Welcome to the IFRS webcast on the 28th of March, 2019. There will be a presentation followed by a Q&A session. If you have a question, please press star 1. If you wish to be removed from the queue, please press star 2. I would like to introduce the first speaker, Mr. Tjerk Huysinga.
Good. Thanks a lot. Good afternoon. Ladies and gentlemen, welcome to Shell's webcast on the impact of IFRS 16. I'm Tjerk Huysinga, the EVP of Investor Relations for Royal Dutch Shell, and I'm joined today by Martin ten Brink, our EVP Controller. Before we start, let me highlight the disclaimer statement. Today, we would like to explain to you the impact of the implementation of IFRS 16. This new accounting standard has significant implications for how our financial results are reported, and we're keen to talk you through these implications ahead of our Q1 results. We will also cover the impact on our financial statements and some of our key metrics. The figures which follow are unaudited, and some figures or conclusions represent estimates of future effects and may be impacted by business or other changes.
Martin will do a short presentation covering IFRS 16, what it means for Shell, and how we have adopted the new standard. At the end, we will open the call for a Q&A. Let me now hand over to Martin.
Thank you, Tjerk. Good afternoon, everyone. As Tjerk mentioned, IFRS 16 has a material impact on Shell's financial statements and metrics. I will explain these impacts over the course of this presentation. However, let me start by pointing out that this new accounting standard does not change the way we do business and has no impact on our net cash position. We will continue to apply the same discipline when we decide whether to lease or buy an asset. Now, as reported in our 2018 annual report, which we published earlier this month, we have recognized an additional lease liability of some $16 billion, and that's reflected on our balance sheet at January 1, 2019, as a result of the IFRS 16 change.
With effects from Q1 2019, you will see a shift from operating expenses and charges in purchases to depreciation and interest expenses on the income statement. Similarly, on the cash flow statement, we will see a shift from both cash flow from operating and cash flow from investing activities to cash flow from financing activities. Let's first focus on the key changes introduced by IFRS 16. In short, IFRS 16 eliminates the distinction that existed between an operating lease and a finance lease. Under the previous standard, operating leases were held off balance sheet and finance leases reported on balance sheet. Under IFRS 16, all leases are now reported on balance sheet. IFRS 16 offers a number of adoption approaches and practical experience. Let me run through the chosen approach for Shell.
Firstly, and naturally, we have adopted the standard with effect from January 1, 2019, and we have chosen the modified retrospective approach rather than the fully retrospective approach. Under the modified retrospective approach, the cumulative effect of initially applying the standard is recognized as at January 1, 2019, and there is no restatement of comparative information. We've chosen this transition approach for practical reasons. At January 1, 2019, we recognized an operating lease liability, which is equal to the present value of the remaining lease payments, discounted using an entity specific incremental borrowing rate. I'll come to that in a moment.
At the same date, we recognized a right of use asset equal to the lease liability and adjusted for items such as onerous lease provisions and lease prepayments that we carry on the balance sheet at the end of 2018. Short-term leases, meaning leases with a contract tenure of 12 months or less, will continue to be held off balance sheet as allowed by IFRS 16. We chose not to adopt an exemption for low-value leases. We, however, continue to apply materiality cut-off principles in our financial reporting, and lease reporting is no exception. Where contracts contain both a lease and a non-lease component, we have chosen to apply IFRS 16 to the lease component only, not to the combination of both. Examples include lease contracts with a maintenance service element. The service element is a non-lease component.
Let's now turn to the substance of Shell's lease portfolio. We lease a wide range of assets across our different businesses. To give you some insight, we carry over 10,000 contracts classified as a lease. As reported in our 2018 annual report, our total future operating lease commitments at end of 2018 was $24.2 billion on an undiscounted basis. Lease assets include also the ultra-deepwater drilling rigs to conduct exploration and production activities, LNG vessels to carry out our trading and shipping activities, retail sites to service our customers, office buildings to house our employees, et cetera. The size of our lease portfolio is significant, and we are aware it's larger than some of our peers. How did we translate the undiscounted future commitments into the lease liability that we carry on the balance sheet?
