Unreasonable projections in a world confronting climate change · confronting climate change. About...

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Carbon Tracker Initiative, July 2016

Unreasonable projections in a world confronting climate change

About Carbon Tracker

The Carbon Tracker Initiative is a team of financial specialists making climate risk real in today’s financial markets. Our research to date on unburnable carbon and stranded assets has started a new debate on how to align the financial system with the energy transition to a low carbon future.

This report was authored by:Rob Schuwerk and Luke Sussams.

Acknowledgements This report draws heavily on internal memoranda prepared and commissioned by John Wunderlin on behalf of Carbon Tracker. The authors would also like to acknowledge the contributions of James Leaton, Mark Fulton, Tom Drew and Stefano Ambrogi for review and edits; Margherita Gagliardi for the design.

DisclaimerCarbon Tracker is a non-profit company set-up to produce new thinking on climate risk. The organisation is funded by a range of European and American foundations. Carbon Tracker is not an investment adviser, and makes no representation regarding the advisability of investing in any particular company or investment fund or other vehicle. A decision to invest in any such investment fund or other entity should not be made in reliance on any of the statements set forth in this publication. While the organisations have obtained information believed to be reliable, they shall not be liable for any claims or losses of any nature in connection with information contained in this document, including but not limited to, lost profits or punitive or consequential damages. The information used to compile this report has been collected from a number of sources in the public domain and from Carbon Tracker licensors. Some of its content may be proprietary and belong to Carbon Tracker or its licensors. The information contained in this research report does not constitute an offer to sell securities or the solicitation of an offer to buy, or recommendation for investment in, any securities within any jurisdiction. The information is not intended as financial advice. This research report provides general information only. The information and opinions constitute a judgment as at the date indicated and are subject to change without notice. The information may therefore not be accurate or current. The information and opinions contained in this report have been compiled or arrived at from sources believed to be reliable in good faith, but no representation or warranty, express or implied, is made by Carbon Tracker as to their accuracy, completeness or correctness and Carbon Tracker does also not warrant that the information is up to date.

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Contents

Executive Summary IntroductionPart I: The Regulatory Landscape: The existing SEC regime for forward-looking disclosure and its shortcomingsPart II: Carbon BudgetsPart III: The US coal crash, revisitedPart IV: EIA’s Energy ModelPart V: Coal Company Disclosures in ContextPart VI: Conclusions

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Executive Summary

EIA Reference Case is not a forecastThe EIA produces its Annual Energy Outlook (AEO) to provide a range of scenarios, from one reflecting existing policies (the Reference Case) to one that assumes economic conditions which drive accelerated coal plant retirements (Accelerated Coal Retirements). The EIA is very clear that these are projections reflecting certain factors, NOT predictions or forecasts. The Reference Case is by definition a scenario in which no announced or new policies are enacted, existing policies with sunset provisions do become ineffective, and technology evolves at a steady pace. This is therefore a high case for coal demand, and there is every likelihood of a downside from this demand level. Indeed, actual results over the past several years have departed dramatically from Reference Case projections. EIA modelling of emissions reduction targets more accurateOn occasion, the EIA has built projections based on specific policy proposals, including the American Power Act and the American Clean Energy & Security Act. These models employed emissions constraints consistent with the laws’ targets (which, in turn, were largely consistent with Obama’s Copenhagen pledges). These projections have proven far more accurate over the past five years than those that assumed no constraints even though the laws were never enacted. This strongly suggests that policy and technology are following in the wake of the overall emissions reductions targets and that those targets should be a leading indicator to be considered by issuers in providing forward-looking information. That said, coal companies have consistently emphasized the Reference Case.

This paper discusses why the EIA Reference Case is not an appropriate basis for coal sector financial planning and strategy, and reviews how it has been utilized in industry SEC filings. With the 2016 Reference Case now reflecting the Clean Power Plan, we ask whether the Paris emissions constraints will prove to be the correct lead indicator?

Known trendsCompanies must analyze “known trends, events, demands, commitments and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance.” We would argue that increasing measures to limit emissions from power generation, and the reducing costs of alternative power generation technologies are known trends. The direction of travel of both these vectors is clear.

Two-part test for disclosureThe SEC requires issuers to apply a two-part test to determine whether trends and uncertainties must be disclosed. First, it must determine whether the uncertainty is “reasonably likely” to occur. Second, if the uncertainty cannot affirmatively be deemed “unlikely,” the corporation must then determine whether the uncertainty would have a material effect on the registrant’s financial condition, assuming it occurred. We would argue that since 2010, a scenario of increased policy measures on pollution, lower costs of renewables and lower natural gas prices was not unlikely and would have a material impact on

The Heart of the Matter | 5

the financial condition of US coal producers. Indeed with the benefit of hindsight, it is clear that such a scenario came to pass and has had a material impact on the value and financial performance of US coal mining companies. Much of this decline has been captured in EIA projections that incorporated climate targets.

Forward projectionsThe SEC encourages the disclosure of “management’s projections of future economic performance that have a reasonable basis and are presented in an appropriate format.” It is also expected that the assumptions underlying these projections should be transparent. This calls into question whether presenting a scenario where nothing changes as the most likely forecast to inform investors is reasonable. If it is not made clear that this scenario also goes against the direction of travel indicated by government policy and market trends, then this failure to disclose assumptions is significant. A business strategy for a growth market with rising prices is very different to one that is shrinking with falling prices.

Range of scenariosWhen selecting projections of future financial performance, management is also advised it “should take care to assure that the choice of items projected is not susceptible to misleading inferences through selective projection of only favourable items.” This would suggest that presenting a range of scenarios, rather than just the one that justified a BAU strategy would be an appropriate approach to disclosure. Reviews of the accuracy of previous projections would also inform whether an informative basis for the projections is being used.

Buying spreeA number of US coal mining companies undertook acquisitions during the last peak of the market in 2011, taking on significant debt in order to do so. This business strategy was predicated on demand continuing to increase, and a strong market for coal products. This misread of demand, and the failure of management to acknowledge that the reality was deviating materially from its chosen projections saw an industry in denial. The implications, however, were clear from sources, such as the EIA, that were being cited in corporate reports. Too lateThe 2015 10Ks1 filed in 2016 started to bring in references to some of this information – but by this time it was too late as many of the companies were already filing for bankruptcy protection. Arch Coal included a wider range of IEA and EIA scenarios. Peabody has acknowledged examining the impact of a range of policies that might impact coal and found that the financial impact could be material. However, in Peabody’s view, such analyses were too fraught with assumptions and therefore could not reasonably quantify potential future impact. All scenarios contain assumptions to address future uncertainties, including those that assume nothing changes. In the context of risk disclosures, the fact that there is uncertainty strengthens the case for using assumptions that convey the extent of the risk.

1 A Form 10-K is an annual report required by the U.S. Securities and Exchange Commission (SEC), that gives a comprehensive summary of a company’s financial performance.


Dealing with uncertaintyWhile companies often expressed uncertainty in forecasting the impact of climate policy, they readily provided third-party scenario information suggesting decades of continued demand for US coal—even though those projections discounted the aforementioned policy uncertainties to zero. From the point of view of a company managing risk, this seems a flawed approach; if an impact cannot be predicted precisely, it should not be assumed there is no impact at all. A more reasonable approach would be to conduct a sensitivity analysis of a range of impacts to demonstrate resilience under a number of scenarios. This does not require the probability of the outcome to be determined. Notably, such scenarios were available from the same third-party sources cited by the companies. A question for capital markets regulators is whether these concerns can be addressed through existing regulations or require new standards that ensure that the key assumptions underlying projections are reasonable and made available alongside the forecasts themselves.


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CPP = Clean Power PlanAEO = EIA Annual Energy Outlook


Introduction

Desperately seeking transparency

As the world turns to addressing climate change, markets are turning to companies to better understand how they are addressing the risks from an energy transition.

The Paris Agreement’s objective of limiting warming to “well-below” two degrees Celsius has fueled on-going efforts to better understand the implications of a transition to a low-carbon economy, including the impact on fossil fuel companies.

In parallel, the Financial Stability Board (FSB) has noted increased demand for “decision-useful” information on how companies will be affected by climate risks (including transition risks) and sought to fill the gap. The FSB has launched a task force (TCFD) to consider such potential disclosures. The TCFD notes that many companies have identified the risks, but goes beyond risk identification to quantify and qualify those risks in a way that is useful to investment and engagement decision-making. As a consequence, the TCFD is considering whether enhanced disclosure of forward-looking information, stress tests, sensitivity analyses and industry-specific guidelines would be appropriate. The TCFD will issue recommendations in December and, while only voluntary, may prompt reconsideration of whether existing disclosure regimes are forcing decision-useful information on climate risks to market.

As the TCFD acknowledges, many existing disclosure regimes, including US SEC regulations, already require companies to disclose forward-looking information on known risks, trends and uncertainties. These, too, are being revisited. In April, the SEC issued a “Concept Release,” asking for comment on whether the current disclosure regime is achieving its stated goals of improving efficiency, competition and capital formation.

Assessing and reporting risk

The foregoing efforts on transparency of climate risk dovetail with efforts at the corporate level to better manage company-wide risks and detail that management for investors. Risk assessment is central to business and oversight and risk transparency is essential to proper capital allocation by securities markets. Proper risk assessment considers downside scenarios—even those that may be seen as unlikely.

In the wake of the global financial crisis, additional attention has been paid to risk oversight practices—the “governance” aspect of risk—to ensure that risk mitigation is incorporated into business planning and strategy. While most risk assessment and mitigation happens at the management level, to varying degrees boards are engaged in the management of risks to the enterprise as a whole.2 Increasingly, governance practices are

2 See, e.g., ANR 2013 Proxy Statement, at 24.

No Rhyme or Reason | 9

turning to enterprise risk management in response. For example, many companies have adopted the COSO framework for enterprise risk management to set firm-wide risk appetite and tolerance to guide the company’s capital allocation decisions accordingly.3

Ideally, risk assessment, risk mitigation and risk oversight are conveyed to markets through corporate reporting in annual reports, proxy statements, and other channels. Especially important are material risks that may not be indicated by past results. Such forward-looking disclosure of principal risks and material trends—good or bad—is typically required by regulation.4

However, existing disclosure regimes focus primarily on risk identification, with less attention paid to how companies have integrated identified risks and trends into their business planning. The increasing focus on risk oversight further suggests that companies should be discussing not just the potential risks but how they are managing them.

Given these inquiries, we believe lessons might be learned from examining past disclosures in the light of the purposes ascribed to existing disclosure requirements. Here, there is perhaps no better starting point than the disclosures made by US coal companies over the 2010-2015 period—a period of radical transformation in the industry, which went from assertions of a coal super-cycle to market peak mergers to bankruptcy court over the course of a few years.

3 http://www.coso.org/default.htm4 See, e.g., 17 CFR 229.303.

Climate targets are carbon budgets

For many, the Paris Agreement marks the beginning of a potential sea change in international action on climate. While the level of governmental consensus may be new, the climate target is not. The two-degree climate target encapsulated in the Paris Agreement has been a mainstay in international climate policy-making since the 2009 Copenhagen Accord.

Moreover, that climate policy target has been the basis for state and federal climate action targets, including President Obama’s Copenhagen pledge to reduce emissions 17% from 2005 levels by 2020 and 83% from 2005 levels by 2050.5 In China, emissions intensity targets have been part of the country’s five-year plans (although the relationship with the 2°C goal is less clear).6 Both the climate targets and related emissions reductions pledges are important because they offer a means of quantifying a downside case for emissions and, therefore, fossil fuel demand.7 While these climate targets have long been in public view, very few companies have presented their consideration of those targets, or the demand implications, to shareholders.

5 http://unfccc.int/files/meetings/cop_15/copenhagen_accord/applica-tion/pdf/unitedstatescphaccord_app.1.pdf6 China’s 12th Five-Year Plan was issued in March 2011, covering the pe-riod 2011-2015, and called for a 16% reduction in energy intensity per unit of GDP, a 17% reduction in carbon intensity per unit of GDP, and an increase of non-fossil energy use to 11.4% of total energy use. See http://www.c2es.org/international/key-country-policies/china/energy-climate-goals-twelfth-five-year-plan7 Central to Carbon Tracker’s research is the recognition that climate target imply climate budgets—greenhouse gases are long-lived so emissions accumulate in the atmosphere over time. Climate models analyse the probability and warming impact of a given level of accumulated emissions. The accumulated level of emissions associated with a given climate target is the effective “budget” for emissions.

http://www.coso.org/default.htm

http://unfccc.int/files/meetings/cop_15/copenhagen_accord/application/pdf/unitedstatescphaccord_app.1.pdf

http://unfccc.int/files/meetings/cop_15/copenhagen_accord/application/pdf/unitedstatescphaccord_app.1.pdf

http://www.c2es.org/international/key-country-policies/china/energy-climate-goals-twelfth-five-year-plan



Existential climate threat—role for regulators?

