Risk and Reward: Navigating the Oil & Gas Sector's Path Toward Competitiveness in a Post-Paris Agreement World
Given that the oil and gas (O&G) industry accounts for more than three-quarters of global GHG emissions, it is unsurprising that its business model has come under increased public scrutiny in recent years. This is prominently illustrated in the growing wave of shareholder rebellions targeting the sector’s five leading firms: ExxonMobil, Chevron, TotalEnergies, BP and Shell. At their respective annual general meetings (AGMs), climate-conscious activists and responsible investors have called for a rethinking of their decarbonisation strategies. However, the obstacles confronting the O&G sector extend well beyond the scope of climate change alone. In this light, the following analysis will delve into and propose practical solutions to three pressing sustainability issues facing the industry today.
1. Market Risk & Stranded Assets
The 2015 Paris Agreement outlines the objective of limiting global warming to well below 2°C, underscoring the urgency for rapid and enduring cuts in CO2 and other GHG emissions. This objective has brought the concept of 'stranded assets' into sharp focus. Following Kefford et al.’s (2018) definition, these are ‘environmentally unsustainable assets’ facing ‘premature write-offs, downward revaluations, or conversion to liabilities due to the world’s transition to a low-carbon future. Experts believe that under the ambitious 1.5°C scenario, 58% of oil reserves, 59% of natural gas reserves, and 89% of coal deposits must stay untapped, placing between $1 to $4 trillion of fossil-fuel-related assets at risk of obsolescence. The latest IPCC report further substantiates this argument, revealing that the emissions projected from current and planned fossil fuel infrastructure already exceed the permissible carbon budget required to limit warming to 1.5°C.
However, at present, there remains insufficient financial impetus for O&G companies to shift towards sustainable business models. Despite increasing regulatory pressures and appeals from organisations like the UN urging financial institutions to cease funding new fossil fuel supply, the response has been slow. A recent study by the Oxford Sustainable Finance Group highlighted a stark divergence between financial institutions' proclaimed climate commitments and their financing actions. Despite the pledges made at COP26 to align $130 trillion in assets with net zero by 2050, O&G companies continue to secure substantial financial support for fossil fuel expansion, allocating roughly 10% of capital expenditure to related exploration activities. Given the average operational lifespan of fossil fuel assets of 30-50 years, this situation magnifies the stranded asset risk significantly.
This inertia is worsened by geopolitical factors, particularly energy security fears in the aftermath of Russia's invasion of Ukraine, and the resulting spike in O&G profits. Despite advocating for climate risk management since 2015, Blackrock cited current geopolitical tensions, energy market pressures, and their inflationary implications as reasons for supporting fewer climate-related shareholder resolutions in 2022. Similarly, UK Prime Minister Rishi Sunak portrayed resistance to his recent decision to issue hundreds of additional North Sea oil and gas licences as intended to "protect Russian jobs”, effectively politicising the U.K.’s ongoing fossil fuel dependency. Concurrently, O&G companies are revising their sustainability roadmaps. Shell recently announced the reversal of their previous commitment to reduce oil output by 1%-2% annually until the end of 2030. Along with the other O&G majors, the company is investing its record profits in share repurchases and dividend rises, rather than in clean energy ventures.
Yet, as articulated by the head of the esteemed International Energy Agency (IEA), fossil fuel companies and financiers may “not be really profitable” in the long term if they fail to transition. Indeed, taking recent profits as a rationale for fossil fuel expansion ignores the lengthy period of underperformance of O&G companies prior to the Covid-19 pandemic. The five supermajors suffered a combined US$207 billion cash shortfall from 2010 to 2019, while the market valuation of all public O&G companies fell by about 40% from mid-2019 to mid-2020. Strikingly, a portfolio of global renewable energy stocks yielded an average return of 18% over the past decade, as opposed to a mere 4.7% for fossil fuel stocks. The expected increases in carbon prices - up to US$147 per metric ton by 2030, according to the OECD - may further exacerbate the industry’s declining competitiveness, by escalating the costs of O&G production and their end products. Added to this are the escalating legal risks related to fossil fuel expansion, in light of the heightened costs of climate change to society. The London School of Economics' climate litigation database reveals a twofold increase in climate-related lawsuits between 2015 and 2022. Notably, these cases are increasingly involving state entities, with over forty U.S. municipalities and states suing O&G majors for damages tied to severe weather incidents and rising sea levels. Financial institutions are equally at risk, as evidenced by a recent lawsuit against BNP Paribas for its fossil fuel financing. Past cases, such as BP's $26 billion expenditures on damages related to the 2010 Deepwater Horizon Spill, highlight the potential financial impact of such liabilities. Overall, these changing dynamics shed a negative light on the sector’s ability to remain profitable in the future.
