Report: Energy Companies Hugely Underestimate Risks to Investors

For over a century, the U.S. based its energy infrastructure -- and therefore its economy -- on electricity generated from coal. Coal producers were influential in the halls of Washington, D.C. and state legislatures. But then new, cleaner and more efficient sources of energy rapidly emerged. Hence the recent collapse of the industry caught many analysts and investors by surprise.

Coal companies indulged in finger-pointing at the Obama administration’s clean-energy policy and had plenty to say about environmentalists as well. But many analysts' response is that the natural gas and fracking boom are what led the shift away from coal.

And investors, from individuals playing the market to large pension funds, were suddenly deer in headlights as these companies’ securities buckled. Had companies taken a closer look at government policies, technological trends and forecasts, they -- along with their shareholders -- would not have been caught flat-footed, a recent report suggests.

Carbon Tracker, a think tank focused on the impact of climate change on capital markets, called out the energy industry for the typical boilerplate risk disclosures plunked into the filings submitted to the Securities and Exchange Commission (SEC). These disclosures can be found in the risk factors and management’s discussion and analysis (MDNA) section in an annual report, or 10K, that publicly-held companies are required to submit to the SEC.

Much of this problem stems from the fact that attorneys specializing in capital markets and securities do not want any disclosures that could spook their clients’ investors. This, of course, could harm the relationship between a company and its retained outside counsel (or threaten that attorney’s employment if he or she is on the company’s payroll). Most attorneys drafting securities filings look for precedent; i.e., they scrub through previous filings in order to gauge how their colleagues at other firms have drafted such disclosures.

The desired outcome is that investors can rest assured, and in the long run, the company is protected in the event conflict over such disclosures plunge it into litigation. Therefore, as Carbon Tracker’s report concurs, coal companies -- and their investors -- suddenly found their business and their stock value drop spectacularly as if it occurred without warning.

Carbon Tracker’s analysts, however, suggest that the coal industry’s demise hardly occurred in a vacuum. A more holistic discussion of risks that could emerge from government policy changes, new technologies, and a broader discussion of future trends and forecasts could have prevented coal companies and their stakeholders from being blindsided. And whatever one may think of the coal industry, these companies’ executives -- had they been armed with better information (or chose to read what was publicly available) -- could have been more proactive in fine-tuning their firms’ scenario planning. As a result, they could have mitigated the impact of the shift away from coal, from tactics such as diversifying their portfolios or even avoiding the mergers and acquisition binge that occurred earlier this decade.

One of the coal industry’s failures, Carbon Tracker points out, is the type of data on which these companies relied. Most companies leaned on “reference case” data that the U.S. Energy Information Agency (EIA) issues on a regular basis. The EIA makes it that its modeling used to suggest trends in the energy industry should not be used as forecasts, as they do not necessarily take into account policy changes at the federal or local level. In sum, EIA data assumes a “business as usual” scenario.

But the reliance on the EIA’s data overlooked the rapid technological change ongoing within the energy sector and the impact of new laws passed in a drive to stem the risks of climate change. Instead, companies should have frankly discussed the impact of the greenhouse gas emissions targets that have become more commonplace across the U.S. While many environmentalists attack the growth of natural gas consumption across America (much of which is sourced by fracking), utilities often made the switch so that they could still be relevant – and profitable – as more stringent regulations related to climate change emerged. Carbon Tracker suggests using data based on the "2 Degree Scenario” espoused by the International Energy Agency (IEA).

Carbon Tracker suggests these companies overlooked the impact of these new mandates on their business. At the same time, many companies arguably cherry-picked third-party data. That data, in turn, was spun to demonstrate that their companies were still viable despite the usual risk. In layperson’s terms, if these companies buried their heads in the sand long enough, they would weather this storm.

They didn’t. And now thousands of coal miners, along with other professionals who once worked in this industry, are jobless, with few retraining programs available to them.

Carbon Tracker suggests a four-pronged approach for energy companies in order for them to be more transparent, allowing investors to have a more lucid understanding of the risks involved in investing in these companies:

• Regulators, including the SEC, should mandate disclosures that integrate market assumptions, the impact of emissions reduction targets and a franker discussion by executives about short- and long-term risks,


• The EIA should consider climate change targets when issuing its forecasts,


• Companies need to offer more realistic reorganization plans in the event they fall into bankruptcy,


• And auditors must develop a more rigorous approach when comparing forecasts, projects and financial reports from a variety of sources.

This report offers lessons for individual investors, too. The updates you receive from companies in which you own stock are important. Whether they are delivered by links you receive in the email, or thick envelopes dumped into your mailbox, they need to be clicked on or opened. And if the language in these reports seem to vague or smack as boilerplate prose, then do more research on these firms, and the wider industry, so that your portfolio does not take a hit.

Image credit: Kimon Berlin/Flickr