Unburnable Carbon

The term Unburnable Carbon refers to fossil fuel energy sources (reserves and/or resources), which physically cannot be burned if the world is to adhere to any given temperature outcome. If burned, the associated emissions would mean exceeding the carbon budget for that temperature. The existence of this overhang of available fossil fuels, or unburnable carbon, leads to the concept of the carbon bubble.

Since 2013, Carbon Tracker has produced a series of reports themed on unburnable carbon which has stimulated a new debate around the future of energy and investment. This has prompted organisations ranging from the IEA, oil companies, NGOs, accountants, investors, the OECD, central banks and investment banks to consider the issue. Given that the IEA and even oil companies such as BP and Shell have confirmed that burning all known fossil fuels would result in more than 2°C of warming, we feel there is reasonable consensus around this issue.

Some aspects to consider:

• Some fossil fuels may be used for other purposes which do not involve immediate combustion, e.g. as lubricants. Hence we use the term unburnable rather than unusable.
• Different organisations may apply a range of carbon budgets, meaning the precise amount of unburnable carbon cited varies, however there is a consensus that there is a clear overhang, and the level of potential carbon emissions exceeds any reasonable carbon budget.

Useful links:

IEA:

“Unabated combustion of all today’s fossil fuel reserves would result in three times more CO₂ emissions than the remaining CO₂ budget.”

Shell:

“The issue of the bubble arises because the combined proven oil, gas and coal reserves currently on the books of fossil fuel companies (and governments in the case of NOCs) will produce far more than this amount of CO2 when consumed.”

BP:

“Existing reserves of fossil fuels – i.e. oil, gas and coal – if used in their entirety would generate somewhere in excess of 2.8 trillion tonnes of CO2, well in excess of the 1 trillion tonnes or so the scientific community consider is consistent with limiting the rise in global mean temperatures to no more than 2 degrees Centigrade. And this takes no account of the new discoveries which are being made all the time or of the vast resources of fossil fuels not yet booked as reserves.”

Carbon Budgets

Global warming is fundamentally linked to the absolute concentration of greenhouse gases in the atmosphere.  To stabilise global temperature at any level vs pre-industrial, then there is a finite amount of emissions that can be released before net emissions need to reach zero. For CO₂ emissions this can be referred to as a carbon budget.

Carbon budgets continue to be a popular approach to frame the challenge of keeping global warming to ‘acceptable’ levels. The IPCC Special Report on Global Warming of 1.5ºC (2018) is the most recent authority on ‘total’ carbon budgets – meaning the total amount of emissions that can be released and hence contribute to warming across all sectors of the economy (which can be categorised as energy sector emissions plus land use, land use change and forestry plus industrial sector emissions). Other sector-specific CO₂ estimates for a given warming outcome may also be published by various organisations, for example, the energy sector CO₂ emissions published by the IEA.

At the 2015 UNFCCC Paris COP, world governments confirmed their intention to limit global warming “well below 2°C” and pursue efforts to “limit the temperature increase to 1.5°C”.  We calculate that the remaining 1.5°C carbon budget was c.495GtCO₂ as at the beginning of 2020 (based on the carbon budgets updated by the IPCC in 2018 and emissions data from the Global Carbon Project). Based on 2019 emissions of 43.1GtCO₂ this budget can be expressed in terms of years remaining at current emissions levels – as of 2020 this equates to 11.5 years for a 50% probability of a 1.5°C warming outcome.

Carbon Tracker’s 2019 report Balancing the Budget discusses global carbon budgets further and translates these to company carbon budgets for upstream oil and gas companies based on IEA fossil fuel demand scenarios using a least-cost approach.

The nature of climate science means that the probabilistic scenarios used produce a range of budgets depending on the parameters applied to the models. In selecting / using a budget, people should consider:

• What assumptions are made for certain underlying variables? Climate sensitivity is one variable that can significantly impact the size of the carbon budget. As is the degree to which net-negative emissions are deployed.
• Does the budget cover just energy-related sources of emissions, or are other industrial, agricultural, land use change, etc. emissions covered as well?
• Is the budget for CO₂ alone, or all greenhouse gases? Some budgets are just for carbon or carbon dioxide (check the units); others cover other non-CO₂ greenhouse gases (GHGs) and are expressed in CO₂e (equivalent). An assumed high amount of non-CO₂ GHGs means less remaining budget available for CO₂ – therefore, does a CO₂ only budget assume a high or low effort to reduce other greenhouse gases?
• What is the probability of delivering the desired global warming outcome is, for example, 50%, 66%, 80%? The more likely the scenario is to achieve the specified temperature outcome, the smaller the carbon budget will be.

Our latest thinking on this concept can be found in Carbon Budgets:  Where are we now?

