Environmental Risk: The Changing Climate: Six degrees of capitalisation
Mark Campanale and Jeremy Leggett consider whether capital markets might be mis-pricing the risks attached to fossil-fuel stocks
Despite tightening climate regulations, the capital markets are becoming more fossil-fuel intense, not less. The major coal, oil and gas-focused companies, with the support of the investment banks and their pension fund clients, continue to be the most successful raisers of capital on the world’s leading stock exchanges. The challenge for the investors brave enough (or bound by tracker portfolios) to invest in them is that the science on climate change is placing increasing uncertainty on their future.
How is the market pricing the ability of these companies to execute their business strategies? The amount of carbon in the world’s proven fossil fuel stocks is some 2,795 gigatonnes – five times more than what climate scientists say we can safely burn for the planet to stay to a 2°C warming target. Clearly, not all of the companies will be able to develop their assets. If the predicted revenues of these publically-traded companies backing their valuations and credit ratings are wrong, are the capital markets mis-pricing these risks?
In a 2009 edition of the journal Nature, climate scientists calculated that if 886 gigatonnes of CO2 were to be released globally during the period 2000-50, there is a 20% chance global warming would exceed 2°C. By 2011, we had already burnt more than a third of this CO2 budget, and the known fossil fuel reserves easily exceed the remaining allowance. The reserves beyond this limit are what we refer to as ‘unburnable carbon’.
This concept has now been adopted by others, not least the IEA which, in its World Energy Outlook 2012, notes that: “In the absence of widespread carbon capture and storage (CCS) adoption, the profits of public and private companies in fossil-fuel-rich countries could be cut and state income from taxes and royalties reduced…. without a significant deployment of CCS, more than two-thirds of current proven fossil-fuel reserves cannot be commercialised in a 2°C world before 2050.”
Investors have very little certainty about viable widespread carbon capture and storage (CCS) being in place within the investment horizon applied by their fund managers, and even then this would not bring the CO2 potential of all the reserves within the budget.
In 2011, the Carbon Tracker Initiative’s report, ‘Unburnable Carbon: are the world’s financial markets carrying a carbon bubble?’ exposed the misalignment between the world’s stock exchanges and the climate change agenda. The levels of coal, oil and gas reserves being financed by the capital markets – including investors such as pension funds and insurance companies – are taking us to 6°C of warming rather than the 2°C target the world’s governments have agreed. This misalignment has been a wake-up call for the climate change community. Rather than counting last year’s flows of carbon emissions, which have already gone into the atmosphere, we need to look at the stocks of carbon being built up. To do this, we must look at the future emissions sitting in the reserves of the companies we own in our pension funds.
The market paradox is that fossil fuel company valuations are counting on future revenue streams to pay debts and dividends, but these revenue streams are dependent on the world continuing on a pathway to 6°C of warming. So what does this mean for pension funds?
The ‘Framtiden i våre hender’ (‘Future in Our Hands’) organisation in Norway has recently investigated the Norwegian Government Pension Fund’s investments in the world’s largest stock-exchange-listed oil, gas and coal companies, measured on the basis of the size of the carbon resources. As a universal investor they currently hold shares in many of the large listed hydrocarbon companies, and therefore have a key role in diverting capital towards a low carbon future.
The South African Government Employees Pension Fund (GEPF) is required to have a domestically-focused portfolio that links its responsibilities to the future of South Africa’s economy. The GEPF is engaged in a process of understanding how the energy sector would need to change to conform to potential carbon budgets and water constraints in South Africa. This is the first time a pension fund has sought to understand its exposure to unburnable carbon. We are now seeing more and more interest from investors in Australia, the US, Norway, France, South Africa, the UK and around the world who want to understand how they build an assessment of the value at risk into their investment approach.
It is this contradiction between international climate policy and capitalised reserves that is at the heart of the financial risk to asset owners invested in fossil fuels. The investment banks upon which so many asset owners depend for the investment recommendations made by their portfolio managers do not currently factor this into their financial models.
The data they provide are typically based on a ‘business-as-usual’ scenario - namely that all the oil and the coal will be developed.
The Carbon Tracker Initiative is using our findings to challenge the assumptions underlying these models. “The regular process of economic evolution is that businesses are left with stranded assets all the time,” says Nick Robins, who runs HSBC’s Climate Change Centre.
“Think of film cameras, or typewriters. The question is not whether this will happen. It will.
Pension systems have been hit by the dot-com and credit crunch. They’ll be hit by this.” As HSBC research concluded in June 2012, current expectations of earnings from coal assets held by the four mining majors listed on the London Stock Exchange could be cut by as much as 44% if investors assumed constraints on carbon post-2020.
For risk managers prepared to dig, there is more to find. While the markets have yet to factor into valuations the effect of a 2°C world, regulators are starting to take notice of this contradiction between policy goals and market behaviour. The Bank of England met the Carbon Tracker Initiative and City representatives in April and is now considering how to deal with the financial stability implications of a carbon bubble.
But markets do not currently have sufficient data to assess this systemic risk. Suppose they require extractive companies to report on the greenhouse gas potential of their reserves as well? For Sovereign bonds this issue divides countries into those that have reserves and those that don’t. Current importers of fossil fuels will surely be better placed to service their debt and maintain stability if they can reduce reliance on an increasingly volatile energy commodities market.
Even countries in the Middle East have realised the opportunity here, with Saudi Arabia announcing a $109bn (€84bn) investment in solar capacity. Countries that currently enjoy the riches of their fossil fuel resources need to prepare for a future when they cannot rely on the same level of demand. Norway has established its pension fund based on oil and gas revenues with precisely this in mind – now it needs to ensure the fund does not get caught with stranded assets.
Investors need to ask much tougher questions about the business models behind deals such as the recent Glencore-Xstrata merger, none of which fitted with climate change targets. They should also challenge investment strategies of companies in their portfolios.
Why should a company spend billions a year to find ever more costly and damaging resources that will be unusable if any value at all is placed on a viable future for the planet?
This issue is also being considered by ratings agencies. Moody’s, for example, has recently noted that the perpetuation of the current business model is central to coal companies servicing their debt. Investors need to ensure that their advisers and research providers are factoring in the increasing uncertainty around fossil fuels.
Mark Campanale is a founding director and Jeremy Leggett is chairman of the Carbon Tracker Initiative, the first project of Investor Watch, a non-profit company established to align capital markets with efforts to tackle climate change