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Climate change and energy investments Technical annex to the position paper Dialogue with participants and other stakeholders is an important part of the new responsible investment policy that we adopted late 2015. As part of this dialogue, we will give more insight into investments that raise questions with (some of) our participants and into certain themes that have an impact on our investments. We do this via position papers that will be published twice a year. This first position paper deals with the topic that generated the most questions during 2015: climate change and investments in energy. The technical annex to the position paper goes into the different aspects of this topic in greater detail. The paper and the annex are both published in Dutch and in English. December 2015 1. Summary Climate change is one of the biggest challenges for the world to overcome in the 21st century. In the Paris Climate Accord of December 2015, 195 countries have committed to restricting the global temperature rise to well below 2 °C at the end of this century. This will necessitate a transition to cleaner forms of energy. ABP is well aware of the changes in the energy sector that this demands. As part of the new responsible investment policy we have formulated a number of ambitious targets for arriving at a cleaner portfolio, with more room for investments in sustainable energy. The transition to a sustainable energy economy allowing the climate goals to be achieved represents a risk to companies and to investors in them, but simultaneously creates opportunities as well. Global energy demand will continue to rise in the years ahead – even in a 2 °C scenario – and fossil fuels will continue to be needed for the foreseeable future in order to meet the energy requirement. We regularly screen our investments in light of various scenarios and in this paper consider a scenario of 2 °C. Companies in the energy sector will continue to play a part in our investment portfolio because they can offer returns, diversification, and a hedge against inflation. Moreover they have a key role to play in bringing about the transition. Companies in our portfolio are expected to anticipate and adapt to these developments in a timely fashion. They will be required to satisfy our sustainability criteria and we will use our position to engage with them and express our expectations. At the same time we will urge governments and regulators to pursue a consistent policy in order to create a level playing field for investments in sustainable technologies. 2. Scope of this technical annex This annex looks at ABP’s position regarding climate change and energy sector investments. We consider the contribution that ABP can make to the energy transition along with ABP’s ambitions. We also take a look at the role of our investments in the energy sector, at companies with reserves of fossil fuels in particular, and at the necessary changes in policy required of other parties such as governments and regulators. This includes a more in-depth look at climate change, future global energy demand, and the ways in which that demand can be met. Next, we consider the role of investments in energy companies in the portfolio and the valuations of companies with fossil fuel reserves. Finally, we provide a brief summary of our current investments in the energy sector. ABP Climate change Technical Annex 2 3. Position of ABP ABP fully supports the goal of the international community to reduce greenhouse gas emissions and to restrict global warming to well below 2 °C and to attempt to limit the rise to 1.5 °C o ABP aims to use its position as one of the largest pension funds in the world to contribute to the energy transition necessary to achieve this goal o ABP attaches great importance to improving efficiency in order to save energy and thus to limit the growth in energy demand o ABP has set itself ambitious targets for contributing to the transition to a cleaner energy supply but also realises that fossil fuels will continue to be needed in the foreseeable future o ABP continues to see added value in investments in the energy sector, not least because of the diversification benefit and inflation hedge they can offer o ABP realises that the energy transition involves risks, but it also creates opportunities. ABP has high expectations of energy companies in the portfolio and actively engages with these companies o ABP realises that not all of the world’s fossil fuel reserves can be exploited but is of the opinion that the risk this represents to share prices is manageable in most cases o ABP continues to engage with governments and regulators with the aim of bringing about the effective government policy that is essential in order to facilitate a rapid but orderly transition o Climate change and global warming There is broad consensus among scientists that the climate is changing as a consequence of greenhouse gas emissions. These greenhouse gases are responsible for climate change largely because they cause the earth to warm up. The United Nations Framework Convention on Climate Change (UNFCCC) has as its objective to limit the global temperature increase to well below 2 °C above pre-industrial levels. This is considered necessary in order to prevent dangerous human