Middle East Economic Survey

 

VOL. L

No 33

13-August-2007

 

GENERAL

 

The Economics Of Climate Change Management In The Petroleum Industry

 

By Paul E Hardisty

 

Prof Hardisty examines the economics of climate change as it applies to the oil and gas industry, arguing that operators need to understand and prepare for a future which is likely to include some form of carbon tax. Application of whole life-cycle cost-benefit analysis is a key tool to help businesses identify optimum economic management strategies. Prof Hardisty is Global Director, Sustainability, for WorleyParsons, helping clients worldwide deliver more environmentally, socially and economically sustainable projects. He is a Visiting Professor of Environmental Strategy at Imperial College, London, UK, Adjunct Professor of Environmental Engineering at the University of Western Australia, and has worked in the Middle East for the last 15 years.

 

Introduction:  Change Is Coming

Academics, scientists and researchers tend to be a highly conservative bunch, routinely qualifying their findings with caveats and warnings about incomplete data, scientific uncertainty, and imperfect models. They are taught this from the outset of their careers – to question, to balance the facts, to examine the sensitivities of their conclusions to changes in input assumptions. So when the vast majority of the world’s leading climate researchers pronounce that their findings represent an unusually strong consensus, and that they are 90% certain that human activity is the chief cause of observed and future predicted climate change, it would do us well to listen. That many of these same scientists have been warning us about rapid shifts in planetary weather cycles for over 30 years, to little effect, highlights how difficult this issue is to understand, and how easy it is to ignore.

 

But with the current issuing of the Intergovernmental Panel on Climate Change (IPCC) Fourth assessment report1, the UK’s Stern Review on the economics of climate change2, and more popular mainstream works by notables such as Al Gore3 and Tim Flannery4, a broad and sweeping change in world public opinion seems to be underway – climate change is real, and it’s very serious. The scientific consensus, built around the IPCC reports, but backed up by literally thousands of peer-reviewed publications in the most prestigious and conservative scientific journals, predicts that the impacts of this phenomenon are going to be felt everywhere, in different ways, for a long time: shifting rainfall patterns, more violent storms, sea level rise, drought, floods, and widespread species extinctions are all predicted, their severity conditional on how quickly and effectively we can act to reduce emissions. Change is coming, and fast.   

 

The Petroleum Industry And Climate Change

Led by the Kyoto Accord, and increasingly spurred by shifting public opinion, national, state, and local governments across the globe are rapidly developing and enhancing legislation designed to reduce atmospheric emissions of the insulating green house gases (GHGs), principally carbon dioxide (CO2) and methane (CH4), that cause radiative forcing, slowly warming the planet. In Alberta, Canada’s oil and gas producing province and home of the Athabasca tar sands mega-reserves, the government has just announced a new CDN $15/ton tax on GHG emissions from facilities emitting more than 100,000 tons of CO2e (carbon dioxide equivalent) which exceeding mandatory 12% reduction targets5. The EU has announced a new goal of cutting emissions by 30% from 1990 levels by 2020. A new administration in Washington in 2008, Democrat or Republican, will almost certainly bring a nationwide carbon reduction programme of some sort to the world’s largest consumer of petroleum products, and largest producer of GHG. Full engagement of the world’s largest economy will have a resounding effect on the way the rest of the planet approaches carbon regulation in the coming decades.

 

In response, many petroleum companies, large and small, are now moving to implement emission reduction programmes, and prepare themselves for a lower carbon future.  Petroleum sector activities are estimated to produce about 1.2bn tons of CO2e annually6, chiefly from refinery operations, venting of CO2 in natural gas streams, and the continued widespread flaring of gas. While the burning of oil is a major contributor to the world’s total loading of GHG (total emissions are now over 40bn tons per year of CO2 equivalent, about 26bn tons of which are from burning of fossil fuels)1,2,7, natural gas is among the cleanest burning fuels currently available, and is seen as an important bridging fuel on the road to a lower carbon world economy6. The petroleum sector’s role in developing secure supplies of this cleanest of hydrocarbons is a major positive contribution to the effort to tackle climate change.

