(This transcript has been edited for clarity)
Total time: 19:23
Nick Erickson: In today's podcast we're going to talk about the energy and mining industries. We will discuss current material financial factors affecting these companies. We will also highlight some of the companies that have been proactive in disclosing financially materially issues, according to the guidelines created by the Sustainability Accounting Standards Board, otherwise known as SASB. I'm Nick Erickson, Vice President of Portfolio Management at Sage Advisory. Today I'm talking with David Parham, who's the Director of Research Projects at SASB. David joined SASB three years ago to cover the extractives and minerals processing sector. David also previously worked in the oil and gas industry as an engineer for nine years. Let's talk about energy and energy-related industries. More specifically, the extractives, mining, and energy production. Most people are familiar with the emissions, air and water quality, and waste management as issues associated with these industries. But what are some industry issues that you found be financially material that might not be as well known?
0:54
David Parham: That's a great question. So I mean, exactly as you highlighted really, the top of mind issues for industries in this sector really are centered around environmental impacts. And that makes quite a lot of sense considering the properties of these industries. But what's interesting to think about is how those externalities generated, associated with those environmental impacts, can affect a company's social license to operate. So really thinking about the social factors, and how their environmental performance can impact that. And just to define really quickly, social license to operate, that's kind of the idea that communities and societies grant companies a license to conduct business in their communities. And, you know, companies can generate both positive and negative externalities to the surrounding communities based on their operations there. So benefits often include economic benefits, such as employment or tax revenues that can support the community. But they can also generate externalities that are negative, such as pollution, consumption of natural resources, and other issues. And so I think as you said, a lot of the issues that pop into people's minds when we think about extractive companies, and energy companies, are these environmental impacts. But the manner in which those issues impact a company's social license to operate may be a little less well known or focused on. And so our standards really recognize that these are important competitive issues that can generate financial impacts, with topics like human rights and community relations being material in both the oil and gas exploration and production and mining standard.
2:32
And just to give a recent example from the news. In Indonesia, there's one of the world's largest copper mines is the Grasberg mine, of course operated by Freeport, and after a long series of disputes between the Indonesian government and Freeport, essentially the Indonesian government acquired an ownership stake in the mine – and there's a lot of things going on around that mine, but really, what it boils down to is social license to operate and who received the benefits from the mine in terms of economic opportunities versus the externalities that are generated? And you know, even the Wall Street Journal quoted the CEO of Freeport, Richard Adkerson, as saying, we really needed to clear out the uncertainty around our right to operate. So that's just one example.
3:22
Nick: Okay. Well, I mean, that's actually an interesting point, the social right to operate kind of segues into another question I had that the Vale damn collapse in Brazil and the subsequent impact to Vale’s share price highlights how a low-probability, high-impact incident can impact the company and lead to changes within industries along the lines of these social factors. So how would SASB evaluate and incorporate incidents such as these into potential adjustments to the materiality map, because if I remember it correctly, these low-probability, high-impact incidents currently aren't necessarily factored in when it comes to the extractives industry?
David: Absolutely great question and certainly very top of mind, really tragic incident in Brazil related to the failure of that mine and the fatalities that resulted. You know, our standard does recognize the importance of tailings facility integrity management – we'll jump into why that is in a minute. But really, that's sort of based on a history of incidents that have occurred in the industry, the financial impacts that those incidents have created, and the investor interest in data and information related to company performance on these issues. And all that forms the underlying basis of evidence that we look at when we consider including an issue like this in our standards. And really, what's particularly tragic about this incident is it's in our standards because there has been a history of incidents related to tailings facilities failures. Of course, another high-profile incident in Brazil occurred in 2015 with the Samarco tailings dam failure that led to the death of 19 people and the discharge of something like 60 million cubic meters of iron wastewater into a local river. Samarco was actually a joint venture of Vale and BHP Billiton. So this is sadly the second incident in Brazil and recent history where a tailings damn failure resulted in a loss of life.
5:21
That incident, the financial impacts of that, are still being determined. But to date, they've already reached well into the billions of dollars, so significant financial impacts there. A lot of companies have focused on this as a priority both due to the recognition of the strategic significance and the risk posed by these facilities, as well as investor interest and understanding as to what companies are doing around this. So a lot of great work has gone on by companies and associations of companies within the industry to really improve performance and monitoring, and hazard assessment and integrity management around these facilities.
6:00
But certainly more work to be done as we continue to see these events occur. So really what it comes down to for us is being able to establish this foundational body of evidence that demonstrates that performance on these issues can lead to significant financial impacts, which clearly we have in this case, as well as evidence of investor interest, which we've seen significant interest in this. Especially as the incidents related to these facilities continue to occur. And so based on that, that's the underlying basis that we rely on to include incidents like this in our standards.
