Stranded Carbon Assets

The Generation Foundation released today a new report: Stranded Carbon Assets: Why and How Carbon Risks Should Be Incorporated into Investment Analysis (pdf).

It builds on the logic that globally, we have a fairly accurate idea of the maximum amount of carbon we can add to the atmosphere and still have a 50/50 chance of avoiding temperature rises of 2 degrees Celcisus.  To stay within that budget we can't burn more than one-third of known reserves by 2050.

This means that 2/3 of known reserves -- which are baked into the valuations of fossil fuel companies -- will need to be stranded, one way or another, to even have a 50% chance of avoiding really devastating impacts of climate change.

The report lays out three ways these assets may become stranded:

1. Regulation -- there are many forms of regulation being pursued around the world limit carbon emissions, but to date most investors have focused primarily on the big, international climate agreements, which have been stalled. Sub-national and indirect regulations represent investment risks that are under-appreciated by most investors.
2. Market forces -- improvements in renewable energy and the potential for breakthrough innovation can cause shifts in capital away from fossil fuels
3. Sociopolitical pressures -- even if they don't lead to comprehensive regulation right away, sociopolitical pressures threaten carbon-intensive business's license to operate 

If the status quo is maintained, the report argues, artificially high valuations of carbon-intensive assets will continue to grow, creating a 'carbon asset bubble' that is not sustainable. 

The report suggests that investors should: 

1. Identify carbon risks across all asset classes in their portfolios
2. Engage corporate leaders on disclosing and mitigating their carbon exposure
3. Diversify their holdings into companies that will bring about a low-carbon economy
4. Divest from fossil fuel intensive holdings

Examples of growing support for regulatory action are everywhere.  The EU Emissions Trading Scheme has been established for years, California has carbon legislation on the books in AB32, as do the Northeastern states through the Regional Greenhouse Gas Initiative. China is launching regional carbon markets, and this summer President Obama laid out plans to limit emissions in the US. Last week, Oregon, Washington, California and British Columbia (which has its own carbon tax) announced plans to cooperate on developing climate protection schemes. 

While we don't know for sure how we will end up limiting carbon emissions, we do know we'll have to if we want even a 50/50 chance of avoiding unthinkable impacts, which will be costly not only in financial terms, but also with regard to loss of human life and suffering.  

The report includes an excellent analysis of how indirect impacts -- like water scarcity -- also pose risks to carbon-intensive assets. Oil and gas extraction and coal power plants rely on large amounts of water, and will will become more costly and difficult as water scarcity (exacerbated by climate change) continues to grow. 

Renewable energy is becoming more competitive, supported by government policy and market forces. In 2007, the installed price of solar was $8 / watt, compared to just $3.05 / watt in the second quarter of this year. 

Perhaps most importantly, the report stresses the potential costs of maintaining the status quo. Most businesses will suffer great losses in a future defined by climate havoc: "Inaction, therefore, is a systemic and salient risk to all investors." 

In laying out options for actions investors should take, the report makes the case for evaluating carbon risks in portfolios and engaging with corporate executives and boards (leveraging tools like the Sustainability Accounting Standards Board (SASB); the Carbon Disclosure Project (CDP); and Integrated Reporting).  It quotes Mercer's Responsible Investment group in encouraging investors to "think about diversifying across sources of risk rather than across traditional asset classes." 

And it offers a nuanced approach to divestment from a risk-mitigation perspective, as opposed to a moral perspective emphasized by activist campaigns calling for divestment, noting that it's not "all or none" when it comes to divestment. There is a "hierarchy of fossil fuel asset stranding" and investors would be wise to recognize that and abandon positions with the highest risks. 

This section ends with a paragraph focused on college and unviersity endowments, which is worth quoting extensively: 

"We fully recognise that divesting can be complicated, both ethically and logistically, for asset owners. College and university endowments, for example, must prioritise intergenerational equity to ensure future students have at least the same resources afforded to current students in order to maintain and enhance the calibre of the institution. Additionally, many of these endowments participate in comingled investment vehicles, delegating complete control of asset selection to the hired fund managers. However, the investment committees of these endowments must not dismiss divestment due to the complexity inherent in outsourcing fund management since carbon risk is significant and only growing... Furthermore, academic institutions in particular are in the unique position to heighten the level of scholarly discourse around fossil fuel risk and the transition to a low carbon economy by integrating these topics into the classroom and across campus life."

Stay going. 

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