Carbon pricing

Other forms of policy risk are embedded in carbon reduction policies include emissions trading schemes such as the European Union’s Emissions Trading System, as well as carbon prices and taxes. For example, British Columbia’s carbon tax is credited with a 13% reduction in per capita emissions and 16% cut in fossil fuel demand between 2008 and 2013. ¹⁴

Carbon pricing is based on the notion that externalities, or social costs, should be included in prices for fuels and services. For example, if the costs to public health from emissions of sulfur dioxide, nitrogen oxides, and other coal pollutants were included in wholesale electricity prices, coal might be less attractive than cleaner power generation fuels. Carbon pricing levies a cost for GHG emissions and the associated damage from warming temperatures, storms, loss of land and property use, and sea level rise. Implementation of carbon pricing is increasing in momentum. The World Bank estimates that 13% of global emission is already subject to a carbon price. If promises made at Paris are fully enacted, some 58% of global GHG emission would be taxed (Fig. 2). ¹⁵

Figure 2. Global carbon emissions subject to international carbon pricing initiatives. Source: (World Bank 2016).

Carbon prices range widely and some appear to have had little effect on fossil fuel demand. Demand for transportation, in particular, is highly price-inelastic and probably not very sensitive to moderate carbon pricing. In the United States, a 25–50% increase in gasoline prices is required to reduce travel by 1%, although the effect on fuel demand is stronger. ¹⁶ Prominent forecasts of future demand incorporate assumptions for carbon pricing. Exxon Mobil’s 2016 Outlook for Energy assumes carbon pricing in OECD countries reaches $80/ton by 2040. Despite the added cost of carbon and improvements in vehicle efficiency, Exxon expects oil demand will continue growing to 2040, by an average of 0.7% per year. ¹⁷

Demand for natural gas and particularly coal is more sensitive to taxation, since substitute technologies are available. The Exxon forecast predicts coal use dropping an average of 0.2% per year globally, while natural gas demand grows 1.6% per year. Noncarbon substitutes become more competitive and grow more quickly under carbon taxation, with growth averaging nearly 3%/year for nuclear and 5% for renewables (Fig. 3). ¹⁷

Figure 3. Global fuel demand in 2040—Projections. Source: Exxon Mobil 2016, used with permission.

In the future, policy risks for the fossil fuel sector could be globalized via the “climate club” scheme conceived by economist William Nordhaus. Countries would align carbon tax policies and impose border tariffs on “free riding” imports from countries where carbon is insufficiently regulated. ^{Reference Nordhaus18} Countries that avoid climate action would face border taxes on exports to countries in carbon-taxation blocs. Governments are thus incentivized to tax carbon so their exports receive preferential market access.

Anticarbon policies also include myriad other restrictions. These include bans on extraction methods–hydraulic fracturing for oil and gas ¹⁹ –and blocking of infrastructure projects, such as the Obama administration’s denial of a permit for the Keystone XL pipeline. ^{Reference Lemphers20} Government policies to encourage competing nonfossil sources could also thwart demand for fossil fuels. One example is the 2016 agreement between the governments of the United States, Canada, and Mexico to generate half of their electricity from carbon-free sources by 2025. ^{Reference Dlouhy and Greiling Keane21}

Divestment risk

In a 2015 speech, Bank of England Governor Mark Carney argued that climate change could precipitate a major selloff that could result in collapsed valuations. ^{Reference Carney38} While that has not yet happened, shares in some fossil fuel companies are coming under scrutiny from investors worried about carbon intensity of earnings. Investor groups such as pension funds, religious organizations, ^39,40 insurance companies, and universities ⁴¹ have shifted investments away from coal. A smaller number of campaigns have targeted oil and gas firms. Activist groups have begun publicizing carbon footprints as encouragement for firms to reduce emissions or shareholders to divest.

Some divestment is based on ethical concerns related to companies profiting while damaging the climate. Some is based on financial grounds, particularly on the likelihood that successful climate action will undercut commercial activity and share values. However, if climate action fails, asset risks may actually broaden. The Economist Intelligence Unit argues that entire portfolios and national economies face weaker returns based on the severity of warming. ⁴²

Other financial obstacles may compound the risk. These include banks’ unwillingness to lend, legal liabilities from environmental damages, and capital assets devalued by premature shut down.