Climate change—and actions to mitigate it—pose fundamental challenges to the fossil fuel sector. To even have a 50% chance of achieving the agreed upon limit of no more than two-degrees, fossil fuel use has to be substantially curtailed—Carbon Tracker’s research suggests that roughly 80% of existing coal reserves with listed companies need to remain unused.8 Researchers as University College London have reached similar conclusions with respect to total global coal reserves.9

This presents an existential risk to undiversified, pure-play coal producers due to a dearth of commercially available and environmentally sustainable ways of combusting coal. In theory, a pure-play coal company could seek to diversify, however difficult operationally.

However, a commonly held belief in capital markets is that diversification at the corporate level is less efficient than what investors can achieve in their portfolios in liquid equities markets. Therefore, where trends such as climate change emerge that pose an existential threat to the business, a company may be faced with the difficult choice of recognizing those trends and managing the decline of the business or resisting them aggressively. In either case, the investing community is best served by clarity on the extent of the risks and the company’s assessment of the best path forward for the business. A company electing to push against those trends may

8 Carbon Tracker, Unburnable Carbon 2013: Wasted Capital and Stranded Assets, (2013).9 See http://www.nature.com/nature/journal/v517/n7533/full/na-ture14016.html

not share those interests. Forcing that information to market is therefore a role for regulators.

US coal a cautionary tale

The precipitous rise and fall in the valuations of US coal companies between 2009-2015 provides a natural experiment—and cautionary tale—for companies, investors, and regulators for how the assessment and mitigation of risk has been conveyed by companies to the markets. That period begins with buoyed optimism of a “coal-supercycle” led by robust demand from China and India and resilient demand for coal in the US. As of today, the industry is undergoing a wave of bankruptcies amidst pronouncements by analysts that the supercycle may never arrive—or, at least not in time to save equity investors. Increasingly, the downturn is seen by mainstream analysts as structural, not cyclical.10 This is in stark contrast to a period of top of the market consolidations, ensuing write-downs, and bankruptcies.

Where’s the assessment?

This report takes a look-back at selected coal company disclosures in the 2010-2015 period, examining company usage of the US Energy Information Agency (EIA) Reference Case projections to forecast future coal demand in the context of other company disclosures related to climate risks.

10 See, e.g., Citi (2014) Global thermal coal: When cyclical supply met structural demand; Bernstein (2015) Asia strategy: Shouldn’t we all be dead by now?

http://www.nature.com/nature/journal/v517/n7533/full/nature14016.htm

http://www.nature.com/nature/journal/v517/n7533/full/nature14016.htm


The examination reveals that coal company corporate reports frequently treated the Reference Case as a forecast, notwithstanding the fact that the EIA merely projects past coal consumption to provide a policy baseline.11 Capital markets regulators should consider how such projections have been used, given their roles in ensuring transparency in corporate reporting.

As the EIA itself states, “EIA’s Annual Energy Outlook is a projection, not a prediction.”12

Box 1: EIA Projections Defined

11 http://www.eia.gov/todayinenergy/detail.cfm?id=2627212 http://www.eia.gov/todayinenergy/detail.cfm?id=26272

EIA Projections As Defined by the EIA

The US Energy Information Administration provides a long-term outlook for energy supply, demand, and prices in its Annual Energy Outlook (AEO). This outlook is centered on the Reference case, which is not a prediction of what will happen, but rather a modeled projection of what might happen given certain assumptions and methodologies. In May 2016, EIA released an annotated summary of the AEO2016 Reference Case — which includes the Clean Power Plan — and a side case without the Clean Power Plan.

The AEO is developed using EIA’s National Modleing System (NEMS), an integrated model that seeks to reflect how various drivers to the US economy and the different compnents of energy production and use will interact to determine energy supply, demand, and prices.

The Reference case, which incorporates only existing laws and policies, is not intended to be a most likely prediction of the future. EIA’s approach to addressing the inherent uncertainty surrounding the country’s energy future is to develop multiple cases that reflect different sets of internally consistent assumptions about key sources of uncertainty such as future world oil prices, macroeconomic growth, energy resources, technology costs, and policies.

The alternative cases in the report show the model’s sensitivity to diffeent assumptions, which EIA updates and publishes each year. The assumptions that inform the modeling play an important role, and any results should be interpreted with the underlying assumptions in mind. These assumptions and results are discussed in the Annual Energy Outlook and EIA’s policy analysis reports such as the studies of removing restrictions associated with US crude oil exports or the then-proposed version of the Clean Power Plan.

http://www.eia.gov/todayinenergy/detail.cfm?id=26272

http://www.eia.gov/todayinenergy/detail.cfm?id=26272


The future is by definition uncertain and therefore entails assumptions and judgments that may subsequently be proven wrong. Therefore, even if companies are required to take an objective look at the future in corporate reports, a failure to offer accurate forecasts does not necessarily indicate a flawed process. That said, many US coal companies have either ignored climate policy targets completely or discounted them due to an alleged lack of regulatory and policy commitment to deliver them. Such a view offers little insight into what might happen until it has occurred and may not meet investor expectations that companies manage capital in light of the risks.

In general terms, companies have discussed the potential for future climate action and technology, but have professed an inability to estimate the impact of those developments because of uncertainties with how specific policies and technology will develop. However, few companies have identified key climate targets encapsulated in international agreements and national

policy that might provide insight into the extent of the risk, much less the implications of those targets for their business.

Without a discussion of such targets, it is not clear that companies were incorporating emissions reductions targets of governments into their downside risk assessments or, if they were, what their conclusions were. Moreover, pairing risk identification with third-party coal demand projections, including those by the EIA, which assume that none of those risks will materialize, only adds confusion to such an assessment.

To be sure, forward-looking disclosure serves an important role of conveying management’s views to the market—assuming those demand projections (or forecasts, as the case may be) are reflective of management’s views, it is reasonable to provide them to investors. But it is equally clear that companies must sufficiently convey the downside risks and, increasingly, investors are asking not just how companies identify risks, but

Policy assumptions tend to be especially complicated. In the US, policies at the federal, state, and local levels can all affect energy supply, demand, and prices. Often these policies have timelines or other attributes that are revised by subsequent legislation or interpreted by executive departments. Some policies can interact in ways that are difficult to foresee. The AEO Reference case generally reflects current laws and regulations within the simplified but often expanding modeling parameters of NEMS.

Tecnological advances are also inherently difficult to anticipate. The Reference case typically projects technological evolutions rather than technological revolutions. For instance, energy production methods may become more effective and energy-consuming equipment may become more efficient in the Reference case, but EIA does not attempt to identify disruptive technologies on the timing of their availability and widespread adoption.

The energy sector has always been dynamic and undoubtedly will continue to change in the future. EIA has tried to make its projections as objective, reliable, and useful as possible. However, the projections in the AEO should be interpreted with a clear understanding of the assumptions that inform them and the limitations inherent to any modeling effort.

Source: EIA


also quantify them and identify what processes are in place to manage them. This leads to the question of whether the board (ultimately responsible for corporate reporting) and company management were confident in the robustness of those third party reports and if so, whether the management’s risk assessment and the boards’ risk oversight responsibilities have functioned as intended.

View to the future?

One way of considering this issue is examining company discussion of coal projections and forecasts in the period leading up to the coal crash. Many companies referred investors to EIA Reference Case scenarios as relevant indicators of future demand. Such projections were never intended to be predictions or the most likely outcome by the EIA, though they appear to be presented that way in the reports. This raises the question of how accurately those scenarios were represented.

In addition, the EIA produced other modelling which did consider potential changes in policy and which suggested a far different trajectory for US coal. This included EIA modelling from 2010 and 2015 that incorporated the emissions reductions targets of, respectively, the American Power Act (APA), the American Clean Energy and Security Act (ACESA) (Waxman-Markey) and the Clean Power Plan (CPP). Those demand scenarios that have imposed demand constraints based on emissions reduction targets have proven to be far more prescient over the relevant period, yet were largely un-noted by companies until after the downside was priced in the equity markets.

Even though most US coal companies were primarily exposed to US markets, they have discounted concerns about those markets with the promise of a growing seaborne trade as a justification for leveraging the company towards exposure to Asian markets, particularly China. There too, better disclosure of emissions reductions targets would have suggested caution. Were these policy targets ignored, or considered and dismissed? And were investors fully aware of the extent of the risks?

The rapid decline of US coal equities has implications for the regulatory role in disclosures. Whether robust assessment of these risks can be developed within existing disclosure regulations or new regulations are required is somewhat of an open question; less uncertain are the benefits that delivering such disclosure would have for the markets in allocating capital efficiently.

In Part I, we review the US regulatory landscape as it related to forward-looking disclosure of trends and risks. In Part II, we examine previously announced emissions reduction targets in the US and China and their carbon budget implications. Part III examines the precipitous decline of US coal companies in the aftermath of top-of-the market mergers. In Part IV, we compare the EIA’s Reference Case to other policy analysis cases developed by the EIA that deploy carbon budget restrains within the NEMS model that undergirds EIA’s analysis. Even though some of the policies identified in those scenarios have not been deployed, they have in fact been better predictors of coal demand and consumption. In Part V, we focus on the evolution of actual US coal company disclosures during the 2010-2015 period. Finally, in Part VI, we make some concluding remarks on how these risks can be better conveyed.


Part I

The Regulatory Landscape: The SEC regime for forward-looking disclosure


Already required?

The SEC requires companies to disclose forward-looking risks13 and trends and uncertainties14 that might materially impact results. For all its merits, the SEC’s existing forward-looking disclosure regime may not have delivered on the most salient information needed in the climate change context—notwithstanding the unusual but salutary decision by the SEC to publish guidance on how its existing regulations pertained to climate risks.15 Correcting this will require a renewed focus on Management Discussion and Analysis (MD&A) or consideration of new regulations aimed at forcing companies to analyse the implications of policy targets for their business models.

Below, we describe the core elements of forward-looking disclosures and their shortcomings:

Item 503(c) risk factor disclosure

The purpose of Item 503(c) risk factor disclosure is to discuss “the most significant factors that make the offering speculative or risky”.16 The aim of the disclosure is to make clear how a particular risk might, in the future, impact a given issuer. In the climate change context, SEC guidance states that “risk factor disclosure should clearly state the risk and specify how the particular risk affects the particular registrant; registrants should not present risks that could apply to any issuer or any offering.”17 (Emphasis added). 13 17 CFR 229.50314 17 CFR 229.303.15 75 Fed. Reg. 6294 Feb. 8, 2010 (“2010 Guidance”).16 17 CFR 229.503.17 2010 Guidance.

Risk factor disclosure is forward-looking and focused on the “most significant” factors that pose a threat to the business. The discussion of those factors must be “concise,”18 requiring a plain language statement of the relevant risk. Given the focus on concision and clarity, SEC staff have frequently admonished issuers for including language that mitigates or minimizes the stated risks.19 This means that companies should not identify risks, on the one hand, while dismissing them, on the other. Few if any companies have downplayed climate risks directly, but many have supplied investors with robust projections of coal demand that do not account for climate-related risks.

“Risk Factor” disclosures may provide an overview of risks but not the type of information that can provide decision-useful information to investors. Indeed, many commentators20 and SEC Chair Mary Jo White21 have asked whether such disclosure is actually useful to investors or merely serves the purposes of shielding companies from litigation. More useful would be information providing an estimate of the downside risk—information that, under certain circumstances, is required by the “Management, Discussion and Analysis” disclosure element, discussed below.