We used a set of incremental borrowing rate assumptions to discount all operating lease commitments onto the balance sheet on January 1st, 2019. Three considerations determine the rates used per contract. The first one relates to the nature of the assets. We differentiate rates according to the classes of assets, namely ultra-deepwater drilling rigs, LNG vessels, and other assets. Other deepwater drilling rigs and LNG vessels attract higher borrowing rates than other assets due to their very specialized nature. The second consideration is the tenure of the lease contract. We apply differentiated rates for lease tenures of less than 10 years and of 10 years and longer. Finally, the rate applied to the contract reflects the credit rating of the Shell entity holding the lease contract. This works out at a weighted average of 7.2% at January 1st, 2019.
That's the rate which applies at transition. You will see that per segment, the weighted average rates are somewhat different and higher for upstream due to the ultra-deepwater rigs they operate and in integrated gas due to the use of LNG vessels. After January 1st, 2019, new lease liabilities will be recognized using the borrowing rate implicit in the lease contract. Unless, of course, that rate cannot be determined, in which case we will use the latest set of incremental borrowing rates that applies. We will review those incremental borrowing rates or rate assumptions on an annual basis going forward. Let's now compare the commitment of $24.2 billion, which we reported in our 2018 annual report with the $16 billion liability recognized on January 1st. Not surprisingly, the discounting effect, the $5.2 billion reflected there, is the largest.
That's determined by the incremental borrowing rates that I have explained just a moment ago. We also have some leases that haven't commenced yet, and that's the second largest effect, reflecting $2.6 billion. These basically represent lease contract commitments for which the asset is not yet in use, and hence, the liability does not exist at this point. Finally, short-term leases not recognized on the balance sheet represent a small amount of $0.3 billion. Let me reiterate that the 7.2% is the weighted average incremental borrowing rate on transition. This is not an indication of the borrowing rate to be expected on future lease contracts. Let's then turn to the impact of IFRS 16 on some of our key financial metrics. Let's start off with gearing.
Gearing is expected to increase by some 4%-5% as the operating lease liabilities are now brought onto the balance sheet and will therefore increase our net debt. Operating expenses are expected to go down by some $2 billion-$3 billion as operating lease expenses are now reported as depreciation and interest. As explained earlier, IFRS 16 will have an immaterial impact on our earnings. However, there will be a shift of earnings between segments. Corporate segment earnings will include the interest expense on operating leases. You will know that up to 2018, corporate earnings already included interest expense on finance leases. The business segment earnings will include the depreciation related to operating leases. If you compare 2019 with 2018, corporate earnings will be lower year-on-year due to the additional operating lease interest expense.
Business segment earnings will be higher year on year as the depreciation charge in 2019 will be lower than the operating expense or the charge to purchase that we saw in 2018. The total increase in interest expense for the corporate segment is expected to be around $1 billion. Although there's no effect on the cash amount paid by our businesses for leased assets, there will be a change to where these payments are presented on our cash flow statement. As the lease payments will be reported on the cash flow from financing activities, this will result in a higher reported free cash flow, as you can see on the slide. In total, we expect this effect to be about $4 billion per annum. Following the adoption of IFRS 16, capital investment will increase.
It will increase by about $1 billion-$2 billion, as not only finance leases will be included, but also operating leases with effect from 1st of January 2019. In order to improve the transparency of our capital expenditure and the continuous discipline we will maintain on capital expenditure, we will supplement our reporting of capital investment with information on our cash capital expenditure going forward. We are bringing more liabilities onto our balance sheet, our capital employed will increase and our Clean CCS ROACE will consequently go down by about half a percent point. With effect from quarter one 2018, we will bring the way we calculate our Clean CCS ROACE more in line with our peers by adding back the after-tax interest expense to the Clean CCS earnings. This is important as the effect of IFRS 16 would accentuate the misalignment between peers and ourselves.
As Tjerk mentioned in his opening comments, these figures are unaudited, and some of the figures or conclusions represent estimates of future effects and may be impacted by our business activity or other changes. Overall, they should give you a good indication of the impact that we are expecting. Let's turn to the impact of the recognition of operating leases on our financial statements. This slide tries to bring it all together. Important to point out, this excludes existing finance leases and associated right of use assets and liabilities, which are unchanged under IFRS 16. Details on those finance lease positions are available in our 2018 annual report. To reiterate, we do not expect the impact of IFRS 16 on RDS earnings to be material.