Divestment participants are among the largest institutional investors in the world, including, ironically, funds responsible for investing fossil fuel profits. The Norwegian Government Pension Fund, the world’s largest hydrocarbon-based sovereign wealth fund with some $900 billion in assets, decided in 2015 to divest from companies that received more than 30% of their revenues from coal. ⁴³ The Rockefeller Brothers Fund, based on the Standard Oil fortune, eliminated its holdings in coal and Canadian oil sands in 2014. ⁴⁴ In 2016, the related Rockefeller Family Fund announced it would sell off fossil fuel shares, including holdings of Exxon Mobil–once a part of Standard Oil–due to the company’s public statements that were at odds with its internal understanding of climate change. ^{Reference Wade and Driver45}

Divestment has not usually damaged share prices or debt of targeted companies, since other investors tend to purchase shares that are sold. ^{Reference Ansar, Caldecott and Tilbury46} However, widespread shunning of coal shares is constraining the availability of financing and raising costs. By 2030, divestment could reduce coal demand by a modest amount, around 2.5%. ^{Reference Glomsrød and Wei47} In the oil business, divestment risk only poses a problem for shareholder-owned IOCs, not state-owned NOCs which dominate oil production.

A greater effect of divestment may be “stigmatization” that marks firms as targets for hostile regulation or other secondary effects. ^{Reference Baron and Fischer48} Activist groups have publicized carbon footprints and climate responsiveness among various industry sectors. A report from a group called BankTrack exposes lending to coal firms. The Asset Owners Disclosure Project ranks investment funds on climate criteria. A group called Fossil Free Indexes published what it described as the carbon footprint of the $300 billion CalPERS state employee retirement fund. Had CalPERS directly owned the fossil fuel reserves implied by its share holdings, the pension fund would have ranked as the 55th largest global oil and gas company and the 88th largest coal company, by reserves. ⁴⁹ The report argued that CalPERS’ holdings exposed California pensioners to climate action risk, while also tarnishing CalPERS’ environmental credentials.

Shortly after the report emerged, the California legislature passed a law forcing state pension funds to liquidate coal-related shares by 2017. ⁵⁰ As a result, CalPERS put pressure on companies in which it owned shares. ⁵¹ The French utility giant, GDF Suez–now Engie–was threatened with divestment if it did not reduce its carbon footprint. ⁵² In 2016, Engie acted, selling its ownership in 17 US coal-fired power plants with 9 GW of generating capacity, along with others in India and Indonesia, reducing its coal portfolio by a fifth, or 13 GW. ^{Reference Blum53} Chairman Gerard Mestrallet said coal ran counter to the company’s climate concerns, and pledged to stop building coal-fired power plants. Engie pulled out of another 2 GW in coal capacity it was negotiating in South Africa and Turkey. The firm is shifting its focus toward lower-emission renewables and natural gas projects. ⁵⁴

In the United States, coal has been hobbled by competition with cheaper natural gas, as well as declining steel production and regulatory uncertainty. Peabody Energy, the largest US coal mining firm, declared bankruptcy in 2016, preceded similar filings among coal producers Arch Coal, Alpha Natural Resources, Patriot Coal, and Walter Energy. US coal firms lost a combined 31,000 jobs and $30 billion in share value since 2010. In 2016, half of all US coal was being produced by bankrupt companies in the process of being broken up. ^{Reference Miller and Jarzemsky55} Incoming President Donald Trump has declared support for a coal revival, but economic factors—and the probability of revived post-Trump regulation–subject US coal to most risk types outlined in this paper.