interference with the climate system. In the climate agreement reached in Paris in December 2015, 195 countries have committed to this target and to pursuing efforts to further limit the temperature increase to 1.5 °C by the end of the century. ABP supports these goals. As part of the new responsible investment policy (October 2015) we have set ourselves a number of ambitious targets. The carbon footprint of our listed equities portfolio, for instance, has to be cut by 25% by 2020. Energy transition Two-thirds of the greenhouse gas emissions attributable to human activity comes from burning fossil fuels to meet our energy requirements. In order to limit climate change and its negative consequences, the world therefore needs to transition to cleaner sources of energy. This transformation to cleaner energy will not be achieved overnight however, so it is vitally important that we use energy more efficiently. ABP is equally aware of both the transition needed in energy supply and the need for greater efficiency in our use of energy. We aim to use our position as one of the largest pension funds in the world to help in bringing about the required transformation. We are convinced that the best way for us to contribute to that transition is by continuing to engage with the companies that will have the greatest amount of work to do and which are essential to accomplishing the transition itself. Our new responsible investment policy for the period 2016–2020 accordingly includes contributing to a more sustainable energy sector as one of the key objectives. ABP Climate change Technical Annex 3 Demand for energy Increasing global population, coupled with growing prosperity, means that demand for energy will continue to rise. According to estimates made by the International Energy Agency (IEA), this will be the case even in scenarios in which global warming is limited to 2 °C. In these scenarios however, growth in energy demand will be much less rapid than if no action is taken. This is not because of lower demand growth for the actual benefit that we derive from energy (transport, heating, use of electrical equipment etc.), but because in these transition scenarios we will use energy much more efficiently. ABP therefore also attaches great importance to the further promotion of energy efficiency. Reducing the carbon footprint therefore applies to the entire listed equities portfolio and not only to the energy sector itself. Additionally, we will continue to invest in sustainable real estate and we shall double the ‘high sustainability investments’ that will help to bring about a better and cleaner future, from €29 billion currently to €58 billion in 2020. This category includes investments with the potential of contributing to efficiency as well as those in cleaner energy supply. Energy supply On the supply side, low-carbon technologies like solar, wind and hydro power and also carbon capture and storage will be an important part of the transition. ABP has accordingly set itself the target of achieving a fivefold increase in its investments in renewable energy from €1 billion to €5 billion in 2020. Given the limited availability of investment opportunities in renewable energy, that will present challenges. On top of that, the energy supply side is an important element in the doubling of the high-sustainability investments. Despite the transition to cleaner sources of energy, a substantial proportion of the growing demand for energy even in transition scenarios will still have to be met by fossil fuels. The required investment in the supply of oil, gas and coal, and in power generation capacity based on fossil fuels is considerable, and the new technologies cannot replace that requirement. Added value of energy sector investments On the one hand, the transition represents a risk for companies, particularly those in the fossil fuels value chain. On the other hand, the transition creates opportunities for energy companies, because substantial investments in energy supply and in energy efficiency are required over the next few decades. Although there will be far-reaching changes in the energy markets in a transition scenario, we believe that the traditional energy companies will continue to have an important role in the future as well. This will be partly as suppliers of fossil fuels (particularly natural gas, for which demand still shows an upward trend), which we cannot do without at this stage. They will also be able to play a key part in achieving the high level of investment in low-carbon alternatives that will be required. Despite the fact that there is competition (especially for funding these new technologies) from new non-traditional players, the traditional utilities are the main developers and operators of, for example, wind farms, hydropower plants, and also storage facilities. Traditional oil & gas companies have an important role especially in developing the infrastructure for gas as a bridge fuel and in the long term for biofuels and carbon capture and storage. Companies in this sector can therefore form an important part of our portfolio, not only because of the expected returns but also because of the benefits of diversification and the hedge against inflation which investments relating to natural resources are specifically able to offer. ABP Climate change Technical