Insight Conversation: Elena Anankina, S&P Global Ratings

As Russia confronts the accelerating energy transition, S&P Global Ratings sees Environmental, Social and Governance concerns overall as a bigger risk for the country's commodities producers than the EU's carbon border tax. Meanwhile S&P Global Ratings lowered ratings for global oil and gas majors in 2021 due to risks associated with climate change, but Russian producers' ratings are proving to be more resilient to ESG risks. In this interview Rosemary Griffin, managing editor for Russia energy and commodities news discusses the impact of the energy transition on the Russian industry with Elena Anankina, senior analytic director, ratings and infrastructure, S&P Global Ratings.

At the start of this year S&P Global Ratings lowered its ratings for most oil and gas companies due to risks associated with climate change policy, but not Russian companies, why was that?

Yes, that's true, at the start of the year, S&P Global Ratings lowered the ratings of several international oil and gas companies because we have now re-evaluated the risk to the oil and gas industry. Across the world the sector is grappling with ESG pressure from investors and regulators. Furthermore, renewable energy is becoming a strong competitor to fossil fuels not only due to political support, but also because the costs of renewable energy are falling.

Meanwhile, oil and gas prices demonstrated major volatility last year. This increases risks for both suppliers and consumers. Amongst other things, this impacts the ability to agree on long-term contracts, for example for LNG, and to attract investment for large projects linked to LNG or construction of gas infrastructure. Oil and gas companies are facing increasing pressure from investors and regulators. This is why we lowered the rating of majors, including Exxon, Shell, TotalEnergies and several others.

At the same time, we kept ratings for Russian oil and gas companies unchanged at this stage. Although ESG pressure is increasing in Russia, Russian oil and gas companies, at least today, are under less ESG pressure compared to what the majors are experiencing. Russia's state energy policy supports development of oil and gas. Russian companies in general never had the same access to cheap financing on global markets as their global peers, due to sanctions on certain big players or to country risk premium, which impacts the cost of funding. Thanks to low production costs, a degree of tax hedge and colossal reserves, Russian companies may play the role of the last man standing who is able to stay profitable even if the market falls.

Also, significant country risk was also already included in our ratings, so if you look at the rating level of Russian oil and gas companies, they are in the BBB category, which is still lower than the majors.

Russia has ambitious plans to develop oil and gas in the Arctic. To what extent is this compatible with climate policy?

It's a really interesting question. Indeed, Russia's energy policy aims to monetize oil and gas reserves while reducing the carbon footprint via greater efficiency. And for credit ratings, global ESG trends certainly matter and so do the financial and ESG characteristics of specific projects.

As an example, there is a large Rosneft project, Vostok Oil, located in the remote North. It has proven reserves of liquid hydrocarbons of 4 billion barrels of oil equivalent and expected peak production is 2.3 million b/d-2.4 million b/d in the 2030s. This is half of Rosneft's current production, it's giant. Management expects the carbon intensity of this project to be 12 kg/boe, much lower than the older assets that Rosneft sold off last year. There is potential to develop wind power because in this region the wind blows very hard.

Of course, when analyzing such a massive, complex and remotely located project, we can't rule out the risk of cost overruns, technical risks, or environmental risks. Still, of the necessary trillion-ruble capex that Rosneft will have to invest before these new fields become profitable, around half will be covered by tax breaks that have already been approved. Above all this is in the form of reduced mineral extraction tax at Vankor, which is included in the Vostok Oil project and which already produces oil. So, this cut in taxation is already helping the company to invest in infrastructure today.

The sale of minority stakes, for example to Trafigura, which has already taken place, has a positive impact on the company's financials. Further sale of minority stakes is possible, but we have not included that in our base rating. We think that it may be an additional improvement compared to what we have already included. All the same, as credit analysts we look at the financial indicators and don't look at how ESG factors impact the characteristics of this or that project, or financial parameters of the company.

How serious a risk is the EU's carbon border tax for Russian companies?

The carbon border tax really is a considerable blow for Russian exporters, but we think that most of Russia's largest exporters are in a position to cope with it. Why? Firstly, because if we believe ESG reports published by Russian companies, their carbon intensity is no worse than their foreign competitors. Emissions on a ton of exported Russian steel are similar to those of foreign competitors.

Secondly, companies have a financial safety margin. Russia's largest exporters are large companies have solid cash flow and quite low debt levels. Many of them have a flexible dividend policy. CBAM may be offset by lower dividend payments, and companies may be able to somewhat increase their debt levels and still remain in a good financial position.

Let me leave the questions on the impact of the carbon border adjustment on prices to Platts specialists. But generally speaking, as we all understand, CBAM may or may not impact commodity prices, so it remains to be seen whether it will ultimately be paid by the consumer or the supplier. Furthermore, although Russia has a very low share of wind and solar (about 1%), it generates quite a lot of carbon-free energy — hydro and nuclear power stations.

Last year the proportion of low-carbon power in Russia was 40%. Of course, 2020 was a COVID year with lower demand for electricity, and with an unusually high hydro output. But on average, the share of low-carbon electricity in Russia is quite solid at about 37-38%.

