NEW YORK, New York — In late 2013, ExxonMobil faced increasing pressure from investors to disclose more about the risks the company faced as governments began limiting greenhouse gas emissions. Of the many costs climate change will impose, oil companies face a particularly acute one: the demand for their product will have to shrink.

For years, Exxon had been using something called a proxy cost of carbon to estimate what stricter climate policies might mean for its bottom line. But as pressure from shareholders grew, a problem came sharply into focus: An internal presentation warned top executives that the way the company had been applying this proxy cost was potentially misleading. That’s because Exxon didn’t have one projected cost of carbon. It had two.

The contents of that presentation are at the heart of a trial set to start next week in a civil case brought against the company by the New York attorney general. Exxon is accused of disclosing one set of these projected carbon costs to investors while planners used an entirely different set internally for evaluating investments. The public set was more conservative and projected that climate policies would be more stringent, while the internal one assumed more modest attempts to limit emissions. The effect of using these dueling estimates, the attorney general says, was that Exxon hid tens of billions of dollars in potential costs, downplaying the risk to investors and inflating the company’s value.

If the company is found guilty of defrauding stockholders, the penalties it faces could be substantial. Exxon’s stock is among the most widely held in the country, nestled in pension funds, 401Ks and IRAs.

While Exxon has denied any wrongdoing, it does not dispute the core fact of the case: that for years it disclosed a public proxy cost that was higher than what it applied to its investment decisions. Its lawyers have argued these different sets of figures did not mislead investors and had distinct and legitimate purposes. But this only highlights another side of the case.

The energy Exxon produces today is more polluting, according to the attorney general’s complaint, because the company took the potential costs of climate change less seriously than it represented to investors. 

Applying a lower estimate for carbon costs made high-polluting projects look more financially attractive, and it undermined the investment case for any project that would reduce emissions. Nowhere is this clearer than in Exxon’s tremendous investments in Canada’s oil sands, a vast expanse of low-grade hydrocarbons that now make up about 30 percent of the company’s oil reserves.

“The oil sands crystallizes, at least from my perspective, everything about this issue that is concerning with Exxon,” said Andrew Logan, who runs the oil and gas program at Ceres, a nonprofit that works with investors to push for more sustainable business practices. “Oil sands tick all the boxes when it comes to a carbon-risky asset.”

Because they require enormous amounts of energy to exploit, the oil sands are among the world’s most expensive and carbon-polluting sources of oil. Exxon is one of the top producers there, and the company has continued to commit billions of dollars to the resource even as much of the rest of the global industry has fled the region, puzzling some investors who have tried to square this with Exxon’s lip service to climate risk, Logan said.

“The oil sands are this very concrete, specific example — and very big example — of the kind of asset you wouldn’t invest in,” he said, “if you actually believed the rhetoric of Exxon and others about climate risk.”

But the trial may prove to be about much more than Exxon’s risky investments. Climate change has abruptly shifted in the public consciousness from a future threat to a present danger, and many people and even local and national governments have begun demanding that courts step in to assign liability for the enormous costs they are facing. In the United States alone, more than a dozen local and state governments have sued energy companies seeking damages. Exxon is a defendant in many of these cases.

“Any one of them presents a real risk,” said Lisa Hamilton, an attorney who until recently led the climate and energy program at the Center for International Environmental Law. She said she expects to see more of these cases enter the courts, and that some companies are now reporting that the lawsuits could have a material impact on their financial health. 

Of all the lawsuits seeking to hold industry accountable for climate damage, the New York attorney general’s case against Exxon would be the first to go to trial. What happens in the New York courtroom will reverberate in the climate cases yet to come.

Rise of a Risky Resource

The story behind the trial begins in the 1990s, when Lee Raymond took control of Exxon as chief executive. The company was under intense competitive pressure. State-owned energy companies were on the rise, and while Exxon was still a giant in the industry, it was having trouble replacing the oil it pumped each year with newfound reserves. Those reserves represent yet-to-be pumped stores of oil and gas, and they are among the most important metrics of an oil company’s value. At least through this lens, Exxon was shrinking.

Soon enough, Raymond began boasting the opposite—that the company was actually increasing its reserves year after year, as Steve Coll details in his history of Exxon, Private Empire. The Securities and Exchange Commission sets the rules for what companies can report as reserves, and at the time, it did not allow for the inclusion of the oil sands, still a fringe part of the industry. But Exxon included them anyway—as an additional row in their reports so as not to run afoul of the rules. (The SEC modified its rules to permit inclusion of these reserves in 2009.)

