By Nathaniel Riley, CFA
From the Summer 2013 Edition of Values

The wisdom of investment in fossil fuels is being questioned for financial as well as environmental reasons. Many investors and environmental advocates recognize that energy companies may be vulnerable if legislation is enacted to reduce carbon emissions enough to contain rising global temperatures. We have seen recent attempts to quantify this vulnerability. In one high-profile example, the International Energy Agency (IEA)—an autonomous organization with ties to the OECD—has suggested that if we are to keep global temperatures within 2°C of the pre-industrialization level, we cannot burn more than one-third of proved reserves before 2050. (Proved reserves are stores of coal, oil, and gas that are known to be in the ground and that could be economically extracted at today’s prices.) If this analysis is correct, energy companies will face a headwind as demand for fossil fuels declines. This shift in demand can occur either directly, through government regulations that set limits on carbon emissions, or indirectly, through carbon taxes that raise the cost of fossil fuels and discourage their use.

This argument can make energy stocks look like a poor investment. But while such a shifting landscape would present great challenges for the industry, not every energy company would be affected in the same way or to the same degree. Even in a scenario in which fossil fuel consumption is limited in order to minimize environmental impact, investors may find opportunities in energy companies less vulnerable to such regulation. In order to do this, we must evaluate how and when regulations may be adopted, and which types of fossil fuels would be most affected.

Any significant regulation of carbon is likely to reduce total demand for fossil fuels. That will in turn lower the aggregate volume that can be sold and the revenue energy companies will receive. More carbon-intensive and more costly sources of energy will be particularly disadvantaged. To generate an equal amount of energy, coal emits 68 percent more CO2 than natural gas during combustion, and 42 percent more CO2 than oil. Although coal is relatively cheap to extract from the ground, this disadvantage will increasingly limit its use in a carbon-constrained world. Similarly, oil derived from bitumen (oil sands) is more carbon intensive and more costly to produce than many other sources, and investments in bitumen reserves would fare worse under broad carbon legislation. Conversely, natural gas investments may come out relatively unscathed; with a lower carbon footprint than other fossil fuels, and lower cost than most major sources of energy, natural gas could ease a transition to a low-carbon world as long as fugitive methane emissions and other production impacts are minimized. In the IEA’s energy scenario that keeps global temperatures within acceptable limits, demand for natural gas will continue to rise over the next two decades as its use displaces coal and oil—a good outcome for companies investing in gas resources.

The path and pace of increasing government regulation of carbon will have an impact on the fortunes of energy companies and investors. Legislation that is introduced gradually, with clear communication from regulators on how laws will be designed and regulations phased in over several years, will be the most benign for energy companies, investors, and consumers. It would allow energy companies adequate time to adjust their investments and capital expenditures toward projects that would be more profitable in a lower carbon world, and away from costlier, more carbon-intensive projects. If a company has no practical path to suitable projects once the regulatory environment becomes known, this long lead time would also give investors the opportunity to demand that cash be distributed to shareholders rather than re-invested in dubious projects. If, instead, regulation is only put in place when the situation becomes calamitous, larger shockwaves will hit energy companies as previously profitable projects are quickly abandoned and demand for fossil fuels fluctuates rapidly; it is in the interest of companies and investors to avoid such a scenario.

Energy investment has long been fraught with uncertainty. Technological change, supply shocks, and shifting global economic growth patterns are but a few of the factors that cause energy companies to continually adapt how they conduct business. This trend will surely continue over the next few decades as we will almost certainly see new limits on carbon emissions. Despite the challenges that the energy industry will face as a result, companies that position their investment in areas ready to meet these challenges can remain a sound investment within a diversified portfolio.