“Catastrophic market failure”: Mispricing gives edge to oil firms that won’t go net zero

Oil and gas firms that have not set credible net zero plans are currently benefiting from higher valuations than counterparts on a more credible transition pathway, a trend which could pose a long-term investment risk, industry experts have warned. 

Earlier this year, BP made headlines when in the wake of posting record profits it reversed a pledge to reduce emissions by 35-40% by 2030, instead shifting the target to 20-30%. In the week of the target revisions being made public, the firm’s share price rose 15%, from 486.05 GBX to 560 GBX.

Similarly, Shell has scrapped its target to reduce its oil price by 1-2% per annum and opted instead to increase its oil output well into 2030, in a bid to restore investor confidence, Shell CEO Wael Sawan announced in June, Shell's share price rose by 4% in the weeks following the announcement. 

These announcements mark a significant turnaround, with European oil and gas giants having initially set more ambitious net-zero targets and invested more in low-carbon projects, particularly renewable power, than their American peers. 

Sawan said at the firm's AGM in May that pressure from investors was a key reason for the oil giant's decision to backtrack on its climate targets. 

Catastrophic failure

But when taking climate risk into account, this mispricing contributes to a late stage shift to net zero by 2050, which could come at a higher price warned Nick Stansbury, head of climate solutions at Legal & General Investment Management (LGIM).

Citing original research, Stansbury said: “The data tells us that the more ambitious [in climate action] these companies will be, the greater the chance that these companies will be large and successful in the future, not the opposite way round. 

“Over a 30-year time horizon, waiting just 10 years to start the transition, we think will increase the global economic cost until around 11 to 12% of economic output” he added. 

“What’s going on is a catastrophic failure to properly articulate this to the market, that the balanced strategy that some of European oil majors are trying to embark upon will result in more value creation for investors in future. Until that is addressed properly, this is a key area for investors to work on and engage constructively with these businesses”, Stansbury warned. 

Transition risks and rewards

His warnings are echoed by ratings firm Morningstar, which argues that investors should approach the energy transition from a risk/reward perspective. Highlighting that European energy companies have so far set more ambitious climate targets, the firm also identifies a failure to transition energy production by 2050 as a key investment risk. 

Predicting the rate of the transition in the oil and gas sector was now the “trillion dollar question” for investors, said Travis Miller, energy and utilities strategist at Morningstar. 

The firm also highlighted Total Energy as an example of a company which has not backtracked on its net zero targets and continues to invest in the energy transition. 

But Morningstar's risk / reward approach does not clearly advocate a divestment from climate laggards, its rating lists for example ExxonMobil as one of the "best buys" due to plans to double earnings between 2019 and 2025, plans to raise $100 billion in surplus cash and ambitious share repurchase programmes. 

A risk not worth taking?

But for some institutional investors, this is a risk not worth taking. Speaking to Net Zero Investor this year, Adam Matthews, chief responsible investment officer at the Church of England Pensions Board, admitted there was “a limit to what you can achieve” with oil and gas engagement.

This remark was soon followed by the decision made last month by the CofE Pensions Board to offload its stake in oil giant Shell as the pension giant looks to end all of its interests in the sector.

“There's a lot of uncertainty right now, around both the timing and the scale of the clean energy transition. An important part of investing is getting not just the investment itself correct, but also the timing right. If it takes one hundred years for the story to play out, that's not necessarily a good investment”, he said.

‘Eye watering’ net zero investments needed

There have been a wide range of proposals put forward as ways for the oil and gas sector to make the transition to net zero, including a shift to classic renewables such as wind, solar, and hydropower, and investment in new technologies such as carbon capture and storage (CCS).

Previously, Sonja Laud, chief investment officer at LGIM, has said that “the world, policymakers and investors need to embrace every legitimate tool in the decarbonisation toolkit” to achieve net zero.

Stansbury backed these claims, hammering home the need for a coalition of net zero solutions to achieve the 2050 Paris Agreement targets.

“Something often set up as a debate is renewables versus new technologies, as if these represent binary choices, either in favour of gas or in favour of hydrogen, either in favour of renewables or in favour of CCS.

“That's just a false dichotomy. In order to reach net zero, what we need is humongous, eyewatering quantities of capital funds and trillions of dollars deployed into all of these technologies. All of these teams need to be working together to get us on a pathway to net zero”, he said.