New York State's three-year, meandering investigation into oil and gas giant Exxon Mobil (NYSE:XOM) came to a resounding conclusion last week when the state's attorney general filed suit against the company for multiple causes of action. The company's share price did not underperform the broader S&P 500 index after the lawsuit was announced, and investors could be forgiven for assuming that it will go the way of the myriad failed lawsuits that municipalities such as New York City and San Francisco have launched against Exxon Mobil in recent years. This one is different from the others for two important reasons, however, and it has important implications for the company's large peers (and occasional fellow defendants in other climate lawsuits) such as BP (BP), Chevron (CVX), ConocoPhillips (COP), and Royal Dutch Shell (RDS.A)(RDS.B).
The genesis of New York State's recent lawsuit was an investigation that then-AG Eric Schneiderman launched in November 2015 into the company's public statements about the threat posed by climate change, which Mr. Schneiderman contrasted with its internal research into the same. The focus of the investigation shifted over the interim before landing on the subject of the internal, or "proxy", hypothetical carbon price that the company used when valuing its reserves and making investment decisions. Then, last spring, Mr. Schneiderman quickly resigned from his post after being accused of committing violence against women, causing the investigation to lose its most visible public proponent literally overnight.
Mr. Schneiderman's temporary replacement, Barbara Underwood, took the helm of the investigation and ultimately brought the investigation under New York's expansive Martin Act as well as state common law on fraud. Her office alleges that Exxon Mobil defrauded investors by telling the public that it was using an internal carbon price in its decision-making and reserves valuation processes that was higher than the price that it actually assumed. Specifically, New York State alleges that the company overstated the cash flow projections of some especially carbon-intensive projects by tens of billions of dollars through its use of an internal carbon price that was based on actual climate regulations rather than the higher price that the company told the public that it was using. To quote the lawsuit itself:
Through its fraudulent scheme, Exxon in effect created a Potemkin village to create the illusion that it had fully considered the risks of future climate change regulation and had factored those risks into its business operations. In reality, Exxon knew that its representations were not supported by the facts and were contrary to its internal business practices. As a result of Exxon's fraud, the company was exposed to far greater risk from climate change regulations than investors were led to believe."
A spokesman for the company responded by describing the allegations as "baseless" and "a product of closed-door lobbying by special interests, political opportunism and the attorney general's inability to admit that a three-year investigation has uncovered no wrong-doing." While the closed-door lobbying claim is true, investors should be more concerned with the company's potential liability for any wrong-doing given that the lawsuit requests the "disgorgement of all amounts gained or retained as a result of the fraud, damages, restitution, and costs." This will revolve around two major legal issues.
First, did Exxon Mobil use an internal carbon price that was different from the one that it told the public that it was using? The lawsuit is quite adamant that it did just that, detailing its allegation across dozens of pages. It details, for example, how the company used an internal carbon price of $40/ton in 2030 for its operations within OECD members even as it told the public that it was using a value of $60/ton for the same year. In another example the lawsuit alleges that the company used an actual internal carbon price of under $5/ton in valuing Albertan tar sand projects compared to a purported price of $80/ton by 2040.
Taking the lawsuit's claims at face value - and there are a number of important pricing issues that it does not address, including trajectory over time and uncertainty - leaves the second major issue of damages. Specifically, assuming that Exxon Mobil did indeed mislead investors regarding its use of an internal carbon price, how much did it benefit from its misleading statements? This will be the most difficult aspect of the lawsuit to determine, and how the courts opt to handle the issue if it gets to that point will have important implications for the rest of the oil and gas sector.