Carbon Bubble

In our first report we asked the question: are the world’s capital markets carrying a carbon bubble?

This question related to the fact that there is a clear overhang of fossil fuels – the carbon bubble –  beyond that which can be burned in a below 2°C scenario. For example, proved reserves alone of oil and gas would last about 50 years each at current levels of production, with proved reserves of coal equivalent to 130 years (based on BP data). Compared to carbon budgets at current rates of emissions of 11.5 years for a 50% chance of limiting warming to 1.5°C and 22 years for 1.75°C, it is clear that there is a significant excess of carbon available.

This excess of carbon beyond climate limits is termed unburnable carbon, some of which is owned by listed companies.  There is a lively debate about the financial implications, which include the potential to create stranded assets and destroy significant shareholder value.

Our carbon supply cost curves research, updated most recently in Breaking the Habit, is a response to demand from investors to understand which projects are less likely to be developed in a world where global warming is limited to below 2°C. This determination is made on economic grounds, with the most competitive oil, gas and coal projects being assumed to go ahead in preference to high-cost alternatives.

A significant proportion of fossil fuel projects outside the carbon budget are related to future projects, which companies still have time to cancel.  The less that energy transition risks are factored into company planning now, the greater chance of value impacts in the future.

Although it is well established that there are greater amounts of fossil fuels available than can safely be burned, it does not necessarily follow from this that there are material valuation implications for most listed companies at present. Valuations tend to be based on near term cashflows, which are less likely to be affected by climate-related factors. However, exposure will vary, and some companies will be better positioned to withstand weak future demand fossil fuels than others.

• Are there assets which are being valued in a manner inconsistent with the expected future scenario?
• Does the short-term bias of valuation models mean that the impact of lower-than-expected future demand is largely discounted out at present?
• Does a valuation model assume that cashflows from a fossil fuel project are paid out to investors in its calculation, when in fact they are recycled into other fossil fuel projects?
• Is the market capable of pricing in the complex set of factors which could affect demand and price?
• Do large diversified companies (e.g. mining stocks or oil majors) dilute the impact of a reduction in coal or oil revenues?
• Do current accounting rules capture the value and any potential impairment of assets in a consistent and useful manner (e.g. compare mining vs oil; contrast IFRS and US GAAP)?
• If capital expenditure continues to be used to replace reserves, could this lead to value destruction in a scenario of sudden market shifts as the energy transition is repriced?

Stranded Assets

Carbon Tracker introduced the concept of stranded assets to get people thinking about the implications of not adjusting investment in line with the emissions trajectories required to limit global warming.

Stranded assets are now generally accepted to be those assets that at some time prior to the end of their economic life (as assumed at the investment decision point), are no longer able to earn an economic return (i.e. meet the company’s internal rate of return), as a result of changes associated with the transition to a low-carbon economy (lower than anticipated demand / prices). Or, in simple terms, assets that turn out to be worth less than expected as a result of changes associated with the energy transition.

The stranded assets concept has been interpreted as encompassing a range of different factors, including:

• Economic stranding – due to a change in relative costs / prices.
• Physical stranding – due to distance / flood / drought.
• Regulatory stranding – due to a change in policy of legislation.

For existing assets, our research can highlight those assets which are most at risk of becoming stranded through the energy transition, as society looks to restrict global warming to well below 2°C, as under the Paris Agreement.  There are already examples of coal mines, coal and gas power plants, and other hydrocarbon reserves which have become stranded by the low carbon transition.

Examples of stranded assets in the oil and gas industry:

• Resources – oil and gas currently in the ground awaiting production, including reserves.
• Exploration and development assets, e.g. drilling rigs / seismic vessels.
• Production and processing facilities, e.g. processing terminals.
• Distribution infrastructure, e.g. pipelines, tankers.

For potential new investments, our research aims to prevent stranded assets arising by identifying where capital expenditure may be allocated to investments which may not yield the expected returns as the world decarbonises. Our focus is therefore on advancing the energy transition through the stewardship of capital, with the intention of preventing it from being wasted.

Investors have recognised the value of companies considering a range of scenarios in their business planning, including a scenario of 2°C or lower, by supporting initiatives and resolutions which ask companies to report on the implications of this future for their business.

Financial regulators have also endorsed the importance of scenario analysis for assessing climate risk through the Financial Stability Board Task Force on Climate-related Financial Disclosures. Mark Carney, the FSB chair stated that a carbon budget consistent with a 2°C target “would render the vast majority of reserves ‘stranded’ — oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics”.

The stranded asset concept has initiated a new programme at the Smith School of Oxford University which considers stranded assets across a range of sectors from an academic perspective. From a financial perspective, accountants have measures to deal with the impairment of assets (e.g. IAS 16) which seek to ensure that an entity’s assets are not carried at more than their recoverable amount.