April 9, 2019 / In-depth

Will coal, oil and gas really become stranded assets?

By John Lappin, Global Investment Megatrends

BP and Glencore changes could be instrumental in bringing more information to investors

Will coal, oil and gas really become stranded assets?

The debate about climate change continues to rage even as global temperatures rise.

It is not just campaigners and engaged citizens, but also increasingly governments and regulators that want to see action.

Much of this is driven by the Paris COP 21 Agreement signed in late 2015 committing almost all the world’s nations to keeping warming below 2 degrees Celsius above pre-industrial levels while pursuing efforts to keep it to 1.5 degrees.

Paris also focused global attention on the issue of stranded assets. This is the contention that resources with the potential to generate CO2 – but particularly coal, oil and to a lesser extent natural gas – will have to stay in the ground rather than be accessed and burned for energy.

In the UK, for example, the Guardian has run a campaign recently with the Keep it in the Ground slogan. The broad campaign has the support of many global NGOs, charities and campaign groups, both long-standing environmental groups such as Greenpeace and more specialist pressure groups such as Oil Change International.

It is also, arguably, underpinning regulation in the UK, Europe, Asia and, at least at state level, the US.

What has had less attention is that the concept is somewhat in dispute though from unsurprising quarters.

OPEC, the oil producers’ cartel, has set out very detailed projections on energy use such as the view that a huge number of cars will continue to be petrol-driven for decades to come. This could be characterised as the case for extraction.

A more nuanced debate concerns the timetable for transition but, beyond those who would reject all hydro-carbon related investing, it clearly has the potential to be very confusing for investors even as the global, national and regional regulatory environment shifts dramatically.

The Bank of England arguably stands out as one of the leaders of the debate.

The Prudential Regulatory Authority, which sits within the bank, has concerns about potential liabilities for insurers and the quality of the loan books of banks and has just finished consulting on rules that will require the senior management to have clear policies and demonstrable processes to deal with the risks.

A climate Minsky moment

Governor Mark Carney, who has been warning about climate risks for most of his tenure, raised the possibility of a climate driven collapse in asset values, in a speech last April to international banking supervisors. Carney was talking about the strains of rapid adjustment rather than climate collapse per se.

“Too rapid a movement towards a low-carbon economy could materially damage financial stability.  A wholesale reassessment of prospects, as climate-related risks are re-evaluated, could destabilise markets, spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a climate Minsky moment,” he said.

But taking the UK as an example, most of the other regulators are following the bank’s lead.

New rules announced last year will require trust-based pension schemes to have to have a policy for considering financially material factors such as environmental, social, and governance factors, including climate change by 2020. They will also have to publish a policy on non-financial factors.

The next raft of detailed requirements derive from the European Union’s Mifid II directive which is set to require ESG concerns to be considered as part of suitability within the financial advice process.

Most experts expect this to become part of UK regulation, regardless of the shape of Brexit, illustrating the international nature of many of these initiatives.

The counterpoint is, of course, the world-famous climate scepticism of President Donald Trump to the extent that he repudiated the Paris agreement in one of the earliest acts of his presidency.

Yet whatever the President thinks, the US asset management market may be shifting too, partly because climate scepticism is falling among the general population. A recent study by Morgan Stanley and Bloomberg found a majority of 300 asset managers adapting environmental, social and governance (ESG) factors for at least part of their portfolios. Indeed the report estimated that this could cover asset worth a staggering $12trn.

Yet surely it is pertinent to ask, will any of these managers, apart from dark green ones, be avoiding CO2 altogether or have a plan to do so in future. In other words, will these assets will be stranded or not?

Here beyond the world of policies and duties, the arguments continue to rage mostly about carbon budgets.

Late in 2018, the Intergovernmental Panel on Climate Change argued that to have a medium chance of limiting warming to 1.5°C, the world can emit 770 gigatonnes of carbon dioxide (GtCO2). To have a likely chance (67%), the remaining budget would drop to 570 GtCO2.

Even in the overly optimistic scenario in which current levels of carbon dioxide emissions are held constant, the IPCC would still exhaust the budget in 2030 (for a likely chance of limiting warming to 1.5°C).

Basically, on current trajectories, we look very unlikely to meet any of these criteria.

Opec makes a demand-based case

Unsurprisingly Opec strikes a markedly different tone though it doesn’t concentrate on the temperature, but on very specific market demands.

In its Oil Outlook Report 2040 published in the autumn, Opec suggested demand could reach 112 million barrels of oil a day by 2040 up from the current £100m. It said that this will come from the airline industry and cars while, in terms of countries, China and India will contribute significantly to global demand.

Even with arguably the worst climate offender coal, Opec estimates that coal usage in the OECD countries will plummet by a third by 2040, but it will increase by 20% in developing countries to reach five times the volumes burned in the west.

It predicts that airline demand will increase 2.2% a year on average, to 2040.