Annex 4 Energy companies’ expectations We actively engage with management of energy companies and this allows us to assess to what extent they are prepared for different low-carbon transition scenarios that might unfold. We question management on large capital projects, especially those with long lead times (such as offshore Arctic oil & gas exploration and development) and projects that will take a long time to break even and become profitable even when they go into production (such as tar sands). We also expect companies to set targets for bringing down their greenhouse gas emissions and increasing their efficiency and we ask that they take account of transition scenarios and possible increases in financial penalties for emitting CO2 in their investment decisions. Additionally, we expect companies to be transparent in reporting their emissions. At shareholders’ meetings we have accordingly generally voted in favour of resolutions making this possible or stipulating reporting transparency. We expect companies that cannot realistically play a role in the transition to return a large share of their cash flows back to shareholders. We do not invest in companies that are unwilling or unable to meet our expectations on managing climate risk. When we engage with companies, we expect to see visible progress within two years. In the absence of such progress we shall divest our position. Fossil fuel reserves When it comes to the valuation of energy companies, we have to take into account the risk that not all of the world’s coal, oil, or gas reserves can be produced and burned in a transition scenario. There will be winners and losers and the outcome will be different for each company, but we believe that the effect this will have on share prices is manageable in most cases. In the case of coal companies, which represent by far the greater part of the reserves, the fact that the reserves are not going to be fully produced and burned already appears to be reflected in the valuations. Western oil and gas company valuations on the other hand appear to imply that all proven reserves will be produced and burned, however given the current rate of production, the reserves will probably have long been depleted before demand disappears. This is partly explained by the fact that the marginal production costs for these oil and gas fields, which are mostly already in production, are very low. Engagement with governments and regulators Finally, ABP realises that effective and carefully considered government policy is essential in order to facilitate the transition. We accordingly urge governments and regulators to pursue a consistent and predictable policy that will create a level playing field for investments in sustainable technology. An example would be a price on emissions that is high enough to be an incentive for developing low carbon technologies. At the same time, it is also crucial that governments around the world gradually reduce subsidies for fossil fuels. Subsidies for renewable technologies can be an effective tool in order to advance promising technologies along the learning curve. Overreliance on unsustainable subsidies can pose risks, as we have seen in a number of countries over the past years. ABP Climate change Technical Annex 5 4. Background: Climate change and energy supply & demand Climate change and energy supply Climate change is one of the biggest challenges for the world to overcome in the 21st century. In 2010 in Cancún during the 16th Conference of the Parties (COP), the 196 Signatories to the UN Framework Convention on Climate Change (UNFCCC) agreed that urgent action should be taken in order to keep the global rise in temperature below 2 °C compared with preindustrial levels. This is deemed necessary in order to prevent dangerous human interference with the climate system. Serious reductions in greenhouse gas emissions are required in order to meet that target. At the 21st COP in Paris in December 2015, it was agreed that the global average temperature increase should be kept well below 2 °C, while efforts will be pursued to limit the increase to 1.5 °C. Since the energy sector accounts for about two-thirds of all anthropogenic greenhouse gas emissions today1 , a major transformation of this sector is required. In a world of growing energy demand and increasing importance of security of supply, this is particularly challenging. What does this mean for fossil fuel reserves? The Intergovernmental Panel on Climate Change (IPCC) estimates that in order to have a 50% chance of meeting the 2 °C target, the world can support a maximum so-called ‘carbon budget’ of 2,900 to 3,200 Gt of anthropogenic CO2 emissions, of which 1,970 Gt had already been emitted before 2014. The International Energy Agency (IEA) reckons that this leaves a budget of about 980 Gt of emissions from the energy sector (including supply, transformation, and consumption). Estimates made by the Carbon Tracker Initiative (CTI)2 show that global proven fossil fuel reserves have the potential to emit close to 3,000 Gt if burned without carbon capture and storage technology, hence far surpassing the budget. The latest estimates also show that the top 100 exchange-listed coal companies and the top 100 exchange-listed oil & gas companies combined had reserves with an emissions potential of 