Intensifying concerns around climate change have fuelled ever-increasing pressures on companies and countries to be even more ambitious. In this context, a growing number of oil and gas companies have sought to respond to investor and stakeholder demands – and strategically prepare for the low-carbon energy transition – including through aligning with the recommendations of the Taskforce on Climate-related Financial Disclosure (TCFD). However, as global climate action accelerates in 2021 – potentially reaching a new peak around COP26 in November – the expectations on oil and gas companies are anticipated to increase even further. In this article, we explore several areas where companies may encounter increased pressures and how they might consider responding in order to stay ahead of the curve.
The ongoing global climate emergency is receiving an unrelenting level of global attention. Despite fears that the Covid-19 pandemic would stall international climate action, efforts by governments, civil society and other stakeholders to tackle climate change have intensified in the past year. These developments, together with changing market dynamics, have entrenched the realisation among many oil and gas companies and their shareholders that the transition to a lower-carbon future will have significant financial impacts on their business.
Numerous regulatory and other initiatives are underway to further strengthen how companies address climate-change related risks, as well as how they report on their progress in a transparent and consistent manner. These include multiple processes at the EU-level – such as the EU climate change taxonomy, the proposed Sustainable Finance Disclosure Regulation (SFDR), and proposals around a non-financial disclosures directive – re-invigorated efforts by the Biden administration, as well as progressive regulatory and strategic frameworks proposed in many major Asian economies. The intense pressure on national governments to raise their respective climate ambitions and agree on a global way forward at the COP26 summit in November could also stimulate the emergence of new regulations on a national or international level, potentially requiring companies to commit to more ambitious goals in order to maintain their license to operate.
Of these various initiatives and tools, the Taskforce on Climate-related Financial Disclosures (TCFD) remains one of the most impactful. The TCFD helps companies better understand and communicate the information required by investors and other stakeholders regarding the climate change-related risks (and potential opportunities) facing their business. The TCFD’s voluntary guidelines for disclosure of material financial risks borne out of climate change are widely recognised as the ‘best-practice’ standard for climate-related reporting.
Several jurisdictions, including the UK, are moving towards mandatory TCFD-aligned reporting in the coming years – as a result many oil and gas companies have recognised the need to strengthen their strategies, improve their understanding of the underlying risks, and enhance disclosure of climate-related risks and opportunities. However, the TCFD’s recommendations are relatively high-level, often creating challenges for companies faced with a rapidly evolving external environment. Many companies also struggle to understand how to reconcile different reporting standards, particularly the use of the Sustainability Accountability Standards Board (SASB) framework versus the TCFD. While a drive to harmonise climate-related reporting standards in the run-up to COP26 – including the International Financial Reporting Standards (IFRS) Foundation’s plans for a new set of sustainability standards to govern company disclosures of climate related risks – could reduce some of these challenges, it could also create additional pressure on companies to improve performance in this area.
Against this backdrop, oil and gas companies can respond to intensifying pressures by developing clear and robust strategies for how they will adapt to a lower-carbon world, supplemented by enhanced disclosures around their actions. Our research, as well as ongoing work to support a multitude of clients strengthen their climate strategies, has revealed some steps companies should take now, in order to stay ahead of the curve:
1. Develop a strong strategy on climate and clearly present it in corporate reporting
Many investors are increasingly aware of the financial implications of an accelerated transition to a low-carbon future on fossil fuel producers. This is evidenced by the growing number of financial institutions announcing net-zero targets for their portfolios and the increasing outspokenness of influential investors, such as BlackRock, in supporting stronger climate action by companies. Increasingly, investors expect companies to go beyond addressing climate change as a sustainability issue and to incorporate climate change-related risks into their corporate strategies and reflect this in their financial statements. Among other things, this means that investors want to see that the ‘front’ of the annual report, where a company might make ambitious statements about its response to climate change-related risks, matches the ‘back’ of the annual report, where for example asset lifespans are adjusted, valuations changed, and profit margins affected.
2. Develop a clear strategic pathway for reducing GHG emissions and set ambitious, but realistic, targets
As governments continue to announce more ambitious climate targets and outline pathways for achieving their own net-zero ambitions, pressure on companies in high-polluting sectors to establish greenhouse gas (GHG) reduction targets will only intensify. While setting targets on scope 1 and 2 emissions was the first step taken by the industry in response to increasing climate change pressures, many companies have struggled to determine both what targets are realistic and how to achieve them. Already, key stakeholders are wary of companies announcing net-zero targets that are not supported by the reality of their businesses. For example, international NGO Friends of the Earth recently published a report denouncing companies’ lack of clear strategic pathways to actually reach net zero. Furthermore, growing pressure to track, record and address scope 3 and methane emissions is likely to create further challenges due to difficulties obtaining accurate measurements and, in the case of scope 3, understanding how to meaningfully reduce emissions along the value chain. In preparation for increased scrutiny and pressure, companies will need to develop a clear understanding of their emissions footprint and determine credible pathways for reducing it.
3. Ensuring the board has strong climate-related knowledge and competence
While many companies have taken steps to ensure strong board oversight of climate change – such as through allocating responsibilities to specific committees and establishing oversight of strategy development and risk management – many boards still lack specific climate change knowledge and expertise. This hinders a board’s ability to fully understand climate-related risks and opportunities and ensure the company has developed appropriate management and mitigation practices in response. The recent campaign by activist investor group Engine No 1 to replace four directors on ExxonMobil’s board in order to fundamentally change the company’s approach to climate change demonstrates how board composition is a key issue for climate-focused stakeholders and provides further evidence of how investor activism is impacting companies.
4. Testing portfolio resilience against a 1.5°C scenario
As a key TCFD recommendation, testing portfolio resilience against low-carbon scenarios has become the norm among oil and gas companies. Until recently, the focus for many companies was on planning for a ‘well-below 2°C’ scenario aligned with the goals of the Paris Agreement. However, the discussion has started to shift – especially in Europe – to examining the implications of a 1.5°C scenario, with some of the more ambitious companies already doing so. The upcoming publication of the IEA’s first detailed net zero 2050 scenario in line with a temperature rise of 1.5°C by May 2021, ahead of COP26 in November, is expected to accelerate this trend. Although companies are unlikely to come under pressure immediately to re-run resilience testing with a 1.5°C lens, they will be expected to address the potential implications of a 1.5°C future on their business in future disclosures. Moreover, as more companies, particularly mid-caps, begin incorporating 1.5°C scenarios into their strategic planning, expectations on peers to do the same will inevitably grow.
5. Understanding and disclosing the possible financial impacts of physical climate risks
Physical climate change risks within the oil and gas industry have thus far received less attention than transition risks. However, they can have significant impacts on production, supply and financial returns. For example, during a recent cold snap, an extreme weather event that was likely intensified by climate change, Texas’ natural gas production fell by almost half. The complexities associated with modelling the commercial impact and a lack of clarity regarding the level of disclosure expected, has meant few companies have disclosed their physical risk assessments with much granularity. Nevertheless, given the direct financial implications of operational challenges, damage to assets or disruptions to supply chains, expectations on companies to demonstrate that they have mapped physical risks and undertaken appropriate mitigation measures are expected to grow.
While many companies have encountered difficulties responding to some of these challenges, it is possible to navigate them. Regardless of how companies ultimately respond to these issues, it is crucial to first understand the gaps in existing approaches to managing climate-related risks and opportunities. Only after developing a clear understanding of the issues can companies begin to address them internally and enhance their climate strategies. Although some companies have taken a disclosure-led approach to these issues, to adequately address stakeholder concerns and the realities of managing climate-related risks, strategy must precede disclosure.