Research calls for regulatory action on carbon valuation risk

A new study from UK institutes has called for regulators, governments and investors globally to re-evaluate energy business models against carbon budgets, to prevent a $6trn “carbon bubble” in the next decade.

The research was conducted by Carbon Tracker Initiative and the Grantham Research Institute on Climate Change and the Environment at London School of Economics and Political Science.

It finds that fossil fuel reserves already far exceed agreed “carbon budgets” set to try to avoid global warming of more than 2°C, yet $674bn was spent last year finding and developing new assets.

In 2011 Carbon Tracker released a report, Unburnable Carbon, which introduced the concept of the carbon bubble and the potential for “stranded” fossil fuel assets. It warned that 80% of the carbon intensive assets owned by governments and businesses are technically “unburnable” (and therefore stranded or worthless) in a world of 2°C climate change.

Governments have committed under the Cancun Accord to reducing annual emissions in line with a 2°C target (above which the level of global warming is considered to create unacceptable risks from sea level rise and other impacts), but financial markets are assuming that emissions continue to increase, the research said.

Analysis shows some 60-80% of coal, oil and gas reserves of publicly listed companies could be classified unburnable if emission reduction targets are to be met. If the drive to identify fossil fuel reserves continues for the next decade, economies could see over $6trn in wasted capital.

“Company valuation and credit ratings methodologies do not typically inform investors whether they have exposure to these stranded assets. The markets continue to reward reserves replacement, rather than considering reserves redundancy,” the report said.

The 200 listed companies analysed in the study own 762 billion tonnes of carbon dioxide (CO2) through their reserves of coal, oil and gas which supports share value of $4trn and services $1.5trn in outstanding corporate debt.

To achieve emissions reductions consistent with an 80% chance of achieving the 2°C target, the fossil fuel reserves of these listed companies would likely have to comply with a budget of about 125 – 275 billion tonnes of CO2. This budget is proportional to a quarter share of reserves which they own.

An optimistic scenario was applied to stress-test the carbon budgets. This assumed that more effort was applied to non-CO2 emissions, (e.g. methane from waste and agriculture), which resulted in freeing up more CO2 budget for fossil fuels. However under a more precautionary scenario, the carbon budget could be around half this amount – 500 billion tonnes, which still does not meet the carbon budget.

The analysis concludes that even a less ambitious climate goal, like a 3°C rise in average global temperature or more, which would pose significantly greater risks for the global economy, would still imply significant constraints on the use of fossil fuel reserves between now and 2050.

“Yet companies in the oil, gas and coal sectors are seeking to develop further resources which could double the level of potential CO2 emissions on the world’s stock exchanges to 1,541 billion tonnes. Current extractives sector business models are based on assumptions that there are no limits to emissions. This strategy is not compatible with a carbon-constrained economy,” the research noted.

Analysing absolute levels of exposure, New York is identified as the oil financial centre having increased its level of embedded carbon through reserves by 37% since 2011. London comes out as the coal capital, having increased embedded carbon by 7% over the same period.

The study makes a number of recommendations to help governments, regulators and investors to manage these substantial carbon valuation risks.

Financial regulators should require companies to disclose the potential CO2 emissions that are embedded in fossil fuel reserves. Finance ministers should initiate an international process to incorporate climate change into the assessment and management of systemic risk in capital markets. And investors should challenge the strategies of companies which are using shareholder funds to develop high-cost fossil fuel projects.

Professor Lord Stern of Brentford, Chair of the Grantham Research Institute on Climate Change and the Environment, commented: “Smart investors can already see that most fossil fuel reserves are essentially unburnable because of the need to reduce emissions in line with the global agreement by governments to avoid global warming of more than 2°C. They can see that investing in companies that rely solely or heavily on constantly replenishing reserves of fossil fuels is becoming a very risky decision.”

“But I hope this report will mean that regulators also take note, because much of the embedded risk from these potentially toxic carbon assets is not openly recognized through current reporting requirements.”

The report questions the ability of the financial system to act on industry-wide long term risk, since currently the only measure of risk is performance against industry benchmarks.

James Leaton, Research Director, Carbon Tracker, said fossil fuel companies are facing a carbon budget deficit. “Pretending business models reliant on more carbon emissions fit with increasing carbon constraints is the equivalent of the emperor’s new clothes. It is time investors and regulators started looking more closely at how capital is being spent.”

“Institutional investors are currently driven by whether they are outperforming the market, rather than understanding the value that is at risk. More forward-looking financial indicators are required if investors are to translate climate change risk into investment decisions.”

In February 2012, following engagement by Carbon Tracker and a number of financial and environmental stakeholders, the Bank of England recognised climate change as a potential systemic risk and committed to provide twice yearly reports on exposure to it.

However, as yet no mention has been made of climate change risk in these reports. The new analysis is a clear signal that carbon assets pose a systemic risk to financial stability. Carbon Tracker and Grantham are publicly calling for regulators to stress test reserve levels and production plans against the 2°C scenario and report back on the status of the market.

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