The growing concern over stranded assets

The growing concern over stranded assets

ShutterstockLukasz Z

For years, the concept of "stranded assets" seemed largely hypothetical and abstract, a far-off concern of climate advocates and progressive investors that climate change could obliterate trillions of dollars of corporate value, if not turn assets into liabilities.

As with so many climate-related topics, the hypothetical is rapidly turning into the hypercritical. Along the way, there is growing significance for our environmental and economic well-being. Unfortunately, Big Oil seems asleep at the switch.

First, a little definition: A stranded asset is something — a piece of equipment or a resource, for example — that once had value or produced income but no longer does, usually due to some kind of external change, including changes in technology, markets and societal habits.

For example, when electricity started replacing oil lamps for illuminating homes, lighting businesses suddenly found their oil lamp inventory devalued, and the whaling industry lost a key market for whale oil, leaving entire fleets idle; those unneeded lamps and ships became stranded assets. When the steel industry fled the United States for lower labor costs overseas, foundries, forges, smelters and coking machines that could not be packed up and shipped abroad were stranded, along with many workers trained to use them.

Today, the term is most commonly used to describe oil and gas resources that haven’t yet been extracted, but which appear as assets on companies’ ledgers. There is growing pressure on oil and gas companies to "leave it in the ground" and avoid burning it. Scientists say that burning these reserves would vastly exceed the world’s "carbon budget" — that is, the amount of greenhouse gases that can be emitted and still stay within acceptable bounds of global warming.

According to a 2015 study in Nature, an estimated one-third of oil reserves, half of gas reserves and more than 80 percent of known coal reserves must remain unburned in order to meet global temperature targets under the Paris Agreement.

Therein lies one of the great economic conundrums of the day: Should oil and gas companies continue to exploit what’s already "theirs" — the leases and options they currently hold? Or should they be banned from doing so, rendering these assets as "stranded," with the potential of crashing the value of these companies’ stock, which is held by tens of millions of individuals through mutual funds and pension plans?

The numbers are sobering: A dramatic drop in oil prices could cause a huge "carbon bubble" built on long-term investments to burst. According to a 2018 study, the equivalent of between $1 trillion and $4 trillion could be wiped off the global economy in fossil fuel assets alone. By comparison, a loss of "just" $250 billion triggered the crash of 2008.

A number of circumstances can contribute to a bursting bubble, according to a 2017 report from Lloyds, the British insurance giant, which focused on the implications of climate change for the banking and insurance industries. Among them: "unburnable carbon" resulting from carbon budget constraints; lawsuits against companies and their directors for being responsible for climate change; premature closure of fossil-fuel power plants due to market shifts or regulatory constraints; renewables plus storage outcompeting fossil-fuel electricity plants; and more-efficient planes, ships and trucks that vastly reduce demand for fuels.

Ship of fuels

There are also knock-on effects. For example, investments in oil tankers and other shipping vessels that carry coal, iron ore and grains could become stranded due to lower fossil-fuel demand or reduced shipping aimed at curbing maritime-born climate emissions, according to a July report by shipping analysts Maritime Strategies International.

As BusinessGreen explained: "If the world manages to avert dangerous levels of climate change, the global trade in fossil fuels and other carbon-intensive commodities is likely to slow dramatically, the report highlights, warning that such a drastic shift in key global markets could slash the value of global shipping operators."

All of which is concerning the banks and insurers that underwrite these vessels. Banks, for their part, are taking action to align their shipping portfolios with global climate targets. In June, 11 major banks with significant holdings in the global shipping industry signed on to an extensive set of guidelines, christened the Poseidon Principles, designed to accelerate decarbonization efforts across the sector.

Determination or denial?

So, how do the affected industries respond? Are they changing their investments or strategies based on a carbon-constrained future? Not so much, according to a new report from Carbon Tracker.

The study, the first to identify individual projects that are inconsistent with the Paris Agreement, found that no major oil company is investing to support its goals of keeping global warming "well below" 2 degrees Celsius and to "pursue efforts" to limit it to a maximum of 1.5 C — goals called for by the 2015 agreement signed by 196 nations and ratified so far by 183 of them. Moreover, investors are under huge pressure to determine which energy companies are "Paris-compliant."

The Carbon Tracker report warns that a lower demand of fossil fuels as a response to climate change will lead to a drop in energy prices, meaning that only the lowest-cost projects will deliver an economic return. The report highlights 18 recently approved projects worth $50 billion — such as Shell’s $13 billion liquefied natural gas project in Canada, and a $4.3 deepwater oil project in Azerbaijan funded by BP, Chevron, ExxonMobil and Norwegian-based Equinor. Such projects will be "deep out of the money in a low-carbon world," said Carbon Tracker. Some will require an oil price of over $80 a barrel to deliver a 15 percent return. Oil prices currently hover between $55 and $60 a barrel. The last time it was $80 a barrel was in 2014.

That is, some of these projects risk becoming stranded assets even before they are built.

That’s hardly the fullness of it. The top 10 energy companies are planning investments approaching $1 trillion by 2030, according to a May report from Bloomberg, which noted: "Some analysts and investors warn that the value of much of that infrastructure risks falling to zero" if governments "make good on tough targets for cutting greenhouse gas emissions."

What’s driving all of these seemingly irrational investments? Is it pure denial? The irresistibly low cost of borrowing money? Or some sense that severe climate impacts are sufficiently far off to avoid short-term scrutiny?

All of those reasons seem myopic and potentially risky for investors, not to mention those of us who have to live in the world they help shape.

One interesting twist to this, argues R. Andreas Kraemer, a senior fellow at the Institute for Advanced Sustainability Studies in Potsdam, Germany, is that all of this unburnable carbon isn’t actually a stranded asset at all (emphasis in original):

Asset stranding results when assets have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities. The first point to note is that nothing about climate change is unanticipated, and climate policy action is certainly not premature, but on the contrary fully predictable and overdue. Thus, there are no stranded assets in fossil energy companies caused by climate policy or the shift to green energy; any write-downs are the consequence of bad investment decisions and unjustified valuations, investments made in willful ignorance of the true costs and risks.

The subtext: Investing vast sums in fossil-fuel resources is just plain dumb, and more than a little irresponsible. And yet.

But we're getting back to hypothetical abstractions. The consequences of how we think about and value our energy future are getting more real, and more critical, every day.