Financial risk in a carbon constrained world


In his latest column for Salt, Sam Gill, CEO of ET Index, explains the concept of carbon risk and the future decrease in profitability of high-carbon companies.

If ‘climate risk’ is the probability of climate catastrophe occurring then ‘carbon risk’ is the probability that investments in high carbon companies and assets will lose value as we transition away from fossil fuels and move towards an increasingly carbon constrained world.

The most famous argument is the ‘carbon bubble’ idea. This is comes down to three simple numbers. The first, is 2 degrees celcius. This is the internationally agreed ‘safe’ limit of global warming beyond which we should not go. This reason for this limit is that once surpassed, the chances of climatic feedback loops kicking in increases dramatically. For example, if the world’s oceans suddenly become net emitters of carbon instead of absorbing carbon, we are in serious trouble as things could move very quickly and we could easily be looking at temperature rises far beyond 4 or 6 degrees.

To avoid this limit we have a total ‘carbon budget’. Given we have already used up a third of the Carbon Tracker’s estimated 50 year budget within the first decade of this century, we now have approximately 565 billion tonnes of carbon dioxide equivalent (tCO2e) left. However, the amount of carbon embedded in the fossil fuel reserves of the largest 200 listed oil, gas and coal companies represents around 2,795 billion tCO2e, a number almost five times greater. Harking back to the previous post about ‘climate change risk’ this would still give us a 20 per cent chance of not exceeding 2 degrees and potentially triggering runaway climate change. Would you get in a car that had a 1 in 5 chance of crashing? Not great odds.

As governments move to limit global warming there is a strong possibility that these assets will become stranded, leading to significant write-downs in the value of the underlying stocks holding them. Equally if investors fear that a significant write-down could occur, this could be enough to bring about a sharp drop in demand for fossil fuel company shares, and indeed carbon intensive stocks more generally, necessitating a sharp decline in price. Stampedes don’t tend to be orderly affairs. One only has to look at the decimation of coal stock prices in recent years to see how this may unfold.

But it is not just about physical carbon assets becoming stranded. There are now over 60 national and sub-national jurisdictions around the world that are putting a price on carbon. And with the world’s three most powerful economic blocs, China, the US and the EU, all committed to curbing emissions, it’s clear which way the trend is going. As regulation of carbon emissions increases, the profitability of high-carbon companies will suffer.

There are two final points to consider from the financial ‘carbon risk’ point of view.

The first is that if the next bubble brewing within the economy is a carbon one, given how widespread carbon is, what kind of global economic shock could ensue? Analysis from HSCB suggests that equity valuations of fossil fuel companies could be reduced by 40-60 per cent in a low emissions scenario. But as we know, sectors tend not to exist in isolation from their supply chains, or indeed the wider economy, and therefore it is unlikely that such write-downs would be limited to only fossil fuel stocks.

The second point is to consider the financial implications of a 4-6+ degree world (our current trajectory). Will our global geopolitical-economic system carry on as normal without suffering any serious losses? That is extremely unlikely and it likely to negatively affect investment returns.

For the prudent investor reducing exposure to ‘carbon risk’ individually while helping reduce exposure to ‘climate change risk’ collectively is the only sensible option. The difference between these two approaches will be explored further in the next post.



Photo credit: Overseas Development Institute from Flickr