The ‘greenification’ of Latin America: moving the needle on oil & gas decarbonisation

14 May 2021

Paul MolanderEmerging Markets Strategy Analyst

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Alvaro VivancoHead of Emerging Markets Strategy and Head of ESG Macro Desk Strategy.

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8 minutes

A closer look at the oil & gas industry in Latin America yields important lessons for oil & gas operators, global governments, and markets to heed on the road to a net-zero future.

Key takeaways:

  • Decarbonising the oil & gas sector is essential for a net-zero future: this is especially so in emerging market regions like Latin America, where dependence on the sector and vulnerability to climate change are high.
  • Mexico’s state-owned oil & gas operator Pemex highlights the risk of not prioritising sustainability: decarbonising from a lower starting point and getting caught out by abrupt shifts in policy or investor sentiment are among them.
  • Investors need to be cautious about perverse incentives created by generous state support: a blending of corporate & state balance sheets can mask the high levels of “environmental leverage” and climate risk accumulated by firms and investment funds.
  • Policy leadership, low-carbon tech investment, and better pricing of climate risk are essential ingredients for decarbonisation: regional & global examples create a strong platform other oil & gas firms can build upon in a bid to decarbonise.

As pressure to act on climate change builds, businesses, markets, and governments globally need to work in tandem to make meaningful and lasting progress on key environmental objectives. Decarbonisation is chief among them, not least in carbon-intensive sectors like oil & gas, which accounted for roughly half of global greenhouse gas emissions associated with energy use before the pandemic. To achieve the climate targets set out in the Paris Agreement, the oil & gas sector will need to reduce emissions by at least 3.4 gigatons per year by 2050 – a 90% reduction in current emissions, according to data from McKinsey. The global energy industry’s reckoning in 2020, when demand for fossil fuels came to a near standstill as a result of pandemic-induced travel curbs & lockdowns, only served to brighten the spotlight on the industry’s vulnerabilities and underscore the importance of sustainability & resilience amidst a wider transition to a net-zero economy.

Those vulnerabilities are amplified in emerging market countries, where dependence on the sector for crucial government revenues is often high and where the estimated economic & public health effects of climate change are comparatively acute. Regions like Africa, Latin America and the Middle East are expected to lose up to 4.7%, 3.8%, and 3.7% of gross domestic product (GDP) respectively by 2050 due to climate change, compared with a more limited (though nevertheless concerning) fallout of 1.1% & 1.7% for North America and Western Europe. More than three quarters of global deaths from air pollution occur in emerging markets.

As we’ve shown in other sectors & regions, both policy & markets can be very influential in persuading businesses to prioritise environmental, social & governance (ESG) goals like decarbonisation. Yet, and as we’ve written before, it’s important to better understand cases where that relationship breaks down, to improve how we collectively go about addressing those objectives. To that end, we took a closer look at some of Latin America’s largest state-owned oil & gas producers – carbon-intensive businesses uniquely positioned at the nexus of government & markets – to see what & whether more can be done to help decarbonise the sector.

Pemex, Petrobras & Ecopetrol: three producers, two broad approaches to climate, one cautionary tale

As the 13th largest crude oil producer in the world, Mexican state-owned oil producer Pemex is both a major player in global oil markets and one of the largest bond issuers in emerging markets. Most of Mexico’s production and refining are controlled by Pemex, providing a vital source of government revenue.

But a number of structural issues – notably, declining production and a lack of progress prioritising ESG – have turned what was once a “cash cow” into a liability to the state, taking on what we call “environmental leverage”: risking tomorrow’s environment for today’s financial profit. The company publishes a sustainability report & sets ambitious targets, but it fails to identify a sustainable path forward. Pemex’s own reporting shows worsening performance against almost all of its environmental goals, including CO2 emissions (an independent study found Pemex facilities may emit as much as 10-times the methane noted in official reports).

CO2 emissions in crude oil refining (Pemex)

Sources: Pemex, NatWest Markets

 

CO2 emissions in ethanol production (Pemex)

Sources: Pemex, NatWest Markets

That performance could worsen still. To increase refining capacity for heavier fuels, Pemex – with generous support from the government – is building the $8 billion Dos Bocas refinery, which will be Mexico’s largest upon completion in 2022. But this is despite its own analysis concluding the refinery would emit high levels of contaminants, to say nothing of the fact that the refinery is being built upon federally protected mangroves – which is prohibited in the plan approved by the country’s environmental regulator.

Pemex’s approach to climate stands in stark contrast to those taken by some peers. Brazil’s Petrobras for example has identified ten commitments to sustainability, including a 25% reduction in operational emissions by 2030, the development of restorative projects, and new investments in low-carbon technology. It also explicitly supports the Task Force on Climate-Related Financial Disclosures (TCFD), the first major oil & gas company outside of Europe to do so. Though Petrobras recently divested from its renewable portfolio, it remains committed to assessing solar & wind opportunities and intends to re-enter the sector. And according to its latest Climate Change supplement, total greenhouse gas (GHG) emissions have fallen 25% since 2015.

Colombia’s Ecopetrol has taken a similar forward-looking approach. It published an environmental management plan last year, which seeks to “prevent, control, mitigate and offset the potential environmental impacts of operations and projects” through targeted technology investments and portfolio diversification into wind & solar projects. Last year, it released its own Climate Change Strategy and plans to introduce a revamped roadmap to carbon neutrality later this year. According to its latest Climate Action report, total GHG emissions have fallen 5% since 2018.

