A rethink in how markets value carbon-based fuel reserves is urgently required
In July the Carbon Tracker Initiative published a new report: Unburnable Carbon – Are the world’s financial markets carrying a carbon bubble? The report makes two basic points.
First we cannot burn all available fossil fuel reserves if we are to meet climate change targets. And second, this fact is ignored by financial markets, in which all fossil fuel reserves (including those that we will not be able to burn) add value to the share price of the companies that own them.
Can’t keep burning
At the Cancun climate summit in December 2010, politicians agreed on the need to limit global warming to 2C.
Scientists at the Potsdam Institute for Climate Impact Research suggest that the carbon we can afford to release in the 40 years to 2050 to give us a good (80%) chance of meeting this target sits at 565 GtCO2e (billion tonnes of carbon dioxide equivalent greenhouse gases).
However, the Carbon Tracker Initiative’s report states that should all the fossil fuel reserves held by the top 100 listed coal firms and top 100 listed oil and gas firms listed be burnt, 745 GtCO2e would be released into the atmosphere.
Furthermore, the burning of all known fossil fuels reserves (including the above and also reserves held by private and state-run companies) would create 2,795 GtCO2e.
Burning these reserves would take us five times over our self-imposed limit on carbon emissions. Clearly, if we are to meet, or even come close to reaching, our target, a large proportion of these known fossil fuel reserves will have to stay in the ground.
Attaching a value to this unburnable carbon has, say the authors, created a “carbon bubble”.
Coal firms and oil and gas firms are currently valued on their proven reserves, but when the carbon limit bites and these proven reserves cannot be extracted, the value of these companies will tumble.
How big is the issue? London, Australian and Toronto stock exchanges have up to 30% of their market capitalisation linked to fossil fuel extraction. In London, over 70% of IPOs in the first half of 2011 were mining companies. The potential losses involved are huge.
This is an indication of systemic issues in the way the stock markets work. Short-termism and ignorance of the future “burn-ability” of fossil fuel assets mean investments are based on misleading valuations.
If emissions reductions targets are adhered to, these companies will be left with worthless stockpiles of “unburnable” fuel, up to 2,230 GtCO2 of it.
Bubble too big?
It’s widely thought that the likelihood of remaining within-budget over the coming century is low, thus the volume bubble described in the report may have been overestimated.
Research by the UK Met Office has already described the possibility of 4C of warming before the end of the century if no action is taken to significantly reduce greenhouse gases.
With the future of the Kyoto protocol uncertain and Europe, which has for so long led the move to more stringent targets, rejecting an increase in its energy efficiency targets, a higher than 2C level of warming is possible.
Moreover, technologies such as carbon capture and storage (CCS) may come online and reduce the atmospheric emissions from the fossil fuels that we burn – instead locking it underground.
There is truth in both of these points, but given the sheer size of the bubble, investors and pension-holders ought to remain uneasy.
To tackle the issue, the report authors suggest increasing the amount of publicly available information and using this information to change the way companies are valued.
Until now the focus of carbon reporting has been on past emissions, and in particular operational emissions. However for coal firms and oil and gas firms, future emissions associated with the burning of fossil fuel reserves seem most crucial.
The Coalition for Environmentally Responsible Economies (Ceres) and the Institutional Investors Group on Climate Change (IIGCC ) have produced templates to guide emissions reporting by oil and gas firms, yet they are largely ignored. BP previously reported emissions potentials but negative press around the size of their figures put them off.
Pushes to make reporting on future emissions mandatory should be high on political agendas to overcome the reluctance of fossil fuel firms to disclose such information. Merely incentivising emissions disclosure may not be enough.
One thing the report does not directly suggest is that investors divest from companies valued highly due to unburnable fossil fuel assets and instead focus on investments that will both reduce our reliance and fossil fuels and protect investors against the carbon bubble.
Low carbon and renewable energy often come with a riskier reputation than tried-and-tested coal, oil and gas, but given the size of the carbon bubble that might not be the case for much longer.
Mechanisms to bolster the clean energy industry could reduce the risk for investors, easing the carbon bubble and allowing it to gently deflate.
Intolerable warming and market failure are clearly extreme outcomes and it is likely that middle ground may be reached that avoids environmental and economic disaster.
But one thing is clear: we need to fundamentally change the way that fossil fuel companies are valued and the way they report to prevent catastrophe one way or another.
Jane Burston is founder of Carbon Retirement.