Looking forward to 2019 and the impact of IFRS 16 on our income statement, we expect to report additional depreciation of $2 billion-$3 billion and additional interest expense of about $1 billion instead of similar amounts under operating expense and purchase lines under the old standard. Looking at the cash flow statement, there's no impact on our net cash position, but we do expect a shift of about $3 billion-$4 billion from CFFO and up to $1 billion from CFFI to CFFS. Over to the balance sheet. I explained the principles of the adoption and entries earlier in this presentation. Now let me quickly run through the amounts. On balance sheet, date of January 1st, 2019, we recognized an operating lease liability of $16 billion.
The associated right of use asset we recognized is $15.6 billion, and that's after netting off the certain items from the lease liability amount. First of all, we reduced the right of use asset by any existing provisions on onerous contracts by about $1.2 billion. And then the right of use asset is increased by any prepayments we've made on leases, and that's about $0.9 billion on the balance sheet as of the end of 2018. And then finally, the right of use asset has to be reduced because we have to recognize that a small amount of these assets are subleased, and that's about $0.1 billion. In 2019, you will see us reporting our key financial indicators both on a pre and post IFRS 16 basis, as well as a number of transition disclosures.
This ensures you can continue to compare our performance with prior periods and also track us against guidance that we've provided previously. This will start in quarter one of this year and run till the end of 2019. At management aim, our outlook will be consistent with IFRS 16 and form the basis of our communication with the market going forward. Let me try to recap. IFRS 16 has a material impact on Shell's financial statements and financial metrics. A lease liability of $16 billion will be brought onto the balance sheet, and lease costs will shift from operating expense and purchase to depreciation and interest expense. IFRS 16 does not change Shell's strategy, nor its financial framework and has no cash impact. With that, let me pause and go for your questions, please.
Thank you. We will now begin the question and answer session. People dialed in, if you have a question, please press star one. If you wish to be removed from the queue, please press star two. And we'll first go to Irene Himona with Societe Generale.
Thank you. Good afternoon. It's Irene Himona with Societe Generale. A question of clarification, please. For operating leases, for those assets which Shell operates itself, do you have to include 100% of the operating lease or do you include your working interest share? Thank you.
Thank you for the question, Irene. The information we provided today reflects our interest share. This is an item which was put forward to IFRIC, and IFRIC recently concluded we have to yet assess the impact of their conclusion. Their suggestion is that we would need to recognize 100%, irrespective of our own interest share.
Thank you.
We'll go next to Jon Rigby with UBS.
Thank you. Yeah. Two questions. First, just to follow up on that question Irene asked. What you're saying is, I think if I understand it, that that is still an outstanding item to be resolved. Is that correct? If it is, are you able to say how much the effect might be of a grossing up exercise within your books? The second question, I guess, is sort of raised from the disclosure you make. If I take what you say on face value, I think it implies that given your raising CapEx, the reported CapEx guidance, is that there is the intention to continue to be taking assets onto the balance sheet using leasing.
You also seem to suggest that the implied interest rate in those leases is significantly greater than the borrowing rate that Royal Dutch Shell, the corporation, could achieve as one of the strongest balance sheets in the sector. I'm curious why you would even be using operating leases as a way of funding the business when it looks, optically anyway, to be so expensive. Thanks.
Good question, sir Jon. Let me try to come to both of them. Indeed, that assessment is pending. Reason that it's pending is we are surprised by the decision of IFRIC as it goes against one of the fundamental principles of the oil and gas industry, where an operator, being an operator should not be worse off or better off relative to the venture partners, i.e., all the venture partners share in the liabilities and in the assets of the venture. In terms of.
Do they understand that, by the way? Sorry to interrupt. Do they understand that? Do they appreciate that? That would seem to be a reasonable contention.
Yeah, that's a very reasonable contention. Something that we have described in our response to them, and they haven't taken it on board. It could potentially have wider implications, which is why we need to review the decision of IFRIC, including with our external auditors. In terms of potential impact, our initial indications are that that may have an additional lease liability of $2 billion-$3 billion associated with it. That is a very broad brush figure, Jon, so please don't quote me on that. On your second question, why would we use leases? I think we need to make a distinction between the IBR that we apply, the incremental borrowing rate that we apply on transition, which in a way we have constructed based on a logical set of assumptions, versus what is a effective interest rate in a lease that we may enter into going forward.
Those decisions are made on economic value considerations. Indeed, we have a relatively lower interest rate RDS. It will need to be the flexibility that is offered by the lease construct. It may be the other services that are brought into the lease that we cannot necessarily procure ourselves in that same way or at the same commercial terms. The consideration is always an economic one, and always one that involves our treasury department, who have clearly an interest to keep a close eye on this.
