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Unseen Risks in Fossil Fuels May Leave Assets and Investors “Stranded”

What do coal, oil and gas companies have to lose from efforts to prevent climate change?

Apparently a whole lot.

In 2010, at the UN Climate Change Convention (UNFCCC) in Cancun, governments from around the world met to “establish clear objectives for reducing human-generated greenhouse gas emissions over time to keep the global average temperature increase below two degrees Celsius.” To keep global temperature increases below two degrees Celsius, models by Carbon Tracker, the EIA and the London School of Economics estimate that global CO2 emissions must be limited to under 565-1,075 Gt CO2 (billions of tons of CO2) until 2050. However, this limit is only a fraction of the carbon embedded in the world’s fossil fuel reserves, which amounts to 2,860 Gt CO2.

This means that only around a third of fossil fuel reserves would be able to be burned before 2050.  Furthermore, these emissions targets provide for an allowance of only 75 Gt CO2 for the second half of the 21st century, leaving more than two thirds of fossil fuel reserves unusable until 2100. According to Carbon Tracker, compliance with these goals would waste close to $7 trillion in fossil fuel industry capital expenditure. These unusable reserves, and the equipment deployed to exploit them, are known as stranded assets and could have large, negative implications for equity valuations.

But how have oil companies responded to international targets for CO2 reduction and the growing presence of renewables?

It appears they have done little to nothing.

In 2000, The Intergovernmental Panel on Climate Change (IPCC) released a report detailing 40 different outcomes in six different scenarios to determine possible future CO2 emissions and temperature increases. At one extreme is scenario A1FI that assumes “very rapid economic growth, global population that peaks in mid-century and declines thereafter, and the rapid introduction of new and more efficient technologies but a continued reliance on fossil fuels”. The upper end of this model coincides with Exxon’s 2013 annual energy outlook, which anticipates large population growth in the developing world and that in 2040 fossil fuels will still provide over 80 percent of global energy generation.

Unsurprisingly enough, Exxon’s projections of energy use have global CO2 emissions hitting approximately 1,100 Gt CO2 in 2050, almost guaranteeing a two degree rise in global temperatures. However, two other IPCC scenarios, with similar GDP growth rates in the developing world and large population increases, project much lower carbon emissions.

Scenario A1B assumes a more even blend between renewable and fossil fuel use whereas scenario A1T assumes a shift towards renewable dominance–both of which substantially reduce CO2 emissions. The gap between government goals and Exxon’s projections means that something has to give. Either global governments stick to their plan of maintaining a global temperature increase under two degrees mainly through the shift to renewables from fossil fuels, or global governments fold to the oil and coal companies and allow global climate change to continue mostly unabated.

How would governments enacting a carbon budget affect equity valuations of fossil fuel companies?

A carbon budget could leave up to $7 trillion in stranded assets worthless, resulting in massive declines in these companies’ equity valuations.

Currently oil companies’ valuations are still dependent on the belief that governments will do little to stop climate change and that renewables will only capture a small portion of the energy market. For example, Exxon believes less than 15 percent of global energy in 2040 will be from renewable sources. However, if this belief is wrong, and renewables prove to be the disruptive technology that even utilities think they could be, there is now an immense amount of risk in being invested in fossil fuel companies.

HSBC Holdings estimates, to uphold climate targets, energy supply mix must shift from 81 percent reliance on fossil fuels today to just 43 percent by 2050, creating a 40-60 percent downside in the market capitalization of most oil and gas companies. This makes traditional investments in oil and gas companies seem much riskier and the prospects for return on investments in solar and renewables a little bit brighter.

(Image courtesy of Richard Dudley)

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