | Publish Date: May 10, 2019

A recent report by the Network for Greening the Financial System, a coalition of 34 central banks and experts working on climate risk, estimated potential climate-related financial losses to the energy sector alone of between $1 trillion to $4 trillion. Moreover, Bank of England chief Mark Carney last month reiterated his stranded assets warning, saying that $20 trillion of assets globally could become worthless if climate change and the burning of fossil fuels was not properly addressed.

Corporate reporting and disclosure aim to bring transparency to current and future investors of the material risks that a company faces. Climate-related risks are clearly material to the upstream oil and gas sector, and warrant disclosure.

Carbon Tracker research has shown that it is future resources and reserves that have not yet been developed into producing assets that are at greatest risk of stranding in a 2°C world. However, current accounting and disclosure practices offer investors little visibility over this.

Given that climate-related financial risks will likely emerge in the long-term while financial statements are largely backwards-looking, climate-related risks will often ‘escape’ the financial statements. Therefore, broader financial reporting, i.e. reporting outside of the financial statements themselves, plays an important role in communicating these risks to investors; this reporting is generally more forward-looking in nature, and provides investors with broader context for the financial statements.

Carbon Tracker has therefore designed a model disclosure, for inclusion in the front half of an annual report, for the upstream oil and gas sector. The disclosure will give investors transparency over the long-term climate-related risks that the sector faces.

Transparency over future capital expenditure plans and project sanctioning criteria is critical

A fossil fuel company’s ability to generate future net cash inflows is largely dependent on its ability to continue to find new economically recoverable hydrocarbon resources and develop these into producing assets; a process which requires ongoing capital expenditure. The economic viability of projects depends on future commodity prices. When management sets the company’s strategy, it makes assumptions about expected oil and gas prices and demand.

Not all exploration activity results in the discovery of resources that are commercially viable; from a climate-perspective, it is the resource discoveries that are deemed commercially viable, and hence are most likely to be developed into producing reserves, that are important.

As such, the focus of the disclosure is largely on the exploration activities of the entity and the decision-making process employed by management when approving reserves and resources for development.

The focus of the disclosure has been determined by reference to the Society of Petroleum Engineers (SPE) Petroleum Resource Management System (PRMS) classification framework.

Figure 1: Reserves and Resources Classification Framework.
Figure 1: Reserves and Resources Classification Framework
Source: SPE, 2007 (adapted by Carbon Tracker)

Table 1: Reserve and resource classification definitions and description of treatment within the model disclosure

Definition (source: SPE, 2007) Treatment within the MODEL disclosure
Proved reserves can be estimated with reasonable certainty to be commercially recoverable from known reservoirs and under defined economic conditions, operating methods, and government regulations. They can be developed or undeveloped. Proved developed reserves require relatively small amounts of ongoing capital expenditure. From a climate-perspective, Carbon Tracker research has shown that these reserves are generally needed, even in a climate constrained world, and have a low risk of stranding. However, they are exposed to impairment risk if commodity prices are lower than expected.

Proved undeveloped reserves require significant future capital expenditure to develop them into producing assets. They are exposed to stranding and impairment risks since it is unlikely that, once developed, all proved undeveloped reserves held on company balance sheets will be needed in a climate-constrained world.

The disclosure focuses on development capital expenditure and the decision-making process associated with proved undeveloped reserves.

Probable reserves are less likely to be recovered than proved reserves but more certain to be recovered than possible reserves. Probable and possible reserves may become proved reserves in the future. Significant capital expenditure has already been incurred at the exploration phase and significant further capital expenditure is required in order to confirm commercial viability and develop into producing reserves. They are at risk of stranding and therefore expenditure already incurred and expected future capital expenditure, as well as the assumptions that underpin these decisions are included within the disclosure.
Possible reserves are less likely to be recoverable than probable reserves.
Contingent resources are potentially recoverable from known accumulations, but the applied project(s) are not yet considered mature enough for commercial development due to one or more contingencies. Carbon Tracker research has shown that, to the extent that contingent resources are approved for development into producing reserves, they are at risk of becoming stranded in the future since they may not be capable of being burned in a climate-constrained world.

The disclosure focuses on the expected capital expenditure on exploration and development of these resources, the underlying assumptions that these plans are based on, and the impact of changes in these assumptions.

Prospective resources are potentially recoverable from undiscovered accumulations by application of future development projects. They have both an associated chance of discovery and a chance of development. These are longer term resources where very little, if any, capital will have been invested to date. Due to the lack of capital investment and the high degree of uncertainty associated with these resources, the disclosure does not focus on these.

We have identified the following disclosures as being critical in allowing investors to fully understand the company’s potential exposure to climate-risk:

  • Expected future capital expenditure on exploration and development activities – A forward-looking measure that allows investors to assess the degree to which a company is continuing with a business-as-usual strategy, i.e. continuing to grow its reserve and resource base, which may result in stranded assets.
  • Transparency over the material assumptions that underpin a company’s upstream strategy – This allows investors to understand whether the company has taken possible future climate-constraints into consideration when setting their upstream capital expenditure strategy, in particular their expected expenditure on exploration and the key assumptions applied when sanctioning a project for development into a producing asset. For instance, investors may be interested to understand whether the company is assuming ever increasing demand and commodity prices.
  • Sensitivity analysis – This allows investors to assess the possible impact on the company strategy and financial position of oil and gas prices being lower than expected – it can help them to assess the potential value at risk.
  • Project economics – This helps investors to understand the resilience of the company to the low-carbon transition. If they have lower cost assets (i.e. a lower breakeven point) then they might be expected to be more resilient.

The model disclosure aims to be realistic

We believe that the information contained within the disclosure is readily available to the management of upstream oil and gas companies and, despite uncertainties, is already an input to management decision-making.

As with any disclosure, comparability between entities is essential and the goal is for all companies to provide this information in their annual reports. This will allow investors to compare the resilience of one company versus another to the transition to a low-carbon economy and factor this into their investment decision making.

Whilst this disclosure was specifically designed for a company operating in the upstream oil and gas sector, it could be adapted for use by companies operating in other extractive industries, such as coal mining.

Kate Woolerton is senior accountant for Carbon Tracker’s regulatory team.
Robert Schuwerk is the executive director of Carbon Tracker North America


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