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Chart of the Day: a new sub-prime ‘bubble’ threat
A 'carbon bubble' could render worthless much of the assets held by some of our biggest companies.
by Chris Marshall on Jan 20, 2012 at 11:22
Up to 80% of the assets held by energy companies could turn out to be useless, knock-down sub-prime junk.
If we are to keep global warming below 2°C – a goal reaffirmed by politicians at December's Durban climate meeting – then between 2000 and 2050 we can get away with emitting 886 gigatons of carbon dioxide (GtCO2) between us. Now, we’ve used a lot since 2000, leaving a ‘Carbon Budget’ of 565 GtCO2 for the remaining years to 2050. But the world’s biggest oil and gas companies have fossil fuel reserves representing potential emissions of 745 GtCO2.
That’s just listed companies. Then there are resources held by state bodies. Of the total reserves held between the two only 20% can be used if we are to meet the 2°C limit. If this 20% rule is applied uniformly, then only 149 of the 745 GtCO2 held by listed companies could be used unabated. The rest remains in the ground.
Comparison of the global 2°C carbon budget with fossil fuel reserves CO2 emissions potential (Source: Carbon Tracker Initiative)
Those calculations are from a report last summer from the Carbon Tracker Initiative which included several recommendations, including for a review of the way in which resource companies are valued.
• Working with capital market regulators and investors to assess systemic climate change risks and propose practical measures to minimise these risks to market stability and the operation of an orderly market.
• Revisiting the way fossil fuel companies are valued including the accounting treatment of fossil fuel-based reserves to ensure that carbon limits are fully integrated;
• Evaluating the concentration risk facing key global markets which are currently over-weight fossil fuels (such as the UK), and how indices, benchmarks and tracking products can be reformed to protect investors
• Improving the quality and utility of disclosures required by regulators and listings authorities to ensure that future carbon risks associated with fossil fuel reserves are fully dealt with to enable investors to make informed decisions;
• Updating the way fossil fuel companies are brought to the capital markets by investment banks.
But now those worried that the next bubble in financial markets will be a carbon-based monster are appealing directly to a man who is being loaded with increasing responsibility for ensuring the financial stability of the UK: Mervyn King.
In an open letter to King, a group of more than 20 signatories make a striking point to accompany the calculations in the summer report: ‘Five of the top ten FTSE 100 companies are almost exclusively high carbon and alone account for 25% of the index’s entire market capitalization’ – that'd be BP (BP.L), Shell (RDSb.L) and the like.
Sir Mervyn King
Chairman, Financial Policy Committee
Bank of England
London EC2R 8AH
Dear Sir Mervyn King,
The Financial Policy Committee (FPC), which you chair, was recently created to, “contribute to the Bank’s financial stability objective by identifying, monitoring, and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.”
As the FPC develops its forward work programme, we urge it to investigate how the UK’s exposure to high carbon investments might pose a systemic risk to our financial system and what the options might be for managing this potential threat to our economic security.
The depth and breadth of our collective financial exposure to high carbon, extractive and environmentally unsustainable investments could become a major problem as we transition to a low carbon economy. Five of the top ten FTSE 100 companies are almost exclusively high carbon and alone account for 25% of the index’s entire market capitalization1. This exposure is likely to be replicated in other indices, by companies, in bank loan books and in the strategic asset allocation decisions taken by institutional investors. At present regulators are not monitoring the concentration of high carbon investments in the financial system and have no view on what level would be too high.
As policy and technology work consistently over time to reduce returns in high carbon areas while supporting low carbon ones, investing in high carbon sectors, say as an institutional investor looking to generate good returns over a 20 to 30 year period to successfully cover future pension liabilities, could result in stranded assets and poor returns. Counter intuitively, institutional investors, as well as banks, companies, mutual funds and retail investors, continue to risk exactly that by deploying significant amounts of capital into high carbon sectors, or in companies with significant exposure to them. This contradiction was observed in recent Financial Times and Guardian opinion pieces, one of which was written by the leading economist Lord Stern2. This could be another example of our capital market fundamentally mispricing assets and, as a result, building up a systemic risk that threatens long term growth.
