As the global economy moves to more sustainable sources of energy, companies must successfully decommission their obsolete operating assets such as:
- Mining sites
- Coal and nuclear power plants
- Oil & gas facilities
The decommissioning of these obsolete assets must be done in a way that addresses environmental considerations and adheres to ever-tightening regulation. It also comes at a significant cost to the energy company. The United Nations Industrial Development Organisation estimates that there are more than 29,000 power plants and 35,000 coal mines worldwide.1 Decommissioning a single asset can cost more than $1 billion.2 In the nuclear and mining sectors, needs such as continuing physical maintenance dramatically increase the final decommissioning cost, as well as the decommissioning period.
Pre-funding: a novel solution to decommissioning
At BNP Paribas Asset Management, we believe companies should seek to pre-fund the decommissioning of mining, coal, nuclear and oil & gas assets, known as decommissioning liabilities.
What is pre-funding?
Prefunding liabilities refers to setting aside funds or assets in advance to meet future financial obligations and liabilities. Prefunding future cash outflows is implemented by companies to ensure necessary financial resources are available when they have to fulfil their commitments. Prefunding is therefore a prudent financial practice to mitigate the risks of not being able to meet future financial obligations and helps ensure the financial stability of a company while fulfilling its environmental obligations.
Oil & gas, nuclear, traditional power, mining and an increasing number of renewable companies currently hold large, long-dated liabilities on their balance sheet. These liabilities are the estimated costs of decommissioning their polluting and retired assets.
Accelerated by the Energy Transition, the decommissioning / remediation / restoration / environmental rehabilitation of these assets has become a focal point for businesses holding these assets. Increasingly the public, regulatory bodies and investors are reviewing how effectively companies are managing their decommissioning obligations. Historically, companies were only required to report such liabilities on their balance sheet and there was no obligation to prefund their liabilities (except for the nuclear sector). Most decommissioning obligations have therefore been unfunded and thus dependant on the available operating cash flow when the obligations come due. In some cases, financial obligations in relation to decommissioning are covered with non-cash guarantees.
However, decommissioning cost matching cash flows cannot only stem from the mine, plant or oilfield operations at the time of their own decommissioning or remediation. Currently corporations make the assumptions that there will always be a new mine, plant or oil fields able to generate such cash flow (a similar principle to a pay-as-you-go pension system). Such assumptions is now being challenged in the context of the energy transition. Indeed, while we know some installations are due to close, there is no clarity on which business model will replace them and whether it will generate as much free cash flow. (comparison between operational margins of solar farm vs oil field show material differences).
In this context, given the increasing awareness of financial, ecological, and reputational risks associated with leaving multi-million or multi-billion obligations unfunded and emphasised by regulatory changes in various jurisdictions, more companies are considering implementing more sustainable and proactive methods to manage long-dated liabilities. This is particularly prevalent as the useful asset life of production assets could be significantly shortened as a result of the Energy Transition as explained above.
Developing an overall strategic framework that supports the establishment of a financial reserve through systematic prefunding is a key facilitator of the Energy Transition. Not only does prefunding help manage the risk of shortfall when the decommissioning costs come due, but it also addresses a number of other critical challenges:
– Supporting a smooth transition to the adoption of renewables. Many countries are changing their industrial infrastructure by speeding up the implementation of innovative technologies. In some sectors, this goes beyond ensuring that the decommissioning phase is fully and successfully completed at the end of the asset’s life, and sectors such as coal are under pressure to undertake earlier-than-planned decommissioning activities.
– Enabling more mergers & acquisitions activities, particularly those involving businesses operating in the North Sea. It is worth noting that in many cases, the sale of oil & gas assets is net of decommissioning costs. Deals often require the seller to retain part or all of the decommissioning liabilities.
– Repurposing polluting assets through alternative energy transition approaches. For instance, private equity funds in the US dedicated to the decommissioning of polluting assets acquire ‘brown’ assets against the payment of a lump sum for taking on the liabilities. They aim to optimise the decommissioning process and repurpose and redevelop the remaining infrastructure and land into sustainable/green investment.
– Investor focus: Institutional investors are evaluating decommissioning liabilities as a key indicator in financial and ESG rating decisions. Ability to meet decommissioning liabilities successfully can have positive share price implications and mitigate reputational risks.
– Technology: While technology developments may assist with costs, the clear direction is toward stricter environmental requirements and the associated increases in cost.
By matching future decommissioning liabilities and avoiding potential cash-flow drawdowns, such a strategy can offer a number of advantages, including:
- Decommissioning payments are no longer directly linked to volatile commodity or energy prices
- Potential cost overruns can be mitigated by investment returns
- Balance sheet, cost-of-capital and credit rating pressures caused by decommissioning liabilities are eased
- Pre-funding provides more exit options when assets need to be sold, and can be crucial if assets face early decommissioning as a result of political decisions or accidents
Our decommissioning solutions draw on our global expertise and that of the wider BNP Paribas Group. Our Multi-Asset and Quantitative Solutions (MAQS) team are responsible for portfolio modelling and management. They leverage the best ideas from our public market investment teams, BNP Paribas Group’s origination channels to source compelling opportunities across private debt and real assets markets, and BNP Paribas custodial, loan administration and loan servicing capabilities.
1 BNPP AM UK Review of 4 power sectors, 2019
2 European Commission, 2019
Any views expressed here are those of the author as of the date of publication, based on available information, and subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This material does not constitute investment advice.
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