Portfolio risk

Stock exchanges and financial regulators have increased reporting requirements for firms to declare their carbon intensity and exposure to climate risk. ⁵⁶ Disclosures have made it easier for investors to avoid fossil fuel shares and tilt portfolios toward “green” indexes. In the United States, the Securities and Exchange Commission requires companies to disclose material risks from climate change and climate action in public filings. These include impact of legislation and regulation on costs, profits, and demand; impact of international accords, including indirect effects such as decreased demand for carbon-intense products. ⁵⁷

MSCI, a company that creates share indexes for investment managers, has developed new indexes and tools that exclude fossil fuel companies or highlight exposure to potential for stranded carbon assets. The company assists in rebalancing portfolios by “deliberately tilting more aggressively toward companies with large and growing renewable capacity”. ⁵⁸ Likewise, Bloomberg’s Carbon Risk Valuation Tool allows its clients to model the effects of scenarios such as “last ditch decarbonization” on their portfolios. ⁵⁹ HSBC provides clients with a similar climate risk analysis framework. ⁶⁰

Climate risk has thus led to the creation of “green” funds and other products that channel investment into firms that compete with fossil fuel companies.

Insurance risk

The global insurance business finds itself on the opposite side of the climate equation from fossil fuel firms. Insurers face increasing losses from climate change, due to the rising frequency of damaging weather events and subsequent payouts. The insurance sector is among those with the largest financial stake in climate progress. In 2016, UN Secretary General Ban Ki-moon urged insurers to anticipate and manage risks–including by decarbonizing investment portfolios used to pay future claims–so that the industry does not contribute to climate catastrophes that undermine its business. ⁶¹

A further insurance risk has not yet materialized, but is under discussion. Insurers could refuse to provide coverage to coal firms–or the fossil fuel industry at large–as a way to hamper a business that is behind rising property damage claims. ^{Reference King62}

Climate risk is already influencing insurance portfolios. Climate-focused investor advisory group Ceres has tallied fossil fuel holdings worth $459 billion among US insurance firms. ⁶³ Some are starting to divest. The California Insurance Commission has asked insurers operating in the state to divest from coal and to report holdings in oil and gas firms, including pipeline and transport companies. ⁶⁴

The French insurer AXA announced in 2015 that it would divest from its last remaining coal mining and utility assets, worth $560 million, while shifting into “green” investments that have lower or beneficial climate impacts. AXA CEO Henri de Castries said climate-driven events already represented 15 to 20% of the firm’s business risk. He said it had become “absolutely clear” that warming beyond 2 °C would make it “tougher and tougher and probably impossible” for insurers to cope with property damage. ^{Reference Patel65} German insurer Allianz, with nearly $2 trillion in holdings, announced it would reduce coal investment in favor of wind power. ⁶⁶

Lending risk

A related source of risk for fossil fuel companies is the drying up of financing. In 2013, the US Treasury Department announced that the United States would no longer support coal investment among multilateral institutions, although the US Export–Import Bank participates in coal projects in poor countries. ⁶⁷ In a similar process to divestment campaigns, activist groups have exposed lending to the coal sector ⁶⁸ and banks have begun stepping back. Bank of America, Citigroup, JP Morgan Chase, and Deutsche Bank have enacted climate-driven lending prohibitions on coal mining and power plants. Citigroup has mandated a “risk review” prior to lending to businesses in Canadian oil sands. ⁶⁹ Lending prohibitions shrink the pool of willing financiers, possibly forcing coal businesses to turn to more expensive sources. ^{Reference Corkery70}

Elsewhere, Brazil’s development bank BNDES has halted financing for coal- and oil-fired power plants. ^{Reference Teixeira71} Japanese banks and export credit agencies, which financed big coal-fired power plants in Mozambique and Vietnam in 2015, have since come under pressure to halt coal financing. ⁷² As OECD banks depart the sector, Chinese lenders have captured the largest share of coal funding opportunities, including the top three spots (Fig. 6). ^73,74

Figure 6. Top 20 banks and their lending to the global coal industry from 2011–April 2014, as reported by BankTrack. Source: BankTrack 2014.

Stranded asset risk

If climate action is effective, the OECD believes that assets will inevitably be stranded. ^{Reference Baron and Fischer48} Stranded asset risk is not unique to fossil fuels. Any industry might be hurt by advances in technology or customer preferences that render capital equipment underutilized or abandoned prior to the expected investment time horizon. Fossil fuel reserves are already routinely stranded, at least temporarily, by falling market prices. Climate risk is different. Governments, firms, individuals, and international organizations are actively pursuing actions that damage fossil fuel businesses irrespective of prices or availability of substitutes.