6:32
And wherever there's this demand by investors for information to help them understand risks, and in some cases they can be these low-probability, high-impact events. In some cases, they can be the types of issues that manifest over longer time frames. Really, that's a strong signal for us in both cases to think about whether an issue may be material in a given industry standard. And then, if so, what are the right metrics to help investors understand how companies are performing and managing and mitigating associated risk to helping investors understand which companies are managing this well, and which companies they may need to engage with to improve performance.
7:07
Nick: Okay. You mentioned that taking a historical look to help determine some of the factors that go into something being determined as financially relevant. But do you foresee the future physical impacts of climate change having a larger impact on this particular set of industries and the financial condition of those companies with those industries? For instance, Hurricane Florence stalling out over North Carolina and the effects it had on Duke Energy’s coal ash ponds?
David: Yeah, another really topical question. Certainly. Physical impacts of climate change – a big deal in this sector and in these industries due to their significant physical infrastructure and assets associated with that. You clearly pointed out the environmental impacts associated with the coal ash ponds overflowing. This is an issue for which we have a metric in the standards related to this. I'll point to a few other incidents that really demonstrate the importance of physical climate risk in the sector and the oil and gas industry, looking at refining and marketing, as well as in the chemicals industry. Hurricane Harvey, which hit Texas in 2017, resulted in something on the order of 1 million barrels of refining capacity being taken offline, which is a huge impact. It resulted in some extensive flooding and then even resulted in an explosion at the Arkema industrial plant due to the failure of a refrigeration system that was designed to prevent a runaway reaction from occurring. When that failed, the reaction proceeded without any ability to slow down, and it led to a significant explosion and loss of containment there. So articles around sort of the aggregate financial impacts of Harvey suggested it may have been one of the most expensive storms of all time, with about $160 billion in damage. And a lot of that damage occurring in oil and gas infrastructure through both physical damage and then as a result of physical damage, interrupted or reduced production capacity for some time.
9:03
I think storms are top of mind, but another one to think about is water scarcity. Water plays a critical role across the infrastructure and extractives industries, certainly in power plant operation for cooling, for oil and gas extraction, for well development, and production and processing. And it's also a critical input for mineral extraction and processing. And so the extent to which regions that have prolific natural resources are subject to water stress, it can certainly lead to financial impacts if we get these chronic physical risks associated with precipitation patterns and water availability showing up in some of these areas where they're high concentrations of natural resources. So an example of that – there was a mine in Chile, the Maricunga mine, which was operated by Kinross Gold, that was ultimately shut down in 2016, due to concerns about its impact on local water availability, which resulted in Chilean regulators restricting water access to the mine below the level which was sort of the minimum viable level for it to continue operations. So the company ended up having to shut that mine, which certainly is a significant financial impact. So these are all examples of the ways in which physical climate risks can impact the industry.
10:14
It's definitely something that’s in our standards, we're looking at what are the right metrics to really capture this. We have metrics around water usage and water scarce regions that are designed to help investors understand these risks. But certainly, there's always more to do. The more we understand physical climate risk and the ways that it manifests will certainly lend itself to continue development of our standards and additional ways for investors to understand this.
10:34
Nick: They can’t all be bad in these industries. So can you can you highlight a company or two that have been industry leaders when it comes to reporting the financially material issues identified by SASB?
David: Yeah, great question. I'm happy to share a few examples of some folks that have gotten out there early and started reporting using our standard, which is really exciting and great to see that companies are finding value and using the standards to communicate to their investors. Folks who are interested – a few companies you can look at that have started reporting using the SASB standards and start to sort of compare and understand performance. There's a company called ARC Resources, which is the Canadian oil and gas producer that included the SASB index in their sustainability report and really points users to where they can find the information in the SASB standard. Southwestern Energy in the United States, a big natural gas producer, similarly includes a great table cross referencing its disclosures with the SASB standards. Kinder Morgan, which is a major U.S. oil and gas midstream pipeline company, produced its own sort of stand-alone SASB report that also included the recommendations of the Task Force on Climate-Related Financial Disclosures, and they go into a great deal of depth describing each of the SASB indicators and how that can be understood and interpreted by investors and how that relates to their overall strategy for managing these issues.
11:55
And then in the in the electric utility space, we have NRG who includes a significant data table in the back of their sustainability report pointing to the SASB-related disclosures, which is a great example of a utility company that's implemented the standard. So really encourage folks to jump in, look at those reports, they really good examples of companies that have taken a leadership role in early adoption of the SASB standards, and we're really encouraged to see uptake and use of the standards.
