Coal and climate change

Polluting relic of the past or a cheap and plentiful source of energy? After the Paris Agreement, what does the future hold for coal? In a 2°C world, the industry may be able to create more shareholder value by agreeing a disciplined reduction in investment, than by pushing for more output.

By Andy Howard, Critical Resource Senior Advisor (former managing director at Goldman Sachs – biography below) and Sebastian Sahla, Associate

Squaring environmental and economic concerns

The future of coal: blowing in the wind?

The Paris Agreement has focused global attention on coal. In December 2015, world leaders agreed to cap global warming at ‘well below’ 2°C above pre-industrial levels. With coal’s carbon footprint nearly twice that of natural gas, burning less coal is seen by many as one of the easiest ways to cut emissions.

At the same time, the coal industry is making the case for it to remain an important and growing part of the global energy mix. Coal can produce usable energy at approximately half the cost of gas or oil. Coal technology is well established, as is the infrastructure to transport raw materials and distribute power. Reserves are relatively abundant (at least twice those of either gas or oil, according to BP Statistical Review data) and well distributed globally.

Particularly for emerging economies, moving away from coal will be costly. Cutting emissions will absorb capital that could otherwise be directed to other, more immediate economic benefits. In India, for example, 8% average economic growth over the last decade has come in tandem with a 5% annual rise in energy use. Coal has been a major part of that story. Without access to low cost energy, India would have struggled to deliver the economic development it has achieved.

However, the equation is changing. The costs of coal fired power have begun to rise everywhere and wind and solar costs are falling. A convergence looks likely over the next five years. In emerging economies, the costs of reducing emissions will be proportionately higher than in developed countries but should drop relatively quickly as clean technologies scale. The International Energy Agency (IEA) estimates that for emissions to fall in line with international targets, emerging economies will need to invest just under $200bn more than they would have otherwise spent. It’s a big number but far from insurmountable, at around a quarter of a percent of global GDP, or roughly 10% of global investment in energy infrastructure. This is the figure that squares development and environmental arguments; global leaders can achieve both if they are willing and able to write that cheque.

Three scenarios for coal’s future

With climate concerns pitted against economic arguments, it will be politicians that determine coal’s future. It is hard to see industry action, investor initiatives or social pressure having too much effect in isolation. The roll call of leaders stepping up to declare long-term emissions targets is growing longer. However, coordinating action across virtually every major economy will be challenging.

Considering the uncertainty that surrounds implementation of the Paris Agreement, we have examined three potential emissions paths. The ‘no change’ path assumes no new policies are introduced to cut emissions. The ‘pre-Paris’ scenario assumes governments meet national policy commitments already in place before Paris. The ‘post-Paris’ outcome implies policy makers actually put global emissions on a path consistent with the 2°C target. Figure 1 provides an overview of how these three scenarios would likely impact global emissions over coming decades.

Figure 1: Emissions paths under three scenarios
Source: Didas Research estimates using data from IEA, OECD, IPCC

CCS: The elephant on the side of the climate debate

With political momentum behind measures to drastically cut emissions, much of coal’s ability to remain part of the post-Paris energy mix will hinge on advances in carbon capture and storage (CCS) technology. In principle, the technology promises to convert dirty coal-fired power into a clean source of energy. However, of the range of clean energy technologies factored into projections, CCS is by far the most immature.

CCS stands as an elephant on the side of the climate debate, promising the energy equivalent of calorie-free chocolate, complicating decision making and slowing the aggressiveness of climate policies. Despite its potential, scaling CCS is likely to be slow. The Global CCS Institute identified 55 large scale CCS projects in its last global review. Those plants have a combined capacity to capture only about 1% of current annual emissions from fossil fuel power generation. Fewer than half are likely to come into operation before the end of this decade.

Despite these challenges, in our scenarios we have assumed that progress on CCS will allow roughly one-third of energy-related emissions to be captured annually by 2050. If that assumption is misplaced, coal faces a much less attractive future. Without CCS, meeting the 2°C target will mean cutting coal’s role in the energy mix by close to 90% – effectively a nail in its coffin. 

The coal industry will have to slow down post-Paris

With the Paris Agreement in place, it is clear that the global energy mix is likely to become less carbon intensive. That change could come very quickly if the right political and economic conditions are in place. As a result, the coal industry should be prepared for a future that is very different to its past, wherever the dust settles.

