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CantheCarbonBubblebecomea seriousFinancialBubble? Backgroundbriefingpaper JorgeNúñezFerrerandPavelKiparisov, CEPS Abstract Thecarbonbubble-thenotionthatasignificantamountoffossilfuelreservesmustbeleftinthegroundif wearetokeeptothe2degreesglobalwarmingthreshold-isbecomingincreasinglyacceptedby policymakers.Thecarbonbubblehassignificantimplicationsforfinanceandinvestment,particularlywithin thefossilfuelsector.Therefore,itisfinancialpolicymakersandregulators,inadditiontothoseintheclimate andenergycommunities,whoneedtoconsideritseffects. Thenotionofthecarbonbubbleoriginatesfromthesciencebasedfactthat–ifwearetokeeptothe 2oCglobalwarmingthreshold–asignificantamountoffossilfuelreservesmustbeleftintheground.A recent estimate, which has been published in Nature1, 80% of current coal reserves, a third of the oil reservesandhalfofthegasreserveswouldhavetoremainunuseduntil2050. Thefinancialrepercussionsofthecarbonbubblehavebeenaconcernforanalystsforsomeyearsbefore this Nature publication. In 2011 a Carbon Tracker Report in 20112 brought to the attention of the financialmarketsthatthewaythemarketwasvaluingcarbonassetsignorestheneedtokeepthefossil fuelsunderground,thusinvestorsbasetheirinvestmentsonthevalueofreserveswithoutconsidering theneedtolimittheiruse.Thetop100companieshavethetop100listedcoalcompaniesandthetop 100listedoilandgascompaniesrepresentpotentialemissionsof745GtCO2,andthereportestimates that565Gtcanbeemittedbasedoncertainassumptionsonthelevelofemissionspermittedunderthe 2oC scenario. The stock market lists approximately 1.500 oil and gas firms with assets over 4.5trn US dollarsandabout275coalfirmsworthover$230bn.AnewestimationbyHSBCof20123arguedthat fossilfuelcompaniesaltogetherwouldseetheirmarketvaluefallbyhalf(worth$2trillion)incasethey wereforcedtoremovethese'strandedassets'.Thiswouldbemorethanthevalueof2008lossesthat triggeredtheGlobalFinancialCrisis.A2013reviewbyCarbonTrackerreachessimilarconclusionstothe 2011 study, but with a deeper analysis and wider ranges and scenarios. Conclusions do not vary substantially. That fossil production constraints may well be developing soon can be inferred from some political developments.TheG7leadersrecentlystatedinJune2015thatdeepcutsingreen-housegasemissions areneededandthattheglobaleconomyshouldbedecarbonisedinthecourseofthiscentury,with70% ofthisdecarbonisationby2050.Suchapoliticalstatementislikelytohaverepercussionsininvestment decisionsinfossilfuels,bettingthatthepoliticalworldwillremaininactiveisgettingriskier. Thedevelopmentsintheenergysectorarealsodifficulttopredict,withdisruptivedevelopment,suchas shale gas or technological change to a large extent driven by governments (e.g. renewable energy, storage).Thisaggravatestheuncertaintyoflongtermfossilfueldemand. AccordingtotheFT4,investmentfirmsarestartingtoconsiderfossilfuelassetsasrisky.Thenumberof investors divesting from fossil fuel assets is increasing. The most significant event in this direction has beenfromAXA,oneoftheworldlargestinsurers,whenitrecently(May2015)announcedthatisselling its shares in coal companies, starting with $559 million now to up to $3 billion by 2020. AXA has declaredthatthedamageriskofclimatechangeimpactswillhaveverylargeimpactsonitsoperations and its financial stability. Investing in fossil fuels would be inconsistent with the operations and the future of the company. Impacts of a 2oC increase in temperatures would in fact threaten the sustainability of insurance companies. Other funds are divesting in fossil fuels, for example the 1 McGladeC.andEtkinsP.(2015),‘Thegeographicaldistributionoffossilfuelsunusedwhenlimitingglobal o warmingto2 C’,letter,Nature,vol517,8January2015,pp.187-203 2 CarnonTrackerInitiative(2011),‘UnburnableCarbon–Aretheworld’sfinancialmarketscarryingacarbon bubble?’ 