Canada’s oil sands, also called tar sands, lie beneath a swath of northern Alberta about the size of New York State. They are a viscous mix of sand and bitumen that’s generally strip-mined and then heated and treated to produce an oil that can be refined into fuel. (Where the resource is found deeper below the surface, companies melt the mix underground with giant steam injections before pumping it out.)

After a wave of energy nationalizations in the Middle East and elsewhere, Alberta’s tarry resource represented one of the world’s largest stores of oil that was open to private investment, and Exxon held a competitive advantage there through its controlling stake in Imperial Oil, a top Canadian oil company. 

After it agreed on a merger with Mobil Oil in 1998, Exxon acquired a project known as Kearl. Decades later, it would become the company’s biggest tar sands operation, with nearly 5 billion barrels of recoverable oil spread across 75 square miles of open pit mines, tailings ponds and industrial facilities in a remote region 280 miles north of Edmonton. For Exxon, this obscure but vast resource represented the difference between shrinking and growing.

It wasn’t until 2008, however, when oil prices spiked above $130 per barrel, that Exxon began construction at Kearl. By the following year, the company had pumped $2 billion into the project, roughly doubling Exxon’s tar sands reserves over two years to 2.7 billion barrels.

Barack Obama had just been elected president, and Congress was debating a bill to cap greenhouse gas emissions. So just as the tar sands were rising in prominence for Exxon, the company was grappling with what a carbon-constrained future might look like.

All in on Kearl

Calculating the future cost of carbon is fraught with uncertainty. Beyond the impossibility of predicting the future, carbon pricing can take any number of forms. It can be direct—a tax on oil at the pump, or on emissions from big polluters—or can come through more complicated regimes like a cap-and-trade system. For an oil company like Exxon, a carbon tax can fall directly on the emissions from a refinery or oil sands facility, but also indirectly by nudging consumers away from oil towards lower-emissions alternatives. A “proxy” cost helps cut through the uncertainty, providing a stand-in estimate to plan around.

In its 2010 Outlook for Energy report, which scanned 20 years out, Exxon projected carbon prices would rise steadily and eventually reach $60 per ton in 2030. But it turns out that, at the time, Exxon had a second estimate for carbon pricing—it called this one a “greenhouse gas cost” rather than a proxy cost—which company strategists used to evaluate investments and which was not disclosed publicly. This internal greenhouse gas cost estimate did not rise above $40 per ton, according to the complaint.

In a 2011 email exchange cited in the lawsuit, Robert Bailes, the company’s greenhouse gas manager, proposed aligning the two cost estimates by using the higher set of figures only.

“Rex has seemed happy with the difference previously,” replied Tom Eizember, a planning manager, referring to then-chief executive Rex Tillerson. Apparently, he wrote, Tillerson liked that the lower greenhouse gas costs didn’t give as much incentive to invest in efforts to cut emissions. 

From this perspective, the low costs were conservative—there was less risk in wasting $1 billion on a carbon capture project, say, that may turn out to be a money-loser if carbon remained cheap. But the opposite was also true, Eizember noted: the low cost estimate would prove to be riskier for assessing polluting projects if carbon prices rose higher. 

In a June deposition, Tillerson said he didn’t recall discussing the issue with Eizember, suggesting that if they did talk about it, “they weren’t substantive discussions because they didn’t stick with me.”

Also in 2011, the complaint says, an internal presentation by Exxon’s vice president of environmental policy and planning warned that high greenhouse gas costs would present a “major concern” for the company’s more energy-intensive operations, including oil sands, which he said would be “vulnerable.”

It’s important to note that the risk in the tar sands is not merely because they are expensive and polluting, but also because the investments last decades. Kearl is expected to continue operating for more than 40 years, past a point when scientists say the world will have to zero out fossil fuel emissions. If a decade gets lopped off the end of a project, that can translate into huge losses.

As Exxon planners were warning in 2011 about the oil sands’ the vulnerability to carbon pricing, the company funded an expansion of Kearl, even before the completion of phase one, which came the following year at a total cost of about $13 billion. The project eventually boosted Exxon’s tar sands reserves to more than 5 billion barrels, or about one-third of its global oil reserves. This gave Exxon a far bigger stake there than any of its peers and placed the company head and shoulders above its competitors in its total reserves. As oil prices hovered above $100 per barrel in the early 2010s, Exxon was sitting comfortably with profits topping $40 billion in some years.

