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 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?