Last year, a new concept entered the investment lexicon. A growing number of voices within the mainstream of the investment world began warning of the risks posed by a ‘carbon bubble’, and of investments in fossil fuel assets becoming ‘stranded’ – no longer viable – by failing to adapt to the energy transition. And investors are starting to ask themselves how they should respond to such risks.
The stranded assets thesis is a simple one. In 2009, governments at the Copenhagen climate talks committed to holding global warming to no more than 2oC above pre-industrial average temperatures. That effectively imposes a ‘carbon budget’ – a limit to the volume of greenhouse gases that can be emitted, or fossil fuels burnt – that must be adhered to if the target is to be met.
If governments are serious about sticking to that carbon budget, the vast majority – perhaps three quarters – of the reserves on the books of the world’s oil, gas and coal companies cannot be extracted and burnt. Meeting the 2oC target therefore implies, over time, a collapse in demand for fossil fuels, raising profound questions over the valuations of the companies that depend upon revenues from exploiting reserves.
Sceptics will point to the word ‘serious’. Without doubt, in tough economic times, governments have proved unwilling to take firm action to cut emissions. But, as the global economy recovers, this is likely to change. And, despite the resistance so far to setting tough emissions targets, there are already clear indications of the direction of travel. Higher vehicle fuel economy standards are changing the trajectory of oil demand in the US and Europe. The penetration of wind and solar technologies is transforming electricity markets. An energy efficiency crusade in China is helping to crimp its demand for coal. Ironically those working to delay the inevitable policy & regulatory response are likely increasing the risk that the carbon bubble will burst, causing a financial crisis. This is because the longer an effective policy response is delayed then the more severe it will be when it does come. The carbon bubble will burst. An effective response now would allow time to transition and for the carbon bubble to be deflated gently.
The fact is that stranded assets are already appearing in today’s market, without a global climate deal or carbon price in place.
A growing number of financial analysts – including at HSBC, Citi and Standard & Poor’s – have paid serious attention to the effects on company valuations of falling demand linked to carbon constraints. Their attention has focused on higher cost production, which stands to be affected first by failing demand and prices, and they have concluded that there is real value is at risk.
Meanwhile, the stranded assets thesis has been co-opted by environmental activists in the US, who have kindled a college divestment campaign that draws heavily on the fight against apartheid in the 1970s and 1980s. 350.org are calling on those who manage university and charitable foundations, and state and city pension funds, to sell out of all fossil fuel companies. They are using ethical arguments about climate change to create political risk for the sector. This pressure often overlaps with where Carbon Tracker is making financial arguments that challenge the business models of fossil fuel-based companies.
While the Fossil Free campaign has thus far met only limited success, with big universities such as Harvard and Yale resisting its demands, it has found echoes in the investment world. Storebrand, the Norwegian financial services company, announced in July that it has sold out of 19 fossil fuel companies, over a conviction that they will become “worthless” as “stated climate goals become reality”.
But for the majority who are not in a position to divest, there is a great deal investors could and should do to begin to anticipate and manage the carbon risks they might face.
First, they should stress-test valuation assumptions for their fossil fuel holdings. How do these change, if you factor in 2oC warming scenarios and a declining carbon budget? Investors should exercise their power as clients to demand from their brokers alternative research which prices in the impact of different emissions pathways on valuations.
They might want to consider which of their investment managers are most exposed to the largest listed global fossil fuel companies. Asset owners, when they appoint new fund managers, can then ‘score’ against these managers in the requests for proposals process, avoiding those investment managers that are ignoring climate risk, and which are most likely to leave them owning shares of companies with stranded assets.
Investors might also seek to hedge their climate exposures. Investing in portfolios of ‘climate solutions’ providers, or in forestry or farmland assets, for example, can supplement broader market investments and offer a hedge to fossil exposures.
And there is a great deal investors can do without altering the composition of their portfolios. Fossil fuel companies are spending billions of dollars of shareholders’ money in finding and developing new reserves which may never be exploited: in 2012 alone, the 200 largest publicly traded fossil fuel companies collectively spent an estimated $674 billion in this way. Investors are beginning to engage with energy companies to ask them to reconsider this capex, and instead return money to shareholders.
Regulators also have a role to play. They need to pay more heed to this latest systemic risk to the markets that they oversee. They should require companies to disclose the potential emissions of CO2 embedded in their fossil fuel reserves, and incorporate climate change risk into their assessment and monitoring of systemic risk in capital markets.
Financial regulators, central banks and finance ministries show some signs of taking notice, and the issue is on the agenda at events such as this week’s World Economic Forum in Davos. At Carbon Tracker, we are working to ensure that today’s capital markets understand the carbon risks to which they are exposed, and that this potentially systemic risk is deflated before it can create a new financial crisis. We believe that currently the financial system is not adequately taking these climate risks into account. But we also believe that this will change rapidly, as the implications of climate change increasingly make themselves felt. Investors and regulators would do well to start to act now to anticipate these effects.