The latest report from the Carbon Tracker Initiative, a non-profit organisation, and the Grantham Research Institute on Climate Change, part of the London School of Economics, sends a strong message to investors about the mounting risks associated with the so-called “carbon bubble” forming around fossil fuel assets.

 The share prices of oil, gas and coal companies depend in part on their reserves. The more coal deposits, oil or gas reserves a firm has, the more valuable its shares, as investors treat reserves as an indicator of future revenues.

According to Carbon Tracker, markets are mispricing risk by valuing companies as if all their reserves will be fully exploited, when it is increasingly likely that much of the world’s fossil fuel resources will never be extracted or burned.

International targets for carbon emissions reduction, confirmed in the Cancun Agreement of 2010, oblige world governments to take drastic action in order to avoid a rise in global average temperature of more than 2 degrees Celsius above pre-industrial levels. The report calculates that to have even a 50% chance of achieving this goal, 70% of identified fossil fuel reserves must be left in the ground; for an 80% chance, only 20% can be developed.

This analysis could have a significant impact on the valuation of energy stocks, suggesting that in future, investors could find that company balance sheets contain large numbers of “stranded assets”, with no commercial potential. HSBC research estimates that oil and gas majors, such as BP, Shell and Statoil, could face a loss in market value of up to 60% if the international community meets agreed emission reduction targets. Standard & Poor’s warns that bonds of fossil fuel companies may be vulnerable to downgrade.

Nevertheless, companies are still investing heavily in fossil fuel resources. Carbon Tracker says that the 200 largest mining, oil and gas companies have allocated up to $674bn over the last year for identifying and developing new reserves and new ways of extracting reserves. It seems that potential investor concerns about “un-burnable carbon” do not carry much weight.

Fossil fuel free portfolios
So should investors immediately sell all traditional energy stocks? That’s certainly what US activist, Bill McKibben, would argue. His grassroots pressure group,, calls for divestment of all fossil fuel investments. Since the start of his campaign, endowment funds at 252 universities in North America have received requests from students to exit coal, oil and gas companies.

Some institutional investors have already removed fossil fuel holdings from their portfolios.  The Uniting Church in Australia became the first church to take this decision, stating that these industries exacerbate the “climate change emergency”.  It was followed by one of the biggest church groups in the US, the United Church of Christ, which recently formed a plan to divest any fossil fuel company that is not considered “best in class” for mitigating the environmental impact of its businesses. Storebrand, one of Norway’s biggest insurers and pension funds, which has €60bn ($80bn) under management, recently announced the exclusion of 13 coal and 6 oil companies.

Fossil fuel divestment has become an important topic for discussion across the investor community. A survey of nearly 500 investment professionals, carried out earlier this year by the First Affirmative Financial Network in the United States, found that 65% of retail investors and 53% of institutions are expressing interest in fossil fuel free portfolios in the face of growing signs of climate change. More than 60% of the survey respondents believe that significant numbers of investors will start divesting over the next 10 years.

Barriers to divestment
But for institutional investors, divestment is not necessarily straightforward. Pension funds do not typically address stranded asset risks as part of their investment policies and processes. Those that do so have to deal with huge complexity and uncertainty about timing of risk events. Greater understanding is required at both board and management levels of stranded asset risks and potential strategies to address them. Fund trustees express concern, for example, about increased diversification risk in fossil fuel free portfolios.  

There are other practical barriers to overcome. Significant portions of the portfolios of many pension funds are managed by tracking a reference or benchmark index. Most stock exchange indices include large extractive companies: for example, in Hong Kong, the energy component of the Hang Seng Index is 10.33% by industry weighting, and includes Sinopec, PetroChina, CNOOC and China Shenhua Energy.

Passive investment strategies mean that stocks in these firms are automatically bought.  Donald MacDonald, Trustee Director of BT Pension Scheme in the UK, speaking in Hong Kong this year at the First Global Investor Forum on Climate Change hosted by the Asia Investor Group on Climate Change, expressed concern that indexation means the fund is not fully controlling the carbon content of its portfolio. He suggested that dealing with sustainability issues like climate change may often require active management.

Not quite business as usual
The importance of the extractive industries, and widespread use of fossil fuels, is unlikely to diminish in the short term. On the contrary, according to the International Monetary Fund, worldwide subsidies to the oil, gas and coal industries total $1.9trn annually.

But the industry is undergoing significant changes, as fracking technology is altering the fuel mix in many parts of the world. New resources released by shale development in the US have caused the price of gas in the country to plummet, driving coal’s replacement with gas in much of the electricity market.  Increased use of natural gas has also had a positive impact on America’s carbon emissions, which have fallen back to levels last seen in 1995.

China, currently dependent on coal for 80% of its electricity, announced a huge gas development programme in its latest Five Year Plan, which targets output of 6.5 billion cubic metres of shale gas by 2015 and 100 billion cubic metres by 2020.