Carbon pressures are mounting and it’s the Chief Financial Officer who is the most alarmed about carbon impacts on the business. And they’re right to be concerned.
Carbon Meets Money
Global interest in all things carbon is keeping CFOs up at night. No, that’s not quite correct—it’s terrifying them beyond reason. And it has to. Every year the price of carbon keeps rising, companies are struggling to hit their carbon targets, and the curve keeps getting steeper and steeper. Miss your 4% target this year and next year it rises to 5%. Just consider some of the implications on the captains of money trying to come to grips with a gas that you can’t see, and you’ll start to feel for them.
A key role of the CFO is to help their company raise money, which means keeping capital markets transfixed on the company story. The CFO is integral to writing and presenting to investors the financial narrative of the company and its performance, both recent and future. Today, they need to tell an increasingly compelling story about the company’s (hopefully reducing) carbon exposure, and to do this, they need confidence that company data about carbon is timely, accurate, correct, and reliable—how much is emitted, where, by what asset or process, what is being captured or offset, what plans are in place to change the trajectory.
Get this wrong, and restatements loom. The fear is that capital markets may start to view carbon accounting misses in the same way that they view subscriber growth for Netflix. Tiny moves can potentially translate into massive shareholder value loss. A few basis points of interest tacked on to account for uncertainty in carbon reporting can translate into millions of incremental financing expense. Not good in an era of accelerating inflation and moves by central bankers to raise interest rates.
Capital markets are deeply concerned about financing businesses that spin an inaccurate and incomplete story. They may then be on the hook for emissions not of their making but which they are financing (to them, a Scope 3 emission).
The reputational damage to a CFO for relaying a misleading story, unintentionally or not, and the financier charged with financing carbon, is incalculable.
To meet their carbon commitments, many companies find themselves in the position of having to acquire carbon credits because they are unable to alter their direct carbon footprint economically, nor capture enough carbon to account for their full scope of emissions. A good example is an oil refiner that relies on natural gas to heat crude to 600 degrees so that it can refine petroleum. Or a liquified natural gas producer that burns gas to produce steam to drive turbines to help chill methane to -262 degrees. Or an ancient oil well that barely produces enough oil to cover costs of the service companies that burn diesel to get service rigs out to treat the well.
As CFOs purchase credits to offset their own carbon excesses, they drive up the demand (raising the price) for credits, which paradoxically lowers the quality of credits as really poor carbon projects are sanctioned. This creates the potential for misstated financials—never a good look.
The costs of insurance are going to rise, driven by climate change. At some point a range of oil and gas assets become uninsurable—those on coastlines, for example, as sea levels rise. Some oil companies, particularly the big ones that benefit from their normally robust cash flows, often self-insure, but smaller firms will find insurance increasingly hard to obtain. The CFO’s organization typically includes a risk management function that handles insurance policies, exposures, and claims, the material of which need to be spelled out in annual financial disclosures.
Under insuring for future losses will sit with the CFO. No one will know if they have over insured.
BALANCE SHEET VALUES
The most important asset on an upstream oil company balance sheet is its reserves position—the barrels or tons of resource held in accessible underground formations. It’s even an annual audit requirement to obtain an independent value of those resources. As carbon prices rise, and as the world adjusts by decarbonizing its energy and reducing demand, some of those resources are very likely to fall in value. National economies that are highly dependent on the resource (the OPEC producers, Russia) have a much higher incentive to simply lower the price of the product to maintain market share or flood the market to squeeze out competitors.
Balance sheets are going to come under attack as the underlying resource value falls. In some cases the resource will simply be stranded and written off by the CFO. But which asset? Operations has a structural incentive to keep assets running at all costs. After all, jobs are tied to specific assets in specific locations. As a CFO once told me “we have the lowest cost assets in the industry, but not all the time and not all the assets, and we sometimes can’t tell which ones.”
The oil and gas industry has perfected capital allocation over the years, and these practices are deeply instilled throughout the sector. In fact, how you allocate capital in oil and gas hasn’t really changed much since the business model was perfected by Nelson Rockefeller in the late 1800’s. To make decisions, the industry relies on established models and methods that flex the price of oil and gas up and down, factor in demand, adjust for currency and interest rates, model out production rates, forecast product yields, speculate on decline curves, allow for capital costs, operating costs, royalties, and taxation. The arrival of carbon as a new decision factor requires a rethink of how companies identify the highest and best uses of shareholder capital.
At a simple level, the CFO assigns a carbon price, which is factored into the project pro forma. But what about Scope 2 and 3 emissions? How to you factor in the risk of carbon price fluctuation? Do you tie a carbon credit to a project, a portfolio or a company? What is the forward price curve for carbon credits? Will changes to the established order pervert decisions or result in unintended consequences?
More than one CFO has lamented that their established internal mechanisms for capital allocation fall woefully short in the world of carbon management.
One obvious process that underscores just how challenging it must be for a CFO concerns the level of actual CO2 and methane emissions detected by some independent party as compared with what the industry maintains is the exposure. Hardly a month goes by without the issuance of another damning report that the oil and gas industry has been emitting far more methane and CO2 than was previously estimated. And not by a little bit.
For these independent measurements to be accurate and truthful, companies throughout the industry must be systematically understating their actual carbon footprints. It is inevitably the CFO that is called to account by the Board to explain the discrepancy from the company’s numbers, those of the industry, and the calculations of third parties.
Another role of the CFO is to sort out how to finance the acquisition of assets or whole businesses. Carbon now looms large as a pricing factor. There’s little sense in acquiring a carbon intense business that does not understand its carbon footprint (or worse, misstates it), with few decarbonization projects underway, no carbon credit program, and no plan for dealing with carbon. Such assets are only accretive to a looming carbon bill.
Selling assets will be equally problematic. If a buyer harbors even a little skepticism about the accuracy of an asset’s carbon footprint, they will discount the value and reduce the offer price.
A rapidly growing worry for CFOs is the accelerating frequency of lawsuits related to climate impacts. For now, the lawsuits are civil, in that companies that are found guilty are fined or sanctioned. Share prices are impacted. But should some courts begin to find carbon misdemeanors a criminal offense, like insider trading scandals, or stock option backdating, then jail terms beckon. This will not be good for cricket.
Boards need to hold someone accountable for the impacts of carbon on company financials, and inevitably, that will be the CFO. Virtually all public companies include the CFO as either a Board member or a key participant in the Board governance process such as the audit committee, and particularly as carbon becomes increasingly a matter of corporate financial viability or opportunity.
What can a CFO do?
There is a pathway forward, but it’s going to be painful.
Stay tuned for part 2 in this series.
Check out my latest book, ‘Carbon, Capital, and the Cloud: A Playbook for Digital Oil and Gas’, available on Amazon and other on-line bookshops.
You might also like my first book, Bits, Bytes, and Barrels: The Digital Transformation of Oil and Gas’, also available on Amazon.
Take Digital Oil and Gas, the one-day on-line digital oil and gas awareness course on Udemy.