555Gt as of the end of October 2014, of which 72% is in the form of coal, 14% in the form of oil, and 14% in the form of gas3. The CTI study concluded that a large proportion of the reserves could not be exploited and that the potentially ‘stranded’ reserves might adversely affect the valuation of the listed companies concerned. In assessing the risks for companies, it is important to consider the expected energy supply and demand developments and the valuations of companies with fossil reserves. Future energy supply and demand In its annual World Energy Outlook, the IEA forecasts energy demand for the next decades under several scenarios. The New Policies Scenario (NPS) serves as a base case, while the main alternative scenario (‘450ppm scenario’) is consistent with limiting global warming to 2 °C. The Paris climate agreement has now tightened up the requirement by setting a target of holding global warming well below 2 °C, while pursuing efforts to limit rising temperatures to 1.5 °C. Compared with the 450ppm scenario, this probably means that greater energy savings will be needed and that the transition to cleaner alternatives will have to be accomplished more rapidly. We will assess the precise implications of a 1.5 °C scenario in the course of the coming year but the trends outlined below provide a good insight into the challenges facing the energy sector. In the base case scenario, total global energy demand will increase by 1.0% per year between 2013 and 20404. In the 450ppm scenario, energy demand growth is lower, although it is still expected to grow by 0.4% per year from 2013 onwards (see Figure 1). World Energy Outlook Special Report on Climate Change, IEA, June 2015. 1 2 Unburnable Carbon, Carbon Tracker, 2012. The original CTI list is currently maintained by Free Fossil Indexes under the name Carbon Underground 200TM. In this report we use the 2015 version of this list. 3 4 IEA World Energy Outlook 2015, pages 584 and 585. ABP Climate change Technical Annex 6 Global energy demand projections in various scenarios Primary Energy Demand Share in the mix Jaarlijkse groei Actual NPS 450ppm Actual NPS 450ppm NPS 450ppm 2013 2040 2040 2013 2040 2040 2040 2040 mln toe mln toe mln toe % % % % % Coal 3.929 4.414 2.495 29% 25% 16% 0,4% -1,6% Oil 4.219 4.735 3.351 31% 26% 22% 0,4% -0,8% Gas 2.901 4.239 3.335 21% 24% 22% 1,4% 0,5% 11.049 13.388 9.181 81% 75% 60% 0,7% -0,7% 326 531 588 2% 3% 4% 1,8% 2,1% 1.376 1.878 2.331 10% 10% 15% 1,1% 1,9% Other renewables 161 937 1.470 1% 5% 10% 6,5% 8,2% Total renewables 1.863 3.346 4.389 14% 19% 29% 2,1% 3,1% 646 1.201 1.627 5% 7% 11% 2,2% 3,4% 13.558 17.935 15.197 100% 100% 100% 1,0% 0,4% Total fossil fuels Hydro Bioenergy Nuclear Total Figure 1. Global energy demand projections in various scenarios. Based on IEA data from the World Energy Outlook © OECD/IEA 2015, IEA Publishing and adjusted by ABP. Licence: www.iea.org/t&c/termsandconditions. The magnitude of the transition becomes clear especially when comparing the share of the different fuels in the mix in the base case to the 450ppm scenario. Where fossil fuels are currently supplying 81% of the total primary energy demand and would drop to 75% (2040) in the base case, their share would fall substantially to 60% (2040) in the 450ppm scenario. Despite the fact that even in the 450ppm scenario fossil fuels remain the largest source of energy, absolute demand for coal and oil is expected to drop. Demand for gas, the least harmful of the three major fossil fuels, is still expected to increase though. On the other hand, the 450ppm scenario foresees a strong increase in the supply of renewables such as bioenergy, wind and solar. Also worth noting is that this scenario envisages a strong growth in the amount of nuclear energy. Total nuclear energy supply is expected to rise to levels of more than 2.5 times the current output. 5 IEA World Energy Investment Outlook 2014, page 162. Nuclear energy does not emit CO2 and for a number of countries it is therefore an important option for reducing greenhouse gas emissions. We recognise these advantages of nuclear energy but we are equally aware of the risks such as safety, costs of dismantling and the issues surrounding final storage of radioactive waste. In the process of increasing the sustainability of our portfolio we shall focus on investments in renewables. Need for investment in energy supply The investment implications of the transition become apparent by looking at IEA’s World Energy Investment Outlook5 published in 2014, which estimates total investments required in the energy sector (across the value chain: upstream, transport, and processing). This is summarised in Figure 2. ABP Climate change Technical Annex 7 Required investment in the energy sector in various scenarios Annual investments Cumulative Actual NPS 450ppm NPS 450ppm '00-'13 '14-'35 '14-'35 '14-'35 '14-'35 $ bln $ bln $ bln $ bln $ bln Oil Supply 427 621 503 13.671 11.062 Gas Supply 252 399 339 8.771 7.457 Coal Supply 61 47 31 1.034 690 106 120 131 2.635 2.877 8 48 78 1.061 1.722 Renewable power generation 153 266 400 5.857 8.809 Power transmission & distribution 212 310 266 6.817 5.851 Power supply total 479 744 875 16.370 19.259 10 15 42 320 920 1.229 1.826 1.790 40.166 39.388 21 34 62 739 1.371 Transport efficiency 115 224 369 4.928 8.120 Buildings efficiency 