China And The US Ratify COP21 Agreement, G20 Meeting: Early Outcomes For Investors?

Summary

• China, US ratify the COP21 agreement, so 26 countries representing 40.06% emissions have ratified; countries covering 14.94% emissions needed to become binding.
• China takes the lead and positions addressing climate change and exit from fossil fuels in a positive light.
• China and US ratification of COP21 means further downward pressure on oil price.
• Capex expenditure by oil and gas majors needs to consider developing assets that will be stranded.
• G20 made limited progress on fossil fuel subsidies, green financing and investment risks.

Source: treehugger

Just prior to the commencement of the G20 summit, the US joined China in announcing ratification of the Paris COP21 climate agreement, bringing the number of countries that have ratified to 26, representing 40.06% of global emissions. The world's two largest emitters of greenhouse gases have agreed to cut emissions to try to curtail global warming to 1.5C.

This is a significant step towards the end of the fossil fuel era and dismantling the fossil fuel industry. This is going to take time to implement, but the agreement to act is clear.

Here I address some immediate outcomes of the US and Chinese action to ratify the agreement and the G20 summit. This creates a new downward pressure on oil prices, as well as immediate need by the major coal, oil and gas companies to reassess capex and new projects.

A major reason for dismissing the possibility of progress in addressing greenhouse gas emissions in the past has been that the developing nations would require action from the developed world (who have caused most of the emissions so far) before the developing world would take action. In recent days China has convincingly demolished that argument by taking the lead on addressing greenhouse gas emissions.

The cross purposes discussion

There have been two dialogues going on about the world's energy supply.

1) Fossil fuels must be burned regardless:

This is the position taken by the fossil majors, traditionalists and fossil fuel entrepreneurs. The argument is that the world's economy needs fossil fuels to continue not only to grow, but also to survive.

This makes the argument a one dimensional one. In effect it says that no matter what the consequences of burning fossil fuels, we have to keep doing so regardless.

You can read this argument clearly in, for example, BP's (BP) Energy Outlook 2106 where the 2C scenario (shown in the BP report as IEA450 scenario, see p 78) is dismissed as "not going to happen". Even BP's most aggressive scenario, involving transition to a lower carbon future, has fossil fuels supplying 70% of total energy in 2035 and not a lot of change from current emissions.

2) The future of humanity requires us to stop burning fossil fuels because it's dangerous climate change:

This has been the position of the scientists for 30 years and citizens have increasingly seen why they have that position.

Until recently the fossil fuel lobby has won, largely because it has been hard to imagine how to exit fossil fuels without massive disruption. The massive disruption by burning fossil fuels, including environmental and health costs, has been ignored.

Recently an alternative has become clear in the form of renewable energy, particularly wind and solar, with energy storage maturing rapidly. The finance community "gets it" as more was invested last year in new renewable energy build than fossil fuels.

The significance of yesterday's ratification of COP21 is that now the leaders of the two major greenhouse gas emitters have decided that we have to address climate change and that this means exiting fossil fuel consumption.

This has not happened in a vacuum and there are signs everywhere. I wrote that the December 2015 COP21 non-binding agreement changed everything, and I believe it did. What we see today is the next steps along a long path to change the energy system away from reliance on fossil fuels.

I suspect the pace of change will quicken now as this must happen if the climate emergency is to be addressed.

Saudi Arabia and oil production in the era of COP21

For some time now Saudi Arabia has talked about renewable energy, with plans for a major initiative in solar power development. Indeed at one stage there was a plan for 41 GW of solar PV development and $109 billion of investment. This was an acknowledgement that there is a future looming, which doesn't involve exploiting oil.

For various reasons this ambition has been tempered and now the goal is 9 GW of solar power by 2030. It will be interesting to see if this is reconsidered now that there has been a dramatic decline in the cost of solar PV and COP21 will be ratified, most probably before the end of 2106.

The flip side of the above plans is the question as to what Saudi Arabia will do about its proven oil reserves, which have the lowest exploitation cost of any reserves (~$10/barrel).

News announced at the G20 of a Saudi/Russian pact concerning oil market stabilization may have a short term impact, although already there seems doubt that this will be successful at controlling output. Iran wants to regain market share. The US is poised to turn on production if the price gets above $50/barrel.

