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ESG Focus: Implications Of Safeguard Mechanism

ESG Focus | Mar 29 2023

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The Australian government’s renegotiated Safeguard Mechanism as a means to emissions reduction will not impact severely on the country’s oil & gas industry.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

-Safeguard Mechanism now stricter than before
-Different LNG projects will face varying impacts
-Carbon capture & storage becomes critical
-No change to FNArena database broker ratings

The Implications Of The Safeguard Mechanism

By Greg Peel

Despite stringent warnings from scientists and the best will of the people, the transition away from fossil fuels towards renewable/green energy is not a simple one, as made more obvious by the energy crisis created by Vladimir Putin.

Europe – a fossil fuel importer – has addressed the issue by establishing a framework that includes both natural gas and nuclear energy as “transition” sources. Natural gas is still a fossil fuel, but gas-fired power is “greener” than coal-fired. Nuclear power is carbon-free once a reactor is up and running, but it takes at least a decade of zero-carbon operation to offset the emissions from the building of a reactor and the initial uranium input.

And reactors continue to require mined uranium thereafter.

In the US, Biden is doing what he can in the face of issues created by the war and a hostile Congress. China is stuck between building out new energy requirements and reacting to pollution problems. In Australia, the prior government’s “gas-led recovery” and policy of reduction targets based on technology that would presumably be developed in the interim were resoundingly criticised.

It has taken a change of government, and a deal with the crossbenchers, specifically the Greens, to cement a carbon reduction policy with a target of a -43% reduction in emissions from 2005 levels by 2050. So is born a newly-tweaked “Safeguard Mechanism”.

LNG Projects

The Greens negotiated a requirement that gas production from the Beetaloo Basin in the Northern Territory and reservoir emissions from new gas fields developed to supply LNG projects will need to be offset from day one. This is set to impact primarily Santos’ ((STO)) Barossa LNG project (off the coast of Darwin), notes Jarden, as its raw gas stream contains 16-20% CO2.

Jarden estimates Santos’ safeguard compliance costs have increased by 9cps to 26cps, enhancing the business case for the Bayu-Undan carbon capture & storage (CCS) project. In contrast, gas in Woodside Energy’s ((WDS)) Scarborough field (offshore WA) contains 0.1% CO2, meaning only a minor change to Jarden’s 57cps valuation impact on Woodside from Safeguard Mechanism compliance.

The difference is new gas fields developed to supply existing LNG plants will now require net zero reservoir emissions from first production, rather than a reducing baseline as was the case in the initial policy. Definitions will be finalised in April, Macquarie notes, but likely impacted projects include Santos’ aforementioned Barossa, Beach Energy’s ((BPT)) Waitsia Stage 2 (onshore WA) and Woodside’s Browse (offshore WA).

Low CO2 fields include Beetaloo and those with proximate CCS opportunities, such as Barossa’s Bayu Undan.

Confirmation of the new policy provides certainty, Macquarie notes, but the already challenged East Coast supply outlook could see further deterioration given large projects exceeding 100kt CO2 (such as Santos’ Narrabri in NSW) are penalised against smaller opportunities which are exempt.

The government will publish a final schedule of FY23 industry intensities in the coming weeks – these will be important for individual company impacts, Macquarie advises, driving compliance obligations and costs.

The government will provide $1bn of funding support, up from a prior $600m, to industries providing “critical inputs” for energy transition (such as steel, aluminium/alumina, cement/lime). The government has made the point this funding is focused on “decarbonisation”, not “expansion of fossil fuels”, in contrast to the Morrison government’s “gas-led recovery”.

Institutional investors are already holding listed oil & gas companies to a high standard, Macquarie notes (reflective of the ESG push of recent years), such that new projects will effectively need to be net zero through the use of a combination of CCS projects where available and/or offsets.

Penalising high reservoir CO2 fields (eg. Browse, Barossa) will provide a competitive advantage to lower reservoir CO2 fields (eg. Beetaloo, Scarborough), which becomes more significant at higher carbon prices.

Macquarie has an Outperform rating on Santos and Neutral ratings on Woodside and Beach Energy.

Origin Energy

Morgan Stanley sees proposed Safeguard impacts for Origin Energy ((ORG)) as manageable.

APLNG in Queensland (Origin 27.5%) is a liable entity, but current emissions are below calculated baselines, according to Origin, so APLNG may create bankable Safeguard Mechanism Credits in the near term.

Origin sold its Beetaloo interests in November 2022.

Morgan Stanley suggests the timing of Origin's announced sale of itself to private equity (subject to approvals) is related to the policy developments.

Downstream, Origin's Energy Market electricity activities are within the electricity sector baseline so are subject to a number of other policies. Origin’s EM gas sales will face secondary impacts, for example lower sales if customers reduce purchases, Morgan Stanley suggests.

Octopus Energy (Origin’s renewables division) primarily operates overseas, so it is not subject to the Safeguard Mechanism, however, an Australian carbon scheme reduces the risk of future carbon border offset mechanisms.

Morgan Stanley has an Overweight rating on Origin Energy. Bearing in mind it is pending potential sale, Origin attracts a total of two Buy (or equivalent) and two Hold ratings in the FNArena database for a consensus target of $8.50.

The database has six from six Buy ratings for Santos (target $9.44), one Buy (Accumulate) and four Hold for Woodside (target $37.20) and five Buy, one Hold (Macquarie) and one Sell (Morgan Stanley) for Beach Energy.

There have been no ratings changes in the wake of the Safeguard Mechanism announcement.

Like it or not, Australia’s oil & gas industry has been screaming out for policy certainty for over a decade, and a clear roadmap is better than none. Like it or not, the industry has long been transitioning to renewables investment of its own, under pressure from ESG considerations and adopting an “if you can’t beat them, join them” approach, whether meant in the interests of the planet or not.

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