 

The supply of energy aside, the petroleum industry is now paying more attention to its own GHG footprint throughout the exploration, production, refining and product delivery life-cycle. The American Petroleum Institute (API) recently published guidelines on sustainability reporting, which include GHG emissions as one of the main reporting criteria8. Among the many major global companies that have announced programmes to substantially cut their GHG emissions are Shell, BP, Statoil, and recently ExxonMobil. All recognize the need to prepare for what now seems almost inevitable, that some sort of significant global tax on carbon emissions is coming, sooner rather than later. 

 

The Economics Of Managing Change

A proposition is defined to be economic if it improves human welfare. That is, the total benefits of the action exceed the total costs, to all of society9. Maximization of human welfare is the rational objective of economics. To be complete, economic analysis must therefore include the costs and benefits not only to the company, but to society. This means including the cost of damage to publicly owned assets, such as the environment. Traditionally, however, a firm’s internal financial analysis has not included accounting in dollar terms for the damage inflicted to the environment. Only by examining the effect of these externalities on decision making can companies understand the true effect and the true economics of their decisions10. 

 

To put this into context, consider the external cost of GHG emissions. According to Stern2, the predicted value of the damage inflicted upon the world’s economy by climate change could be as much as 5 – 20 % of global GDP every year, for all time – a cost to society of trillions of dollars annually. Depending on emissions trajectories over the next 50 years, this equates to a median expected damage value (or social cost of carbon) of $85/ton CO2e, although several studies suggest much higher values2. So a purely private investment decision which results in the production of an addition 1mn tons of CO2e per year, actually ignores $85mn a year in costs which others (society) must bear. 

 

In many cases, investment in energy and water efficiency, for instance, can result in net cost reductions for the company, in addition to reductions in emissions2. In comparison, the current cost of commonly available offsets is in the range of $3-5/ton CO2e. More costly methods, such as gas stream CO2 capture and sequestration (CCS), for example, may cost operators as much as $15 to more than $50/ton CO2e 6,11. So from an economic perspective, measures to reduce GHG emissions which focus on efficiency, energy use reduction, waste minimization and offsets, can be highly attractive now, with benefits (measured as costs savings to operators plus the value of the external damage avoided) strongly outweighing costs. This is particularly the case for new projects or project upgrades currently being contemplated or designed. Design changes which reduce emissions can be implemented now at much lower cost than retrofits forced on operators later. For offshore developments, for instance, retrofitting emission reductions equipment in future will be far more costly, in current dollar terms, than the same measure included at the original design stage. Understanding the future likely trajectory of carbon costs is becoming vital to project decision-making.

 

Justifying more aggressive GHG reduction measures requires a longer-term perspective, and a view on what changes in legislation and taxation are likely. With evidence of the severity of the impacts of climate change mounting, and heightened public awareness, there can be little doubt that carbon taxes (in one form or another) will eventually be levied in most, if not all parts of the world. Stern’s figure of $85/ton CO2e is useful in that it provides an indication of the true cost of emissions to the world’s economy2. However, Stern does not explicitly account for the full value of damage to the environment itself. Other studies have suggested that the true damage-avoided value of carbon could be as high as $200/ton CO2e or higher11,12. At these levels, many of the more costly GHG reduction technologies and approaches become economic propositions for society.

 

Example – LNG Facility Design

LNG is highly energy intensive to produce. The process of compressing and refrigerating the gas uses as much as one Joule of energy for every eight Joules of energy produced, producing about 0.2 to 0.3 tons of CO2 per ton of LNG. For a new facility comprising two 7.5mn tons/year trains, using a feed gas containing approximately 10% CO2, conventional design, at full operational capacity and venting CO2 to atmosphere, would produce approximately 20mn tons of CO2 each year. In social economic terms, using Stern’s $85/ton CO2e, this would reduce the overall value of the project by $1.8bn each year over the expected 30-year project life. Even using the benchmark Alberta Government carbon tax of about $15/ton CO2e, the impact is still significant at $0.3bn/year. Anticipating that the external damages caused by GHG production will come to be recognized and valued at some point during the life of the project, alternatives for reducing GHG emissions should be considered.