Finally, it suggests the number of vehicles on roads across the world will jump from 1.1bn now to around 2.4bn in 2040.

In its central scenario, Opec expects just 320 million cars to be electric or 720 million in the scenario in which electric vehicles do best.

If the higher prediction for electric cars is correct, oil demand would slip to 109 million bpd rather than 112 bpd by 2040 while renewable energy will make up only 20% of the world’s electricity demand.

“Our view is that oil demand continues to rise until 2030 and then peaks around then somewhere between 110 and 120 million barrels a day and then there is a tail-off as electrification takes hold. It creates a curve for the next 50, 70 or even 100 years and the area under the curve is the amount of oil consumed.

Will Riley, co-manager of Guinness Global Energy Fund, says: “If you come at this from the question of how many hydro-carbon reserves will be used, it is outside Opec’s hands.  That is set by free market economics and government regulation.

“The BP Statistical Review of World Energy (2018) reckons there are proven reserves of about 1.7 trillion barrels. We would consume about half of that in the run up to 2035. We would be in Opec’s camp in terms of thinking a lot of the oil assets will be consumed. Coal is under most pressure as the dirtiest burning hydro-carbon and where there is lack of investment and some divestment. Yet even there you will still see growth in absolute terms though you will see oil demand slow due to electrification.”

That may suggest that energy demand will see resources extracted unless campaigners can stop it.

Some are focusing on the International Energy Authority which advises governments on energy policy including controlling emissions.

A report by Oil Change International says: “The IEA’s roadmap “New Policies Scenario” (NPS), the foremost guide to decisions on energy policies and investments, steers those decisions towards levels of fossil fuel use that would cause severe climate change.

“Emissions under the NPS would make the Paris goals unachievable, exhausting the carbon budget for the 1.5-degrees Celsius limit by 2022, and for a 2-degrees Celsius limit by 2034. Of the NPS’ recommended upstream oil and gas investment, between 78% and 96% – USD 11.2 to 13.8 trillion over 2018 to 2040 – is incompatible with the Paris goals.”

This may strike at the nub of the problem – that investors whether sustainability minded or not – have to take into account a range of factors that are almost as complicated as the global economy itself. Within this it is very difficult to assess the interaction of regulations governing demand such as bans on the internal combustion engine, the adoption of new technology and therefore how much oil, gas and coal will be extracted.

Two global companies may change the picture dramatically

It looks likely that investors will get significantly more information soon. In the UK campaign group Share Action was among the first to start campaigning around climate risk around a decade ago focusing initially on tar sands.

Yet in the wake of Paris, the group has been involved in demanding that oil majors begin to assess their risks accurately based on the goals set out in the treaty. Until recently, it has been unimpressed. The group had been unimpressed with most of the oil majors up till now with only an oil minor Oil Search undertaking an analysis based on two International Energy Authority projections and, perhaps surprisingly, a further one from Greenpeace.

Jeanne Martin, senior campaigns officer – fossil fuels at Share Action says: “A lot of oil majors have undertaken a two-degree scenario analysis. They rely on a lot of implausible assumptions that have been beneficial to their business model. They don’t actually go into asset level detail. Almost every major is saying: ‘Great we have done this analysis and almost everyone said that the assets were safe. We can continue behaving the way we have always done. We don’t to change anything right now, because we are monitoring these global trends, then if it causes problems for us. Then we will change.’”

However, she says, the picture looks set to change. Investors have put down a resolution for BP to produce an annual report analysing their capital expenditure risk and how it aligns with articles 2.1 A and article 4 i.e. how it compares to the 1.5 degree and two-degree goals.

BP, admittedly after months of negotiation, now supports the motion.

“If BP takes this analysis seriously, we should be able to see what assets are exposed,” says Martin.

Share Action was also involved with another campaign – led by the Church Commissions – that has persuaded mining conglomerate Glencore to do likewise. A great deal of attention will be on the coal division.

She says that the pattern is following previous work with tar sands where campaigns of this nature moved from campaigning groups to religious or trade union institutional funds to the investing mainstream. Hence the involvement in of mainstream investors such as L&G, M&G and Hermes.

Certainly with the involvement of these global companies listed on a major stock exchange could bring a wealth of information for investors to really begin to make up their own minds.

No quick fix

However some fund managers believe that campaigning will only take things so far.

Riley adds: “This is not going to be turned off overnight. Campaigners are going to nudge us towards slightly faster curtailment. In a sense, what they are doing makes sense.

“You have country-wide bans coming in, in the 2030s and 2040s for diesel and petrol engines, but it is a matter of weighing up economic growth versus the needs of the environment. There is no quick fix where we can move to wind, solar and geothermal. This is the issue. Governments are recognising their responsibility to cap carbon emissions but not wanting to curb economic growth. No-one can quite work out where the line should be drawn.”

* This article first appeared on ESG Clarity‘s sister site, Global Investment Megatrends