For many investors an exposure to high carbon and environmentally unsustainable assets is not an active or an informed decision. Instead it is frequently driven by the fact that a large proportion of capital must flow into funds that aim to track the main indices. Many investors have little choice but to do this due to liquidity requirements and the desire to track average market performance. Moreover, new regulatory requirements, such as Basel III and Solvency II, can make it more difficult for investors to deploy capital into longer term assets, such as low carbon infrastructure, and simpler to invest in the status quo, even though there might be significant appetite to do the opposite. In such situations we believe that regulators have a role to play in protecting investors from systemic risk.
To understand the extent of the potential problem we need to assess global, and particularly UK and European, financial exposure to high carbon, extractive and environmentally unsustainable investments. While the exposure of listed companies is beginning to be understood3, that of non-listed companies, bank loan books and institutional investor portfolios is significantly less appreciated.
We then need to look at how exposure and relative values, between high carbon and low carbon investments, could change over time and how this might affect different parts of the financial system and the system as a whole. For example, how might a sudden change in relative values be different from a longer period of transition? The purpose of this work should be to evaluate the health, soundness and vulnerabilities of the financial system as we proceed with a low carbon transition.
After these studies are completed, we need to develop a strategy that could manage the challenges that might arise as a result of an over-exposure. If this is indeed akin to a systemic risk in our financial system, what macroprudential instruments might be designed and deployed to help to restrain the build-up of risk? Could we change the risk-weightings used to calculate capital requirements? Could we use different discount factors for high carbon investments? What steps can be taken in each part of the financial system? What is the role of regulators – nationally and internationally? What might we do to create sustainable, low carbon alternatives for investors with the right risk-reward profiles? And how could we predict and manage the risks associated with sudden changes in exposures and relative values?
Given its significance over the long term, we hope that the FPC can incorporate this work into its forward programme, with the appropriate expertise and personnel. There are also a variety of organisations, such as the Carbon Tracker Initiative, Oxford University’s Smith School of Enterprise and the Environment, Climate Change Capital, the London School of Economics and Anglia Ruskin University’s Global Sustainability Institute, that are working in this area and they would be able to develop collaborative partnerships with the FPC to help enhance resilient low-carbon economic development, as well as reduce systemic risk in the UK financial system.
We look forward to hearing from you and the Committee in due course.
Yours sincerely,Paul Abberley
Aviva Investors London and Global Investment SolutionsPeter Ainsworth
Chairman, Conservative Environment NetworkBen Caldecott
Head of Policy, Advisory
Climate Change CapitalCatherine Cameron
Agulhas: Applied KnowledgeJames Cameron
Founder and Vice-Chairman
Climate Change CapitalPaul Ekins
Professor of Energy and Environment Policy
UCL Energy Institute, University College LondonZac Goldsmith MP
Member of Parliament for Richmond Park & North KingstonThe Rt Hon. John Gummer, Lord Deben
Former Secretary of State for the EnvironmentCatherine Howarth
FairPensionsDr Aled Jones
Director, Global Sustainability Institute
Anglia Ruskin UniversityMark Kenber
The Climate GroupSir David King
Director, Smith School of Enterprise and the Environment
University of OxfordJeremy Leggett
Solar Century and Carbon Tracker InitiativeNick Mabey
Greenpeace UKPenny Shepherd
UK Sustainable Investment and Finance AssociationPaul Simpson
Chief Executive Officer
Carbon Disclosure ProjectMatthew Spencer
Green AllianceDimitri Zenghelis
Senior Fellow, Grantham Research Institute
London School of Economics & Political Science
The collection of signatories adds: ‘This could be another example of our capital markets fundamentally mispricing assets and, as a result, building up a systemic risk that threatens long term growth.’
The group warn that long-term institutional investors such as pension funds may find that if they continue to invest in unsustainable areas they are left holding ‘stranded assets’ with poor returns.
The argument is compelling. But the risk is that UK regulators – faced with so many immediate concerns – will dismiss the concerns as green, conspiratorial and bonkers (albeit not in so many words).