Figure 2: Share of global energy mix by fuel type, including projections based on pre-Paris targets
Source: IEA, Didas Research estimates

Even if governments only live up to their pre-Paris commitments, the coal industry will have to grow significantly more slowly than it has in the past. Its recent declining fortunes will make that pill easier to swallow. The industry has been under pressure for the last decade. At ~5%, its collective return on assets (operating income relative to assets in coal mining activities) is well below its cost of capital, and the industry has pared its annual capital investment to around 6% of assets in 2014. That stands in contrast to the oil and gas industry, which delivered returns at twice the coal level in 2014 and continued to invest relatively aggressively, with capital investment standing at 17% of assets.

Figure 3: Coal industry profitability and investment in recent years
Source: Thompson Reuters, Bloomberg, Didas Research estimates. Data is calculated at a divisional level for each company, including only divisions directly related to coal mining. ROA is calculated as the sum of segment operating income divided by segment assets for all coal mining focused divisions in the universe analysed. We include only divisions for which both numerator and denominator are disclosed

Slower growth could create value for shareholders

Slower growth can create shareholder value if approached with discipline. There is no consistent relationship between industry growth rates and profitability. Supply-side discipline in contrast is closely linked to profitability. If the coal industry can improve discipline while adapting to slower growth, it may actually become more valuable.

Projections for coal consumption in each scenario are calculated using our own modelling of the energy mix most likely to result from each emissions target, which are close to IEA projections. These projections assume CCS technology is successfully commercialised and use ramps through the forecast period.

Figure 4: Coal production in each scenario
Source: IEA, Didas Research estimates. Projections for coal consumption in each scenario are calculated using our own modelling of the energy mix most likely to result from each emissions target, which are close to IEA projections. These projections assume CCS technology is successfully commercialised and use ramps through the forecast period.

Over the last decade, the industry’s capital investment has averaged 9% of its assets, resulting in growth far quicker than the natural depletion rate of existing assets. We estimate a similar level of investment will be required in the no change scenario, 6-7% of assets in the pre-Paris scenario and 4% in the post-Paris scenario. Already in recent years, the industry’s financial challenges have brought its capex in line with the requirements of pre-Paris targets.

Assuming coal mines last 40 years on average, we have assessed the cash flow the industry would generate in each scenario, if it brought capital investment down to the levels each scenario required.

Perhaps surprisingly, in present value terms, meeting the 2°C target may prove the most attractive of the scenarios for the coal industry. Using a 10% discount rate, that profile is worth $108bn in today’s money, against $95bn or $54bn in the pre-Paris or no change scenarios. By cutting back on capital investment aggressively, free cash flow would improve significantly in the near term, more than offsetting the lower long-term growth that would result. Put another way, if the industry could collectively cut production, the most attractive option would be the one offering the least volume growth.

Figure 5: Profile of net operating cash flows in each scenario
Source: Thompson Reuters, Bloomberg, Didas Research estimates. Projections assume assets deplete at 2.5% pa, capital investment is 9%, 6.5% or 4% of assets in the no change, pre-Paris and post-Paris scenarios respectively, returns on assets remain at the average level of the last decade and tax is applied at 30% to net cash flows

Binding regulations might be a blessing in disguise

Unfortunately many companies will likely continue to plan for more rapid growth, either led by political goals or through a desire to avoid a fading future and outgrow their peers. Those that do so, will add to the overcapacity that has begun to emerge, pushing down returns on assets and depressing profitability for the industry as a whole. High-cost producers would suffer disproportionately but the whole industry would likely lose out; local cost curves are not steep enough to allow large volumes of new low-cost capacity to generate attractive returns by putting higher-cost mines out of business.

For an industry to shrink profitably requires a level of capital discipline that is rare in commodity markets, particularly without regulatory intervention. Taking the principle to its logical conclusion, if the industry could successfully impose fixed production quotas for every miner, discipline would be forced upon an industry that is unlikely to reach it unaided. Perhaps tough binding regulations could be a blessing after all.

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Andy Howard is a Senior Advisor to Critical Resource. He is closely involved in Critical Resource’s ‘The Heat is On’ initiative, which aims to catalyse leadership by fossil fuel companies on climate change.

Andy was previously Managing Director at Goldman Sachs where he led the bank’s GS SUSTAIN research team in London, integrating environmental, social, and governance (ESG) and fundamental and financial analysis. As well as former roles with McKinsey and Deutsche Bank, he has worked for the NGO Global Witness. He is Managing Director of Didas Research.

Read more about Critical Resource’s work on climate change here