Recent estimates by McGlade and Ekins find that roughly 80% of known coal reserves must remain unburned if the 2 °C target is to be met. The authors find that carbon capture and storage technology is of little help, given its expense, the unwieldy parasitic load on power plants, and a lack of carbon pricing that might incentivize its construction. Citicorp estimates that the mining and power industries will lose investments worth $11.5 trillion over the next 25 years. ⁷⁵ (Table 1) Further, half of global gas reserves need to remain in the ground to meet the 2 °C target. ^{Reference McGlade and Ekins31}

Table 1. Dollar values of unburnable fossil fuels in a 2 °C scenario.

Note: Assumes $70 per barrel of oil, $6.5 per MMBTU of gas and $70 per metric ton of coal.

Source: Citi Research, McGlade and Ekins (2015).

Financial reports outline the potential for enormous losses in revenues, the risk of which increases relative to concentrations of carbon and the costs of extraction. The French bank Kepler Cheuvreux finds that adhering to the 2 °C carbon threshold would, by 2035, leave the fossil fuel industry with $28 trillion in lost revenues from stranded reserves. ⁷⁶ As mentioned, Citicorp estimates that the value of stranded fossil fuels will surpass $100 trillion by 2050. The New York bank believes that climate-inspired reductions in earnings should be considered when weighing creditworthiness of producer companies and countries. ⁷⁵

A similar “stranded assets” predicament is said to threaten long-term earnings potential of fossil-fuel based utilities. Electricity providers appear to be overbuilding generation infrastructure to the extent that capital stock will have to be retired prematurely if CO₂ emissions are to be kept within the bounds of a 2 °C temperature increase. Complying with the 2 °C carbon budget requires that no new power generation plants be built after 2017 unless other infrastructure is retired early, underutilized, or retrofitted with carbon capture and storage technology. ^{Reference Pfeiffer, Millar, Hepburn and Beinhocker77}

By 2035, myriad fossil-fuel assets could become “stranded,” or unable to earn a financial return prior to the end of their economic lives. The IEA estimates some $300 billion in unrecovered investments amid nearly $3 trillion in yearly energy investment of all types the IEA has forecast over a similar period. ^{Reference Birol78}

1. (i) 165 GW of fossil fuel power generation capacity with unrecovered sunk costs of $120 billion.

2. (ii) Oil and gas exploration costs worth $180 billion.

3. (iii) Some $4 billion in unrecovered coal mine investment. ⁷⁹

Examined in this light, Japan’s plans to build 49 new coal-fired power plants with 28 GW of capacity would create risk of stranded assets and write-downs worth at least $50 bn under various scenarios, because–for environmental or cost competitiveness reasons–the plants would probably be retired before their 2070 investment time horizon. ^{Reference Caldecott, Dericks, Tulloch, Kruitwagen and Kok80}

Should these sorts of forecasts affect share prices of publicly traded firms? A number of climate-based activist groups such as the Carbon Tracker Initiative and the Institutional Investors Group on Climate Change believe that they should, and that climate risks have not yet been priced into oil company stocks. ⁸¹ The combined risks to the industry suggest the possibility of a “carbon bubble”. This is the contested notion that market capitalizations of publicly traded companies are exaggerated because the enforcement of carbon targets may prevent them from producing the reserves they have booked.

However, climate risks are already priced into coal shares and probably into oil company shares. Share prices are based on investor assumptions of future earnings over a relatively short time horizon. Since climate effects accrue gradually and since IOCs hold just five to 15 years of proved reserves, investors are probably betting that production of booked reserves is unlikely to be upended by climate concerns. Analysts and oil company officials have stated that long-term effects of climate on their business models are a different issue than investor expectations for short-term earnings. ^{Reference Crooks82} The transition away from fossil fuels, in particular oil and gas, is a gradual process that is being incrementally priced in by markets. ^{Reference Yergin and Pravettoni83} For IOCs, climate risk looks more threatening over the long term, possibly affecting the value of future reserves. ^{Reference Mathieu84}

For producer countries like Saudi Arabia or Kuwait, where reserves can support current production for another 50–100 years, successful climate action probably will render some underground reserves unburnable. Of course, a rapid shift in technology that renders fossil fuels obsolete could have the same effect on asset values.