The challenge to determining damages is that the internal carbon price is a largely hypothetical mechanism. Exxon Mobil used it (or, according to New York's AG, purported to use it) to simulate possible operating conditions decades in the future. At present no major cap-and-trade or carbon tax mechanism imposes costs that are remotely close to those that Exxon Mobil told the public that it was assuming. The carbon price of the world's largest multinational cap-and-trade system, the European Union's Emissions Trading Scheme [ETS], hit a decade high as it passed 17 euros per metric ton earlier this year after trading as low as 5 euros per metric ton in recent years. California's carbon price is comparable at $15/ton while the Northeast's Regional Greenhouse Gas Initiative's [RGGI] carbon price is a fraction of that at $4.50/ton. Whether Exxon Mobil assumed a future carbon price of $40/ton or $60/ton, then, is largely an academic question at this point. Even the lower of the two prices assumes that the world's major economies will do far more to limit greenhouse gas emissions than they have shown any inclination of doing to date.
The hypothetical nature of the internal carbon price will greatly complicate efforts to determine what benefit, if any, Exxon Mobil gained through its alleged actions. The lawsuit points to a number of statements that have been made by various investment entities over the years about the importance of accounting for the possible impacts of future climate regulations on fossil fuel producers. How much of an impact the $20/ton difference between the internal carbon price that Exxon Mobil told investors it was assuming for OECD countries and allegedly used in practice had on its market valuation will be very difficult to quantify, however. While the lawsuit emphasizes the revenue streams and project cash flows that would have been disqualified under the higher carbon price, the fact that this is a hypothetical construct means that the real question is whether or not the behavior of Exxon Mobil's shareholders and the broader class of stock market participants was affected by the price difference. The salient point here is that, as a long-term price forecast, rational investors are incorporating their own assumptions regarding future carbon prices into their investment decision-making since Exxon Mobil has no knowledge advantage regarding the policy conditions that will prevail in the 2030s and 2040s over any other market participant. Misstating possible conditions in the distant future does not fall into the same category of deception as misstating actual conditions in the past or present.
The issue of damages also raises an important question with regard to shareholder protection. New York's lawsuit argues that Exxon Mobil overstated the value of its assets because the internal carbon price that it claimed to use would have resulted in "large write-downs" of its reserves. Again, though, any internal carbon price that is higher than the current carbon price (or regulatory equivalent) is an uncertain forecast that is in turn extremely sensitive to the underlying assumptions regarding the future state of technology, state of politics, demographic shifts, etc. Basing present investment decisions on a carbon price forecast for 2030 or 2040 is comparable to basing those same decisions on energy prices in the equally-distant future. Rational investors necessarily view companies' long-term energy price forecasts with a large amount of skepticism given analysts' historical difficulties in accurately making even short-term energy price forecasts (e.g., 2008, 2014, and 2017, to name recent years in which energy prices rapidly experienced major unexpected changes). Predictions regarding long-term carbon prices fall into the same category, especially given that the vast majority of the world's major emitting countries have implemented climate policies that would result in far more global warming than they agreed to under the 2015 Paris Climate Agreement; the U.S., for example, is on track to achieve emissions that would result in warming of more than 4 degrees C if copied by the world's other large emitters.
Finally, regardless of how New York's lawsuit concludes, it contains an important (if unintended) message for other large fossil fuel producers that do business within the state: don't utilize a hypothetical internal carbon price absent a binding shareholder resolution or regulatory mandate requiring the use of one. The legal downsides to implementing one can be immense, as Exxon Mobil is discovering. For example, New York's lawsuit points to the alleged use of different internal carbon prices for projects in different countries. This would make sense if the carbon price was not hypothetical as different jurisdictions impose different regulatory burdens. Because the internal carbon price is hypothetical, however, there is little room for such analytical granularity.
Ironically, Exxon Mobil would have avoided the lawsuit entirely had it refrained from using an internal carbon price in the first place. As it is, the company's use of such a mechanism in, if the lawsuit's allegations are correct, a rather haphazard way has resulted in a substantial legal headache for it at best and potentially large monetary damages at worst. That the lawsuit has been brought under New York's Martin Act will make it far harder for the company to quickly win than the earlier federal lawsuits proved to be.
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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.