ConocoPhillips’ February 2019 climate report lays out a thoughtful approach to governing climate risk. It addresses transition risk by focusing on becoming a low-cost producer but eschews providing the types of information that would address the climate concerns regarding the dwindling carbon budget that are driving shareholder engagement.
Conoco should focus on capex, but in the context of the remaining carbon budget
It is increasingly clear that the range of investor climate-related concerns that are fueling engagements with oil and gas companies fall into two primary categories:
Market misread: This is primarily the risk that the low-carbon transition will reduce commodity demand, lower prices, and financial results and that companies predicating business plans on higher future demand will fail to generate returns that pay back on these projects.
- These are risks posed directly to investee companies and require companies to demonstrate discipline in actual and planned capital expenditures. Conoco’s climate reporting focuses heavily on this issue, and its recent asset sales reflect both the needed strategic response—divestiture of high-cost, high-carbon projects, and the risk—many of those divestitures resulted in reported impairments as the purchase prices failed to cover capital already invested, as noted in its annual report.
Climate externalities: This is the risk to investor portfolios from the physical risks of unabated climate change. To the extent that physical climate change has adverse macroeconomic impacts that cannot be meaningfully hedged against or diversified away, investors may lose on net, even if individual fossil fuel producers see some local benefit. This may not concern Conoco directly, but it concerns Conoco’s investors.
- Actions to mitigate this risk by large-emitting companies serve the objective of reducing physical climate risk through reduced emissions by aligning production with a lower-carbon future; they can do this in an economic way by sanctioning only on the highest-margin projects. Companies may then choose to return cash to shareholders or diversify into low-carbon businesses.
- Aligning production in this manner requires an estimation of the future carbon budget for the company’s products as well as a notion of where the company’s current and potential production sits relative to its peers.
While the concerns are different, many investors are focused on both the market misread and climate externalities—this includes many investors in the Climate Action 100+.
In its most recent report, ConocoPhillips (COP) makes useful progress on the market misread issues but lacks information on how it would fare in a lower carbon budget relative to its peers—it does not view the latter component as helpful to investors. However, despite COP’s protestations, its work on capex points the way towards addressing the carbon externality side of the equation.
Conoco on Capex
First, let’s note what COP has done well. The company’s governance disclosures–how the board evaluates climate-related risks, how they are incorporated into business planning, and how scenarios are used to challenge business plans–are clearly articulated and suggest a robust process.
With respect to capex, COP discloses information about the expected, point-forward future costs of its supply on a “fully loaded” basis. The company argues, fairly to our knowledge, that it is the only oil major to offer disclosure on this basis. COP contends it has 16 billion BOE of resource that can be produced at a cost of less than $40/bbl (delivering a 10% internal rate return):
This is more than three times the total reserves of 5,263 MMBOE that COP reported in its FY 2018 10-K (consolidated, including equity affiliates). It implies a sub-$40/bbl resource life of 34 years at current production rates—COP’s therefore implying they can sustain current levels of production through 2050 with sub-$40/bbl supply. We will return to this below.
There are several useful elements here.
First, COP focuses on the cost of the resource base—not just the proven reserves. Companies such as COP are continually investing in the resource base. Today these are the investments that need to be most carefully managed in the climate context and COP is improving transparency by identifying expected future costs. This demonstrates that such disclosure can be provided—we would expect other companies to be able to do the same.
Separately, it would clearly benefit investors to have similar disclosures from other companies in a like for like basis—COP cannot do this alone; it requires instead that capital markets regulators play a role. Requiring companies to disclose comparable information would make it easier to see the bigger picture in the context of climate constraints as well—how many of COPs’ competitors have, like COP, lowered the expected costs of producing the resource base? And how do these volumes relate to an overall carbon budget?
Second, COP’s focus on the cost of supply, reiterated throughout the report, demonstrates the importance of this indicator in understanding which companies are better or worse positioned to address the low-carbon transition.
Indeed, the conclusions COP draws from its scenario work substantiate this point. COP’s multi-scenario analysis arrives at the same conclusions we draw regarding resilience to a low-carbon transition. COP states that, “…[a]s a result of our strategy and scenario work, we have focused capital on lower cost of supply resources, reducing our investments in oil sands and exiting deep water, while increasing our investments in unconventional oil projects.” We find much to agree with in COP’s assertion that “resources with the lowest cost of supply are most likely to be developed in scenarios with lower demand, such as the IEA’s Sustainable Development Scenario.”
COP’s recent divestitures substantiate this point. COP notes that in the energy transition, “it will be important to be competitive on both cost of supply and carbon. We have adjusted our portfolio to concentrate on lower-cost production and have divested some of our higher-emissions-intensity natural gas and oil sands fields.” Tellingly, as we noted in Under the Microscope, many of these asset sales resulted in impairments (i.e., the carrying costs exceeded the sale prices)—in part, a product of having to shift from valuing these assets “in use” to valuing them at the sale price.
