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Operational risk management

Stranded assets: Balancing the books in light of climate change

Shari Littan  GAAP Report Editor, Thomson Reuters

Shari Littan  GAAP Report Editor, Thomson Reuters

A warmer future means industries from agriculture to retail need to understand the concept of a "stranded asset."

As organizations worldwide step up their attention to climate change and the transition from fossil-fuel energy to renewable sources such as solar and wind, businesses and their investors have expressed concern about stranded asset risk.

What are stranded assets?

The term “stranded assets” lacks a precise technical meaning in terms of accounting rules.

Ben Caldecott and a team of leading researchers on stranded assets at the Smith School of Enterprise and the Environment, at the University of Oxford, have broadly defined stranded assets as “assets that have suffered from unanticipated or premature write-downs, devaluations, or conversion to liabilities and they can be caused by a variety of risks.” Specifically, the term is often used to describe financial losses from the diminished value of conventional energy producers’ reserves of coal, oil, gas, and similar hydrocarbon properties.

The assets listed on the financial statements of energy producers reflect a portion of this value. Another portion, which represents expectations about cash flows from future production, is not reported on the balance sheet. This expectation, however, is reflected in the price of the energy producer’s securities. As expectations of future profitable production diminish, properties become subject to impairment and abandonment, and financial losses may result.

How do energy prices affect stranded assets?

Over the last decade, the overall market price of fossil fuels has declined for a variety of reasons, including efforts to increase efficiency and respond to climate change through the reduction of greenhouse gases. Reduced demand affects the long-term market price and the viability of conventional energy-producing assets. If prices remain at historic lows, the investments may increasingly become at risk.

How much is at risk?

Given the risks, investor groups, NGOs, and certain government and banking entities around the world have begun to sound alarms..  Using the phrase “unburnable carbon,” in 2013, the Carbon Tracker Initiative concluded worldwide efforts to limiting global warming to 2 degree Celsius could result in significant losses to current worldwide investment in conventional energy companies, $4 trillion in market value of equity investments and $1.27 trillion in debt. Financial leaders including Henry Paulson Jr. and Mark Carney, governor of the Bank of England, began warning the financial markets to pay attention. The actions taken toward meeting or exceeding the 2015 Paris Accord targets could accelerate impairment. More recent publications by CTI, moreover, alert investors not only about existing operational assets, but hydrocarbon production projects that are planned but not needed.

How can information help identify stranded asset risk?

Estimating potential stranded assets and related losses is a challenge. It requires assessing expectations about future energy use, prices and regulatory initiatives. These drivers affect projections of not only the amount but also the timing of when particular fossil-fuel assets may lose viability.

The Financial Stability Board has established a Climate-related Financial Disclosure Task Force, which is developing enhanced disclosure guidelines regarding climate change. Sensitivity analyses that reflect a range of scenarios, including a 2 degree Celsius limit, are described as critical for identifying stranded asset risks.

Is stranded asset risk limited to energy companies?

An abandoned excavator is partially covered by coal waste at a coal mine of the state-owned Longmay Group on the outskirts of Jixi, in Heilongjiang province, China, October 24, 2015.
An abandoned excavator is partially covered by coal waste at a coal mine of the state-owned Longmay Group on the outskirts of Jixi, in Heilongjiang province, China, October 24, 2015.

The need for these stress tests is not limited to energy producers. Entities up and down the energy supply chain, such as equipment and transportation companies and utilities, are similarly at risk. A broad range of other industries, such as agriculture, leisure and retail may also be climate-dependent or have operations concentrated in energy-producing regions. Data-based stress tests can help companies meet increasing demands for climate-risk disclosure, which can enable investors to make informed decisions.

Learn more

Download our thought leadership paper for energy executives, Redefining Success in Uncertain Times – A business perspective for energy executives.

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