Stranded Assets

Developments in Finance and Investment

Ben Caldecott

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781351329804
• Edition: 1
• Topic: Commerce
• Subtopic: Commerce Général

The topic of 'stranded assets' created by environment-related risk factors has risen up the agenda dramatically, influencing many pressing topics in relation to global environmental change. For example: how best to manage the exposure of investments to environment-related risks so that financial institutions can avoid stranded assets; the financial stability implications of stranded assets and what this means for macroprudential regulation, microprudential regulation, and financial conduct; reducing the negative consequences of stranded assets by finding ways to address unemployment, lost profits, and reduced tax income; internalising the risk of stranded assets in corporate strategy and decision-making, particularly in carbon intensive sectors susceptible to the effects of societal action on climate change; underpinning arguments by civil society campaigns attempting to secure rapid decarbonisation to reduce the scale of anthropogenic climate change; and designing decarbonisation plans developed by governments, as well as companies and investors.

Taken as a whole, this book provides some of the latest thinking on how stranded assets are relevant to investor strategy and decision-making, as well as those seeking to understand and influence financial institutions. This book was originally published as a special issue of the Journal of Sustainable Finance and Investment.

Investment consequences of the Paris climate agreement^*

Howard Covington

ABSTRACT
This paper develops a simple model of an energy transition. Projections for growth in renewables and electric vehicles suggest that the oil and gas industry will be disrupted during the 2020s, but that, as things stand, carbon dioxide emissions are unlikely to fall fast enough to keep within a 2° emissions budget. To keep warming to 2°, additional ways of reducing emissions from industry or of accelerating emissions reductions from generation, transport and buildings will be needed together with an extensive programme of carbon dioxide removal.

Investor concerns

Investors are becoming aware of the possibility that action to decarbonise the global economy may disrupt business models and change asset values. Some investors have begun to support resolutions put to energy company shareholder meetings to request information about how the energy transition might affect the company’s business and value.

Many projections are available of future energy demand and supply. Some of these explore the extensive changes needed if the world is to limit warming to the politically supported 2°C above the level of the late nineteenth century (IRENA 2014). Others seek to justify a view that demand for fossil fuels will be robust in the foreseeable future (BP 2016). The purpose of this study is to formulate an almost trivially simple model of the energy transition that nonetheless contains useful insights about the consequences of pushing ahead with decarbonisation as fast as practicable given the rate at which low-emissions technologies are developing. Its main conclusions are that there is likely to be enough change substantially to undermine the revenues of the petro-economies and the profits of the oil and gas industry during the 2020s and to disrupt business models in high-emissions industries but that holding warming to below 2° will be difficult.

By way of introduction, the next section describes some of the implicit arithmetic consequences for investors of the climate agreement reached in Paris in December 2015. Subsequent sections explore how decarbonisation might be given effect by changes to the world’s energy infrastructure.

Paris arithmetic

In Paris almost all the world’s governments agreed to limit global warming to at the most 2°C above the level of the late nineteenth century. Warming is caused by the accumulation in the atmosphere of greenhouse gases from human activities, mainly (but not exclusively) the burning of oil, natural gas and coal to fuel the global economy. Taking likely future emissions of other greenhouse gases into account, and working to a 50% probability, the remaining budget for emissions of the principal greenhouse gas, carbon dioxide, is around 1,000 billion tonnes (gtCO₂). Annual emissions of carbon dioxide are currently around 40 gtCO₂ (IPCC 2014).

If the global economy’s energy infrastructure could be changed so that carbon dioxide emissions were in future to fall at a constant annual rate, then this rate would need to be 4% pa to keep to budget (see Supplementary Information). This would mean that emissions fell by three-quarters by mid-century and by 90% by 2075. These are the kinds of numbers that are sometimes cited as national objectives. Keeping within budget therefore implies a 60-year ‘energy transition’ during which the global economy is substantially decarbonised. If output grows at 3% pa while emissions are being reduced in this way, then the reduction in emissions per unit of global output would have to be 7% pa. The growth in energy-related emissions ran at 2.7% a year in the first decade of this century, but may now have slowed to almost zero (IEA 2016).

It may not be practicable to cut emissions at 4% a year for 60 years. If, instead, carbon dioxide emissions fell steadily at 2% pa until the end of the century and from then on all further emissions were removed from the atmosphere and stored, the emissions budget would be exceeded by about 650 gtCO₂. To keep within budget, these emissions might also be removed and stored – at a rate, say, of 10 gtCO₂ pa starting in the mid-2030s.

