Will carbon cause the next financial crisis?

If governments around the world are serious about reducing carbon emissions, stranded assets could have major implications for global financial markets.

Stop me if this sounds familiar: A slew of large companies fail to disclose millions of dollars in speculative risks; iconic investment firms also neglect to scrutinize these risks; it all adds up to a global financial meltdown.

No, this is not an accounting of the circumstances leading up to the 2008 financial crisis.

This is also what the Group of Twenty (G20) major economies suggest could happen if nothing is done about energy companies’ “stranded assets” — or the carbon reserves, such as coal mines and oil fields, that would become untenable and have to be written off as financial losses in the event of stricter global climate regulations.

According to a recent article in the Telegraph, the G20 has asked the Financial Stability Board in Basel to investigate the risks that stranded assets might pose to global financial markets. The Carbon Tracker Initiative, meanwhile, projects that the vast majority of fossil fuel reserves would be affected.

“Between 60-80 percent of coal, oil and gas reserves of publicly listed companies are ‘unburnable’ if the world is to have a chance of not exceeding global warming of 2 degrees Celsius,” Carbon Tracker noted.

How much stock fossil fuel companies and their financiers are putting in those warnings remains much less clear cut. 

Shell, for example, wrote in a letter to investors last year that, "the world will continue to need oil and gas prices. As such, we do not believe that any of our proven reserves will become 'stranded.'

“There is a risk that focusing on ‘stranded assets’ or the concept of the ‘carbon bubble’ distracts attention away for the reality of a growing population, increasing prosperity and growing energy demand." 

That disconnect over how fossil fuels fit into climate action likely will rear its head at the United Nations Climate Change Conference, COP 21, set for Paris this winter,  where world leaders will meet to discuss new targets. The White House already submitted its plan to the U.N. in March, which stated that the U.S. will work to reduce carbon emissions by 26 to 28 percent in 2025, using 2005 levels as a baseline.

When it comes to the price tag that could be attached to efforts to achieve such goals, some analysts project that energy companies, such as Shell, ExxonMobil and BP, will be forced to write off huge losses on inaccessible stranded assets. A Rolling Stones article projects that the current value of all carbon emissions is $27 trillion, meaning that an 80 percent reduction would require a write-down of as much as $20 trillion in loses. 

The potential for the risks of stranded assets seems severe, but will it actually materialize? That is the question facing both energy companies and investors as talk about an impending “carbon bubble” heats up.

The investor's dilemma

Of the 500 largest global asset funds, no fund has calculated its portfolio-wide fossil fuel reserves investment exposure, according to the Asset Owners Disclosure Project’s recently released 2015 report. 

The report also mentions that only 1.4 percent of asset owners have reduced their carbon intensity from the previous year.

“There are leaders, but the point is that there aren’t that many at the moment," said Ben Caldecott, director of the stranded assets program at Oxford University’s Smith School of Enterprise and Environment. "I think that this will change rapidly because it actually takes quite a long time for institutions to absorb this information.”

The risk of investing in carbon-intensive assets goes beyond pending climate regulations.

A recent Wall Street Journal article reported that Goldman Sachs Group has sold some of its investments of coal mine in Colombia at a loss due to a combination of factors. According to the article, Goldman Sachs’ commodities operation’s revenues deteriorated from $3.4 billion in 2009 to $1.5 billion in 2013.

This was in part due to steady declines in coal prices, which have declined by more than 50 percent since 2011, as well as an instance where local women and children formed a human blockade around its La Francia coal mine. As a result, the mine ceased operations for nine months and Goldman Sachs recorded losses of more than $200 million on the mines, according to the article.

"You don’t have to believe in the 2-degree climate target to see that these things are having an impact on your bottom line," Caldecott said.

Still, the effects of government regulations on climate change do have the potential to be much more perilous for energy companies and their investors.

A regulatory gamble

One possible example of how the issue of stranded assets could gain momentum with shifting regulation is mentioned in a report by the University College of London. The paper states that in order to meet the 2-degree goal, drilling anywhere in the Arctic Circle would be impossible, along with extracting 75 percent of Canadian oil.

“All these trends point in the same direction, which is that global demand for fossil fuels, in general, are likely to be less than companies are assuming,” said Andrew Logan, director of oil and gas and insurance programs at Ceres.

According to a recent private report seen by Newsweek from the multinational banking and financial firm HSBC, "The speed of the collapse in energy prices over the past three quarters has taken the fossil fuel industry by surprise."

Newsweek also elaborated on the more specific financial machinations at work: "As rigs are dismantled, capex is cut and operating assets quickly become unprofitable, stranding risks have become much more urgent for investors to address, including shorter term investors."

While institutional investors such as HSBC, Citigroup and Deutsche Bank have released reports on the risks of stranded assets, investment advisers for individual investors have not been as successful, Logan said.

“My sense is that community as a whole is kind of behind the curve on this issue," he explained. "I think it’s more of the highly sophisticated asset owners — big, institutional funds — who are more on top of this, which is a shame because you don’t want to see individual investors burned on something like this after they have been burned before by emerging risks.”

And gray areas are surfacing with existing disclosure rules. Under the Securities Exchange Commission’s Advisers Act of 1940, investment advisers must make “an affirmative obligation of utmost good faith and full and fair disclosure of all facts material to the client.”

The SEC, so far, has made little effort to distinguish any sustainability concerns as material. This means that companies are not required to disclose this information in their annual filings, nor are advisers required to inform investors of these risks.

"Environment-related risks, including climate change and societal responses to climate change, should be analyzed by investment advisers," Caldecott said. "These issues are financially material and should be factored into investor decision-making. Neglecting to advise investors appropriately could potentially breach legal responsibilities."

Enforcing climate change

Given the tendency for politicians and government leaders to fail to fulfill promises, one may wonder whether governments around the world actually will enact and stand by their policies on climate change.

While that will be a recurring question heading into Paris later this year, some institutional investors already have divested from fossil fuels, most visibly eschewing coal.

The Wall Street Journal reported this week that Norway’s largest sovereign wealth fund, Norges Bank Investment Management, has reduced its holdings in coal mining companies from $350 million to $66 million.

Another Scandinavian country is also cutting ties to coal as six Danish pension funds — which combined manage $36.3 billion in assets — decided in April to divest from coal, tar sands and deepwater and Arctic oil exploration. 

“My take is that the current trajectory on the fossil fuel industry is clearly financially unsustainable," Logan said. "Companies that continue with the business-as-usual approach are going to see real damage to their finances."