Some regulatory and economic forces are calling into question the business models of some of the world’s largest oil and gas, coal and electric power companies, and posing a new kind of risk to the investors who own them. Variously described as “unburnable carbon,” “carbon asset risk,” “stranded assets,” “peak carbon,” or the “carbon bubble,” this issue has recently become a hot topic among institutional investors, energy analysts, the International Energy Agency (IEA) and a handful of NGOs—and as a result, some of the world’s largest energy companies.
According to the International Energy Agency and UK NGO Carbon Tracker Initiative (CTI), 2/3 of the current proven carbon reserves of the world’s publicly listed fossil energy companies need to be left in the ground to avoid warming exceeding 2 degrees. Yet according to CTI, these oil, gas and coal companies spent over $650 billion in 2012 to explore and develop new reserves. If these reserves are substantially unusable, or if their use causes catastrophic change, this business model and strategy are unsustainable.
The “unburnable carbon” thesis is based in part on the premise that governments will take action to restrict GHG emissions to avoid catastrophic climate change. Alternatively, global demand for fossil fuels may peak and decline due to a combination of advances in energy efficiency, switching to renewables and cleaner fuels (e.g., from coal to gas), and environmental regulation generally.
These regulatory and market forces, in combination with energy companies’ varying production costs for conventional and unconventional (e.g., tar sands, hydraulic fracturing, deepwater drilling) resources, are predicted to cause high cost producers’ reserves to become “stranded assets.” Indeed, we are already seeing some stranded assets in the U.S. coal industry, where demand— and share prices —have fallen significantly. Proven, producible reserves are a key determinant of the market valuation of fossil energy companies. If the “unburnable carbon” theory is even partially valid, some of these companies’ valuations are at risk.
Based on concerns about “Carbon Asset Risk,” in September 2013, 70 institutional investors, who collectively manage assets of nearly $3 trillion and own substantial shares of major energy companies’ stock, sent letters to 45 of the world’s largest oil & gas, coal and electric power companies inquiring about their exposure to this issue. The letters asked the companies to do scenario analyses on the impact on their business of regulations that would limit global warming to 2 or 4 degrees Celsius, to assess their capital expenditure plans for reserve development under differing demand scenarios, and also to assess the impact of unmitigated climate change on their operations, and to share the results of these analyses with their investors.
More than 30 of the recipient companies have made initial responses, ranging from agreeing to do the requested analyses, to requesting clarification on what the investors are seeking. Others claim they have fully assessed these risks, or dismissed the requests and underlying concerns as totally unfounded. The participating investors intend to engage in dialogues with those companies that respond constructively, and initial meetings have occurred with several major oil companies.
It is anticipated that investors will file shareholder proposals seeking the same assessments and disclosures from U.S. listed companies that are unresponsive or decline to cooperate, and nine such proposals have been filed to date. Some of these resolutions will likely be voted on at corporate annual meetings during the 2013-14 proxy season.
It is unlikely that the institutional investors’ Carbon Asset Risk initiative will convince Exxon Mobil or Peabody Energy that they are in the wrong business or to abandon production of oil, gas and coal. But the unburnable carbon thesis and the risk of stranded assets do raise serious questions about the viability of the long-term business strategies of many fossil energy companies. They are effectively betting that governments will not take meaningful action to curb climate change anytime soon, that climate change won’t have serious physical and economic impacts on their businesses, and that demand for their products will continue to increase for the foreseeable future.
As an investor, I would not bet my money that they are right. And as a lawyer I’d ask if there are material SEC disclosure issues about these risks, the value of their reserves and potential liabilities to shareholders should these assets become stranded.