77 106 184 2.334 4.040 213 364 615 8.001 13.531 1.442 2.189 2.405 48.167 52.919 Power generation from fossil fuels Nuclear power generation Biofuel supply Total supply Industry efficiency Total efficiency Total energy investments Figure 2. Required investment in the energy sector in various scenarios. Based on IEA data from the World Energy Outlook © OECD/IEA 2014, IEA Publishing and adjusted by ABP. Licence: www.iea.org/t&c/termsandconditions. Investment requirements in the energy sector are higher under the 450ppm scenario than in the base case, since the transformation would be more disruptive, however the difference is only 10%. More interesting is the radical shift in the mix. Although investments in energy supply are roughly the same in both scenarios ($40 trillion cumulative), the required investments in efficiency are much higher in the 450ppm scenario. In absolute amounts, transport efficiency requires the most investment, at over $8 trillion cumulative. Apart from transport, investment requirements in real estate efficiency are also substantial. In energy supply, the difference between the base case and the 450ppm scenario is particularly apparent from the investment requirements in renewable power generation. These are expected to reach $8.8 trillion cumulatively or $400 billion per year, compared with $153 billion per year historically. Large increases in wind and solar generation capacity also require more investment in power storage and flexible backup. Investment requirements in coal supply will be only $31 billion per year or half the historical level. Despite the transition away from fossil fuels though, investments in oil and gas supply are still expected to be higher than historical levels on an annual basis in the 450ppm scenario. ABP Climate change Technical Annex 8 For oil this is mostly because of the decline of the production from existing conventional fields, which needs to be compensated partially by higher-cost sources such as deepwater fields. Altogether in the 450ppm scenario between 2014 and 2035, a total of $22 trillion will need to be invested in oil, gas, and coal supply, and in fossil-fuel fired power generation. This equates to 56% of the total investment requirement in energy supply. Electrification of the transport sector A better understanding of the magnitude of the transformation in the transportation sector can be gained by looking at IEA’s Energy Technology Perspectives6. Its 2DS scenario (2 °C) is broadly consistent with the 450ppm scenario while the 2DS-ET scenario (Electrifying Transport) shows what the impact could be of an even more ambitious electrification of the transport sector. 4DS (4 °C) is the base case. Figure 3 gives an analysis of the penetration of electric technology in transport. The most ambitious scenario foresees a 4% penetration rate of electric vehicles for passenger cars by 2030. However, by 2050 that will have gone up substantially to 17%. Bigger steps are to be made for instance by urban buses/minibuses, and especially for 2-wheelers which are expected to be 50% electric by 2030 and 70% by 2050 in the 2DS-ET scenario. Electrification of road freight is also substantial in this scenario, with 5% penetration for light commercial vehicles and medium freight trucks and 2% for heavy trucks in 2030. In 2050 in this scenario, these numbers are expected to increase to close to 30% for the light and medium freight and 15% for heavy trucks. Key assumptions for vehicles technology penetration rate Stock share in the fleet (%) Dominant electric powertrain type 2DS-ET 2030 2DS 4DS 2DS-ET 2050 2DS 4DS Passenger 2-wheelers BEV 50 40 28 70 50 27 Cars BEV 4 4 <1 17 17 2 Urban minibus BEV 8 <1 <1 30 <1 <1 Urban bus Trolley electric 7 <1 <1 27 <1 <1 Intercity bus Diesel hybrid with pantograph 1 0 0 8 0 0 LCVs BEV 5 1 <1 26 1 <1 MFTs BEV 5 1 <1 27 1 <1 HFTs Diesel hybrid with pantograph 2 0 0 15 0 0 Rail Electric with pantograph 55 51 45 71 61 50 Freight Figure 3. Electric transport penetration in various scenarios. © OECD/IEA 2014 Energy Technology Perspectives, IEA Publishing. Licence: www.iea.org/t&c/termsandconditions. 6 Energy Technology Perspectives, IEA, 2014. ABP Climate change Technical Annex 9 Figure 4 shows the impact that such an ambitious electrification of the transport sector would have on the fuel mix. Diesel and gasoline’s share in the mix would be reduced to about two-thirds in 2030 and to below 50% in 2050. The role of biofuels in these scenarios is also significant. Other fossil Hydrogen Biofuels Electricity Diesel Gasoline 180 160 140 120 Exajoule 100 80 60 40 20 0 2011 6DS 2030 4DS 2DS 2DS-ET 6DS 2050 4DS 2DS 2DS-ET Figure 4. Breakdown of final energy use for transport by fuel type. © OECD/IEA 2014 Energy Technology Perspectives, IEA Publishing. Licence: www.iea.org/t&c/termsandconditions. Conclusion All the developments and scenarios presented show us that the demand for energy, in the 2 °C scenario, will continue to grow, and that in a transition scenario the mix will shift to relatively more renewables and nuclear energy and less fossil energy. It also shows that investments in the energy sector will be significant, even higher in a low-carbon scenario than in the base case, and that even in a low-carbon scenario investments in oil and gas in the next 20 years will have to be higher than