New York's #ExxonKnew Investigation Takes Another Hit

Summary

• A recent study out of Oxford University illustrates the shortcomings of using petroleum and gas companies' climate policy forecasts as a basis for securities fraud investigations.
• The Oxford study suggests that the global "carbon budget" will not be exhausted for decades, rather than by the end of this decade as previous models had concluded.
• This development illustrates the difficulties inherent in the making of convincing, let alone accurate, forecasts about future climate policies, and creates new doubts about the legal implications of such forecasts.

The academic literature giveth and the academic literature taketh away. That, at least, is what the supporters of New York State's Martin Act investigation into Exxon Mobil (NYSE:XOM) must be thinking in the wake of some recent high-profile publications in the academic literature. Last month saw the publication of an op-ed in The New York Times by two Harvard researchers that highlighted what they concluded to be "explicit factual misrepresentation" by the company in the 1990s on the state of climate change research.

Now comes a study published in Nature Geoscience by researchers at Oxford University finding that, in the words of The Economist, "climate researchers have been underestimating the carbon 'budget' compatible with the ambitions expressed in [The Paris Climate Agreement]." While both studies have generated headlines around the world, the latter is the one that Exxon Mobil's investors will want to pay attention to because of its Martin Act investigation implications.

To recap, New York's attorney general launched an investigation in 2015 into Exxon Mobil on the basis that, as the #ExxonKnew hashtag suggests, the company may have covered up the findings of its internal research into the impact of greenhouse gas emissions on the climate in the 1980s and 1990s.

When that line of inquiry revealed that the company had instead published its research results (even if it didn't trumpet them), the investigation shifted to focus on whether or not the company has been accurately valuing the impact that future climate policies will have on its fossil reserves. The investigation's latest iteration has focused on the proxy carbon price that Exxon Mobil shows its investors to simulate the risks to its finances posed by future climate policies.

The study by Harvard researchers would have likely had a bigger impact had it been published at the time of the AG's investigation's first iteration. The Oxford study, on the other hand, is directly related to the investigation's current iteration. I refer to the "proxy carbon price" because there is no nationwide carbon price in the U.S., so the company uses such a price to serve as a proxy for future climate policy developments that will increase the costs of, or otherwise discourage, the emission of greenhouse gases.

This proxy carbon price is in turn closely related to the stranded assets theory, which predicts that companies' future fossil reserves will be "stranded" underground by future policies that will be enacted to minimize greenhouse gas emissions. A high proxy carbon price reflects a large future impact on fossil reserve values while a low price reflects a minimal future impact. When New York's AG accuses Exxon Mobil of using an inappropriate proxy carbon price, he is really saying that the company has underestimated to its investors the magnitude by which future climate policies will strand its assets.

As I have argued here before (and as any investor with a rudimentary knowledge of probabilities who is reading this article has no doubt identified by now), a shortcoming of the AG's line of attack is that it assumes the existence of specific future policies that will cause Exxon Mobil's reserves to be stranded.

As the U.S. has demonstrated not once but twice in the last decade, first with the surprise failure of the American Clean Energy and Security Act and then with President Trump's election victory and subsequent decision to withdraw the country from the Paris Climate Agreement, policy predictions are very uncertain when the forecast window is a matter of months, let alone years or decades.

And that is assuming the existence of accurate information regarding how much carbon dioxide can be emitted in the future without breaching a predetermined temperature increase threshold (1.5 and 2 degrees C having been the most oft-mentioned thresholds).

That is where the Oxford study comes into play. Earlier this year, the UN's former climate chief stated that the international community has until 2020 "to safeguard our climate," i.e., that the global "carbon budget" would be exhausted within three years. The Oxford researchers calculated an updated carbon budget, however, by developing a new warming model that eliminated observed discrepancies between older warming models and recorded temperature measurements.

The carbon budget calculated by the new model was larger than that calculated by the old models - substantially so. To quote The Economist again, under the new model "the carbon budget lasts a few decades, not just a few years."

The point of this is not to argue that Exxon Mobil could have used $X as its proxy carbon price when it instead used $X + 20 (or something similar). That matters, of course, as far as New York's investigation is concerned since the attorney general has at different times accused the company of both underestimating the value of its future stranded assets and of using an internal proxy carbon price that was lower than the proxy price that it showed to investors.

If the global carbon budget really is larger than previously expected, then the threat of policy-induced stranded assets is neither as great nor as imminent as previously believed. Nor, to take the opposite tack, does the Oxford study mean that climate change is either not occurring or is not a threat to global security (although it is regrettably being portrayed as suggesting both in some circles).

Rather, the main takeaway of the Oxford study for investors in the fossil reserves sector is that our forecasting ability regarding the implementation and timing of future climate policies continues to be too inaccurate to be used to make findings of criminal or civil wrongdoing on the part of reservesholders when it comes to the estimation of future carbon prices.

This statement should not be conflated with the argument, which I disagree with, that too much uncertainty exists in climate models to merit the taking of action to mitigate climate change. Within the narrow bounds of New York's #ExxonKnew investigation, however, it is not inaccurate to say that uncertainty in climate models only amplifies the uncertainty in policy forecasting models and, as the Oxford study demonstrated, some uncertainty in climate models still remains.

Inasmuch as New York's investigation into Exxon Mobil is a test case for subsequent inquiries into the policy forecasting of other U.S. firms such as ConocoPhillips (COP) and Chevron (CVX), the Oxford study's results weaken the legal basis for using stranded assets theory as a basis for legal investigations into petroleum and gas firms.

Disclosure: I am/we are long XLE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.