12:21
Nick: Great. So I'm an investor, hypothetically and realistically, are there any factors that a forward-looking investor can monitor that at this time might not be deemed financially material but could be in the future?
David: Yeah, it's a great question. And so there's something that is in our standard that is likely to be material, but that many companies really aren't disclosing right now in a highly localized way that could be conducive to a potential emerging risk. And so I'll dive into that and really want to zoom in on one particular production region, which is the Permian Basin in the United States, in West Texas and New Mexico, which is a prolific region for production. In the U.S., it's the largest area of production in in the U.S. with millions of barrels of oil being produced from that region daily. And I think there's a couple important trends that really highlight this as an area to watch. First, it’s a major production region, as I just said, and there's been significant commitments made by major companies to grow production in the region significantly over the next five years, including Chevron – they just recently announced that they are going to double production in the region to just under a million barrels a day. And Exxon Mobil, which announced that they plan to increase their production from the region by about 80%, to a million barrels a day. So significant growth announced and significant activity occurring in that region. And interestingly it also happens to be a region that is very frequently characterized by a high degree of water scarcity. And so why does that matter?
14:09
The answer is that water is a critical input to production in the region because production is largely driven by hydraulic fracturing. Hydraulic fracturing is of course, a drilling technique that is utilized by exploration and production companies to extract oil and gas from shale formations. And the shelf formations are very tight formations that are not conducive to the flow of oil and gas. And so the only way to get oil and gas to flow is to fracture, or induce these cracks in the reservoir that are pathways for oil and gas to flow. And the way to create those cracks is by pumping down the well bore a mix of water, chemicals, and sand. And that high pressure fractures the reservoir, hence the term hydraulic fracturing. And so that's really critical to enable production and of course, you can't have hydraulic fracturing without water. So no water, no new wells. And that means no new oil. So that's the interesting interaction there between water and the ability to produce in this area for which there's significant growth commitments, but also a degree of water scarcity.
15:18
So to put another layer of complexity on top of this – there are other industries in that region that also rely upon freshwater; for example, that part of Texas is a major dairy and cattle region. And of course, they're very dependent on fresh water for their business. So we have different economic actors that are in competition for what can be a very limited supply of fresh water. Now, I think it's important to take a step back and talk about how much water we really talking about. So the water needed to fracture wells really varies significantly, depending on the type of well, but no matter how you slice it, the total amount of water that goes into hydraulic fracturing is really a slim fraction of the water that's used for others uses. So across the United States, the water used for hydraulic fracturing is something like 0.1% of the total water that's used in the U.S. for irrigation, for example. So that's all well and good at the aggregate level. But I think what's really important is thinking about how this risk manifests on a localized basis, and especially when there's competition for scarce water resources. And so, as I just explained, I think the Permian is a region where that sort of issue can come rapidly to the fore. This isn't something companies are aware of, they're well aware of these risks, and they're already managing it in a number of ways. So certainly I would encourage diving into what the companies are disclosing around this in terms of the diversity of their water management strategies.
16:11
But I think it's interesting because you can observe that there are some similarities and differences in the ways that companies are going about managing this. Some companies are choosing to minimize their water usage based on how they design their well. So they're drilling fewer wells, but they're designing them in a way that they produce more, so achieving the same amount of production but drilling fewer wells, so less water usage. Some companies have employed strategies to reprocess or recycle water, and that really reduces or breaks their dependency on fresh water sources. Some companies are deploying interesting chemistry that doesn't require them to use fresh water to do hydraulic fracturing. And so they can use disadvantaged sources of water as an alternative. So I think it's interesting to think about these different companies’ strategies, and the optionality that it provides them to meet their growth targets should water scarcity become more of an acute issue. And that may be an interesting thing to monitor. Unfortunately, a lot of the disclosures that I just described to you aren't really comparable, and I think that's where this as be standards can be particularly helpful and investors understanding this issue.
17:45
Nick: Yeah, well, coming from the municipal side, when you're talking about this huge increase in production that's coming out of there. And naturally, I go to the infrastructure and the water resources that are available in the municipalities for these companies and the people that are going to support from water, wastewater treatment, to transportation, roads, and those types of things. So, you know, that would be kind of an unintended consequence or impact of this type of increased production.
David: Great point. It's all very interconnected. And I think that's, that's what makes it so interesting.
Nick: Alright. Well, David, thank you very much. That was actually really fun conversation. I appreciate all the insights you brought to this.
David: Yeah, no, thank you. It was a lot of fun for me as well really appreciate it.
18:26
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