they have been previously. Finally, it shows us that investments in efficiency will become increasingly important going forward. ABP Climate change Technical Annex 10 5. Background: Role of the energy sector in our portfolio We discuss the characteristics of investments in listed shares of companies owning fossil fuel reserves and their role in our portfolio. A proper assessment of their role in our portfolio requires a long-term horizon. Only a long-term horizon can provide a view that is not blurred by naturally occurring cycles of supply and demand. Diversification Besides returns, diversification is an important reason for investing across sectors, including the energy sector. Sectors are not perfectly correlated and therefore the risk of a diversified portfolio is lower than the weighted average of the individual risk of the sector portfolios. In our ex-ante analysis, the MSCI AC World Index has an annual risk of 15.5%, while the weighted average of the individual sector risks adds up to 18.3%. In other words, sector diversification caused by imperfect correlation reduces risk by 2.8 percentage points. The fossil fuel companies have a relatively low correlation, which makes them a relatively valuable sector in terms of diversification. Using a utilitybased approach we estimate that the economic value added by sector diversification is equivalent to a 0.6% outperformance per annum7. Inflation hedge Another advantage of investments exposed to commodities, for example in the energy sector, is that they can serve as a hedge against inflation. Commodity prices have a big impact on consumer price indexes, both directly and indirectly. ABP has exposure to commodity prices, not only through investments in energy companies, but also more directly through our investments in listed commodity futures and unlisted commodityexposed investments. Most energy infrastructure investments can also provide a certain inflation hedge, since tariffs are generally linked to inflation through a regulatory formula. Returns Fossil fuels have on average generated higher long-term returns than the MSCI AC World Index. These companies have outperformed the global market by close to 0.8% annually for the past 20 years based on geometric means8. We should mention however, that although this represents an outperformance of economic importance, it is not statistically significant. 7 If the return were actually 0.6% per annum lower, the level of pension contributions needed to produce the same level of benefit payments – based on analysis of historical results – would have to be approximately 20% higher. 8 We define fossil fuel companies as a separate sector here by taking MSCI’s “Oil, Gas, and Consumable Fuels” industry within the Energy sector and the “Metals & Mining” industry within the Basic Materials sector since MSCI’s ‘ex fossil-fuels’ index has only 5 years of history available. The MSCI ‘ex fossil-fuels’ index excludes any company that owns any oil, gas, or coal reserves. ABP Climate change Technical Annex 11 On the left hand axis: On the right hand axis: Brent Oil 7 160 6 140 120 5 100 4 80 3 60 2 40 1 20 0 Dec-95 Oil Price ($/barrel) Cumuulative Performance ‘Fossil Fuel’ Companies World 0 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Figure 5. Cumulative total return of the fossil fuels sector and the MSCI AC World Index. As can be seen from Figure 5, the performance of the fossil fuels companies has been volatile. In the second half of the 1990s for instance, they were roughly keeping pace with the MSCI AC World Index whereas, from the start of the century, with commodity prices reaching unprecedented heights, they have shown a sharp rise. This was the result of very strong demand from emerging markets such as China, just after a sustained period of underinvestment caused by low prices, particularly in upstream oil & gas. In the last few years, however, the returns in this sector have fallen back. Share prices of especially US coal companies came under pressure due to the technological breakthrough in the field of shale gas exploration and production. Vast reserves of natural gas have been unlocked in the US over the last 10 years through the application of hydraulic fracturing and horizontal drilling. This cheap and abundant natural gas has displaced coal-fired power generation in many regions in the US and in turn this has sharply reduced the demand for domestic coal. US coal producers have had to either close their mines or find ways to export their coal into the international markets. On top of that, tougher environmental regulations reduced the demand potential for coal in the future, putting additional pressure on the share prices of these companies. Recently, the share prices of oil and gas companies have also come under pressure, largely because of the sharp decline in oil and gas prices since mid-2014. The drop in oil prices is mostly a result of cyclical supply/demand dynamics. A combination of the unlocking of large amounts of oil supply from the US, a change in strategy of the largest oil producer in the world Saudi Arabia, and weaker than expected demand growth from emerging markets have created a strong decline in global oil prices and in some regional gas prices that are linked to oil. The high oil prices that we have seen in the past 10 years have fuelled