18 Id.19 SEC Staff Comment, Mar. 4, 2009. Available at: https://www.sec.gov/divisions/corpfin/guidance/cfsmallcompanyregistration.htm20 See, e.g., Pillsbury, Winthrop, Shaw, Pittman LLP has identified risk factor disclosure as the “cheapest form of insurance” against potential future litigation. Available at: http://www.pillsburylaw.com/siteFiles/Publica-tions/77EA643CE089DDA568EFF79F0A35F681.pdf21 Speech, “The Path Forward on Disclosure,” SEC Chair Mary Jo White, Oct. 15, 2013. Available at: https://www.sec.gov/News/Speech/Detail/Speech/1370539878806; IRRC report.

https://www.sec.gov/divisions/corpfin/guidance/cfsmallcompanyregistration.htm

https://www.sec.gov/divisions/corpfin/guidance/cfsmallcompanyregistration.htm

http://www.pillsburylaw.com/siteFiles/Publications/77EA643CE089DDA568EFF79F0A35F681.pdf

http://www.pillsburylaw.com/siteFiles/Publications/77EA643CE089DDA568EFF79F0A35F681.pdf

https://www.sec.gov/News/Speech/Detail/Speech/1370539878806

https://www.sec.gov/News/Speech/Detail/Speech/1370539878806


Item 303: Management, discussion and analysis

Item 303 requires disclosure of the trends and uncertainties reasonably likely to make operational results vary, giving insight as to how past performance may not be repeated in the future.22 Companies must analyze “known trends, events, demands, commitments and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance.”23 Trends and uncertainties include “legal, technological, political and scientific” developments that might indirectly impact a company by, for example, lowering demand for its products.24 SEC guidance indicates that management’s review of potential material trends should extend to non-financial information and even external developments necessary to assess the impact on the company.25

The SEC indicated in its 2010 Guidance that physical and financial impacts of climate change and mitigation efforts may be material to companies and, like any other material trend or uncertainty, should be disclosed.26 Issuers are clearly required to assess enacted legislation and regulation in determining whether to issue MD&A on it; the same standard applies to international accords relating to climate change.27 22 17 CFR Parts 211, 231 and 241, SEC Release Nos. 33-8350; 34-48960 (Dec. 29, 2003).23 75 Fed.Reg. 6294 (Feb. 8, 2010).24 75 Fed.Reg. 6294 (Feb. 8, 2010).25 75 Fed. Reg. 6294-5 (Feb. 8, 2010).26 75 Fed.Reg. 6294 (Feb. 8, 2010).27 75 Fed.Reg. at 6296 (Feb. 8, 2010).

Two-part test

The SEC requires issuers to apply a two-part test to determine whether a trends or uncertainty must be disclosed. First, it must determine whether the uncertainty is “reasonably likely” to occur. The Commission has explained that “reasonably likely” is a lower disclosure threshold than “more likely than not” but more likely than “remote.”28 As “reasonably likely” scenarios may have a less than 50% probability of occurring, issuers should be disclosing the impact of even some outcomes that they believe likely will likely not occur.

Figure 1: Evaluating likelihood

28 Commission Statement About Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release Nos. 33-8056 and 34-45321 (January 25, 2002); See also In the Matter of Bank of Am. Corp., File No 3-16028 Release No. 72888 (Aug. 21, 2014).

< <remote reasonablylikely

more likelythan not


No

Yes

Is the trend or

uncertainty reasonably

likely to occur?

Remotelylikely

Uncertain

Reasonably likely

More likelythan not

Assuming the trend or uncertainty

occurred, would it be material?

No disclosure obligation

No disclosure obligation

Obligation to disclose

Quantify the impact if reasonably

available

Figure 2: MD&A Analysis

Second, if the uncertainty cannot affirmatively be deemed “unlikely,” the issuer must then determine whether the uncertainty would have a material effect on the registrant’s financial condition, assuming it occurred.29 The SEC Guidance states that the materiality of possible future developments “will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’’30

29 Id., at 6295.30 75 Fed.Reg. 6294 (Feb. 8, 2010) (quoting Texas Gulf Sulfur Co., 401 F. 2d 833 (2d Cir. 1968) at 849.


In practice, this means that if management believes that there is a reasonable likelihood that an adverse event might materially impact the company’s finances, that event must be disclosed. Pending legislation, regulations and treaties related to climate change are, under the statute, considered “known uncertainties” and require management to employ the aforementioned two-part test.31 A similar requirement applies to legal, technological, political and scientific developments related to climate change, though precise content and timing of the disclosure is left to management. What constitutes a ‘trend’ is open to some debate. However, with respect to the time frame for the impact, the SEC has rejected the notion that it should be limited to a fixed number of years in the future, providing instead that the “necessary time period will depend on a registrant’s particular circumstances and the particular trend, event of uncertainty under consideration.”32

Perhaps even more important than identifying the trends and uncertainties themselves, companies must analyze how these will impact the company’s financial condition. This may then require disclosure. Such disclosure may often be qualitative, but quantitative disclosure may be required if “reasonably available.”33 The Commission has made clear that disclosure of known trends and uncertainties is not optional.34

31 Id.32 75 Fed.Reg. at 6296 (Feb. 8, 2010).33 17 CFR Parts 211, 231 and 241, SEC Release Nos. 33-8350; 34-48960 (Dec. 29, 2003).34 “Not all forward-looking information falls within the realm of optional disclosure. In particular, material forward-looking information regarding known material trends and uncertainties is required to be disclosed as part of the required discussion of those matters and the analysis of their effects.” 17 CFR Parts 211, 231 and 241, SEC Release Nos. 33-8350; 34-48960 (Dec. 29, 2003).

How material is the risk?

As discussed in greater detail below, climate targets typically identify (or imply) emissions reductions levels that, based upon certain assumptions, further imply reductions in demand for particular fossil fuels. As a first order approach, the salient question for investors is not the degree to which those targets are achieved by technology or policy, but what the implications of achieving them are for company results — they are, at the very least, a fair proxy of the downside case.

The foregoing standards suggest that companies should be considering government emissions reductions pledges as a potential risk to the business—certainly from a risk management perspective, investors would expect management to consider that governments will do what they say.

In the context of the top of the market mergers that took place in the coal industry, this raises the question of how well informed investors were of the extent of the risks that companies were facing. However, few companies have identified climate targets much less their implications, and the SEC has not sought to compel such disclosure.

This may be for several reasons. First, while management must objectively assess known trends and uncertainties, it may render a judgment on the “likelihood” of those trends coming to fruition. Certainly such a judgment cannot be made for self-serving reasons, but this still leaves some room for companies to determine that it is unlikely, including up until such disclosure is of little informational value to investors.


Yet, the two-degree target, now being reconsidered in light of the more stringent goal of limiting warming to 1.5 degrees, has been a centerpiece of international climate policy since 2009. The significant threat posed by climate change, the amount of attention it has engendered at all levels of government, and perhaps most importantly, the ability to imply potential demand destruction from emissions reduction targets all suggest that it would be within the range of known trends that companies should consider and disclose to investors.

Second, companies may contend that while they believe such a transition likely, they cannot reasonably predict how the future may unfold, particularly given the long time-frame considered. But testing against an emissions reduction trajectory need not require a prediction of all policy and technology uncertainties; the two-degree climate target offers sufficient clarity of objective to frame disclosure of the extent of the risks in a general but meaningful way. But very few companies endeavored to provide this analysis to investors.

And while it is the case that no company can be asked to predict the future, it is clear that many companies offered forward-looking projections to investors that relied upon the critical assumption of no climate policy over the relevant period. A key question is whether equivalent disclosure of the risks should also be required.

Reasonable projections encouraged

Companies are not always required to supply the market with their internal forecasts, but many deem it useful to provide forward-looking information in other sections of their corporate reports. The SEC encourages the disclosure of “management’s projections of future economic performance that have a reasonable basis and are presented in an appropriate format,”35 (emphasis added) and has issued guidelines for companies offering such projections. In light of many company risk factor disclosures, one would question whether the use of Reference Case projections, which assume a substantial build out of coal infrastructure under a “business-as-usual” trajectory, would be reasonable.

Although the guidelines appear to apply only to projections formulated by management, the purpose of the guidelines is to provide a framework for transparent presentation of forward-looking information, recognizing that such information may be useful for investors considering future performance of the stock. Consistent with that purpose, the guidance should apply with equal force to third party projections, such as the EIA projections, whenever management chooses to include them in annual reports. Several elements of the guidance are relevant here:

First, while projections typically focus on revenues, net income and earnings, the SEC notes that the guidelines are not limited to such projections. This suggests that demand projections for a company’s core market might similarly be subject to the guidelines.

35 17 CFR 229.10(b).


Second, the inferences drawn from forecasts are important, and the SEC cautions that management “should take care to assure that the choice of items projected is not susceptible to misleading inferences through selective projection of only favourable items,”36 and that management should caution investors against putting undue emphasis on management’s assessment. 37

Third, the SEC notes that assumptions are a critical part of forecasts and that investors’ understanding is “enhanced by disclosure of the assumptions which in management’s opinion are most significant to the projections or are the key factors upon which the financial results of the enterprise depend….”38

It therefore “encourages disclosure of assumptions in a manner that will provide a framework for analysis of the projection.”39

Fourth, the guidelines encourage management to provide information on the accuracy of past projections when compared to actual results in order to “highlight for investors the most significant risk and profit-sensitive areas in a business operation.”40

Fifth, the guidelines remind registrants of their obligation to notify investors of changes, favourable and unfavourable, which give management reason to know that “previously disclosed projections no longer have a reasonable basis.”41

36 17 CFR 229.10(b)(2).37 17 CFR 229.10(b)(3).38 Id.39 Id.40 17 CFR 229.10(b)(3)(ii).41 17 CFR 229.10(b)(3)(iii).

Figure 3: SEC Guidance on management’s projections

Guidance applies to any projections.

Should avoid misleading inferences from selective use of favourable data.

Critical assumptions should be disclosed.

Consider comparing past and present projections to reveal forecasting accuracy.

Notify investors when prior projections no longer have a reasonable basis.

1

2

3

4

5


Climate risk material, but business as usual?

Many coal companies have included EIA Reference Case projections in the Item 101 “Business Description” portion of the corporate report. Such disclosures are substantively related to the purposes of the risk factor and MD&A but lie outside those sections (and therefore are governed by the “Business Description” regulations). Although disclosures of such forecasts are not required, there is still a duty to ensure that such information is truthful, accurate and complete if it is made.42 As noted above, the Reference Case is a modelled projection that assumes that only existing laws and policies are maintained over the projection period. Presumably the incorporation of the Reference Case into corporate reports means they are generally reflective of company beliefs, though that is not entirely clear.43 This raises the dual questions of how those disclosures interrelate with company recognition of the material risks of climate change (discussed in Part III) and, more generally, how the company was assessing the risk from efforts to mitigate climate change.

42 17 CFR 240.12b-20.43 In analyst presentations companies do often cite sources such as Wood-Mackenzie, Doyle Trading Consultants and their own internal analyses, disclosures to investors are largely dominated by reference to the EIA.

Applying the SEC guidelines on the use of EIA projections in company reports suggests that few companies considered the use of EIA projections in light of these guidelines. As discussed below, only one company indicated that the projections were contingent upon a substantial build out of new coal-fired power plants—an assumption that proved increasingly untenable over the period reviewed and, in any event, presented a one-sided assumption about the future development (or lack thereof) of climate policy and regulation. Moreover, the reports generally did not offer management’s views on the accuracy of the EIA projection anywhere in the corporate reports. Finally, even though the EIA Reference Case failed to even reflect the direction of travel for US coal markets, companies continued to utilize those numbers without identifying the significant gap between actuals and projections.


Part II

Carbon Budgets


The two-degree carbon budget The 2009 Copenhagen Accord included a non-binding pledge by governments to limit warming to no more than two-degrees above pre-industrial levels.44 Under the Copenhagen Accord, “Annex I Parties commit to implement individually or jointly the quantified economy-wide emissions targets for 2020.”45 The Cancun Agreements formalized these targets by deciding, “Developed countries should submit annual greenhouse gas inventories and inventory reports and biennial reports on their progress in achieving emission reductions, including information on mitigation actions to achieve their quantified economy-wide emission targets and emission reductions achieved.”46 In 2011 at Durban the parties established a formal reporting and review structure for reporting emissions.47

The salience of Copenhagen was the incorporation of a climate target that, in turn, implied a significant reduction in emissions when compared to business-as-usual. The implied emissions reductions provide a signpost for potential impact on fossil fuel demand and therefore a means of quantifying the risks —however they might materialize.

44 http://unfccc.int/resource/docs/2009/cop15/eng/11a01.pdf 45 Copenhagen Accord, ¶4. Available at http://unfccc.int/resource/docs/2009/cop15/eng/l07.pdf.46 Cancun Agreements, ¶40. The targets are also discussed in ¶¶36, 44, and 46.47 FCCC/CP/2011/9/Add.1 ¶¶ 23-31, Annex II: Modalities and procedures for international assessment and review.