While a full fossil fuel phase-out by 2050 may not be realistic due to broader sectoral dependencies on technical carbon, avoiding diversification may force fossil fuel companies to play “catch-up” in new energy markets, harming their competitive advantage. As highlighted by McKinsey, fossil fuel players are uniquely positioned to become energy transition leaders, due to their scale, risk appetite, and technical know-how. Additionally, investing in the energy transition allows for portfolio diversification, improving risk/return profiles, while offering a buffer against geopolitical and demand shocks. Strategic capital allocation is key, considering the lengthy planning and construction periods for renewable projects and the risk of stranded assets in immature markets. Focus should be on mature technologies, such as onshore wind and solar PV projects, which are more cost-effective than the cheapest fossil fuels, including natural gas, as well as Carbon Capture, Usage and Storage (CCS/CCUS) solutions, which could even face negative learning curves over time. Furthermore, asset divestment should be minimized to prevent ownership shifts to less environmentally-conscious entities, as seen in EDF's case, where asset sales led to short-term increases in GHG emissions. The Glasgow Financial Alliance for Net Zero (GFANZ) advocates for a 'Managed Phaseout' strategy, using data analytics to set a flexible asset retirement strategy under different climate scenarios, underpinned by credible key metrics and targets and the use of sustainability-linked financing tools. Finally, to ensure the success of these multifaceted strategies, a supportive political environment will be crucial, highlighting the need for Paris-aligned lobbying activities.
2. Reducing operational emissions
Still in the realm of climate action, O&G companies should focus on quickly achieving net-zero operational (Scope 1 and 2) emissions. Despite comprising just 15% of oil and gas sector emissions, operational activities generate 40% more emissions than the entire steel industry. According to the IEA's Net Zero Emissions Scenario, operational emission intensity should decrease by 50% by 2030, yet reduction plans have only been declared by companies responsible for less than half of today's worldwide oil output. Additionally, the urgency of regulatory constraints is apparent with the rapid worldwide adoption of fracking bans, which are being enacted due to its significant contribution to methane emissions and various other pollutants. Combined with the relative ease and cost-effectiveness of cutting operational emissions versus Scope 3 emissions from end-product use, immediate action on this front is therefore essential.
To reduce operational emissions, the O&G sector should start with the establishment of ambitious, long-term goals supplemented with interim targets set at approximately five-year intervals, as recommended by most net-zero standards. These targets should be backed by credible measures, including increased efficiency in operations. For instance, unconventional extraction methods, such as tar sands, CO2 venting, and fracking are known for their greater environmental impacts than conventional methods. Methane is another crucial source of operational emissions, but can be relatively easily addressed by reducing or eliminating venting, fugitive release, and flaring, with the assistance of specialist methane measurement technologies, such as on-site drones and satellites. Additionally, the industry can effectively reduce emissions by utilising green energy for its operations. While CCS/CCUS has been lauded for its potential to reduce operational emissions, its use should be strategic and limited due to its current cost-efficiency challenges and the unclear fate of the captured carbon, which is predominantly used in enhanced oil recovery (EOR), contributing to further fossil fuel expansion. Closely related, the use of carbon offsets should only occur as a final resort intervention. This is especially important in light of Net Zero Tracker’s findings that only 13% of companies clearly articulate the conditions under which offsets would be utilised. This raises concerns regarding the transparent and excessive use of offsets, which have been criticised for their lack of additionality in reducing carbon emissions and negative social impacts. On that note, it is vital to transparently report all actions and their respective emission reductions, with external, independent result verification.
