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Fossil Fuels and Stranded Asset Risk

Posted by
Anita Belitz Krasniqi
on
Thursday, April 7, 2016 - 08:45

Will the rise in the consensus that countries need to move to low-carbon economies mean the end of fossil fuels? What does this mean for the investor? Will investments in these companies become stranded assets?


Research in climate science suggests that global temperature change should be kept below 2°C compared to pre-industrial levels in order to avoid severe climate change events. Scientific research of this kind was echoed in the recent Paris Climate Agreement under which the parties agreed to pursue efforts to limit temperature increases to 1.5°C. Given the relationship between atmospheric greenhouse gas (GHG) concentrations and average global temperature, only a limited quantity of GHGs can be emitted between now and 2050 in order to respect the 2°C limit.

 

An interesting debate in sustainable finance pertains to the question of whether current financial valuations of fossil fuel producing companies reflect this political will to limit temperature increases to 1.5 or 2°C. Typically, valuations of fossil fuel companies are proportional to the amount of theirproven reservesi.e. reserves which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years. Given that parts of the proven reserves would have to stay in the ground in order not to exceed the 2°C limit, it has been argued that fossil fuel companies are overvalued, simply because many of these companies would not be able to extract and sell their proven reserves. A large portion of known fossil fuel (e.g., coal, oil, gas) reserves could not be burned because the burning would lead to temperature increases exceeding 2°C. Scientists[1] estimate that approximately 82% of coal, 50% of gas, and 33% of oil reserves cannot be extracted and burned if a 2°C target is to be achieved.

 

The Carbon Tracker Initiative, an NGO, has argued that investors in fossil fuel companies are exposed to stranded asset risk, for instance, which it defines as the risk that fossil fuel energy and generation resources will, at some time prior to the end of their economic life and as a result of changes in the market and regulatory environment, no longer be able to earn an economic return.

 

“Ecological Limits, Technology and Stranded Coal Reserve Assets” a paper co-authored by John Byrd and Elizabeth S. Cooperman, presented at the Geneva Summit on Sustainable Finance on March 22nd, studies whether investors recognize such stranded asset risk. To examine this question, the authors study whether and how investors react to capture and sequestration (CCS) technology. According to the Global CCS Institute, CCS technology is technology that allows capturing, transporting, and storing carbon dioxide at a large scale. The idea is that if CCS technology becomes economically viable, fossil fuel may remain part of the energy mix in a carbon-constrained world.

 

Byrd and Cooperman provide evidence that stock prices of coal companies increase when major CCS breakthroughs are achieved. In contrast there is no systematic stock price reaction for CCS setbacks. The authors argue that the lack of a response to CCS setbacks is consistent with investors previously embedding stranded asset risk into their valuations. Alternatively, the evidence is also consistent with the psychological bias of information avoidance, under which investors avoid information that is undesirable (i.e., failing to reflect stranded asset risks).

 

This will be an interesting debate to follow. Will the climate change discussion and political pressure influence funds that would traditionally have invested in fossil fuels to start moving to sustainable investments ? The Rockefeller Brothers Fund (a multimillion-dollar charity fund set up by the Rockefeller family who made their fortune from oil) recently committed to divest from investments in fossil fuels. This may be the first of many to come.
 

Faculty expertise provided by: Prof. Philipp Krüger
 

Dr. Réné Buholzer will talk about the transition to a low-carbon economy at the SFI Annual Meeting in Zurich on October 4th. Register here.