In 2014, the Fifth Assessment Report (AR5) of the Intergovernmental Panel on Climate Change (IPCC) concluded that to limit climate change to 2°C, a total of 1,000 GtCO2 can be emitted by 2100.48 According to the International Energy Agency (IEA), the total CO2 embedded in just the world’s coal, oil and gas reserves is equal to 2,860 GtCO2.49 This simple comparison gives an indication of the extent to which fossil fuels will have to be left in the ground to achieve acceptable levels of climate change.

This 2°C climate target has subsequently been incorporated into a chain of UNFCCC international agreements and accords culminating in the recent Paris Agreement in 2015, which saw each participating nation submit national targets to keep global average temperature to “well below 2˚C” above pre-industrial levels.50

48 https://www.ipcc.ch/news_and_events/docs/COP20/LCAHLD.pdf49 IEA World Energy Outlook 2012.50 The current Nationally Determined Contributions (NDCs) do not yet provide a clear regulatory pathway to the 2°C goal, but the Paris Agreement con-tains a ratchet mechanism for increasing ambition over time. https://unfccc.int/resource/docs/2015/cop21/eng/l09.pdf

http://unfccc.int/resource/docs/2009/cop15/eng/11a01.pdf

http://unfccc.int/resource/docs/2009/cop15/eng/l07.pdf

http://unfccc.int/resource/docs/2009/cop15/eng/l07.pdf

https://www.ipcc.ch/news_and_events/docs/COP20/LCAHLD.pdf

https://unfccc.int/resource/docs/2015/cop21/eng/l09.pdf

https://unfccc.int/resource/docs/2015/cop21/eng/l09.pdf


The sum total of those targets currently exceed a two-degree compliant level of emissions, but countries have agreed to regularly update those targets:

Figure 4: Current INDCs exceed the emissions trajectory for 2°C 51

Source: IEA WEO 2015, IEA Energy and Climate Change 2015, CTI analysis 2016

51 The IEA INDC trajectory has been adjusted to the 2013 emissions level published in the 2015 World Energy Outlook. This represents the latest, most up to date data for this year.

Annu

al CO

2 em

issio

ns (G

tCO

2)


Many organizations have analysed how these climate targets might affect demand for particular fossil fuels. Figure 5 shows how a 2°C trajectory (the 2014 IEA 450 Scenario) and a pathway that models implemented and announced policies (the 2014 IEA’s New Policies Scenario) would impact each fuel type differently. Evidently, demand for coal declines most dramatically, highlighting that, of all fossil fuels, coal is most at risk of being “stranded”.

Figure 5: Implications of Climate Targets for Fossil Fuels

Source: IEA World Energy Outlook, 2014

Mto

e


National carbon budgets

At the national level countries have sought to develop plans compliant with these climate targets. The structure of these plans varies—some are incorporated into national legislation, others are coterminous with a country’s INDC pledge. For OECD countries, these plans are often articulated as percentage emissions reductions levels from a baseline year. As such, they imply a fixed budget of available emissions going forward. For developing countries, these are often expressed as reductions in energy and carbon intensity of GDP in which case absolute emissions reductions are in part a function of GDP growth.

US carbon budgets

Through the previous half decade, the US has been increasingly proactive in its ambition to mitigate climate change, providing clear policy signals for future emissions reductions. As part of the 2009 Copenhagen Accord, President Obama’s administration pledged a reduction in US greenhouse gas emissions of 17% by 2020, 42% by 2030 and 83% by 2050, compared to a 2005 baseline.52 For the US, this is broadly consistent with a 2°C trajectory over that time period.53 This equates to 3.8% compound annual reductions per year.

52 http://www.washingtonpost.com/wp-dyn/content/arti-cle/2010/01/28/AR2010012803632.html53 If you consider CO2 emissions as a proxy for GHG emissions more broadly, the IEA 450 scenario determines that annual CO2 will need to fall by 65% by 2040 on 2013 levels. IEA World Energy Outlook 2015.

The 2009 Waxman-Markey bill that passed the US House of Representatives but stalled in the Senate aimed at similar emissions reductions of 17% by 2020 and 42% by 2030, compared to a 2005 baseline. The recently proposed Clean Power Plan, which only covers emissions from the power sector, mandates reductions of 32% through 2030, compared to a 2005 baseline. Pursuant to the Paris Agreement, the US further specified a target of 26-28% emissions reductions by 2025, compared to a 2005 baseline. Some commentators have noted that existing policy is so far insufficient to meet US climate targets.54 However, it is also unlikely that these are the last regulatory or policy efforts enacted to mitigate warming. As the Clean Air Act already vests the EPA with substantial authority to regulate GHG emissions, further action would likely not require the support of the US Congress and could therefore be more easily implemented.

These climate targets imply meaningful reductions in coal demand. For example, in 2015 the EIA modelled the impact of the CPP on coal demand. In Figure 6, we have compared that modelling to selected Reference Case projections over the years. In each case, the EIA used the same underlying economic model (NEMS), but in the CPP case it added the emissions reductions constraints:

54 Rhodium Group, “Taking Stock: Progress Toward Meeting US Climate Goals,” (Jan. 2016) (available at: http://rhg.com/wp-content/uploads/2016/01/RHG_Taking_Stock_of_US_Climate_Goals_Jan28_2016.pdf)

http://www.washingtonpost.com/wp-dyn/content/article/2010/01/28/AR2010012803632.html


http://rhg.com/wp-content/uploads/2016/01/RHG_Taking_Stock_of_US_Climate_Goals_Jan28_2016.pdf

http://rhg.com/wp-content/uploads/2016/01/RHG_Taking_Stock_of_US_Climate_Goals_Jan28_2016.pdf


Figure 6: Comparing across EIA scenarios to what actually transpired

Source: EIA Annual Energy Outlooks 2006-2014

Coal

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Actual 2014 AEO 2010 AEO

EIA Clean Power Plan EIA CPP Extended 2006 AEO

0.4%

1.6%

1.6%

-1.0%

-1.8%


Figure 6 demonstrates the drastically different results when CPP policy action is considered—shifting the demand curve from stable or modest growth to decline.

China carbon budgets

The Chinese government has also established emissions reduction targets. In its 12th Five-Year Plan (FYP) released in March 2011, the Chinese government announced goals for the 2011-2015 period of reducing the energy intensity of GDP by 16%, carbon intensity of GDP by 17%, and 7% annual GDP growth. Table 1 shows that China actually exceeded its 12th FYP targets through 2015:

Table 1: Chinese FYP Targets and Actuals55

12th FYP target Actual Results

GDP growth 7% pa 8.4% pa

Energy intensity -16% -18.2%

Carbon intensity -17% -20%

Sources: World Bank, WRI

55 http://www.c2es.org/international/key-country-policies/china/ener-gy-climate-goals-twelfth-five-year-plan

These targets inherently required China to meet the target to increase non-fossil energy supply by 11.4% over the same period. Considering that China’s political environment typically ensures that the FYPs are met, the 12th FYP made clear that China intended to move away from coal consumption that had grown so rapidly since the turn of the century.

Over the 2011-2015 period, coal consumption in China grew by 0.8% on average each year. However, this masks a more relevant story that total coal consumption inverted over this 5 years, from 7.7% growth in 2011, to declines of 2.9% and 5% in 2014 and 2015.56 China’s FYP gave US coal companies a clear indication that demand was likely to slow, if not decline, and it did, consistent with the governments’ reduction targets. It does not appear that companies disclosed these targets or incorporated them into their decision-making or forecasts.

56 http://seekingalpha.com/article/3334735-new-china-coal-data-has-se-rious-implications-for-peabody-energy



http://seekingalpha.com/article/3334735-new-china-coal-data-has-serious-implications-for-peabody-energy

http://seekingalpha.com/article/3334735-new-china-coal-data-has-serious-implications-for-peabody-energy


China’s 13th FYP, released in March 2016, provided a pathway for further slowing of CO2 emissions growth, for the 2016-2020 period:

Figure 7: CO2 emissions implied by China’s 13th FYP, 2016-2020 (annual changes)57

Source: CTI analysis 2016

57 Percentage change figures are annual compound growth estimates. Diagram sourced from: http://www.carbontracker.org/china-five-year-plan-coal-co2-emissions-renewables/

The energy-related targets in the 13th FYP are no weaker than those in the 12th FYP. As such, China’s transition away from coal consumption will not slow to 2020. The continuing restriction on CO2 emissions has led the IEA to state that 2013 might have been peak coal in China.58 This would have catastrophic implications for US coal companies that were hoping for a robust seaborne market built around Chinese coal demand.

58 http://www.carbonbrief.org/iea-china-might-have-passed-peak-coal-in-2013

Moreover, China’s Central Government are expected to continue protecting domestic producers, as illustrated by the quality tariffs imposed on foreign coal imports. Exports to China are already falling as a result. This is set to continue towards the eventuality that China hits net-zero imports.

http://www.carbonbrief.org/iea-china-might-have-passed-peak-coal-in-2013

http://www.carbonbrief.org/iea-china-might-have-passed-peak-coal-in-2013


Box 2: The technology/policy nexus

The technology/policy nexus

The foregoing does not mean that long-term climate policy targets were a direct driver of the recent emissions reductions. But not considering those policy targets because of a lack of existing regulation or binding law to meet them is perhaps more perilous; it ignores the important ways in which policy targets influence both subsequent regulations and technology.

A top-down view—translating climate targets to emission budgets to implied demand reduction—may provide a clearer picture of trends than an assumption that business will continue as usual. This is because the policy/technology nexus is complex and self-reinforcing. Policy support has played a role in incentivizing the technology and driving initial cost reductions that has fuelled the coal-to-gas/renewables switch in power. Regulation has further facilitated the switch by increasing compliance costs for dirtier fuels and increasing uncertainties for coal-fired generation. This has a feedback effect: as cleaner technologies become less expensive and dirtier fuels more expensive, the cost-benefit calculus for policymakers shift, allowing more significant policy action while also making the need for policy less relevant.

Precisely how policy and technology will evolve is difficult to predict. However, less difficult are the implications that a given emissions reduction target would have on fossil fuel demand (even though certain assumptions would still have to be made). This has implications for how companies consider and report the risks, suggesting that it may be useful to understand how company business plans compare to standardized demand scenarios consistent with the two-degree target.

title title title title title title | 31

Part III

The US coal crash, revisited


The last decade has seen drastic changes in the US coal sector. Global coal production and prices boomed in the immediate years after the 2007-2008 global financial crisis (GFC). Most coal companies characterized this as a resumption of a coal ‘supercycle’ and borrowed to finance acquisitions. For the most part, investors did not punish companies for taking on that additional risk.

Both regulatory and technology drivers have been influential in the shift from coal consumption to gas and renewables in the US. Figure 8 shows that environmental and pollution regulations emerged with great regularity in the US to suppress coal consumption. Simultaneously, huge technological breakthroughs were achieved that instigated the ‘dash for gas’ that caused gas prices to fall and undercut the costs of coal supply. The result has been particularly significant for investors, who have seen dramatic declines in coal equities.

Figure 8: US Coal Crash

Source: CTI, US Coal Crash, 2015


Companies leveraged up for the supercycleCompanies appeared to believe that growth in developing markets presented a great opportunity for US coal companies. Consequently, a number of the larger companies took on substantial debt to acquire smaller competitors to gain market share, focusing on seaborne thermal and metallurgical markets:

• Alpha Natural Resources: Alpha Natural Resources acquired Massey Energy in the early 2010s, making Alpha the second largest producer in the US and increasing its exposure to metallurgical coal. The takeover cost $6.7bn, of which the cash outlay was just $1bn. This was a major driver in Alpha Natural Resource’s net debt level increasing from under $200m to $2.4bn at the end of 2011.59 Alpha Natural Resources filed for bankruptcy protection on 3rd August 2015. • Peabody Energy: In 2011, Peabody Energy acquired Macarthur Coal, a metallurgical coal producer in Australia, to increase its exposure to the Asian market. This was a very highly leveraged takeover, with $4.1bn of the $5.1bn total purchase being funded through new loans and senior notes.60 By the time of Peabody’s bankruptcy protection filing in April 2016, it was servicing liabilities of $10.1 bn.61

59 http://marketrealist.com/2014/12/alpha-natural-resources-mas-sey-energy-acquisition-got-messy/60 http://app.quotemedia.com/data/downloadFiling?webmas-terId=101533&ref=7931317&type=PDF&symbol=BTU&companyName=Pea-body+Energy+Corp.&formType=8-K&dateFiled=2011-11-30 61 http://www.reuters.com/article/us-peabody-energy-bankrupt-cy-idUSKCN0XA0E7

Investors are therefore set to lose out, with about $4bn of the outstanding $6.3bn debt held by unsecured bond investors and the remaining controlled by a syndicate of banks.62

• Walter Energy: On April 1, 2011, Walter Energy completed the acquisition of Western Coal Corporation, a Canadian company with mines located close to Canadian ports on the West coast. The acquisition cost Walter Energy $2.2bn in cash and $1.2bn in equities.63 The intention was that this additional production and proximity to export terminals would position Walter Energy to compete for coal sales to Asia. When additional demand failed to materialise, the capital structure of the company came under stress. Prior to this takeover, Walter Energy’s net debt was zero, but the end of 3Q 2014, this had increased to $3.2bn, largely as a result of the Western Coal Corp. acquisition.

