Stranded Assets and the Bank of England

41ECa85N+ILMark Carney, the former Goldman Sachs banker and head of the Bank of Canada who now heads up the Bank of England, threw the City of London financial community into a bit of a tizzy recently. Carney picked up on a line of argument that a number of NGOs have been pushing for several years now—that investing in fossil fuels carries some potentially serious financial risks that investors should be giving some thought to. Carney simply pointed out the obvious, or what has been increasingly obvious to a number of investors for a while now. And that is the notion that if governments really do stick to adopting measures that will help to insure that global temperatures rise only 2 degrees Centigrade, many of the carbon assets currently on the books of fossil fuel companies—coal in particular, but other fossil fuels as well— will be “unburnable.”

This is not a new issue. A number of NGOs have spent the past several years leading the charge to “de-carbonize portfolios.” This portfolio de-carbonization effort is based on the perception that, aside from whatever “ethical” concerns may justify this, there is also a high likelihood of increased financial risk associated with carbon ownership—the exact point that Carney made. Much of this effort has been led by Carbon Tracker, a UK organization, but the original argument actually goes back to a presentation by environmental activist Bill McKibbin.

The arguments here are actually straightforward. A large number of energy companies have substantial fossil fuel assets on their books, at various valuations. In many cases, these assets represent the majority of a company’s asset base. However, if governments are to meet their carbon reduction targets through greenhouse gas reductions by 2020 or beyond—or in general, if governments act to limit the increase in temperature from global warming to 2oC— then most of these assets will never be consumed, and will therefore be “stranded.” This raises several issues.

First, how much carbon is actually out there to be burned? Numbers vary a bit here. If we use a number that’s been out there for a little while (and is therefore probably a bit out of date) let’s say it’s 565 gigatons burnable before 2050, a level deduced by Carbon Tracker and the International Energy Agency (IEA). (A newer number would undoubtedly be lower, but this number will serve the present discussion.) Then we ask how much carbon is on the books of major energy companies—oil, coal, and natural gas? According to Carbon Tracker, in conjunction with the Grantham Institute for Climate Change, HSBC and Citigroup, this amount is on the order of 2,860 gigatons. This means that in order to not exceed the 2°C target, roughly 80% of global carbon reserves are “unburnable.” (Note that if I were giving an actual presentation on this, I’d need to update these numbers a bit, but the order of magnitude wouldn’t change all that much.)

This is not a new suggestion—the IEA has expressed a similar position in its 2012 World Energy Outlook, where they estimated that only one-third of current fossil fuel reserves could be burned before 2050, with the balance being “unburnable.” However, it remains one not widely shared among investors, apparently. A number of observers, incidentally, have noted that the bulk of global fossil fuel reserves are actually not in the hands of private companies, but rather in the hands of state-owned oil companies or national governments themselves—the Russian state, for example, or Saudi Arabia.

The second issue is what then happens to those 80% of currently estimated oil, coal and gas reserves if they are not burned—if future development of reserves becomes unnecessary or irrelevant? They essentially become what accountants call “stranded assets”—assets that are still on the books as having value, but the value has basically disappeared because of external events. These assets presently represent a significant portion of the valuation of oil, coal and gas companies. Moreover, these assets, through the valuations of the companies carrying them, represent non-trivial percentages of the total market value of various stock exchanges—not too long ago fossil fuel valuations (along with those of mining companies) represented about one third of the value of the FTSE 100, for example.

In fact, the potential financial impact here can be readily quantified in many cases. These assets are on the books of potentially affected companies at a specific valuation. The question then becomes whether these valuations are realistic, or need to be adjusted. To date, the companies and industries affected have not yet made this adjustment, although we may start seeing some impact as proposed projects that assume $110 oil get cancelled. And, in fact, in the minds of some of the potentially affected companies, they don’t believe they will need to—both ExxonMobil and Shell have released statements in which they indicated that they believe these risks are not likely to materialize. Whether this will be the case remains to be seen—it depends pretty much on public policy measures on a global basis that may be difficult to obtain. Whether this potential risk becomes a real risk is an import question, but not one that can be answered readily at this point. None of this, incidentally, has prevented a steady increase in the number of shareholder resolutions dealing with carbon-based assets. Nor have the arguments put forward by ExxonMobil and Shell gone unchallenged.

The area of the fossil fuel industry where there may be the greatest disconnect between values and valuations may be in the coal sector, where stranded assets can arise for several possible reasons. As has been pointed out by the folks up at the Stranded Assets Programme at the Smith School of Business and the Environment at Oxford, stranded assets may arise in the coal sector, particularly in Australia, in the event that China suddenly curtails its buying of coal. And that appears to be starting, actually—China has recently indicated that it will phase out and then eliminate the production and use of higher-sulphur coal, and move more aggressively to renewables. While this will unquestionably have an impact on domestic Chinese coal producers, it may also have an impact on parts of the Australian coal mining industry as well. Coupled with the possible impacts of the long term drought in Australia, as well as other issues of water availability (or the lack thereof), this could raise the legitimate prospect of stranded coal assets. For a number of different reasons, this issue has also arisen in the US coal mining industry, as utilities steadily move away from coal to other energy sources, principally natural gas. In fact, Obama’s recent moves to regulate parts of the US energy industry will have this effect—it’s pretty much unavoidable at this point. It is a war on coal, for good reason.

Given all this, the response to Carney’s comments was a joy to behold. A substantial number of commentators had never heard about any of this, apparently, even though the media coverage of the global disinvestment campaign has been aggressive. In addition, there were a number of commentators who apparently still believe that global warming is some sort of liberal plot, so many, in fact, that my contribution to the comments was to wonder whether global warming denial was higher among Financial Times readers than the general population. It certainly appears to be. But there were also a fair number of commentators who indicated their support for Carney, suggesting that this is exactly the sort of longer range thinking that has been absent from central banking and the Bank of England in particular, and they welcomed it. The FT itself , predictably, published a number of negative articles (I can just imagine how The Wall Street Journal covered this), and some positive (or at least mixed) ones, including an excellent piece from former FT Alphaville writer Kate Mackenzie which nicely summarizes what Carney did (and didn’t) say, and why it needed to be said.

Ironically, all of this has occurred at a time when Wood MacKenzie, one of the most highly regarded energy consultants on the planet, issued a report indicating that at current oil prices, the fossil fuels industry has about $1.5 trillion (yes, trillion) of planned capital investments that probably couldn’t proceed economically, and therefore probably shouldn’t. This has actually been one of the arguments that NGOs like Carbon Tracker have been putting forward—that it makes little sense to keep investing in fossil fuel exploration and production, given the amount of assets that are already at risk.

Actually, we think Carney knew exactly what he was doing when he raised this issue. It was a speech to the insurance industry, after all, an industry that has been pushing (with only mixed success to date, admittedly) to get the financial industry more up to speed on these issues, particularly the potentially catastrophic losses that could be coming along. And, of course, those of us still lucky enough to have actual retirement packages should be drilling our pension fund managers about what they think of all this—and if they’re unsure, we should probably be finding new managers. The negative reaction of many commentators to Carney’s speech is disappointing, but not surprising. The finance sector still has a long way to go here.

2 replies »

  1. Ditto. Whenever I see a post on the masthead with a stamp as the visual, I jump to it. Smart, insightful and as usual, helpful.