The industry was projecting that Canada’s tar sands production would grow to 5 million barrels per day by 2030—about half of Saudi Arabia’s current output. With three major tar sands projects now producing, Exxon applied to build a fourth in 2013, called Aspen, about 20 miles south of Kearl.

At the same time, as scientists continued to report ever more ominous risks posed by climate change, activists and politicians began turning up the pressure for sharply reducing emissions. The math of the global carbon budget was hardening. To avoid dangerous warming, some of the world’s oil reserves would have to be left in the ground, the scientists and climate advocates said. The tar sands were like a fatty cut of meat in the world’s energy mix—lower in value and higher in carbon—ripe for trimming.

In March 2014, hundreds of protesters were arrested at the White House while urging President Barack Obama to deny a permit for the Keystone XL pipeline. Because the pipeline would carry oil from the tar sands to refineries on the Gulf of Mexico, environmentalists had turned it into an embodiment of the climate fight, something concrete around which to rally activists.

That same month, Exxon was forced to issue reports to investors about how it was managing the risks posed by climate change, after activist shareholders threatened to force a vote at the company’s annual meeting over the issue. One of the reports asserted that “none of our hydrocarbon reserves are now or will become ‘stranded,’” or remain stuck in the ground at a steep financial loss due to climate policies or market forces.

“Investor concern was really focusing in on the risk to the core business plan of these companies, and how they were investing for a future where carbon is going to have a price and renewables will be competing for market share,” said Logan, whose organization was involved in the investors’ talks with Exxon at the time. Logan and other advocates argued that the company’s public claims of the risks it saw coming didn’t seem to match its investments in the oil sands. “It just didn’t make a lot of sense,” he said.

Exxon and many in the industry argue that some newer tar sands projects, including Kearl, are not much more carbon-intensive than the average barrel of crude oil. Independent experts say the statements are hard to evaluate, since companies do not always publish emissions data for the project sites. And whatever Exxon’s public statements, the evidence released by prosecutors indicates the company’s own planners saw the project’s high energy demand as a potential liability.

The internal presentation to Exxon management about the potentially misleading internal carbon cost came in May 2014, according to the complaint. It contained a warning to executives that the lower internal estimate risked painting an overly rosy picture of Exxon’s energy intensive projects, and that the company had implied to investors that it was using the higher proxy cost across all of its accounting. Management was sufficiently concerned that it decided to change the policy that year, according to the complaint, ordering that the corporate plan’s greenhouse gas costs be revised higher to match the proxy cost contained in the Outlook reports. (In a pre-trial memorandum, Exxon asserts that it aligned the costs in response to shifting climate policies.)

This greenhouse gas cost, which after the policy change rose as high as $80 per ton in 2040, would get plugged into economic models for any given project that the company was considering investing in. A project like Kearl would already have an array of costs associated with it—production costs, energy costs, royalties. The greenhouse gas costs added one more. And when the planners plugged these higher costs into the models, the results were troubling.

Jason Iwanika, a development planner at Imperial, warned in November 2014 that the higher greenhouse gas costs would have a “very material” impact on some future tar sands prospects. At the company’s Cold Lake project, other employees would later report, the higher costs would force Exxon to slash the project’s reserves and cut its lifespan by 20 years. At Kearl, another wrote, they would impose “massive” costs.

Oil prices had plummeted, dropping below $50 per barrel in 2015, well beneath a level that made many tar sands projects profitable. In a court filing, prosecutors say they obtained evidence showing that costs were exceeding

the “price that Exxon had been realizing” at Kearl. By this point, according to the complaint, Exxon had spent $33 billion there. That same year, New York prosecutors working for then-Attorney General Eric Schneiderman issued their first subpoenas, provoked by investigative reports published by InsideClimate News and the Los Angeles Times, which would one day lead to the upcoming trial. A tumbling oil market had dramatically changed the picture for Canada’s tar sands.

While oil prices played a major role, pressure from climate activists was having an effect, too. Their intense opposition was making it difficult to complete new pipelines connecting Alberta’s oil to refineries in the U.S. or ports on the Pacific Coast. Increasingly, several advocacy groups were warning that tar sands projects, because of high costs and high emissions, faced a dim future once the world began transitioning away from fossil fuels. And privately, at least, planners at Exxon appear to have been warning this, too.