• Arch Coal: In May 2011, Arch Coal agreed to the takeover of International Coal Group (ICG) for $3.4bn. Like many of the other takeovers, this acquisition aimed to increase Arch’s exposure to the metallurgical coal market, which it expected to grow from 11mt to 14mt between 2011 and 2014.64 The takeover was an all-cash transaction, which put Arch’s balance sheet under strain when expected demand growth did not transpire.

62 http://www.afr.com/business/australian-takeover-drags-pea-body-near-bankruptcy-20160318-gnm7z163 http://services.corporate-ir.net/SEC/Document.Service?id=P3Vyb-D1hSFIwY0RvdkwyRndhUzUwWlc1cmQybDZZWEprTG1OdmJTOWtiM2R1Yk-c5aFpDNXdhSEEvWVdOMGFXOXVQVkJFUmlacGNHRm5aVDA0TnpZM-k1UazNKbk4xWW5OcFpEMDFOdz09JnR5cGU9MiZmbj1XYWx0ZXJFbmVyZ3l-JbmMucGRm 64 http://www.prnewswire.com/news-releases/arch-coal-to-acquire-icg-for-34-billion-121077269.html

http://marketrealist.com/2014/12/alpha-natural-resources-massey-energy-acquisition-got-messy/

http://marketrealist.com/2014/12/alpha-natural-resources-massey-energy-acquisition-got-messy/

http://app.quotemedia.com/data/downloadFiling?webmasterId=101533&ref=7931317&type=PDF&symbol=BTU&companyName=Peabody+Energy+Corp.&formType=8-K&dateFiled=2011-11-30



http://www.reuters.com/article/us-peabody-energy-bankruptcy-idUSKCN0XA0E7

http://www.reuters.com/article/us-peabody-energy-bankruptcy-idUSKCN0XA0E7

http://www.afr.com/business/australian-takeover-drags-peabody-near-bankruptcy-20160318-gnm7z1







http://www.prnewswire.com/news-releases/arch-coal-to-acquire-icg-for-34-billion-121077269.html

http://www.prnewswire.com/news-releases/arch-coal-to-acquire-icg-for-34-billion-121077269.html


Leveraged balance sheets spelled trouble

The leverage taken on at the beginning of a stunted supercycle ultimately weighed the industry down. Over the past 5 years, US coal company share prices have collapsed. Table 2 shows many lost in the region of 90% of their share value between 2010 and 2014. This resulted in approximately 30 companies going bankrupt. Those remaining are doing so by the skin of their teeth. Three of the four largest US coal producers are now in bankruptcy. The greatest losses have been borne by the companies that made market-peak acquisitions.

Table 2: US Coal Company Performance

Company Last 18m share price perf. (as of 2 Jun. '16)

Last 5y share price perf.

Net debt (USDm)(3 Jun. '16)

EBITDA (USDm)(3 Jun. '16)

Peak Market Acquisitions Bankrupt?

Westmoreland Coal -73% -49% 1278.5 150.9 - No

Hallador Energy -61% -56% 249.9 84.9 - No

Alliance Resource Part. -64% -60% - No

Consol Energy Inc. -55% -69% 3615.8 600.8 - No

Cloud Peak Energy Inc. -77% -90% 491.5 71.9 Youngs Creek Mining Co. - $241m (Jun 2012) No

Peabody Energy Corp. -99% -100% 7187.2 303.2 MacArthur Coal - $5.2bn (Nov 2011) Yes

Arch Coal Inc -98% -100% 5487.3 158.3 Int’l Coal Grp. Inc - $3.4bn (Jun 2011) Yes

Alpha Natural Resources Inc. -92% -100% 1342.5 -84.9 Massey Energy Co - $8.4bn (Jun 2011) Yes

Rhino Resource Partners Lp -91% -99% 46.4 11 Elk Horn Coal Co. - $128m (Jun 2011) Yes

Walter Energy Inc. -93% -100% 0.2 -178.3 Western Coal Corp. - $3.4bn (April 2011) Yes

James River Coal Co. DELISTED Int’l Resource Part. LP - $519m (April 2011) Yes

Foresight Energy Lp -90% N/A 1404.9 269.7 - No


Major market misread

Each of the mergers above implied a commitment to expanding coal production in the 2010-2020 decade and beyond. Most companies sought exposure to seaborne markets. For thermal coal, companies made moves to lower cost basins (i.e. PRB) or areas closer to export markets (i.e., Australia) or sought greater exposure to met coal supplies on the hope of selling those reserves in the seaborne market. These markets have failed to deliver.

Supercyle, or boom and bust?

It is evident that these acquisitions were a major misread of the markets, justified by a belief in high future demand in the metallurgical and thermal seaborne trade and resilient demand in the US for legacy assets. Neither of these conditions held.

As Citi put it in mid-2013, the last five years has seen ‘the death bells ring for the commodity supercycle’. The upturn that management teams were betting on has not materialised, particularly in the US where structural headwinds have been building. The ensuing value destruction is the result of a number of structural drivers that were misread by the companies, many of which sought expansion at the wrong time. Those drivers were consistent with but not the exclusive product of climate-proofing the US energy supply — the economics of shale gas played a central role.

On the climate side, the overall direction of travel was signalled by President Obama through the Copenhagen pledges to cut US greenhouse gas emissions by 17% by 2020 against 2005 levels. this was followed by subsequent regulations.65 Generally speaking the key factors were:

• The emergence of cheap shale gas: Advances in horizontal drilling and slickwater hydraulic fracking techniques facilitated a large increase in natural gas production in the US. This boom resulted in the price of share gas falling by approximately 82% between the 2008 high and end of 2015. Consequently, the share of the US power market supplied by gas increased by 11% over the same period, while that met by coal fell by 15%. Renewables captured the bulk of the remaining coal decline - refer Figure 9.

• Environmental regulation: Since 2005, approximately 7 key regulations have been implemented or are in the process of being implemented by the US Environmental Protection Agency (EPA), which have served to suppress coal demand. These policies are broadly aimed to mitigate the detrimental environmental and human health consequences of coal burning. The more influential policies include the Mercury and Air Toxics Standards (MATS), air quality standards (NAAQS), the carbon source performance standards (NSPS) and the Clean Power Plan. While harder to clearly attribute, these regulations may have played a role in generating uncertainty about the long-term future of coal and thus hampered the build out of new coal generation (an assumption built into the EIA Reference Case).

65 http://www.washingtonpost.com/wp-dyn/content/arti-cle/2010/01/28/AR2010012803632.html




Figure 9: US Energy Mix by Energy Source

Source: CTI, US Coal Crash, 2015

50% 49% 49% 48% 44% 45% 42% 37% 39% 39%

33%

19% 20% 22% 22% 24% 24%

25% 31% 28% 28% 33%

2% 2% 3% 3% 4% 4% 5% 5% 6% 7% 7%

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Other renewables Hydro Nuclear Natural gas (and other gases) Petroleum Coal

US an

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Seaborne coal fails to arrive

Between 2008 and 2013, China and India alone accounted for 98% of the increase in world seaborne coal trade. In this period, China’s coal import growth slowed and then declined by 10% in 2014 and 30% in 2015. This resulted in overall global coal imports declining in 2014 and 2015, resulting in a collapse in prices. This was a very important driver in the collapse of US coal companies.

These changes largely appear to have caught the coal industry by surprise. For example, in 2013, Peabody stated in their annual report that ‘coal demand is projected to expand by some 700 million tonnes, with China and India driving nearly 80% of this growth’.66 Still in 2016 Peabody expected to see ‘100mt of import growth to China and India’.67 Instead, 2013 transpired to be the year of peak demand for domestic and imported coal in China as a result of domestic air pollution measures, coal quality legislation on imports and incentives towards non-fossil energy sources.

66 Peabody Energy 2013 Annual Report, at 3.67 https://mscusppegrs01.blob.core.windows.net/mmfiles/files/investors/annual-reports/pe-ar2013.pdf

That the market collapsed so quickly raises the question of whether there was a clear understanding of the policy risks in targeted export markets whether those risks were conveyed with sufficient clarity and force.

Notwithstanding this collapse, coal companies seem to have pointed to long-term forecasts that offered light at the end of the downturn. In many cases, those disclosures acknowledged potential climate risks, but focused on scenarios, especially those from EIA, that estimated resilient US coal demand and robust growth in the seaborne trade.

https://mscusppegrs01.blob.core.windows.net/mmfiles/files/investors/annual-reports/pe-ar2013.pdf

https://mscusppegrs01.blob.core.windows.net/mmfiles/files/investors/annual-reports/pe-ar2013.pdf


Credit: Kimon Berlin/flickr

Credit: Kimon Berlin/flickr

Part IV

EIA’s Energy Model


The Energy Information Administration produces estimates of future energy demand using the National Energy Modelling System (NEMS), which takes a market-based approach based on existing regulations and standards, to model developments in energy markets and usage. NEMS includes a number of constituent modules that “represent each of the fuel supply markets, conversion sectors, and end-use consumption sectors of the energy system:”68

Figure 10: EIA National Energy Modelling System69

68 EIA, “Assumptions to the Annual Energy Outlook 2015” (Sept. 2015), at 1.69 Id., at 3.


As with any model, NEMS relies on data, assumptions and key inputs which are updated annually. It produces alternative scenarios by modifying key variables, such as oil prices and supply and economic growth, to isolate the impact of these variables on energy markets.

The EIA Reference Case assumes business as usual…

The EIA’s Annual Energy Outlook focuses on a business-as-usual policy scenario—the EIA Reference Case—that “assumes that current laws and regulations affecting the energy sector are largely unchanged throughout the projection period (including the implication that laws that include sunset dates do, in fact, become ineffective at the time of those sunset dates).”70

The Reference Case projection is a business-as-usual trend estimate, given known technology and technological and demographic trends.” The EIA cautions that it should not be considered a forecast of how things will unfold, since “[p]rojections by EIA are not statements of what will happen but of what might happen, given the assumptions and methodologies used for any particular scenario. Consequently, the Reference Case results ‘should not be viewed in isolation’, but against the other scenarios to gain perspective and a truer sense of the inherent uncertainties. The Reference Case does not analyse the policy implications of climate targets at the national or local level and therefore does not incorporate emissions reductions targets.

70 EIA AEO 2012, at 6.

The ‘no new policies’ assumptions used in the Reference Case help inform policy makers of how markets might evolve absent policy changes, and many policy makers use the EIA Reference Case to demonstrate the need for additional policy action. The Reference Case is not intended to be a predictor of the likely actual development of energy and policy and, unsurprisingly, has proved to be a poor “forecast” of actual events.

…which is playing catch-up with actual outcomes

As we discuss in Part V, many US coal companies referred to the Reference Case as if it were a “forecast.” Figure 11 shows the EIA’s Reference Case projections for coal’s share of the US power market from 2007 onwards as compared to actual results. It illustrates that although projections of coal’s demise in the US became gradually more significant, the Reference Case projections overestimated coal’s role. Over the past several years, the recent Reference Case scenarios have projected coal’s share of the US power market to decline, but only gradually. These projections were far more optimistic than the severe decline that has actually transpired. For example, the latest EIA data put coal’s share of power generation at 33% in 2015, but the 2015 EIA AEO Reference Case only projects coal’s share of power generation fall just below 40% in 2040.71 This calls into question the coal company usage of the Reference Case as a credible forecast of future demand.

71 In May of this year, the EIA released an early version of the AEO 2016. That version incorporates the CPP into the Reference Case and, significantly, pro-jects that coal will power just 28% of electricity generation in the US in 2040. This assumes, of course, that no additional measures after the CPP are implemented to further reduce coal’s share.