investments in technologies such as hydraulic fracturing and horizontal drilling, but also in other relatively expensive sources of oil supply such as deepwater, arctic and tar sands. Hydraulic fracturing and horizontal drilling in particular have generated a strong increase in oil production from the United States. Whereas the Organization of Petroleum Exporting Countries (OPEC) had until recently countered such supply increases by reductions in its own production volumes in order to protect the price, OPEC (and especially Saudi Arabia) changed course towards the end of 2014. Since it is the lowest-cost producer it decided to no longer support the oil price and instead to produce in order to protect its market share. ABP Climate change Technical Annex 12 Through this strategy it aims to curb the growth of the more expensive energy supply sources, including alternative sustainable sources of energy, while at the same time fuelling global demand for oil through lower prices. The cost of this strategy for them and other OPEC members comes in the form of (at least temporarily) a sharp reduction in available government funds. Finally, we should mention that these analyses of risks and returns have been based on historical trends. Historical returns in particular have limited use for forecasting future performance. In order to say something about possible risks and returns of investing in companies with fossil fuel reserves, it is therefore important to look at the valuations of such companies and what they imply. We do this in the following section. 6. Background: Valuation When assessing the potential future return contribution of any sector, including the energy sector or the fossil fuel companies in particular, we need to understand the valuations. Valuation is a critical factor in any investment decision. Even if the outlook for a certain company or sector looks unattractive, for instance due to slowly growing or even falling demand for its products, investments in that company or sector can still generate attractive returns, depending on the extent to which the outlook is already reflected in current valuations. Although we can make a number of general remarks regarding sectors as a whole, it is important to note that we assess valuations on a company-by-company basis. There are many different aspects to such assessments, including a company’s strategy and its position in the market, the expected future levels of investment, the risks inherent in its investment plans and the actual implementation thereof, the company’s cost control and its debt position. As mentioned before, in a transition scenario not all the proven reserves of coal, oil, and gas can be produced and burned. In order to understand whether this poses a risk to the share prices of the group of listed companies holding some of these reserves, we need to understand what the valuations of these companies imply, making a 9 APG internal analysis, using a weighted average of all 76 companies in the MSCI AC World Index with available reserves data, weighing by index weight. distinction for this purpose between coal on the one hand and oil & gas companies on the other. The listed coal companies together represent by far the greater part of the reserves (402 Gt or 72% of the total emissions potential of listed companies). The combined market value of these companies, in both developed and emerging markets, is around €670 billion at the time of writing. If we exclude the diversified mining companies and the utilities from this group (whose market values arguably represent a lot more than just their coal mining activities), the total market value of the more ‘pure play’ coal companies is €157 billion. This means that collectively this subset of 46 companies (representing 254 Gt or 63% of the total reserves of listed companies) is worth less than half of the value of the single largest oil & gas company ExxonMobil. While a full assessment of the valuation of these companies is beyond the scope of this paper, it seems highly unlikely that these valuations imply that all coal reserves will be produced and burned. For listed oil & gas companies the situation is different. In developed markets in particular, the valuations generally imply that all of the proven reserves (and some of the probable reserves) will be produced. These companies represent 59 Gt of emissions potential or less than 11% of the emissions potential of the top 200 listed companies (and less than 2% of the total emissions potential). Furthermore it is worth noting that the average socalled ‘reserve-life’ or R/P ratio (reserves divided by current production) for oil companies typically available in our investable universe is only around 15 years9. In other words, if they continue to produce at the current level they will have used up all of their reserves long before the demand for oil & gas disappears, even in a low-carbon scenario. This is partly explained by the fact that the marginal production costs for these oil and gas fields, which are mostly already in production, are very low. The companies with the larger oil and gas reserves on the other hand are typically the National Oil Companies (NOCs) that are owned by governments of resource-rich countries, often in emerging markets. Saudi Aramco, the Saudi NOC, has a reserve life of more