In theory, this low-carbon electricity generation volume should be enough for Russian exporters, if they either sign direct contracts with nuclear and hydro power stations, for example Phosagro and Rusal have signed such contracts. Russia is considering new legislation that will allow trading certificates for carbon-neutral electricity.

Still, it's clear that these certificates may redistribute the carbon footprint, but they won't change Russia's overall carbon footprint. The mechanism of the carbon border adjustment and reporting requirements are yet to be fully defined in Europe. The European parliament said that companies should be able to reduce CBAM payment if they can prove that their carbon footprint is lower.

We believe it is very important that European and Russian ESG regulation is harmonized and develops in the same direction. Otherwise companies run the risk of double payments and double reporting. At the same time, many Russian companies prepare financial reports according to Russian standards and international standards. Some Russian exporters (e.g. Rusal) have already managed to obtain international certificates (I-REC) for the green electricity they currently buy.

Infographic: EU carbon border adjustment mechanism

How much will the proportion of renewable energy increase in Russia's energy balance in the near future?

Renewable energy in Russia currently accounts for less than 1% of production capacity. The popular theory is that Russia has lots of oil and gas and little solar and wind resources. This is of course partially true. Russia has very cost-competitive gas generation. Nevertheless, the cost of renewable energy is gradually falling. Judging by the late 2020 auctions, the unit capex of renewable energy was already comparable with some coal projects.

Aside from this, for the consumer, the key is their overall electricity bill, not the production cost at the power station. In Russia capacity payments are increasing, partially due capacity supply agreements for new nuclear and hydro projects, additional charges to support the Far East. Cross subsidies are also considerable.

Therefore, for some industrial consumers in the South of Russia, the electricity price can be sufficiently high to justify investments in in-house generation including from renewable energy. In remote regions, renewables may be cheaper than connecting to a network across many kilometers.

As a result, we expect renewable energy to grow, even if from a low base. In contrast to the EU, state support for renewables is not very significant in Russia. A new renewable support program that has been approved in 2021 is only Rb360 billion ($4.85 billion), and even that is subject to difficult localization and export requirements. In Russia, state support to renewable generation is nowhere near the EU's green deal.

What is the potential for developing hydrogen production in Russia, including with western partners? Will Russia reach the targets recently set by the government?

With high uncertainty presented by energy transition, Russian companies are really thinking about what they should do. Hydrogen is an interesting opportunity, but it's at a very early stage.

The main risk for Russian companies in my view is energy transition, it's not the carbon border tax. Even if for now, the carbon footprint of Russian companies and Russian electricity is comparable to global peers, how will it evolve going forward?

We see the risk that carbon intensity of Russian electricity will not fall as fast as that in other countries. What will happen to the structure of the Russian economy? Will companies retain access to capital, which increasingly depends on ESG?

Now what we see is that Russian companies are looking at how to monetize their colossal reserves, while it's still possible. The largest projects in the country are LNG, Vostok Oil, expansion of the BAM-Trans-Siberian railway to export coal to Asia while there is still demand. The main question is who will pay for this – the companies themselves? State infrastructure companies which will build the infrastructure? Or will there be some financing from the state budget?

The second thing that Russian companies are doing is improving efficiency in their core businesses, including reducing their carbon footprint by improving efficiency, e.g. by cutting fuel usage and electricity losses in grids. The draft decarbonization strategy prepared last year covers these traditional ways of decarbonization. Although this is reducing the carbon footprint, it doesn't bring it down to zero. Of course, companies are thinking about what new things they can do.

In Russia there is a lot of potential for hydrogen production, but what kind of hydrogen? Russia has a lot of gas, so there is the potential for blue hydrogen production. There is potential for carbon capture and storage, which can be used for producing blue hydrogen or in other ways. There is a wealth of nuclear power generation, which in principle can also be used to produce yellow hydrogen.

But green hydrogen, produced from renewable energy, is not that promising in Russia, because renewables production is quite low.

So, what could Russian companies' hydrogen strategy be? It is possible to export hydrogen to Europe, but EU strategy focuses on green, or renewable, hydrogen. In accordance with EU strategy blue and yellow hydrogen will only be accepted for a limited period of time, and it's not clear if it's enough to pay back investment

At the same time Russian companies are thinking about how to use hydrogen domestically, where there is no preference for the type of hydrogen. For example, metal companies have interesting pilots, and there is a hydrogen train project on Sakhalin. Sakhalin is aiming to be carbon neutral by 2025, that's practically tomorrow. We will carefully follow how companies experiment with hydrogen within the country. We think that hydrogen is a market that currently has almost no supply and demand yet, but may grow fast in the future. For us financial analysts it looks like an option. The greater the uncertainty, the higher the option value. The companies are at the stage of assessing opportunities and technologies, with limited capex so far. If the pilots are successful, great. If they are not, it's likely to be financially manageable.

This interview was conducted during S&P Global Platts' recent Moscow virtual energy forum. It has been translated from Russian and edited for clarity. More information on Platts' online and in-person events is available here.