Figure 11: Coal’s share of electricity generation

Source: EIA Annual Energy Outlook 2007-2016

As it assumes no new policy developments, the Reference Case does not incorporate the rapidly changing conditions for the US coal market from increased regulation and efforts to prevent the lock-in of coal intensive power generation. Of course, the point of the Reference Case is not to forecast the future, but to provide a projection of existing policies. But this raises the question of the value of such a scenario in the context of a corporate report, and specifically a discussion of the potential risks to the business.

Interestingly, when the EIA has modeled the evolution of energy consumption and generation trends by embedding emissions reductions targets from stated policies—including policies that were ultimately not enacted—it has produced coal demand scenarios much closer to the actual trajectory than the Reference Case.

Other EIA scenariosIn each Annual Energy Outlook the EIA also runs dozens of scenarios aside from the Reference Case. In its most recent Outlook, this includes high and low variants on economic growth, oil price, technology, renewables and fossil fuel costs and climate policy stringency. Though the alternative cases were typically not referred

to in company reports, some demonstrated a very different direction of travel. Figure 12 identifies the Climate Policies case, produced in 2009 and the Accelerated Coal Retirements Case, produced in 2014:

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Figure 12: Comparison EIA Scenarios and Actuals, Coal Power Generation

Source: EIA Annual Energy Outlook 2009 and 2014

As seen above, the EIA’s strong climate policies scenario, referred to as ‘LW110’, was most bearish on coal demand projecting -1.0% growth per annum in coal power generation (compared to 0.7% CAGR increase in coal power generation under the Reference Case).

Even though LW110 was still bullish compared to actual results through 2013, it at least reflected the actual direction of travel.

Figure 12 also shows how other cases later in the period examined would have shown a downward trajectory in coal generation as opposed to the stable demand projection in the Reference Case. In 2014, when companies were able to inform their outlook with the on-going crash, projections such as ‘accelerated coal retirements’ case were overlooked in favour of the business-as-usual Reference Case. Indeed, by ignoring climate policy and technology risk, the Reference Case scenario represents something more like a “best case scenario” for US coal rather than one built upon reasonable assumptions of future developments.

EIA’s top-down modelling constraintOn occasion, policy makers ask the EIA to identify the energy market implications of proposed legislation and regulations. Three recent examples include the August

2009 analysis of the American Clean Energy and Security Act (ACESA/ Waxman-Markey), the July 2010 analysis of the American Power Act (APA)72, and an analysis of the Clean Power Plan (CPP) in 2015. While the APA/ACESA bills were not

72 The APA bill was very similar to Waxman-Markey, a bill that passed the US House of Representatives. The EIA analyzed both and the results were similar. Below, we have focused on Waxman-Markey.

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enacted and the Clean Power Plan has yet to take effect, the projections from each are instructive since they required the EIA to integrate proposed emissions reductions targets into the NEMS model and thus represent an interesting, if temporally limited, comparison of the Reference Case to a NEMS-based analysis of emissions constraints and actual results. The Waxman-Markey bill proposed an “economy-wide, GHG cap-and-trade system and critical complementary measures to help address climate change.”73 In line with President Obama’s Copenhagen pledge, the cap required a 17- percent reduction in covered emissions by 2020, 42% by 2030 and an 83-percent reduction by 2050, all relative to a 2005 baseline, with targets that declined steadily for intermediate years.74

The CPP would establish standards to limit carbon emissions from existing power plants for the first time. The key emissions reduction target in the CPP is a 32% reduction by 2030 from 2005 levels—lower than the Copenhagen pledge but also only one of several policies directed at reducing emissions.

73 http://www.c2es.org/federal/congress/111/acesa74 See http://www.eia.gov/oiaf/servicerpt/hr2454/execsummary.html; http://www.c2es.org/federal/congress/111/comparison-waxman-markey-ker-ry-lieberman

Table 3: Comparison of Emissions Reduction Targets from 2005 Baseline75

Year Copenhagen Pledge

Waxman-Markey

Clean Power Plan

2020 17% 17% --

2025 30% -- --

2030 42% 42% 32%

2050 83% 83% --

By overlaying those emissions reductions targets and CPP policy measures on the NEMS model, the EIA estimated the impact of the CPP for coal demand.76

75 The CPP proposed rule contained a 30% reduction by 2030 and this level of emissions reduction but the Final Rule revised the goal upwards to 32%. See, https://www.whitehouse.gov/the-press-office/2015/08/03/fact-sheet-presi-dent-obama-announce-historic-carbon-pollution-standards. The EIA modeled the proposed rule76 With the exception of Arch, no companies we examined identified either this analysis or any other estimate of reductions in coal demand driven by the CPP.

http://www.c2es.org/federal/congress/111/acesa

http://www.eia.gov/oiaf/servicerpt/hr2454/execsummary.html; http://www.c2es.org/federal/congress/111/comparison-waxman-markey-kerry-lieberman



https://www.whitehouse.gov/the-press-office/2015/08/03/fact-sheet-president-obama-announce-historic-carbon-pollution-standards

https://www.whitehouse.gov/the-press-office/2015/08/03/fact-sheet-president-obama-announce-historic-carbon-pollution-standards


Imposing a top-down emissions target is more consistent with actual results

Figures 13 and 14 demonstrate that the EIA’s Reference Case was not an appropriate gauge for what transpired in the US coal market. Figure 13 demonstrates that the Reference Case has had to shift downwards year after year to reflect on-going reductions in coal demand and even still, suggests a flat or slightly rising increase in coal demand going forward:

Figure 13: EIA Reference Cases vs. Actual

Source: EIA Annual Energy Outlook 2006-2014

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By contrast, Figure 14 shows that the EIA scenarios that modelled emissions reductions targets from Waxman-Markey—targets that were similar to what President Obama pledged to effectuate—have been far more accurate than the Reference Case, even though the bill was not enacted. Figure 14 demonstrates that EIA’s multi-scenario analysis of that bill more accurately reflected coal consumption since 2007 than the EIA Reference Case.

Figure 14: EIA ACESA Modelling 77

Source: EIA, 2009, Energy Market and Economic Impacts of H.R. 2454, the American Clean Energy and Security Act of 2009

77 http://www.eia.gov/oiaf/servicerpt/hr2454/pdf/sroiaf(2009)05.pdf

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http://www.eia.gov/oiaf/servicerpt/hr2454/pdf/sroiaf(2009)05.pdf


The two scenarios representing the most drastic decline in US coal consumption - ‘no international offsets’ and ‘no international/limited’ - both reflect an environment in which the use of carbon offsets through credit trading is ‘severely limited by cost, regulation and/or slow progress in reaching international agreements’.78 This means consumption of CO2-intensive fuels like coal must decline rather than be transferred to another company or region. This is tantamount to what happened in the market even absent the passage of detailed climate regulation.

This suggests that President Obama’s 2009 Copenhagen pledge to reduce US GHG emissions by 17% by 2020 (on 2005 levels) was a critical signal of future policy action. Nonetheless, most companies eschewed such projections for the Reference Case scenario. Importantly, the EIA’s analysis of the APA which reached similar conclusions to Waxman-Markey was published in August 2009, and therefore would have been available to all companies filing their 2009 10-Ks in early 2010 and thereafter.

Companies did not need to wait until COP21 in Paris to recognize the shift. Research from as early as 2012 was suggesting that the US was already on track to meet this emissions reduction target.79 Companies that accurately assessed the risks of these intentions to the coal market might have identified the alternative Waxman-Markey scenarios as being more reflective of what might transpire in the short-term than simply assuming business-as-usual.

78 http://www.eia.gov/oiaf/servicerpt/hr2454/pdf/sroiaf(2009)05.pdf79 http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-12-48.pdf

http://www.eia.gov/oiaf/servicerpt/hr2454/pdf/sroiaf(2009)05.pdf

http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-12-48.pdf

http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-12-48.pdf


The Clean Power PlanIn 2015, the EIA published a similar analysis of the Clean Power Plan (CPP), which has been promulgated but stayed by the Supreme Court until the courts resolve legal challenges. EIA’s analysis of the CPP quantifies the impact it might have on coal consumption in the US:

Figure 15: Change in Electricity Generation by Fuel in Clean Power Plan Cases Relative to Baseline80

80 EIA CPP Analysis, at 32 (May 2015).


In Figure 16, we focus on three key EIA CPP scenarios compared to actual trends: (1) a base policy scenario (CPP), (2) a CPP policy extension scenario (CPPEXT), including extended emissions reductions of 45% below a 2005 baseline by 2040, and (3) a CPP scenario with new nuclear capacity benefiting from as favourable scoring under the CPP as other zero-carbon technologies (CPPNUC).81 These demonstrate that the CPP is largely an extension of current trends in declining coal demand:

Figure 16: Changes in CPP Scenarios82

Figure 16 shows a consensus that under each of these scenarios, coal consumption is substantially reduced compared to the EIA’s 2015 Reference Case.83 Figure 16 also demonstrates that restrictions imposed by the Clean Power Plan will likely carry through the existing trend line of decreasing coal demand.

81 https://www.eia.gov/analysis/requests/powerplants/cleanplan/pdf/powerplant.pdf82 https://www.eia.gov/analysis/requests/powerplants/cleanplan/pdf/powerplant.pdf83 The 2016 EIA Reference Case incorporates the CPP.

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Source: EIA 2015 Analysis of the Impacts of the Clean Power Plan

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https://www.eia.gov/analysis/requests/powerplants/cleanplan/pdf/powerplant.pdf

https://www.eia.gov/analysis/requests/powerplants/cleanplan/pdf/powerplant.pdf


Mistaking the forest for the trees

The CPP was not announced until 2014 and its particularities could not have been easily foreseen. However, very few companies sought to inform investors of the magnitude of the risk it posed once that information was released. In 2015 it was run as an alternative scenario by the EIA and in 2016 forma part of the Reference Case. This shows how it takes time for laws to be put in place, but forward-looking companies would want to consider their implications before its too late. Furthermore, it is by no means clear that the CPP is the last word on climate policy; many commentators have noted that it does little more than codify the new “business-as-usual” trend of declining coal consumption. Indeed, between proposing and finalizing the rule, the Obama Administration strengthened the 2030 target by 9%. Other emissions reductions efforts to “ratchet” up ambition to meet the Paris Agreement’s two-degree goals may also be looming on the horizon. Given that the ACESA emissions forecasts led the AEO back in 2010, it is quite possible the new targets set in Paris could lead again.

The foregoing suggests that deploying a top-down view of emissions reductions targets on forward-looking models may be more reflective of policy trends than models that assume no action going forward. Here, with the many indicia of policy action on climate change already evident, the default for forward looking information in company reports should be to analyse the implications of climate targets rather than assume business-as-usual trends that continue to point away from actual results.


Part V

Coal Company Disclosures in Context


In Part V, we take a closer look at company disclosures in the annual corporate reports for the years 2010-2015. Annual filings generally acknowledged the materiality of several climate related risks even as companies took on a substantial debt to fund expansions into metallurgical and seaborne thermal markets.

Certainly, such expansions suggest an expectation of growing global demand (even whilst the Chinese government was pledging to disappoint), but did the focus on metallurgical and seaborne trade also signal a lack of belief in the US coal markets going forward? If so, this raises the question of how companies saw trends in the US coal markets, especially emerging emissions reduction targets.

Risks identified…

Our review of the risk factor disclosures by the coal companies that pursued top of the market mergers show that that they included a discussion of climate risks that remained substantially the same over the 2010-2015 period. The disclosures included: the potential for international treaties, national legislation, climate and environmental regulation, renewable portfolio standards, changes in financial standards for funding new coal generating plants and cost competitive technologies to adversely impact coal markets. In general, companies further recognized that weakened demand for their products might result in lower prices with material impact on results:


Table 5: Risk Factor Disclosures Made by Selected US Coal Companies in 2010-2015 10-Ks84

Peabody Arch ANR Cloud Peak

Substitution Risk from:

Renewables Cost Declines 2010-15 2010-15 2012-14 2010-2015

Natural Gas Competition 2010-15 2010-15 2010-14 2010-2015

Regulatory Risk from:

UNFCCC 2010-15 2010-15 2010-14 2010-2015

CAA/EPA Regulation 2010-15 2010-15 2010-14 2010-2015

Federal Cap and Trade or Carbon Taxes 2010-15 2010-15 2010-14 2010-2015

State Utility Regulation/RPS 2010-15 2010-15 2010-14 2010-2015

Other Env’l Regulation and Enforcement 2010-15 2010-15 2010-14 2010-2015

Financing Risk to New Coal Plants 2014-15 2010-14 2015

Litigation Risk 2015 2010-2015

84 See table headlines:Peabody: Discussion of climate risks detailed in the “Business Description” of the 10-Ks section as well as “Risk Factors” section.Arch: Discussion of potential for additional regulation detailed in the “Business Description” of the 10-Ks section rather than “Risk Factors” section.ANR did not file a 2015 10-K as it had filed for bankruptcy. Noted litigation risk related to permitting.Company 10-K filings.


