A Question of Balance

Steps 2 to 5 were repeated for both of the environmental issues examined here. Steps 1 and 6 frame the overall analysis. In formulating scenarios and assigning probabilities, we consulted with oil and gas company representatives, and with others familiar with the industry, in order to tap a broad range of perspectives. In order to ascertain companies’ exposures to different scenarios, and the subsequent financial impact, we compiled a database of company information, comprising information from company annual reports and from industry information sources such as John S. Herold and IHS Energy.

For this study, we applied WRI’s methodology to 16 prominent oil and gas companies, including the integrated “super majors” and smaller upstream or downstream producers, to illustrate the financial impacts of environmental risks and opportunities across the sector. Our company sample consisted of Amerada Hess (AHC), Apache (APA), BP (BP), Burlington Resources (BR), ChevronTexaco (CVX), ConocoPhillips (COP), Eni (E), Enterprise Oil (ETP), ExxonMobil (XOM), Occidental Petroleum (OXY), REPSOL YPF (REP), Royal Dutch/Shell Group (RD), Sunoco (SUN), TotalFinaElf (TOT), Unocal (UCL), and Valero Energy (VLO).

In the following sections, we outline how the financial impacts of the two environmental issues were determined for each company.

Climate Change In discussions with industry experts, climate change emerged as the single most important environmental issue facing the oil and gas sector. The combustion of fossil fuels–the industry’s main products–is the chief cause of increased atmospheric concentrations of GHGs, which are considered to be driving climate change. To mitigate the impacts of climate change, the Kyoto Protocol seeks to reduce GHG emissions in developed countries to 5.2% below their 1990 levels by 2010. While several companies have made well-publicized efforts to reduce GHG emissions from operations, the industry’s main vulnerability comes from the impact that policies could have on sales of gas and, particularly, oil (which emits more GHGs per unit of energy). Ninety percent of the GHG emissions associated with the industry result from final combustion of fuels by end users.

Following Russia’s recent declaration of support, the Protocol will likely come into force in the near future, but almost certainly without the participation of the United States (and possibly Australia). Even without U.S. participation, U.S.-based companies will be affected by the Protocol. Changes in the global oil market, transmitted by price, will be felt throughout the industry. In addition, many U.S.-based companies have extensive assets abroad that could be impacted. For example, about 25% of ExxonMobil’s petroleum products are sold in Europe, where several countries have already ratified the treaty and are implementing measures to reduce GHG emissions.

To assess the possible financial implications of climate policies, we modeled several different scenarios, ranging from no action to widespread adoption of the Protocol. The results show that future climate policies could create “most likely” financial impacts for companies spanning from a 5% loss in shareholder value to a slight gain. [See Figure 2 above, Potential Financial Impacts.]

Perhaps the most likely scenario is that Canada, Europe, Japan, and Russia will adopt the Kyoto Protocol, while the United States pursues its own (more limited) measures to reduce GHG emissions. Under this scenario, Burlington Resource’s shareholder value could increase slightly while Enterprise, Occidental, and Repsol YPF could lose about 4% of shareholder value. In some scenarios, two companies with significant natural gas assets–Apache and Burlington Resources–could benefit from a substitution away from coal and toward natural gas in electricity markets.

Restricted Access to Oil and Gas Reserves Another important environmental issue facing oil and gas companies is their ability to access reserves in ecologically sensitive areas of the world. As conventional sources of oil and gas become exhausted, the search for new reserves often brings companies into regions that are remote, pristine, or close to existing communities. Intrusion into these new areas may result in vociferous environmental and social controversy. In developed countries, NIMBY (“not in my back yard”) attitudes can markedly restrict industrial development and impinge on the industry’s plans for additional infrastructure. Residents of developing countries are also becoming more vocal in their opposition to oil and gas projects through informal networks of community leaders, local nongovernmental organizations (NGOs), and international environmental or human rights organizations. Such opposition can raise operating costs, constrain production, or block access to reserves. As one example, Shell reported that community opposition in Nigeria had resulted in them being able to produce at only 40% of capacity in 2000.