3. Maintaining a social licence to operate
The “social licence to operate” is a term introduced over twenty years ago by Ian Thomson, an expert in stakeholder management theory and practice. It is defined as “the level of acceptance or approval continually granted to an organisation’s operations or project by local community and other stakeholders”. With origins in the mining sector, the term is also relevant for O&G companies, due to their tendency to operate in complex areas where their activities can have an impact on local communities.
The Alberta oil sands projects, while grappling with numerous sustainability issues, serve as an illustration of the complex societal consequences of fossil fuel extraction. A recent publication from Canada's University of Guelph illuminated these issues in depth, focusing on the Trans Mountain Expansion Pipeline (TMX) project. The project aims to boost Canada's tar sands production by 890,000 barrels daily, and is set to cross over 500 kilometres of indigenous Secwepemc land. However, the Secwepemc Nation has withheld consent for the projects, citing the historical environmental degradation and adverse health impacts, including toxic exposure and premature deaths, associated with tar sands. The authors further reveal that such resistance has frequently been met by arrests and forced displacement. These factors indicate a failure to gain a "social licence to operate" and non-compliance with the the United Nations Declaration on the Rights of Indigenous Peoples (UNDRIP), particularly the principle of Free, Prior, and Informed Consent (FPIC).
However, failing to adhere to such principles exposes firms to substantial risks. For instance, intense public opposition and calls for divestment from the Secwepemc tribe - amplified through social media - prompted some of the pipeline’s key insurers to divest in 2020. Shell and ExxonMobil faced similar consequences with their Sakhalin II project in Eastern Russia in the early 2000s. Shortcomings in social and environmental impact assessments, along with the project’s role in oil spills, environmental degradation, and the disruption of indigenous lifestyles, resulted in major project financiers such as the European Bank for Reconstruction and Development (EBRD) pulling out, while Russian authorities even forced Shell to divest its $20 billion stake. The legal risks are highlighted in Shell's string of recent litigations. In 2021, the company was held liable by a Dutch court for damages incurred by four Nigerian farmers due to pipeline leaks. Moreover, Shell faces ongoing lawsuits from 13,000 Niger Delta residents suffering chronic health issues linked to protracted oil spills. The company has reported over 1,010 oil leaks since 2011, contributing to the region’s status as ‘one of the most polluted areas on earth'.
To sustain their social licence to operate, O&G companies must enhance stakeholder engagement and due diligence, ensuring adherence to international standards such as the International Finance Corporation (IFC) Performance Standards on Environmental and Social Sustainability and the World Bank Group (WBG) Community-Driven Development Principles. The International Petroleum Industry Environmental Conservation Association (IPIECA) has outlined a comprehensive approach for social investment in the oil and gas industry. Relevant recommendations include conducting Social Impact Assessments (SIAs) at least a year before construction, involving all affected stakeholders. The goal of the SIA is to obtain insights into the local context, opportunities, and risks, aiding in the design of strategies to mitigate social impacts throughout the project lifecycle. Additionally, the guidance underscores the importance of establishing an exit plan from inception, to prepare for unforeseen circumstances and ensure ongoing community benefits after the project’s end. Finally, the development and adherence to Key Performance Indicators (KPIs), designed in conjunction with stakeholders, are critical for project monitoring, risk identification, and the evaluation of mitigating measures.
4. Concluding remarks
In summary, while the O&G industry faces several challenges, three core issues stand out, each with varying degrees of actionability. Reducing operational emissions and maintaining a social licence to operate can be more readily addressed through sound business planning, effective risk management procedures, and recruitment of personnel with the appropriate expertise. However, the issue of stranded assets, which requires transitioning away from fossil fuels, is considerably more complex and calls for society-wide collaboration. The financial sector shares responsibility for the problem, due to its ongoing investments in fossil fuel expansion. Yet, without credible governmental action that compels markets to account for the societal costs of fossil fuels - such as enforcing a global carbon tax and terminating pervasive fossil fuel subsidies - the transition to a sustainable energy future could be unnecessarily delayed.