Two Costs of Carbon

The allegations set forth by the attorney general are complex. But broadly speaking, Exxon is accused of deceiving investors by saying it was doing one thing, while in fact it was doing quite another. Central to the case is the charge that this deception hid risks from the company’s shareholders and creditors by disclosing the proxy cost only, and not its “greenhouse gas cost.” (The case was filed by Schneiderman’s appointed successor, Barbara D. Underwood, and it will be tried by her successor, Attorney General Letitia James, who was elected in 2018.)

In its 2014 report to investors, for example, the one prompted by the threat of a shareholder vote on carbon risk, the company wrote that “all significant proposed projects include a cost of carbon—which reflects our best assessment of costs associated with potential GHG regulations.” A footnote elsewhere in the report indicated that the price varied by country, but that developed nations generally had carbon costs approaching $80 per ton in 2040. Other reports the company published at the time also suggested that a cost of $80 per ton in 2040 might apply in Canada.

At its 2016 shareholder meeting, Tillerson noted that the company had for years included a carbon price in its Outlook for Energy. “And that price of carbon gets put into all of our economic models when we make investment decisions as well,” he said, according to the complaint. “It’s a proxy.”

But the complaint notes that before its decision to align its various costs of carbon in 2014, Exxon was actually applying lower costs to many of those investment decisions, or in some cases no cost at all. From 2011 to 2012, the complaint alleges, Exxon decided to spend nearly $1 billion on its Syncrude project in the tar sands without applying a proxy cost. What’s more, the complaint says, even after the company aligned its internal greenhouse gas costs with its public proxy cost, it continued to apply lower estimates to its work in many parts of the world.

Critically, this included Alberta, where rather than applying the proxy cost, Exxon managers in Texas directed Canadian planners to use an emissions fee that the province had enacted, which was significantly lower than the public proxy cost, the complaint alleges, particularly in future decades. What’s more, the complaint says, the fee applied to only a fraction of any given oil sands project’s total emissions. The result, prosecutors say, is that Exxon understated the future costs at its tar sands operations by $25 billion, compared to if the company had applied its public proxy cost. At Kearl alone, the complaint says, the gap was $11 billion.

In interviews with prosecutors, Exxon employees said that the corporate plan and its greenhouse gas cost estimates were intended as a guide, and that it was prudent to incorporate local policies where they existed. Exxon’s public reports also indicated that greenhouse gas costs were informed by local policies.

The attorney general’s allegations go beyond Alberta, too. The complaint says Exxon understated greenhouse gas costs at operations around the world, including its natural gas assets in the U.S., a refinery in Belgium and a liquid natural gas terminal in Cyprus.

Exxon did not respond to a list of questions about the case submitted by InsideClimate News and declined to comment for this article. But the company has asserted in filings that it was appropriate to use different estimates. It’s public facing proxy cost, it said, was used to estimate global demand for fossil fuels, so it reflected a wide collection of policies Exxon expected to see enacted internationally. While this would affect how much oil Exxon would sell, it wouldn’t necessarily reflect the direct costs at each of the company’s various projects scattered around the globe. The internal “greenhouse gas costs” were meant to estimate the direct costs for its operations, and therefore were informed by a more limited set of expected policies.

In part, the judge’s ruling may rest on semantics. Exxon asserts that it did in fact disclose that it used something it called a “greenhouse gas cost,” as distinct from its proxy cost, pointing to a sentence in its 2014 report to investors that reads “we require that all our business segments include, where appropriate, GHG costs in their economics when seeking funding for capital investments.” Exxon also says it was clear to investors that the figures behind these internal economic analyses were not disclosed for competitive reasons. The attorney general argues that no reasonable investor would have noticed the distinction between a proxy cost and a greenhouse gas cost.

In order to prevail, prosecutors do not have to prove that Exxon executives were intentionally misleading investors. But they will have to show that the company’s policies had a “material” effect on its stock price, said David Shapiro, a financial crimes specialist at John Jay College of Criminal Justice.

“The devil is in the details,” he said. The case will come down to a precise and technical breakdown of the company’s accounting and business evaluations, he said. “Conceptually they have a great case.”

The attorney general says Exxon’s accounting practices cost shareholders between $476 million and $1.6 billion. Beyond any damages Exxon may have to pay, a verdict against the company could also put the rest of the industry on alert that New York prosecutors can closely scrutinize how companies disclose climate risk, even if the SEC does not.

And then there are the documents. Prosecutors compiled millions of pages of internal reports, communications, investment analyses and more from Exxon, only a sliver of which have been unsealed by the court so far. Exxon is facing several other lawsuits—including a class action suit brought by shareholders on similar grounds and more than a dozen liability cases brought by cities, counties and the state of Rhode Island—each of which could draw on the materials generated by the case if they are released.