Super. Thank you.
We will go next to Lydia Rainforth with Barclays.
Thank you. Two questions as well. Just to follow up on Jon's point around the optically, the interest rate looks expensive. Is there any way for you to be able to go back and have a look at those leases and reopen them to try and reduce that interest rate? Then the second one, probably more for Tjerk around the free cash flow definition. Clearly, you are showing that this free cash flow in the IFRS 16 world will be about $4 billion higher. Can I just ask why not change the free cash flow definition to be able to give us more of an indication of what is available for shareholders? Thank you.
Go back to the renegotiation. Yeah.
Why would we first of all, the incremental borrowing rate that we apply at transition is a constructed grid. That's part of this, what we describe as the modified retrospective approach. In terms of the economic decision that we have taken, we will have satisfied ourselves that it was the logical economic rationale to enter into that lease. Going back to renegotiate contracts, it doesn't come into play in any way, I would say, Lydia.
Yeah. Lydia, on your question on the free cash flow, as we've said, and Martin has said earlier as well, for this year, we will keep reporting on both the old basis and the new basis, so we can have the comparison. That's also because we will not restate 2018. I think on the free cash flow, yes, that will be $4 billion higher, as we have already highlighted in Q4 and we're highlighting now as well. At Capital Markets Day, we'll look at all the various definitions, and that's what we have said here as well. Going forward, we will use the IFRS numbers, and therefore the Capital Markets Day outlook will be based on the IFRS 16 numbers. We are looking at all of these different KPIs and what will be the effect.
We're giving you now the numbers, but we also will give during this year, we will give the old basis as well, so you can compare like with like, both on free cash flow and also the other areas, including the capital investment. There will be not a difference there versus the targets which we have given at Capital Markets Day 2017.
Understood. Thanks very much.
Does that answer your question, Lydia?
Yeah, it does. Understood. Thank you very much.
Okay. Next question.
We'll go next to Christopher Kuplent with Bank of America.
Thank you. Three questions, if I may. Firstly, I'm aware that a few rating agencies have said, of course, for some time, we've taken all these off-balance sheet liabilities into account already. In the process of preparing these numbers that you're presenting today, have you had additional conversations with credit rating agencies or are you assuming that for them this is an absolute non-event? Secondly, two follow-up questions briefly. On IFRIC, do you have an estimate when they will come to a resolution that will force you to revisit the numbers you've presented today on 100% working interest basis? Third follow-up, and I appreciate, Tjerk, this is probably more one for you, why not take this opportunity and actually present cash flow from operations, let alone free cash flow, post net interest expense? Thank you.
All good questions. I can probably address all three of them, Christopher. With regard to the rating agencies, we have regular contacts and engagement with the rating agencies. They are well aware of the lease portfolio that we carry, the associated commitments, and I don't believe this will fundamentally alter their perspective on the rating of RDS. Turning to IFRIC, they have made the decision only, I believe, as recently as a week ago, this is relatively hot off the press, hence why we still need to consider the implication of their decision, and we will need to take some time, particularly because of the potential implications for other liabilities. That's a real concern for us, and we'll need to understand how IFRIC came to this position. Choice to report interest payments either on the CFFO or CFFI.
We take a view that these payments should logically flow through CFFS as they are of a financing nature and not an operating nature. We also are mindful of the fact that the IASB is considering a change to IAS 7, and that will require IFRS reporters to report interest payments on the CFFS in future. That would remove the optionality that currently exists. Really, from a reporting perspective, there is no overriding reason to change our presentation at this point in time.
Chris, that last answer is really important because clearly we know from the market about these questions, and we've been looking into this. Especially this thing which Martin has just said about the potential that this will change would make us change now and then change again, and that's clearly not what we want to do. Finally, you can find these lines very clearly in the cash flow anyway. We know it's not aligned with everyone, but this could be a change, and therefore, we don't want to have to be forced on another change at the later stage.
Makes sense. Thank you.
As a reminder, that's star one for questions. At this time, there are no further questions. I'll turn the call back to Tjerk Huysinga.
Okay. Well, if there are no further questions, I think that is great. We really hope this is useful, and we'll seek your feedback on that later. As you all know, our first quarter results will be announced on the 2nd of May. We hope many of you can join us there as well. Thanks a lot. We'll speak to you later, and especially on the 2nd of May. Appreciate it.
This does conclude today's conference. We thank you for your participation.