Will The Carbon Bubble Be The Next Financial Crisis?

Author

Chris Wright, Contributor

February 13, 2015

The gross overvaluation of commodities companies, based on resources that they will never be able to extract from the ground, will lead to a new market crash and global financial crisis. That’s the warning in a new study released in Europe yesterday.

It comes from the Green party, and specifically a study commissioned by the Green European Foundation, and that fact will probably be enough for many investors to ignore it and move on to the next story. But – although clearly the Green party has a mandate to keep the environment in the news, and is doing an admirable job, as demonstrated by the fact that I’m writing about it – behind the politics there are some interesting investment points that are worth discussing.

The key to the argument is the theory that we must limit the rise in global surface temperature to 2 degrees celsius relative to the pre-industrial age. Many people do accept this: that rises beyond those levels risk catastrophic and potentially irreversible changes to our climate and our way of life. The thing is, if we accept that two degree ceiling, then instead of worrying about when fossil fuels will run out, we should instead be accepting that most of them have to stay in the ground.

This is not, incidentally, a contention that just comes from the Greens. A study from University College London, published in the journal Nature in January, argues that trillions of dollars worth of natural resources – including over 90% of US and Australian coal, and almost all Canadian tar sands – cannot be extracted and burned if the global temperature rise is to be kept under the two degree celsius safety limit that has previously been agreed by the world’s nations. It’s possible we can bury carbon – this is what we mean by carbon capture and storage – but there are limits to that. Ideally, we would stop burning fossil fuels in about 20 years.

If that’s the case, then clearly it has considerable implications for energy companies. “This means that the majority of fossil fuel reserves are stranded assets: they cannot be used if harmful climate change is to be avoided,” says the study by the Greens. “Private oil, gas and coal mining companies own about a quarter of fossil fuel reserves. If a large part of these reserves cannot be extracted or extraction becomes commercially unviable, that reduces the valuation of these companies and their ability to repay their debt.”

One can extrapolate the consequences of this to the sovereign level, since there will be a consequent loss of revenue to governments that have relied on their hydrocarbon resources for the future; think, for example, what it would mean for Saudi Arabia, the Middle East, and global geopolitics if they had to turn off the taps. But in the first instance it’s interesting to think about what this might mean for the likes of BHP Billiton, Rio Tinto, Total, ExxonMobil and BP; and some of the darlings (sometimes) of emerging markets, such as CNOOC, Petrochina, Gazprom, Vale and (as if it needed another problem) Petrobras. Since coal is the resource highlighted most clearly in the UCL study, coal mining companies would expect to be most severely affected by stranded assets, such as China Coal, Coal India and Peabody Energy. If their share prices were to reflect a reality in which most of their assets could never be extracted, then clearly, that would represent a dramatic decline.

The green study then goes further and thinks about what the consequences of this would be in the global financial system. This is a European report, and so its frame of reference is Europe. It estimates the exposure of 23 of the largest EU pension funds, and the 20 largest EU banks, to oil, gas and coal mining firms, and reaches a figure in excess of Eu1 trillion: Eu260-330 billion for pension funds, Eu460-480 billion for banks, and Eu300-400 billion for insurance companies. In percentage terms, that’s 5% of total assets for EU pension funds, 4% for insurers and 1.4% for banks. The report is not just a shock headline: there is considerable underlying research, and readers can look in more detail here if they wish. Pension funds the report names as exposed include the UK’s Universities Superannuation Scheme and BAE Systems Pension Scheme, as well as Dutch PFZW and Finnish Keva; banks “that might suffer relatively large losses” include Lloyds Banking Group, Societe Generale, BNP Paribas and Standard Chartered. This study didn’t address US, Asian or any other non-European institutions.

Perhaps mindful of the fact that it doesn’t want to be making a case against leaving hydrocarbons in the ground, the report then argues that “on its own, the shock to financial institutions resulting from a quick adoption of climate and energy policies or a breakthrough in low-carbon technology is unlikely to be a source of systemic risk. Carbon bubble risks, while significant, are not so large that they post a threat to the pension, banking and insurance sectors as a whole.” So what do the Greens really want from this? Investors to abandon energy stocks? Not necessarily. The point the Greens want to make is that the damage will be much less with a quick and decisive transition to a low carbon economy than with a slow and uncertain transition. “The study,” says Reinhard Butikofer, Member of the European Parliament, “illustrates the price of doing too little too late.”

Now, the hole in the argument is glaring: there is no guarantee at all that the world’s governments, energy companies and consumers will agree to the idea of keeping most of the world’s fossil fuels in the ground. One can assume that any energy company will fight tooth and nail to extract and sell the assets it holds. We can argue at length which outcome is worse in the long run.

Nevertheless, the climate change debate is not going away, and if we do move closer to a global accord in which it is agreed that hydrocarbon extraction has to be slowed or even ended, then at the very least we can expect further pressure on resources companies. Whether as investors or simply as occupants of planet Earth, there are themes worth thinking about here.

This article was written by Chris Wright from Forbes and was legally licensed through the NewsCred publisher network.

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