…But climate targets largely absent

While companies identified the litany of risks from action on climate change, very few identified the relevant international and national emissions reductions targets themselves, nor their potential impact. Some companies mentioned Copenhagen85, but did not identify the key development of the two-degree target. Similarly, there was virtually no discussion of President Obama’s related goal of emissions reduction targets of up to 83% by 2050 from a 2005 baseline, or the carbon budget implications of those targets.86 While these long-term targets may not be immediately responsible for the recent declines in US coal markets, they more clearly reflect a long-term structural problem rather than a cyclical ebb and flow of regulation.

The exceptions suggest that a more robust discussion of the implications of emissions reductions targets on coal demand would have been useful. In its 2014 10-K, Arch identified the Clean Power Plan goal of reducing emissions 30% of 2005 levels by 2030, implying a 25% reduction in coal generation — a significant change:

“If the Clean Power Plan is passed as proposed, and withstands legal challenges, it is projected to have an adverse impact on the demand for coal nationally. Some studies estimate that the Clean Power Plan will reduce coal generation in the US by 25%.”87

85 See, e.g., ANR’s 2010 10-K, which notes the Copenhagen Agreement but emphasizes that it was considered a “modest” outcome by most observers. Id., at 61-62; see also Cloud Peak 2010 10-K, noting agreement in principle with US pledge constituting an emissions reduction of “at least 17% by 2020.” Id., at 26-27.86 See, e.g., ANR 2010-2015 10-Ks.87 Arch 2014 10-K, at 28.

Arch’s disclosures are notable because they identify both the emissions target and the implied coal generation shrinkage—suggesting companies could provide valuable quantification of the impact that climate policy would have on demand. Unfortunately, the disclosure came long after Arch’s expansion with the acquisition of ICG, and no similar discussion of President Obama’s pre-ICG merger Copenhagen pledge is contained in earlier disclosures.88 In any case, there is little discussion of how the company intended to address such an impact.

Arch’s 2015 10-K was submitted after the company filed for bankruptcy in January 2016.89 That filing contains an analysis of future coal markets that considers a range of IEA and EIA scenarios for coal demand, including the IEA 450 Scenario and the EIA CPP Scenario, focusing on the key emissions reduction metric.90 There, Arch reveals that under the 450 Scenario, coal’s share of power generation would drop from 41% in 2013 to just 12% in 2040—a substantial decline that would require significant market rebalancing. The IEA has been publishing this scenario since 2010, and its inclusion here, but not in earlier reports, raises the question of how seriously the company was considering this risk in the lead up to the June 2011 ICG merger.

88 Arch’s 2012 10-K identifies the US emissions reductions target under the Kyoto protocol—93% below 1990 levels—though it also notes that the US had not ratified the Kyoto agreement. Arch 2012 10-K, at 27.89 Arch 2015 10-K (Mar. 15, 2016).90 Arch 2015 10-K at 9-11.


A second example is Cloud Peak, which identified the 30% emissions reduction target in its 2015 10-K filing. However, Cloud Peak indicated that it could not quantify the implications for the company, noting that, “we are not currently in a position to make any meaningful determination about the extent of the impacts to our operations.”91 This is in contrast to Arch’s 2014 disclosure, which suggests that companies can analyse the potential that given climate targets may have for reducing demand for their commodities.

Third, Peabody Energy identified the emissions reductions targets identified by the Clean Power Plan and noted that they could have a significant impact on coal demand in the US.92 However, no quantification of the potential impact on coal demand is given. Separately, and as part of a settlement with the New York Attorney General’s office,93 Peabody’s 2015 10-K noted that it did examine the implications of various climate policies from time to time but that doing so required numerous assumptions, making those analyses an unreliable predictor of future results:

“From time to time, we attempt to analyze the potential impact on the Company of as-yet-unadopted, potential laws, regulations and policies. Such analyses require that we make significant assumptions as to the specific provisions of such potential laws, regulations and policies. These analyses sometimes show that certain potential laws, regulations and policies, if implemented in the manner assumed by the analyses, could result in material adverse impacts on our operations, financial condition or cash flow, in view of the significant

91 Cloud Peak 2015 10-K, at 18.92 See, e.g., 2014 10-K at 14; 2015 10-K at 13.93 http://ag.ny.gov/pdfs/Peabody-Energy-Assurance-signed.pdf

uncertainty surrounding each of these potential laws, regulations and policies. We do not believe that such analyses reasonably predict the quantitative impact that future laws, regulations or other policies may have on our results of operations, financial condition or cash flows.”94

Aside from these examples, most other coal companies did not discuss emission targets, nor were efforts made to quantify the level of demand destruction implied by them. Instead, many emphasized that uncertainties were too great to estimate the impact:

• “The content of new treaties or legislation is not yet determined and many of the new regulatory initiatives remain subject to review by the agencies or the courts.”95

• “We cannot predict the financial impact of future greenhouse gas or clean energy legislation on our operations or our customers at this time.”96

• “[I]t is not possible for us to reasonably predict the impact that any such laws or regulations may have on our results of operations, financial condition or cash flows.”97

• “We routinely attempt to evaluate the potential impact on us of any proposed laws, regulations or policies, which requires that we make several material assumptions.

94 Peabody 2015 10-K, at 19.95 ANR 2010 10-K, at 22.96 ANR 2010 10-K, at 21-22.97 Cloud Peak 2010 10-K, at 79.

http://ag.ny.gov/pdfs/Peabody-Energy-Assurance-signed.pdf


From time to time, we determine that the impact of one or more such laws, regulations or policies, if adopted and ultimately implemented as proposed, may result in materially adverse impacts on our operations, financial condition or cash flow; however, we often are not able to reasonably quantify such impacts.”98

• “Enactment of laws or passage of regulations regarding emissions from the combustion of coal by the US or some of its states or by other countries, or other actions to limit such emissions, could result in electricity generators switching from coal to other fuel sources. The potential financial impact on us of future laws or regulations will depend upon the degree to which any such laws or regulations force electricity generators to diminish their reliance on coal as a fuel source. That, in turn, will depend on a number of factors, including the specific requirements imposed by any such laws or regulations, the time periods over which those laws or regulations would be phased in and the state of commercial development and deployment of CCS technologies. In view of the significant uncertainty surrounding each of these factors, it is not possible for us to reasonably predict the impact that any such laws or regulations may have on our results of operations, financial condition or cash flows.”99

Each of the foregoing statements failed to acknowledge the emissions reductions targets advanced by the UNFCCC process, the US President, and the US Congress (Waxman-Markey) and therefore ignored a potential top-down approach.

98 Arch 2015 10-K, at 48.99 Peabody 2010 10-K, at 48.

While companies often expressed uncertainty in forecasting the impact of climate policy, they readily provided third-party scenario information suggesting decades of continued demand for US coal—even though those projections discounted the aforementioned policy uncertainties to zero. From the point of view of a company managing risk, this seems a flawed approach; if an impact cannot be predicted precisely, it should not be assumed there is no impact at all. A more reasonable approach would be to conduct a sensitivity analysis of a range of impacts to demonstrate resilience under a number of scenarios. This does not require the probability of the outcome to be determined. Notably, such scenarios were available from the same third-party sources cited by the companies.

Companies use EIA numbers on long-term coal demand…

During the period reviewed, companies referenced EIA, World Coal Association (WCA), and IEA scenario analysis projecting coal demand through 2030-2040. The EIA Reference Scenario was commonly cited. That scenario assumed no new policies to mitigate climate change over the relevant time period, providing a baseline view assuming decades of future inaction on climate change. Typically, these forward-looking projections were included in the “business description” section of the reports.

For example, this figure was included in ANR’s 2010 10-K, with updated numbers provided annually through its most recent (2014 10-K) filing. The numbers are from the EIA Reference Case, one of several scenarios that form a part of EIA’s Annual Energy Outlook (AEO).


Although the Reference Case is a baseline policy case built for comparison purposes, many companies appeared to treat it as a forecast. Here, ANR simply reference EIA “data” with respect to this forward-looking information100:

100 ANR 2010 10-K, at 9. The chart includes “annual growth” calculations for the increase in coal consumption. Rather than providing a compound annual growth rates (CAGR), ANR appears to have provided an overall growth number for the referenced period. In subsequent reports, ANR used CAGR.

Cloud Peak similarly included EIA projections (likely the Reference Case, though not referred to as such), for coal consumption through 2035 in its 2011, 2012 and 2013 10-Ks. Cloud Peak’s reference to EIA projections is included in its “Risk Factors” discussion. It frames them as a potential downside risk from impending environmental regulation and natural gas competition, stating that, “[a]ccording to the EIA, the market share of coal used in electric generation is expected to decrease from 42% to 39% from 2012 to 2035 as a result of various factors, including low natural gas prices, regulatory and environmental pressures on coal-fired electricity generation and domestic and foreign economic conditions and associated electricity demand.”101

101 Cloud Peak 2011 10-K, at 24.

However, those figures appear to represent EIA’s view of what would happen assuming no new regulations, implying that these potential declines are, in fact, a “best case” scenario for coal demand under EIA’s analysis. Cloud Peak notes that they are accordingly seeking to increase the export of their PRB coal reserves in order to grow the company.102 By characterizing the Reference Case as a downside scenario when, in fact, it assumes no new climate regulations, seems to mischaracterize the Reference Case projections.

Cloud Peak no longer relied on EIA numbers in its 2014 or 2015 10-Ks, potentially suggesting that it no longer found them useful predictors of the future.103

102 Id. 103 See Cloud Peak 2014 10-K, 2015 10-K.


Of all the 10-K filings reviewed for years 2010-2015, only Arch Coal identified the important assumption on which the EIA statistics relied, noting in its 2010 10-K that, “[t]hese amounts assume no future federal or state carbon emissions legislation is enacted and do not take into account subsequent market conditions.”104 Arch cited the EIA Reference case in its filings for years 2010-2014, noting in its 2013 and 2014 10-K105 “risk factor” disclosures that EIA demand projections assumed that some number of additional coal plants would be built and such build-out might be adversely affected by environmental regulations.106 However, no equivalent quantification of the downside risk using EIA analysis is explored.

In later years, some companies appeared to waiver in their use of the EIA Reference Case scenario. In its 2015 10-K, Arch identified the demand implications that the EIA modelled under its CPP scenario, noting that the CPP modelling had not yet been incorporated into the EIA AEO but that Arch expected that it would be107:

104 See, e.g., Arch 2010 10-K, at 5.105 Arch 2013 10-K, at 7.106 See, e.g., Arch 2014 10-K, at 46 (“The EIA’s expectations for the coal industry assume there will be a significant number of as yet unplanned coal-fired plants built in the future which may not occur.”); see also Arch 2012 10-K, at 42.107 2015 10-K Arch, at 11.


…But do not consider alternative forecasts based on emissions reduction targets

Coal company MD&A discussion of the implications of climate targets has varied. Several companies did not mention climate targets at all and consequently did not discuss the implications of those targets. As companies are required to disclose “material” trends should they deem them “reasonably likely” to occur, these omissions are difficult to square with the risks discussed elsewhere in the annual reports. After the announcement of the Clean Power Plan, some companies identified that it could have significant impact and identified the CPP’s emissions reductions targets, but deemed it too difficult to quantify the impact it might have. Only one company endeavoured to quantify the impact that the CPP would have on overall coal demand, demonstrating that such estimates could be made prior a regulatory rule becoming finalized.

Arch: No discussion of climate risk in MD&A—until after bankruptcy filing.

Arch had comparatively detailed risk factor disclosures though, like other companies, failed to consider the carbon budget implications of climate targets. In the earlier part of the period reviewed, Arch expressed optimism about the long-term prospects for coal.