than 70 years for instance. Most of these companies are not available for outsiders to invest in. ABP Climate change Technical Annex 13 Within the energy sector, individual company valuations can differ and reflect different expectations, also through time. We assess these differences continuously and use them in order to take individual company exposures that may differ from the general average market weights. In general, however, our conclusion is that, despite the fact that the lion’s share of the proven global reserves of coal, oil and gas (including a proportion of the reserves of listed companies) will inevitably remain in the ground in a transition scenario to a low carbon economy, we do not see this as a major threat to the share prices of these companies. On the one hand, the valuations of the companies that own most of these reserves (coal companies) do not reflect full production and, on the other hand, the companies whose valuations do reflect full production (Western oil and gas companies) represent only a small fraction of the total and, given their current production levels, they will have produced all of their reserves long before demand disappears. For the development of new reserves, however, it is important that these companies show caution in their investment decisions, both as regards cost and as far as the life of the projects is concerned. This is not only important in the present situation, with the sharp drop in oil prices we have seen, but particularly in the future, too, with possibly higher oil prices. When oil prices are high, the risk that companies will invest in high break-even projects is greatest. 10 IEA World Energy Outlook, November 2015; IEA Renewables Information – Excerpt – Juli 2015. 7. Background: The existing portfolio As of 30 September 2015, ABP’s total investment in the energy sector was €27 billion or approximately 8% of the total assets under management. This includes total investments in the broad energy sector, including the oil & gas industry, the coal industry, power generation, electric utilities and related investments in suppliers and infrastructure such as pipelines, transmissions cables and power distribution grids. Roughly 38% of these investments was in listed equities, 24% was in listed commodity futures, 19% was in illiquid instruments and 19% was in bonds. Figure 6 shows our exposure broken down by fuel type, compared with global energy demand figures from the International Energy Agency (IEA) for the year 201310. Not included here are the investments in commodity futures (mostly oil and oil products). In contrast to the other categories, these investments do not serve to finance part of the energy value chain and would give a distorted view if we included them. Excluding these commodity futures, our investments in the energy sector totalled €21 billion. ABP Climate change Technical Annex 14 12 % 5% 5 % 9% 21 % 3 1% 29 % 9% 41 % 5% % 33 Figure 6. ABP’s energy investments analysed by fuel type compared with the breakdown of global primary energy demand. The fuel types are nuclear, renewables, charcoal and solid biofuels, coal, oil, and natural gas. The analysis shows that our greatest exposure is to natural gas. Our coal exposure is significantly below the share of coal in the global fuel demand mix. The differences compared with the global energy supply picture mainly reflect the opportunities or lack of opportunities for investing in certain fuel types. Charcoal, for instance, is used mainly in developing countries with limited access to electricity or other sources of energy. Methodology Where data was available, we have used a lookthrough approach for our portfolio in order to split the exposures to companies that are active in multiple fuels, such as integrated oil & gas companies. Our oil & gas company exposures, for instance, have been broken down on the basis of the production volumes. In the case of electricity generators, the breakdown is as far as possible arrived at on the basis of production volumes per fuel type. The aggregated fuel type breakdown includes exposures to all parts of the specific fuel value chain (upstream, midstream, downstream). Comparability In 2014, we produced a detailed analysis of our energy sector investments, which was included in our responsible investment report for 2014. In that exercise we arrived at an estimate that approximately 10% of our investments was energy-related. This figure is not directly comparable with the analysis in the present document, partly because we have refined the methodology this year. Last year, for example, we included our total investments in diversified mining companies. This year we have better data and we have included only the share of coal in a company’s total revenue. In the case of large diversified mining companies, this makes a big difference. Other effects are fluctuations in share prices and more detailed analyses in the case of oil and gas companies and power producers for example. The analysis is also not directly comparable with the one on which our investment of €1 billion in renewable energy in 2014 was based, because those calculations only took account of the direct investments in renewable energy projects and investments in companies that were predominantly active in renewables. ABP Climate change Technical Annex 15