October 2, 2014

Carbon Bubble

Diversify beats divest

pic for carbon bubble

As investors are integrating climate change impacts in investment decisions, fossil fuel-reliant companies should diversify their energy sources. This will sustain company valuations and manage future cost of capital.

Carbon bubble. Divest movement. Unburnable carbon. Stranded assets. These are recent additions to the Bay Street executive’s vocabulary as well as any company board director whose company is involved in the extraction, processing and distribution of coal, petroleum and natural gas. From having been a term previously used by fringe climate change activists, the mainstream investor is now taking note. With climate change awareness on the rise, companies in all industries need to seriously test the robustness of their business models to ensure future shareholder value.

Companies in the fossil fuel industry may face serious limitations in how much of their carbon-based resources they can monetize as climate change regulation forces governments to limit greenhouse gas emissions, and that has major investors concerned. With stock market valuations based on reserves of coal, petroleum and gas deposits, investors may hold portfolios that will significantly decrease in value as 1) restrictions make extraction unprofitable or 2) alternative energy sources become more economically viable.

Many significant investors, including the national Norwegian and Swedish pension funds and the university endowments of Harvard and Stanford University, have recently adopted restrictions in their portfolios’ exposure to coal and other fossil fuel assets. In November 2013, Goldman Sachs divested its equity share of a new coal terminal to be built in Washington state. Moreover, the global investment giant BlackRock teamed with the FTSE Index Group in May to create a fossil-fuel-free index to track the performance of non-carbon exposed portfolios. Serious investors are taking action and managing their exposure to the carbon bubble. This leads us to pose the question – “What are the implications for companies that are dependent on capital markets?” Will investors move away from companies which are heavily reliant on carbon-based fuels or weight portfolios towards the ones that are most “carbon lean” or that diversify into low-carbon energy?

According to the Financial Times, there is currently $670 billion invested in the fossil fuel industry, of which a large share of value could be at risk. There is no exact figure of the total capitalization of companies whose value chains rely on access to inexpensive fossil fuels, but it is presumably in the tens of trillions. Producers of steel, cement, paper, glass and metals are heavy users of coal and natural gas. Most North American rail and truck operators use diesel as their primary energy source. Diesel and gasoline power most agriculture equipment. In many parts of the world, real estate is dependent on natural gas for space and water heating. And a large share of electricity producers are heavily weighted towards coal and gas in their generation mix.

How will these sectors be exposed to carbon restrictions? Even if companies will still be able to access fossil-based fuels, the expectation is that energy costs will increase significantly compared to alternative energy sources that continue to fall in price. Will these companies be able to compete with peers investing in more efficient technologies and alternative energy sources? Will investors discount these companies’ share prices or increase the risk premium in financing and lending decisions? Or will investors simply restrict investments to top-sector performers?

With so many unknown parameters, what strategies should you consider to evaluate more sustainable business models and hence minimize future risk of increased cost of capital? The following suggestions ensure that you and your management team have done the strategic research and analysis that will equip you to make better decisions and answer questions from board members and stock analysts:

  • Incorporate climate change and carbon restrictions in your risk matrix and integrate in your strategic plan
  • Map your company’s dependency on fossil fuels both in internal operations and in the supply chain
  • Benchmark your carbon intensity – carbon emissions per production output or revenue – relative to a set of your competitors
  • Perform a scenario analysis of your exposure to both fuel supply limitations and changes in input costs
  • Consider where you can decrease dependency of finite energy resources by energy efficiency investments and use of renewable energy
  • Incorporate a carbon “shadow price” in investment decisions to consider higher future energy costs

In conclusion, stranded assets are being seen as a realistic scenario and investors will evaluate risks relating to carbon exposure. How can your company take steps to mitigate this risk and contribute to the transition to a low-carbon economy?

Sustainability Qncepts

This is the first note in our series Sustainability Qncepts Explained. For further insights on managing the risk of stranded assets or effectively responding to requests from investors concerned about the carbon bubble, please contact us.

Carbon Bubble by the Numbers

Annual global greenhouse gas emissions from fossil fuels (2010)30 Giga tonnes
Total greenhouse gas emissions from current reserves of all public and private companies (excludes potential reserves)2,900 Giga tonnes
Total greenhouse gas emissions from current reserves of TSX -listed companies33 Giga tonnes
Capital invested in fossil fuel industry in 2013$ 670 billion
Capital invested in the Alberta Oil Sands in 2013$ 33 billion
Price of one barrel of oil 1964 vs 2014 (inflation adjusted)$ 20 vs $106
Cost to produce one watt of solar electricity 1974 vs 20127667 vs 74 cents