 

A combination of measures, including removing CO2 from the gas stream and re-injecting it into the producing formation, waste heat recovery for steam and power generation, selection of efficient turbines for compression, and energy efficiency optimization throughout the process, could be used to reduce the overall GHG impact.   Through these design changes, GHG emissions can be reduced by 7mn ton/year, at an anticipated capital cost to the project of $0.7bn. Over 75% of this cost is for carbon capture and storage (CCS), a unit cost of about $10 to $15/ton CO2e over the anticipated life of the project. Other studies of CCS around the world have suggested costs of in the order of $10 to $50/ton CO2e5. The design changes also reduce the use of fuel gas in the facility and improve reservoir performance, resulting in improved project revenues.

 

With conventional financial analysis, this expenditure would be difficult to justify. However, the benefit of these measures to the rest of society, using $85/ton CO2e, would be $0.6bn a year, a present value (PV) of $11bn over 30 years at a social discount rate of 3.5%. Thus, for every dollar invested, society as a whole is more than $18 better off (in terms of damage avoided). Even at $10/ton CO2e, the proposition is economic. Set in terms of managing future carbon taxes, whatever form they take, such an analysis provides a useful decision-making tool, allowing companies to assess planned spending on GHG emission mitigation with the future expected costs of emissions curtailment measures (taxes, cap-and-trade schemes), and the real social economic benefits which are produced.  Speculating on the future of global carbon management, there is every possibility that as time goes on, the cost of carbon emissions which firms will have to directly bear will start to converge towards the true social cost of the damage that those emission cause.

 

Conclusion

Whatever one’s perspective on the uncertainties surrounding climate change, it appears certain that the petroleum industry will be required to manage its GHG emissions more comprehensively as time goes on. Many companies are already establishing their own internal emissions reduction targets. With a focus on design and process efficiency, significant reductions can be achieved at relatively low cost, in many cases actually reducing overall costs to operators, and improving profitability. But only by considering whole life-cycle economics, and the projected value of GHG emissions, either as damage avoided or as some form of carbon tax, can the petroleum industry fully understand the implications of investment decisions, and better manage its operations in this period of profound change.   

 

References

 

1.   Intergovernmental Panel on Climate Change (IPCC) Fourth Assessment Report, 2007. 

2.   N Stern, 2006. The Economics of Climate Change – The Stern Review.  Cambridge University Press.

3.   A Gore, 2006. An Inconvenient Truth,  Bloomsbury, London. 

4.   T Flannery, 2005. The Weathermakers. Text Publishing, Melbourne.

5.   Alberta Government, 2007. Climate Change and Emissions Management Act. Specified Gas Emitters Regulation 139/2007.

6.   Intergovenmental Panel on Climate Change (IPCC). 2004. Carbon Capture and Storage

7.   S Pacala, and Socolow, 2004.  Stabilization Wedges:  Solving the Climate Problem for the Next 50 Years with Current Technologies.  Science Vol 305, 968-972.

8.   American Petroleum Institute (API) and International Petroleum Industry Environmental Conservation Association (IPIECA), 2005.   Oil and Gas Industry Voluntary Sustainability Reporting. API, Washinton, DC.

9.   D Pearce, 1981.  World without End.  World Bank.  Washington, DC.

10. P E Hardisty, and E Ozdemiroglu, 2005.  The Economics of Groundwater Remediation and Protection.  CRC Press, NY.

11. T E Downing, D Anthoff, R Butterfield, 2005.  Social Cost of Carbon: A Closer Look at Uncertainty.  UK Department of Environment, Food and Rural Affairs (DEFRA).

12. D Pearce, 2005.  The Social Cost of Carbon, in Helm, D Climate Change Policy. 2005.  Oxford University Press.