When the reality sinks in that COP21 is going to happen and a lot of oil has to stay in the ground, I suspect there will be a scramble by producers (notably Saudi Arabia) to turn on oil production and take the money when it is available. The oil price has to fall a very long way for Saudi Arabian production to become uneconomic. This has to be relevant to the oil majors ExxonMobil (XOM), Chevron (CVX), BP , Royal Dutch Shell (RDS.A) (RDS.B) and Total (TOT).

Investment in long term fossil fuel projects or renewable energy?

A consequence of COP21 will certainly be about where long term capital is to be deployed.

The first signs of this are already apparent. For example Dong Energy (DC:DENERG) has chosen to cease investment in its oil and gas assets to focus on offshore wind. Dong Energy is one of the first fossil fuel companies to decide to refocus its whole business to renewable energy and to exit fossil fuels.

Note that these decisions are across the board in the energy space. For example a board member of (EDF) the French Government company seeking to develop the massive Hinkley Point C nuclear reactor, resigned because investment in this project would prejudice EDF's ability to invest in other renewable energy projects.

The major oil and gas companies continue to invest in their fossil fuel assets, even as profitability of oil and gas is plummeting, in the hope that the industry will recover and prices rebound. This means that debt has doubled since 2014 to $184 billion. More than 90 smaller oil and gas companies have gone bankrupt.

And yet oil discoveries have dropped dramatically because of cuts in capex. Of course there is a lot of already discovered oil to be exploited, but the above statistics show that the longer term future is already disappearing. A ratified COP21 provides further pressure because it brings doubt on whether resources developed in the future will be stranded.

How might 55% emissions be achieved? When?

With China and the US on board, the pressure on other countries to ratify is intense and it is likely that a meeting at the UN on September 21 will be the time when countries accounting for 55% of emissions will ratify. This is the trigger for the agreement to become binding and it needs countries representing 14.94% of emissions to ratify (since the current total is 40.06%).

The World Resources Institute indicates that a further 31 countries have either committed to ratify in 2016 or are highly likely to do so. If that happens, then 57 countries will ratify the COP21 agreement by the end of 2016 (maybe as early as September 21) representing 58.40% of emissions. This is enough to make the COP21 agreement binding.

Ratifying the COP21 Agreement is just the beginning of addressing greenhouse gas emissions. There are many further steps needed to make the world safer.

After the 21 September UN meeting, the next formal meeting (COP22) will be held in Marrakech, Morocco 7-18th November 2016, where it could be that the first steps to implement the ratified agreement are made.

Whose fossil fuel assets will be stranded?

Coal

In the first instance there will be focus major projects that are in the planning stage. In the coal sector, two huge projects in Australia, Adani's Queensland Galilee Basin project and Shenhua's NSW Watermark project, have both lacked financial support despite Australian Government urging. Surely COP21 will put these projects out of their misery?

More generally, Market Realist has given a recent summary of the US coal majors, indicating that most coal (VanEck Vectors Coal ETF (KOL)) mining companies had losses in Q2 2016. Detailed analysis of Q2 earnings and future prospects for Cloud Peak Energy (CLD), Westmoreland Coal (WLB), Alliance Resource Partners (ARLP), Peabody Energy (BTUUQ) and Arch Coal (OTC:ACIIQ) was depressing. In the short term it is all about day-to-day survival. In the long term it was concluded that the Clean Power Plan and other environmental regulations will determine the future of coal mining in the US.

Ratification of the COP21 agreement brings a new dimension to the pressures on the coal industry, as there are specific targets to reduce emissions and plans to tighten them going forward. While no particular fossil fuel is mentioned in the COP21 agreement, everyone agrees that coal is the first to go.

Oil: the rush to special pleading

I think there is a near certainty that, once the oil & gas majors acknowledge that COP21 means exit from fossil fuels, there will be a rush to establish that "other people's" assets are the ones that have to stay in the ground.

As reported in the prestigious journal Nature, the amount of fossil fuel resources that must stay in the ground is huge. Even at 2C temperature rise, 80% of the world's coal is unburnable, while 30% of known oil and 50% of gas reserves are unburnable. The 1.5C target requires even less fossil fuel exploitation and a more rapid decline in emissions.

Drilling in the Arctic is out of the question. Further exploitation of unconventional oil is also not possible.

This issue has already been considered by Oxfam America, which has flagged equity issues about which assets become valueless. The Oxfam research indicates that thus far the focus for equity concerns has been on who consumes fossil fuels.