The attorney general’s office did not reply to a question asking whether it will publish the documents it obtained, and declined to comment for this article.

A Carbon Bubble

Over a remarkably short period, the concept of climate risk has gone from a fringe concept put forward by activists to a central piece of international financial planning. More than 200 of the globe’s largest companies have reported nearly $1 trillion in climate risks, including $250 billion in stranded assets, such as coal plants that have to be retired early at a financial loss.

If you wanted to conjure up a type of oil investment at risk of “stranding,” you’d be hard pressed to find a better example than the tar sands. Even a leading Canadian oil company has raised the idea of stranding its dirtiest reserves. Over the past few years, some climate advocates have started to wonder whether we’re seeing the first hints of this play out.

Oil prices have not rebounded substantially since the crash of 2014, and the continued inability to build pipelines out of Canada has meant that oil from Alberta fetches even lower prices on the global market, because more and more is being shipped out on trains, which is more expensive. Canada’s industry and its supporters say it has been cutting costs and emissions, and that it will play an important role in the world’s future energy mix. But in 2019, new investment in the oil sands is expected to fall to its lowest level in 15 years, according to IHS Markit, an energy research firm.

Last year, Alberta’s government was forced to limit the industry’s production to ease the bottleneck with pipelines, after the Canadian government had already spent billions of dollars to purchase a pipeline expansion project that its owner, Houston-based Kinder Morgan, deemed too risky because of opposition from environmentalists and indigenous groups. Over the past few years, nearly all the major U.S. and European oil companies have either left the tar sands or reduced their interests there. All, that is, except for Exxon.

One month before Alberta capped production, Exxon announced it would spend about $2 billion to build the long-planned Aspen project, though it announced only months later that it was slowing development, citing the production limits as one reason for the delay. No other company has moved forward with a major new oil sands project since the oil crash of 2014.

Markets are cyclical. Oil prices could rise again at some point, perhaps enough to make expensive new tar sands projects profitable. The U.S. Energy Information Administration, in fact, recently projected that oil sands production will soar by 2050. But that prediction also sees oil demand rising, and emissions climbing substantially. And there’s the rub. For the oil sands in particular, when it comes to tackling climate change, it may be either one or the other.

A recent report by the energy and financial think tank Carbon Tracker determined that no new tar sands projects will be profitable if nations meet the commitments they’ve made in the Paris climate agreement. The report modeled what declining demand for fossil fuels would do to oil prices, and then assessed which global oil and gas projects could turn a profit based on pure economics.

The only way a new oil sands project like Aspen won’t lose money, according to the report, is if emissions continue to rise enough that the world warms to dangerous levels, setting off widespread collapse of ecosystems and multi-meter rise in sea levels, while rendering sections of the globe uninhabitable.

The big question is whether the corporate world and financial sector will come to believe this looming choice between profits and catastrophe will cause the value of carbon-heavy investments to collapse. The oil and gas industry as a whole has underperformed the stock market in recent years. According to Exxon, the total shareholder returns it has generated over the past 10 years were just 1.5 percent, well below the industry average. In 2018, the company reported, returns were negative 15 percent. And while it remains one of the largest and most profitable companies in the world, Exxon dropped out of the S&P 500 index’s top 10 corporations in August for the first time.

Exxon’s stock is still widely held by investment giants like Vanguard, and most Wall Street analysts give it a hold rating, rather than buy or sell. But these financial trends have led some of the industry’s critics to warn that the company is facing a reckoning.

“Are they in trouble?” said Tom Sanzillo, financial director at the Institute for Energy Economics and Financial Analysis, which promotes a transition to sustainable energy. “It looks that way to us.”

The weak performance of Exxon’s stock has come without strict, widespread climate policies. The future will look even worse if and when nations adopt some form of carbon pricing or hard emissions cuts. That’s when the “massive” costs that analysts in Alberta warned of would hit projects like Kearl and, if it ever goes forward, Aspen.

Sanzillo said the accounting practices the attorney general has zeroed in on, whether they’re deemed to violate the law or not, are indicative of the larger problems the oil and gas industry and its investors are facing.

“The fossil fuel sector has really lost a financial rationale,” he said. “It is now increasingly an industry that is resorting to things like this. Flouting the law, regulatory shenanigans, scientific distortion, you can go through the whole list. That occurs when a company’s basic, fundamental financial model doesn’t work anymore.”