Companies’ exposure to future resource accessibility pressures differs markedly. To assess this, we mapped company reserves around the world against areas identified by the World Wildlife Fund and the World Conservation Monitoring Center as environmentally significant. It transpires that Apache, ChevronTexaco, ConocoPhilips, TotalFinaElf, Repsol YPF, Occidental, and Unocal have a larger than average share of their upstream reserves in areas identified as ecologically important. Burlington Resources, ENI, ExxonMobil, and Shell have relatively few reserves in environmentally sensitive areas, while none of Enterprise’s reserves lie in these areas.

As with the climate issue, we modeled several future scenarios concerning access to environmentally and socially sensitive reserves, including formal commitments by governing bodies and corporations, increased NGO networking pressure, or the weakening of this issue due to national security or oil supply concerns. We found that future access policies could create “most likely” financial impacts for companies averaging a 2% loss in shareholder value across several different scenarios. Non-integrated producers were the most affected. Apache, Occidental, and Unocal had a “most likely” loss of 3% in value. [See Figure 3 above, Range of Consequences of Restricted Access.]

One likely scenario is that communities living in or near environmentally sensitive areas will increase their opposition to oil and gas development, either through a political process or other means, such as protests and sabotage. Under this scenario, Enterprise was unaffected while Apache, Occidental, and Unocal lost more than 3% of shareholder value.

Not enough disclosure?

Advisors relying on companies to forewarn them about environmental pressures risk being caught unprepared. Few companies have disclosed the degree to which they are financially exposed to these issues, and no company has attempted to quantify the financial implications for its shareholders.

Of the companies examined in our study, only three–BP, Conoco, and Phillips–made any reference in their latest 10-Ks (or 20-F equivalent) to climate change as an issue that may affect future operations. Three other companies–Enterprise, ExxonMobil, and TotalFinaElf–refer to the issue in their annual reports, but do not elaborate on any possible implications for their business. The remaining 11 companies do not mention climate change in the principal materials prepared for investors.

None of the sample companies attempt to quantify the possible financial implications of climate change and policy responses. BP, Conoco, and Phillips come closest. In their separate reports last year, Conoco and Phillips both state that expenditures under the Kyoto Protocol are hard to predict but “could be substantial.” In contrast, BP notes that the Kyoto Protocol could lead to “some” reduction in the use of fossil fuels; however, “the impact of the Kyoto agreements on global energy (and fossil fuel) demand is expected to be small.” Though better than others, even these disclosures fall short of quantitative estimates of financial impacts that advisors would find useful in evaluating potential investments for their clients.

These sector-specific findings on climate change disclosure are mirrored in other industries. A report published this year by Friends of the Earth (Survey of Climate Change Disclosure in SEC Filings of Automobile, Insurance, Oil & Gas, Petrochemical, and Utility Companies) finds that only a quarter of a sample of firms in those sectors inform their shareholders of the relevance of climate change for future business performance.

Reporting of access issues is more difficult to monitor, mainly due to the piecemeal nature and the variety of ways financial consequences may be felt (e.g., lawsuits, asset losses, increased operating costs). Most companies report political risks inherent in overseas operations, particularly in developing regions of the world, yet describe community investments as corporate stewardship rather than as a risk-mitigation policy.

Furthermore, in regions that are highly dependent on natural resources for survival, the link between social unrest and environmental quality is rarely made. Only Repsol specifically links environmental and social policies in sensitive areas with the goal of preventing disruptions and losses in oil and gas operations. Despite the fact that access issues have always been at the heart of the upstream oil and gas business, their financial significance goes largely unmentioned in annual reports.

Lack of disclosure on these issues is curious given the efforts expended by the industry to prevent implementation of the Kyoto Protocol and to attempt to secure access to reserves in remote areas.

Ask for More

Few advisors and in- vestors have heeded the financial relevance of current environmental trends. Even industry analysts familiar with traditional regulatory pressures will find in the issues reviewed above fundamental new drivers for corporate value.

While environmental issues have not always been easily translated into financial terms, the approach used above establishes a means by which environmental risks and opportunities can be integrated into conventional shareholder valuation frameworks. Moreover, this approach could readily be transferred to several other sectors where climate pressures in particular will be important–for example, autos, petrochemicals, and utilities. As a framework, it could also be used to assess many other environmental issues.

As advisors take stock of the implications of Enron and other disclosure failures for the way in which they evaluate companies, prudence would seem to demand a careful review of pending environmental trends. Advisors seeking to avoid environmental “surprises” from the companies they recommend should press for greater disclosure from companies themselves, and look to verify that information with independent analysis and research.