Their decision to sell reflects a concern about holding high-cost assets; the fact that sales prices did not cover carrying costs illustrates the reality that the best-laid plans may not succeed—whether because of perceived future climate constraints or shifting price expectations more generally. In a climate-constrained world, COP agrees that this will likely lead to greater competition on costs; it would be logical to expect such impairment risks to become more significant. Notwithstanding the impairments taken, COP’s asset sales have helped position it lower down the cost-curve which would increase its resilience to a low-demand, low-price environment.
Conoco, what about the carbon externalities?
Where we take issue with COP’s report is the lack of focus on the concerns about carbon externalities. COP doesn’t want to provide a means of benchmarking its alignment, or lack thereof, with Paris climate targets, and offers little to allow investors to understand that dimension. As COP’s own scenario analysis evidences, it will likely take more than reductions in emissions intensity to achieve Paris compliance.
We mentioned we’d return to COP’s estimate of 16 billion BOE resource base with less than $40/bbl costs—i.e., the ability to maintain low-cost production at today’s production levels through 2050. Below is a chart of COP’s two-degree scenarios, with comparisons to other scenarios. The chart characterizes emissions levels from each scenario but provides no detail as to commodity demand changes through each scenario—it is therefore unclear the extent to which reductions in oil and/or gas demand are baked into these scenarios cannot be discerned, and the extent to which each scenario differs in total volumes of oil, gas, and coal. Moreover, the scenarios only go out to 2030 (though COP has indicated its next iteration will extend to 2040). 
As can be seen, emissions plateau before 2020 and decline at an increasing rate through 2030. COP’s three two-degree scenarios are similar to the IEA 450 scenario and the IPCC 490 PPM scenario, which further show dramatic declines in emissions through 2050. Though COP’s scenario disclosures are insufficient to say, definitively, how much of these emissions reductions must come from oil and gas—would COP’s $40/bbl position be sufficiently low to outcompete other offerings? No one can say for sure, but COP’s expectation of how it would be the company that meets demand in a dwindling carbon budget would help. That means not just focusing on the supply stack but focusing further on the supply stack in the context of a limited and shrinking carbon budget.
COP does not conduct this analysis and therefore cannot describe how or why its current resource base fits within a carbon budget built around the Paris climate targets. It therefore cannot address the key focus of the Climate Action 100+, i.e., the alignment of investments with the Paris climate targets.
The company is not focused on the carbon externalities generated by its products because it does not view it as a problem it intends to help solve. COP’s strategic objective is limited to building resilience to lower-price environments. Like many of its competitors, COP maintains the view that it is a passive supplier of fossil energy rather than an agent in the emerging energy transition. But investors’ concerns are driven not just by the potential for a market misread by COP, but also by the impact that physical climate risks will have on their portfolios as a whole.
Given COP’s use of scenarios and the focus on cost of supply emerging from that scenario work, it could evaluate not just where it sits on a cost curve compared to its peers (which, at an aggregate level, it does), but also where its resource base sits within a 2°C carbon budget, relative to its peers. Presumably, COP’s two-degree scenarios generate profiles for oil, gas, and coal demand over time and COP could therefore conduct such analysis using those profiles. Alternatively, it could use publicly available reference scenarios to do the same.
While COP believes scenarios are instructive for planning and managing risks, that planning around low carbon scenarios means implies a strategy to be on the low end of the supply cost curve, and that it believes it compares favorably to competitors in this regard, it nonetheless rejects the use of reference scenarios “… as a tool to characterize and disclose comparative financial risk.”
In our view, COP’s principal focus on cost competitiveness in an energy transition is precisely why such comparisons are essential for evaluating companies, even as companies make portfolio adjustments and reposition themselves over time.
Robert Schuwerk, Executive Director Carbon Tracker North America
 ConocoPhillips defines “fully burdened” costs of supply to include the costs of “exploration, midstream infrastructure, facilities cost, price-related inflation and foreign exchange impact, and both regional and corporate general and administrative costs.” ConocoPhillips, Managing Climate-Related Risks, Building a resilient strategy for the energy transition, (Feb. 2019).
 COP 2018 10-K, p. 5 (Feb. 19, 2019).
 COP 2018 10-K, p. 46 (Feb. 19, 2019) (BOE production, including crude oil, NGL, natural gas and bitumen of 1,283 MBOED).
 COP, Managing Climate-Related Risks, p. 20.
 COP, Managing Climate-Related Risks, p. 30.
 COP, Managing Climate-Related Risks, p. 18.
 COP, Managing Climate-Related Risks, p. 18.
 COP, Managing Climate-Related Risks, p. 3.