3 HSBCGlobalResearch,‘Coal&Carbon,Strandedassets:assessingtherisk’,June2012 4 FT,Fossilfuelinvestmentswidelyseenas‘risky’,8June2015 RockefellerBrotherFund5ortheNorwegianSovereignFund6,agrowingnumberofcitiesinEuropeand theUS7.Thismovementhasnotyetreachedanysizethreateningthecoalandoilcompaniesyet. Meanwhile,sluggishdemandandlowpricesforoilandcoal,oilandgas,hasreducedthevalueassetsin the sector putting pressure on more expensive producers. A number of assets are presently already ‘stranded’, such as some north-sea platforms and other costly oil sources. Prices are not expected to increase in the short run. If to this we add an agreement of major economies to decarbonise, the specterofacarbonbubblegeneratingalargefinancialbubblecouldbecomeareality.Butdependingon the speed and size of the changes, as well as overall value of the companies involved, results can be considerablydifferentdependingonthescenarios.Afterallmediumtermoilpriceshockshaveoccurred inthepastandthisonemayjustbecyclical. InaBankofEngland’sofficialstatement,PaulFisher,DeputyHeadofthePRAandExecutiveDirectorfor Supervisory Risk and Regulatory Operations warned that “investments in fossil fuels and related technologies–agrowingfinancialmarketinrecentdecades–maytakeahugehit”.Healsostatesthat thereare“specificexamplesofthishavinghappened”.8Ifgovernmentsdotakeclimateactionseriously muchoftheinvestmentsoverthelastyearsinnewfossilfuelsourceswillleadtolosses,i.e.stranded assets. HowseriousistheCarbonBubblerisk? The “Carbon Bubble” arguments are largely a construct, which depends on policy developments. The commitmenttoprinciplesandtheimplementationoffossilfueldivestmentmeasuresonagloballevelis questionableinthenearfuture. Peter Helm in his recent Energy Futures paper9 considers the carbon bubble theory too simplistic, in particular a new interpretation based on initiatives to divest in the sector. He argues that the climate policy,divestmentandevenchangesintheenergysectorhavelittletodowithpresentlossesbyfossil fuelcompanies.Itismainlyanimpactfromeconomicslowdownand/oroversupply.Hearguesthatas longasthereisnocarbonpricetheCarbonBubbleissueisoverstated.Currentlowfossilfuelpricesarea resultofacommoditypricecycle. Healsowarnsofthecontradictoryeffectsoflowpricesinoil.Ontheonehanditisareflectionoflower demand,butifpricescontinuetofallwithoutabigdecreaseindemand,producersmaystartincreasing supply to sell quickly. This will drive oil prices lower and not reduce in the short run production, but increaseit,whileslowingdownchangeintocleanertechnologies.Coalreservesarealsoveryhighand abletoexpandatlowprices. Therelationshipbetweeninvestments,assetvaluations,prices,technologicalchange,publicpolicyand production requires further analysis. The impact on investors may not be as high, as sometimes portrayedbecausefossilfuelassetsareoftenownedbythegovernments.Inothercases,investorshold 5 http://www.rbf.org/about/divestment http://gofossilfree.org/norways-divestment-is-great-news-but-this-is-the-last-moment-to-be-complacent/ 7 forexampleSanFranciscoorSeattleintheUSAorOsloinEurope.TheLondonAssemblyvotedfordivestmentin Aprilthisyear,butthedecisionhasnotbeenyettakenbytheLondonAssembly 8 ‘Confrontingthechallengesoftomorrow’sworld’-speechbyPaulFisher’,3March2015. 9 HelmD.(2015),‘StrandedAssets-adeceptivelysimpleandflawedidea’,EnergyFuturesNetwork,22October 2015 6 diversified diversifying portfolios exactly to reduce excessive exposure to risks due to changes in the fossilfuelsector. KeyIssues • While addressing the climate change challenge will require that no more GHG emissions will be emitted, a lot of uncertainty about the scale and the pace exists. Carbon capture and storage or moregenerally,sequestrationwillinfluencethisrate. Therewillbesectoraldifferencesbetweencoal,oilandgasbothbetweenespeciallyregardingthe paceandpossiblythescale. TheriskofaCarbonBubbledependsalsoonwhoholdstheassets,e.g.governmentsorfirmsand howdiversifiedtheinvestorsare. With divestment taking place already, the pace of divestment will be important to the risk of a burstingbubble. Thecarbonbubblemayalsobegeneratedbydisruptivetechnologies. • • • • Scenariosmayvaryconsiderably,forexample: • • • IfpoliciesareputIplacetocurbemissions(suchascarbonprices)thereisariskofanimpacton marketsduetostrandedassets,buthowhightheimpactisunclear. Ifpricesremainlowwithoutefficientpoliciestoaddressclimatechange,wemayendhavingthe inconveniencesofstrandedassetsinadditiontoahighrateofcheapfossilfuelextraction.This mayhappenifdisruptivetechnologiesenterthemarketsufficiently.Cheepfossilfuelextraction thencouldlimittheadoptionoflowcarbontechnologies. Pricesoffossilfuelmayincreaseduetotheendofthefinancialcrisisorotherfactors,leadingto anincreasedemandandmoreoilextraction.Nomorestrandedassets,buthigherclimaterisks. The issue of concern is the lack of any transitional strategy for the sector in the path to a low carbon economy. If the decarbonisation strategies for 2050 are intended to be achieved, then some orderly transitionmaybeneededinthefossilfuelsector.Inadequate,conflictingorslowresponsestoclimate changeininvestmentandfinancecanentailrisksthatcouldbeavoidedunderamoreorderlytransition.