Who gets to sell the fossil fuels going forward is another issue that needs to be confronted. This is an area where financially strong major corporations like ExxonMobil and Chevron are likely to claim that they are the best at exploitation, so they should exploit the assets.

In the existing paradigm resource rents to poorer countries for exploiting their fossil fuel assets are substantially greater than total aid flow. In the case of all resource exploitation, resource rent is 5x great than total aid.

A recent paper argues that countries should receive preferential treatment for exploiting fossil fuel assets based on i) low level of human development; ii) lack of historical benefit from exploiting fossil fuels; iii) whether undeveloped countries have other options available.

It is easy to imagine how contested this might become between countries and of course between corporations, who are accustomed to winning. Rough calculations suggest that, if China is excluded, all undeveloped world fossil fuel assets could be exploited and there would still be a 50% chance of keeping temperature rise below 1.5C. It is hard to imagine that those exploiting developed world assets will defer to the developing world.

There are interesting and complex challenges ahead. Given the fact that these issues will need to be considered, even sorting it out is going to slow down the oil and gas majors.

G20 outcomes: fossil fuel subsidies, green financing and investment risks

While China and the US ratification of the COP21 agreement was a major news item immediately prior to the commencement of the G20, action during the G20 meeting was less dramatic. Some progress was made in three areas, perhaps in response to financial groups managing trillions of dollars of assets.

i) Fossil fuel subsidies: These have been on the G20 agenda since 2009, but they haven't been faced in any practical way.

Last week Bloomberg editorialized that "Fossil fuel subsidies are the world's dumbest policies". In that editorial Bloomberg pointed out that the IEA estimates $493 billion was spent globally in 2014 on consumption subsidies for fossil fuels, despite the fact that these subsidies mostly enrich the rich.

G20 countries spent an additional $450 billion on producer supports. These are not well targeted subsidies and they are worse as they promote harmful fossil fuel consumption that has massive environmental and health costs, making the real cost of fossil fuel subsidies a massive $5.3 trillion annually according to the IMF.

It is clear that if the COP21 emissions reductions are to be met (and they need to be ramped up) it makes no sense to encourage more fossil fuel consumption. The G20 response was weak, but there is hope that the next G20 summit chaired by Germany will put some firm timelines and teeth into plans to end fossil fuel subsidies.

ii) Green financing: China has stated that it needs ~$460 billion each year to finance its green investment programs. China presented an initiative comprising 35 action points to develop green financial instruments and various green incentives such as central bank re-lending, guarantees and a national level green development fund.

iii) Investment risks: Things are happening in this area both in terms of making sure that quality information is available, as well as activist efforts to ensure that major greenhouse gas companies acknowledge the facts and don't spread misinformation.

A report has been commissioned on disclosure standards for environmental risks and this will be presented to G20 finance ministers and central bank governors in coming months. This is a start to remove ability of the coal, oil and gas majors to obfuscate, as they have done until now. Investors will soon get information allowing them to understand climate change risks involved with particular investee companies.

Insurers are taking the lead in modeling impact of extreme weather events on various secondary issues, such as food prices. Central banks are looking at monetary and financial stability in the context of climate change.

Carbon pricing and new energy regulation is being examined by investor groups. This impacts on different energy sources. For example the rise of gas in the US has had a dramatic effect on the profitability of coal companies.

Each of the above activities have direct relevance to an investor in the fossil fuel industry and also for investors contemplating renewable energy investments. Currently it is hard to be knowledgeable about these issues, but transparency is on the way.

Conclusion

Given the heavy focus on short term supply/demand issues in relation to oil and gas prices on Seeking Alpha, some comment about the effect of ratification of COP21 on coal, oil and gas prices is warranted.

Fossil fuel industries will be tempted to sell their fossil fuel products if they can, as the clear intent of the COP21 agreement is to leave a massive slice of existing reserves in the ground. This will provide new downwards pressure on oil and gas prices. So I remain skeptical about optimism that there will be recovery in oil prices to the levels that make the oil majors business activities (including paying dividends) possible. Notwithstanding the new Russian/Saudi agreement, watch the tap get turned on in the near future.

A no less urgent issue is capex expenditure, especially opening up major projects in the coal, oil and gas industries. How the oil majors in particular respond to their unrealistic (in the light of US and Chinese ratification of COP21) goals to continue to increase their output of their fossil fuel products into the long term will give investors an idea as to whether they have a Kodak model or they plan to have a future.

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