There are many proposals (ranging from reforestation to liquefaction of carbon dioxide and storage in depleted oil wells) for how industry-scale carbon dioxide removal might be achieved (Caldecott, Lomax, and Workman 2015). The lower end of indicative cost estimates is around $50 per tonne of carbon dioxide. At the current level of emissions, a carbon dioxide price at this level would imply additional costs to emitters of $2 trillion pa and a carbon removal industry of $0.5 trillion pa, about one-third the size of the oil industry when the oil price is $50 per barrel. So that businesses did not relocate to avoid the cost, such a price, and the mechanisms to enforce it, would need international agreement. Many models of the energy transition rely on carbon dioxide removal at this scale to keep within the carbon dioxide emissions budget, although it is far from clear whether it is socially, politically, environmentally, technologically or economically acceptable or possible (Williamson 2016).

Suppose that the global energy infrastructure is progressively changed so that carbon dioxide emissions do indeed decline by between 2% and 4% a year while the economy continues to grow. This implies that demand for fossil fuels will decrease at this rate as energy comes to be used more efficiently and fossil fuels are displaced by the increased use of renewables and nuclear energy. Demand for oil is currently around 95 million barrels a day (mb/d). Around a quarter of this is for feedstock into the petrochemicals industry, so about 70 mb/d is for energy production. A reduction in demand of 2–4% of this amount is equivalent to 1.4–2.8 mb/d. During 2015, surplus supply on this scale caused the oil price to fall by two-thirds from the $90 per barrel or more, where it had been between 2007 and 2014, to touch $30 in early 2016.

It is typical of extractive industries that there is a large sunk cost for preparing a well or a mine and then a much smaller operating cost. Although a high expected product price may be needed to justify investment in a new extraction project, only a relatively low price is necessary to cover operating costs once the initial capital costs have been sunk. A small decrease in demand can therefore trigger a large fall in price as suppliers compete to supply the lower demand and the market price changes from the full unit cost of investing in the next marginally profitable extraction project to the marginal cost of keeping existing projects in production. A steady reduction in demand of a few percent a year for several decades would be likely to send the oil, natural gas and coal prices to historically low levels for several decades while higher cost projects were progressively shut down and supply was gradually cut back to match falling demand. Perhaps anticipating this kind of development, in 2016 Saudi Arabia announced its intention to re-orient its economy so that it can withstand an oil price of $30. During the next few years the price of oil may again rise to $90 per barrel or more as demand and supply come back into balance. If the price were then to fall indefinitely to $30, as the arithmetic of the Paris agreement suggests should be the case, the petro-economies as a whole would lose around $2 trillion of revenues compared to what revenues would have been without decarbonisation.

A price of $50 per tonne on carbon dioxide emissions and a steady fall in demand for oil each imply the potential redirection of $2 trillion, or around 2% of world GDP, each year. Annual transfers of this amount away from carbon dioxide emitters on the one hand and fossil fuel producers on the other would shift the economic balance of some countries and change the business models of several industries. Petro-economies would undergo a period of social and economic adjustment. Some of them might fail as states. The revenues of fossil fuel companies would fall to perhaps a third or so of their level of the recent peak years. The profitability of energy-intensive industries such as electricity generation, steel, chemicals, cement and transport would change. Legacy assets might become uneconomic (‘stranded assets’) as prices varied and new technologies that helped reduce fossil fuel demand disrupted established industries and resulted in financial distress and bankruptcies. If the world holds to the Paris agreement, these changes will come about during the 2020s, a period that is well within the time-frame of major capital investment projects being considered by company managements and project finance proposals being approved by banks.

The Paris agreement therefore gives investors good reason for concern. Without information on whether and how companies are preparing themselves for the far-reaching changes that it implicitly contemplates, investors cannot properly and responsibly manage their portfolios or approve financing proposals or remuneration plans when asked to do so by the high-emitting companies whose shares they own. We now turn to a simple model to quantify the consequences of an energy transition at the speed contemplated by the Paris agreement.

Method

A model is constructed that summarises the changes that the world’s energy infrastructure might undergo. The intention is to make this model as simple as it can be in order to capture the main drivers of carbon dioxide emissions through the energy transition. It is based on the International Energy Agency’s 2...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• Citation Information
• Introduction: stranded assets and the environment
• 1. Investment consequences of the Paris climate agreement
• 2. Blindness to risk: why institutional investors ignore the risk of stranded assets
• 3. Transition risks and market failure: a theoretical discourse on why financial models and economic agents may misprice risk related to the transition to a low-carbon economy
• 4. Social and asocial learning about climate change among institutional investors: lessons for stranded assets
• 5. Assessing the sources of stranded asset risk: a proposed framework
• 6. Climate change and the fiduciary duties of pension fund trustees – lessons from the Australian law
• 7. Game theory and corporate governance: conditions for effective stewardship of companies exposed to climate change risks
• 8. A comparative analysis of the anti-Apartheid and fossil fuel divestment campaigns
• Index