Opposite cases are also possible: energy shares could get a boost from a breakthrough that allows carbon-rich fuels to be exploited without harming the climate. Fossil fuels might also get a reprieve from large-scale adoption of geoengineering techniques that intervene in the Earth’s climate system to reverse the greenhouse effect. ⁸⁵ And, as mentioned above, there is a high likelihood that humanity will fail to attain the 2 °C carbon budget, which pushes climate risk into the future.

Market risk and the green paradox

Climate change could exacerbate competition for market share by encouraging price war behavior. If oil producers believe climate restrictions might lead to stranded assets, they may decide to step up production to reduce risk exposure. Sinn has labeled the phenomenon “the green paradox”, arguing that environmental policies that restrict carbon emissions have the perverse effect of accelerating fossil fuel production, thus exacerbating carbon emissions and global warming. ^{Reference Sinn94}

It is possible that the green paradox is already affecting energy markets. OPEC members Saudi Arabia, Kuwait, and the United Arab Emirates–holders of some of the largest and lowest-cost oil reserves–had until recently favored long-term depletion strategies that limited production and propped up market prices. This future-oriented strategy allowed greater participation by higher-cost producers outside OPEC. But the cartel’s future orientation appears to have diminished. Since November 2014, OPEC–led by Saudi Arabia–has emphasized retaining a share of the oil market rather than sustaining high prices. Despite an OPEC agreement to cut production in late 2016, Saudi Arabia continued to maintain production at historic highs at the time of writing, pushing higher-cost oil from the market. The Saudi change in strategy was probably driven by rising competition with US shale and other non-OPEC oil.

However, if the Saudis worried that reserves might someday be stranded, they might behave the same way, increasing current production in hopes of reducing the amount of resources abandoned in the future. ⁹⁵

Curtailment of future oil demand would be disastrous for Saudi Arabia, Venezuela, and other large producer states, few of which have diversified economies ready to move beyond oil. By increasing production and pushing down market prices, they might shift the risk of stranded assets to higher-cost players, including shareholder-owned IOCs. The same phenomenon could be affecting coal producers. For them, selling at a discount is preferable to seeing reserves stranded. By encouraging stepped-up production, the climate threat to fossil fuels can perversely lead to cheaper, more attractive fossil fuels. Over the long term, cheaper prices could destabilize producer economies and trigger social unrest.

Other geopolitical risks

A global transition away from fossil fuels represents a major disruptive force in international relations. Declining demand for oil could diminish the strategic importance of petro-states. In turn, importing countries might find themselves less committed to guaranteeing external security and regime survival in exporting countries. One potential casualty might be the US Carter Doctrine, which declares that the United States will use military force to protect oil exporting states in the Persian Gulf. If the global economy grows less dependent on energy sourced in the Gulf, the United States may feel less compelled to spend some $50 to $100 billion per year ⁹⁶ in protecting its allies in the region.

State-to-state competition could assume more dangerous form. A “green paradox” battle for oil rents could evolve into a quest to shut down competing resources. Verbruggen and Van de Graaf argue that an era of oversupply would incentivize producer states to prevent competitors from producing oil. Actions could range from embargoes to sponsoring armed intervention or terrorism, all of which would be aimed at creating chaos in producing countries, so reserves cannot be produced. ^{Reference Verbruggen and Van de Graaf97}

Finally, if decarbonization proceeds on a two-speed track, with developed countries acting to reduce emissions while developed countries engage in carbon-intense industrialization, relations between the OECD and non-OECD could worsen. Developed states could take on a quasienforcement role, imposing restrictions on trade and multilateral funding. Climate action could thus create a new arena for geopolitical competition among opposing blocs.