Government policy combined with structural factors to create perverse market incentives

At a time when other large oil companies in the region and elsewhere seek to cut the carbon they emit, why has Pemex lagged behind its peers? We think a combination of government policy & structural factors help explain its lack of progress on decarbonisation – and the absence of a market response.

In general, there appears to be no major push by the Mexican state to promote low-carbon technologies. For example, the 32 projects included in President López Obrador’s four-year Infrastructure Plan include multiple carbon-intensive investments, while no investment is planned in renewable energy. Similarly, recent moves to implement a new regulatory framework for the power sector would give the state-owned utility, CFE, a monopoly over supply, crowd out private investment into renewables projects and boost demand from its fuel oil generation plants.

At the same time, Pemex continues to benefit from generous government capital injections to make up for dwindling productivity, as well as tax breaks and debt support – totalling $9.5 billion in 2021 alone.

This blending of corporate & sovereign balance sheets creates perverse market incentives. The more the company struggles, the more support it receives from the state, which – at least in the short-term – anchors its financial performance and papers over its poor decarbonisation record. But Pemex’s large outstanding debt and broad inclusion in major emerging market bond indices means it forms an integral part of many investors’ portfolios; excluding it could dent fund performance. This is likely one of the main reasons why, despite no shortage of calls for greater transparency and progress on decarbonisation, we’ve seen little evidence of ESG factors influencing investor allocations to Pemex – and why, more worryingly, investors appear to be under-pricing climate risk at the firm.

Bond performance compared: Pemex has outperformed peers in the bond market despite underperforming environmentally (%)

Sources: Pemex, Haver, NatWest Markets. Each line represents the yield (%) performance of a bond issued by the oil & gas company named, with the numbers (’47, ’49, ’45) corresponding to the year the bond matures

We think Pemex’s steady accumulation of environmental leverage puts it at a disadvantage relative to peers more advanced at climate change mitigation. The company risks greater scrutiny from investors as global regulatory momentum and institutional capital shifts firmly in favour of low-emitting companies. It could also face greater pressure to make quick progress on decarbonisation from a lower starting point, and provoke a swift market reaction for failing to do so – particularly if domestic policy shifts abruptly or a distinct event sparks a wave of environmental activism, or both, as in the case of the Amazonian wildfire crisis of 2019.

We’ve also seen this play out in the US, with markets punishing high-emitting power providers and rewarding decarbonisation in the wake of Joe Biden’s election victory; one of Biden’s core climate goals is for the US to have 100% carbon-free electricity by 2035. That said, investors need to take a more comprehensive approach to ESG investing – especially when state-owned businesses are concerned.

Lessons learned: more coordinated policy support, low-carbon tech investment and better market pricing of climate risk

Pemex’s lack of progress on decarbonisation serves as a cautionary tale for others in the region and elsewhere – but its challenges are not unique, and their closer inspection yields important lessons for other oil & gas companies (in the region & elsewhere), governments, and markets as they look to achieve a net-zero future:

  • Government leadership is key: needless to say, without clear and consistent policy leadership on climate, which includes embracing a science-based climate policy agenda and pathway towards net-zero emissions, businesses across the economy will struggle to prepare for a low-carbon future. Policymakers need to set out – and consistently reinforce – realistic climate change mitigation, adaption, and finance policies to ensure businesses can draw from government leadership and – crucially – an ecosystem of stakeholders to support decarbonisation efforts.
  • Much can be achieved through decarbonising operations: many oil & gas producers seek to decarbonise by diversifying their portfolio into lower-emitting production like solar & wind, but as others in Latin America and elsewhere have shown, much can be also achieved by focusing on existing operations. Swapping diesel for renewable for onsite power generation, cutting fugitive emissions through improved leak detection & vapor-recovery units, reducing routine flaring, improving energy efficiency, increasing carbon capture, use & storage (CCUS), and replacing conventional-oil feedstocks in refineries with bio-based or recycled materials are among the ways in which oil & gas producers can make substantial progress on decarbonisation – and in many cases, reduce costs. Another option is to offset emissions by promoting and protecting natural carbon sinks, including oceans, plants, forests, and soil to remove emissions from the atmosphere. For example, ENI, a leading Italian producer, has committed to planting 20 million acres of forest in Africa to help offset emissions.
  • Sustainable finance can help oil majors move the needle on emissions: Pemex’s environmental record has deteriorated steadily over many years, and in the absence of a specific trigger like those alluded to earlier, markets may have become complacent. Part of this is driven by the market’s failure to adequately price ESG risks (and isolate ESG from traditional credit risks) and influence corporate behaviour & accountability on climate. Sustainable finance can help here. Instruments like sustainability-linked bonds or loans, which tie bond coupons or loan repayments to specific, science-based sustainability targets, reward positive behaviour change through lower borrowing costs if those targets are met. We’ve seen this structure gain wider adoption in recent years, and major oil & gas producers (and their investors) are warming to them. In 2019, Royal Dutch Shell plc raised $10 billion through a sustainability-linked loan, with repayments linked to progress towards reaching its short-term net carbon footprint intensity target. And earlier this year, French oil major Total stunned markets when it announced that all new bond issues would be linked with climate performance targets.

Oil & gas companies play a crucial role in the wider transition to a net-zero future, and the consequences of failing to become more sustainable – for businesses, investors, and ultimately, the environment – severe. But moving the needle on decarbonising the sector will require efforts across the entire value chain, and as we hope to have shown, may involve looking past perverse incentives and taking a longer-term view on the opportunities ahead.

For more insights on managing the transition to a net-zero economy, check out our Road to COP26 series, get in touch with your NatWest Corporates & Institutions representative, or contact us here.

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