In 2010, Arch “expect[ed] growing global demand and continuing supply constraints in traditional coal exporting countries to continue to fuel seaborne coal markets for steam coal from the U.S.”108

108 Arch 2010 10-K, at 36.

In 2011, Arch expressed optimism as to seaborne metallurgical markets but noted continued weakness in US steam coal consumption, due, in its estimation, to “abnormally mild weather and muted economic growth,”109 ascribing power generation switching away from coal to “decade-low prices for natural gas and abnormally high hydroelectric availability.”110 Subsequent years attributed disappointing US steam coal demand to “unseasonably warm” winters and “low natural gas prices”111 but did not discuss climate change and growth in renewables and efficiency as a related driver in the MD&A.

It was not until after its bankruptcy filing on January 11, 2016, that Arch’s MD&A identified environmental regulations as having been a significant driver of declines in US thermal coal markets:

“The domestic thermal market was depressed by low natural gas prices and the implementation of new environmental regulations. Abundant supply depressed natural gas pricing to levels that made it increasingly economical to dispatch for electric generation relative to thermal coal. Implementation of the MATS regulation resulted in the closure of some older coal-based generating facilities, further depressing domestic thermal coal demand. Pricing in international thermal coal markets was uneconomic for our operations throughout 2015.”112

109 Arch 2011 10-K at 62.110 Id.111 See, e.g., Arch 2012 10-K at 58; Arch 2013 10-K, at 58; Arch 2014 10-K, at 63.112 Arch 2015 10-K, at 62. In its business description, Arch further ascribed coal’s rapid decline to “a convergence of factors including record high natural gas production along with the lowest natural gas prices since 1999, coal unit retirements following the implementation of the Mercury and Air Toxics Standards regulations and growing power generation from wind and solar.” Arch 2015 10-K, at 9-10.


By this time, a focus on the potential for a precipitous decline was not worth much to equity investors of the bankrupt company.

While many of these regulations were disclosed as risk factors throughout the period in Arch’s 10-Ks, the omission of any discussion of management’s views in the MD&A over the early part of the period reviewed means investors were given little information on the likelihood of those risks, much less a quantification of how they might impact the company. Unlike unseasonably mild weather conditions or abnormally low natural gas prices, action on climate change and downward trends in the cost of renewables represent long-term downward drivers of demand and therefore long-term drivers of company value—precisely the type of information that should be found in the MD&A. This view is corroborated by other elements of Arch’s 2015 10-K, where it includes the IEA’s modelling results of the 450 Scenario and the EIA’s modelling analysis of the CPP.113

113 “The IEA expects coal to retain its prominent presence as a fuel for the power sector worldwide under the Current Policies Scenario. Coal’s share of the power generation mix was 41% in 2013. By 2040, the IEA’s Current Policies Sce-nario estimates that coal’s fuel share of global power generation will be 38% as it continues to have the largest share of worldwide electric power production. Under the New Policies and 450 scenarios, coal’s fuel share of global power generation is projected to be 30% and 12%, respectively.” Arch 2015 10-K at 9-10.

Cloud Peak: Climate policy likely material, but no way to quantify impact

In its MD&A, Cloud Peak has typically noted that climate policy, both regulation and subsidy for low-carbon energy, could result in fuel switching away from coal, but that in view of policy uncertainties, “it is not possible for us to reasonably predict the impact that any such laws or regulations may have on our results of operations, financial condition, or cash flows.”114

In its 2014 10-K, Cloud Peak identified the emissions reduction targets in the Clean Power Plan and indicated that it could significantly impact the business, but noted that it was “not in a position to make any meaningful determination about the extent of the impacts to our operations at this early stage in the rulemaking process.”115 Cloud Peak’s 2015 10-K MD&A section acknowledged that regulations had had and would continue to have a “significant adverse effect” on coal’s “competitive position relative to certain other sources of electricity generation,”116 and also indicated that the CPP could impact demand significantly.117 However, it did not endeavour to quantify that impact, presumably because of the uncertainties related to the details of those policies. Notably, in the first year that the CPP was announced, Cloud Peak ceased its reference to the EIA Reference Case.

114 Cloud Peak 2010 10-K at 77; 2011 10-K at 80; 2012 10-K at 88; 2013 10-K at 78; 2014 10-K at 70; 2015 10-K at 74.115 Cloud Peak 2014 10-K, at 56.116 Cloud Peak 2015 10-K, at 59.117 Id.


ANR: Initially acknowledges risks but then reduces discussion of climate risk as conditions worsen ANR acknowledged the risks posed by increasingly stringent climate policy in 2010 but, paradoxically, had very little discussion of the climate risks in the MD&A section of its 2014 10-K MD&A. Moreover, its concerns related to climate policy were mitigated by reference to the Reference Case suggestion that coal demand would increase significantly.

Shortly before finalizing its acquisition of Massey Energy, ANR acknowledged that, “the global demand for and use of coal may be limited by any global treaties which place restrictions on carbon dioxide emissions,”118 referencing the UNFCCC process and the Copenhagen Accord but not the related emissions reduction target.119 This acknowledgement was paired with the assertion that, according to the EIA International Energy Outlook (IEO), worldwide demand for coal was “expected” to increase 56% by 2035, and that longer-term, “the delicate balance of coal supply and increasing coal demand is expected to result in strong, but potentially volatile fundamentals for the US coal industry” and that internationally, “coal industry fundamentals remain intact and significant additional growth is expected worldwide.”120 Like the EIA AEO cases, the EIA cautions that the IEO is not a statement of “what will happen,” but instead “what might happen given the specific assumptions and methodologies used…”121 It is therefore not what EIA “expected” to happen.

118 ANR 2010 10-K, at 61-62.119 Id.120 ANR 2010 10-K, at 61-62.121 EIA IEO 2010, at ix.

ANR’s analysis of climate-related risks in the early period reviewed suggested that it did not consider them too likely. Indeed, until the 2012 10-K, ANR suggested that the slow rate of growth in electric vehicles and the “inability” of “wind and solar to become the base load source of electric power” as sources of its optimism.122 Understanding the implications of carbon targets, however, would have helped investors understand the level of optimism implied.

By 2012, ANR was no longer touting the long-term fundamentals of US and international coal markets. However, it articulated the problems in the coal industry as cyclical rather than structural and provided little analysis of the structural threat posed by climate change mitigation. For example, ANR characterized the downturn in metallurgical coal as “a period of cyclical weakness” and that it expected “to be well-positioned to benefit from an eventual recovery in the global metallurgical coal market.”123 Though climate risks appear to have increased since 2010, ANR no longer mentioned climate-related risks as a long-term structural downward driver in its MD&A as it had in its 2010 10-K.

122 See, e.g., ANR 2010 10-K at 61-62 (“Long-term demand for coal and coal-based electricity generation in the US will likely be driven by various factors such as the economy, increasing population, increasing demand to power residen-tial electronics and plug-in hybrid electric vehicles, public demands for affordable electricity, the inability of renewable energy sources such as wind and solar to become the base load source of electric power, geopolitical risks associated with im-porting large quantities of global oil and natural gas resources, increasing demand for coal outside the US resulting in increased exports and the relatively abundant steam coal reserves located within the United States.”). See also ANR 2011 10-K, at 64-65.123 ANR 2012 10-K, at 62-63.


Indeed, the only climate-related MD&A discussion from 2012 onwards shows that its discussion was focused on anything but the structural implications. ANR mentions the EPA’s MATS regulation in its 2013 10-K. Rather than focusing on the impending closures and demand impact, ANR instead notes “speculation that some power grid operators will designate additional plants, such as the Brayton Point power plant in Massachusetts, as “must run” facilities.”124 This note of optimism may have not provided a clear picture of the extent of structural change underway.

In its 2014 10-K, ANR’s outlook beyond the following year became less certain, noting that “Recent price trends suggest that the thermal coal market will remain challenging for 2015. Price trends thereafter will be significantly influenced by the price of natural gas, the pace of economic growth, ongoing regulatory pressures on the domestic coal-fired utility fleet and the weather.”125 As with other companies, there was no discussion of the demand implications of international or national emissions reduction targets.

124 ANR 2013 10-K, at 61-63.125 ANR 2014 10-K, at 63.


Figure 17: EIA projections of coal’s share of power generation cited in coal company 10-Ks

Coal’

s sha

re o

f pow

er g

en. (

%)

Sources:CLD = Cloud Peak EnergyANR = Alpha Natural ResourcesACI = Arch CoalHNRG = Hallador EnergyJRCC = James River CoalBTU = Peabody EnergyCNX = CONSOL EnergyARMS = Armstrong EnergyAEO = EIA Annual Energy OutlookACESA = American Clean Energyand Security Act

No Rhyme or Reason | 6363 | www.carbontracker.org

Conclusions

Part VI


The impact on US coal company valuations has already been felt; the question now is what policymakers, regulators, and other stakeholders can do to make such risks more transparent going forward for other sectors, especially oil and gas.

With hindsight, it is clear that the EIA’s “Reference Case” has not been aligned with the actual demand levels - although given it is not intended to predict them, this should not in fact be a big surprise. Its modeling of emissions-reduction legislation impacts has been more informative in indicating actual developments as they are consistent with the clear direction of travel. Though the policies were not passed, they better predicted actual developments over the last several years. In our view, these projections have been more accurate because they incorporated emissions reduction targets, which are a proxy for the range of policy and technological actions that undermine fossil fuel demand.

Companies have often suggested that policy uncertainties make it difficult to quantify the impact of action on climate. What this suggests, however, is that it may be better to focus simply on the emissions reduction targets, rather than the specific policy details, in identifying the scope of the risk. This would better allow investors to see the forest for the trees.

Emissions reduction targets are public and long-term. This suggests that markets should naturally incorporate them, assuming that the connection between those targets and sectoral impact is well understood. It may not be. The abrupt changes in US coal markets suggest that they were caught by surprise.

This has implications for company disclosure. While many coal companies frequently relied upon the Reference Case, few identified the drastically different results for coal that would flow from even moderate climate policies.

We believe a number of important steps could be taken to address these concerns. The EIA makes its modelling assumptions available and cautions that they are not forecasts; very few corporate reports have done the same. As a first step, the SEC should ensure that the underlying reports are accurately represented and that the critical assumptions are disclosed. Second, it would help to understand whether such third-party forecasts are indeed reflective of management’s beliefs — whereas robust risk disclosure suggests the company may be taking steps to mitigate risks, business as usual projections suggest the opposite. Clearly, companies should not be relying on overly optimistic scenarios. Implicitly, the use of a third-party forecast suggests that the company views it as reasonable (without more being said). Did companies believe there would be no meaningful climate regulation over the next 20 years? If so, it would be helpful for the markets to know.

Third, the SEC should also consider how to incorporate emissions reductions targets into company disclosures. Those targets may seem long-term, but the US coal crash demonstrates how quickly those risks can develop. Moreover, such targets fall well within the 20-25 year time horizon for EIA projections that companies frequently discuss. That discussion should go beyond best-case scenarios to consider the downside case. Here, further attention should be given to the overall presentation — i.e., are business-as-usual projections and forecasts consonant with the numerous risks factors identified in corporate reports? This is also relevant for auditors—to


what extent are forecasts and projections in narrative reports consonant with the assumptions made in underlying financial reports and to what extent are those assumptions reasonable?

At root, the question is whether the future will replicate the past—precisely the data sought by MD&A. Emissions targets very much call that into question. Regulators should consider whether, as a first order estimate, companies should be quantifying the impact of relevant emissions reduction targets for their businesses. Such disclosures would provide insight into how companies are considering and managing the risks, not just identifying them.

The EIA is also a critical reference point. While there are sound reasons for continuing to publish reference scenarios, the EIA is right to admonish readers for considering them in isolation. It could augment its modeling with regular analysis of climate targets to identify pathways of how the future may unfold, including potentially a two-degree scenario as the IEA does. Such an analysis is at least as plausible, if not more plausible, than the assumption that business will continue as usual.

Emissions reductions targets also have implications for company planning, particularly in the current restructuring process sweeping the industry. For coal companies, bankruptcy is not the end of the road, but instead an opportunity for a “fresh start.” The foregoing suggests that stakeholders in the increasing number of coal bankruptcy administrations should consider how the projections will impact the ability to reorganize. This means considering the implications of emissions reduction targets to ensure that companies do not “double-dip” in bankruptcy court. This is especially relevant when evaluating the feasibility of reorganization plans.

It is possible that such disclosure would even inure to the benefit of management. Investors tend to disfavor corporate diversification so companies may not perceive many options when confronted with downward declines in their business. However, growth does not always equate to value, and in articulating the case for less being more, companies need a way to frame that case for investors. Detailing the demand implications of climate targets may be one way for companies to make that case.


Figure 18: Recommendations


© Carbon Tracker Initiative June 2016

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