FFI Perspectives

Carbon Emissions Measurement for Investors, Part 2: Stranded Assets

As I mentioned in Part 1 of this post, our research shows that global proven reserves of fossil fuels will release about 3,200 GtCO2 if burned.1 For a better than even chance at limiting global warming to 2° C, only about 700 GtCO2 can be added to the atmosphere. What happens to the 2,500 GtCO2 that can’t be burned?

Recall that global proven reserves are the coal, oil, and natural gas that is still in the ground but expected to be pulled out of the ground soon. In the energy industry, “soon” typically means the next ten to fifteen years, give or take. A little less than 20% of global proven reserves (measured by carbon content) are controlled by companies listed on public stock exchanges. These public companies report the proven reserves they own on their balance sheet. Proven reserves are an asset, just like inventory or real estate. The vast majority of their value comes from the energy that they’ll produce when the assets are burned. If these assets can’t be burned, they are virtually worthless—and referred to as “stranded assets.”

How does an asset become stranded? Proven reserves can lose value in a number of ways. For example: low oil prices may eventually cause some oil reserves to become uneconomic – particularly those with high production costs like Canadian tar sands, San Joachim Valley steam assisted wells, or deep water platforms. Company restructuring could cause stranding. A firm like Alpha Natural Resources, which is currently moving through the bankruptcy process, may need to write down some of their coal assets. Environmental restrictions could come into play: in the Netherlands’ Groningen field and around Cushing Oklahoma, for example, gas fields have had production restricted due to the connection between the extraction process and earthquakes. Also, any form of carbon tax will increase the cost per BTU of fossil-fuel-powered energies and render some portion of proven reserves uneconomic. So there are lots of different ways for fossil fuels to become stranded. Some can be anticipated and some can’t. The recent oil glut came as a complete surprise to the investable oil industry. The next stranding event may also be a surprise.

It is difficult to predict how fossil fuels might become stranded assets. It’s not difficult to predict who will be affected. National oil companies hold 80% of proven reserves, so because of the sheer volume of their holdings, it’s tempting to assume that they will take the biggest hit. But national oil companies hold more conventional reserves, which are relatively easy to extract and monetize. On the other hand, publicly-traded companies, i.e., the firms that investors large and small help fund, have used their access to capital and innovative extraction processes to develop the technologies that make hydrofracking, tar sands, and deep water and Arctic platforms a reality. These reserves have a high cost per barrel and are at a higher risk of becoming stranded than conventional reserves.

In conclusion, it is reasonable to assume that some portion of the 555 GtCO2 in proven reserves on the books of public companies will not be emitted. Whether carbon taxes raise the cost of fossil fuels, and/or industry subsidies lower the cost of renewables, and/or other unanticipated developments emerge, a significant portion of current proven reserves will become stranded. In a low-carbon economy, certain reserve-owning energy companies will be more at risk than others. Those companies that embrace the eventuality and position their businesses for the transition to renewables have an opportunity to thrive. Investors in the energy sector can position portfolios appropriately by assessing both the risk (and opportunities) at an individual company level.

To read Part 1 of this post, click here.

1 The 3,200 GtCO2 figure is our own consensus estimate, based on data from the following sources: “BP Statistical Review of World Energy June 2013,” Conglin Xu and Laura Bell, “Worldwide Reserves, Oil Production Post Modest Rise,” Oil and Gas Journal, 12/02/2013; IEA (2013), “World Energy Outlook 2013,” IEA; and inventory estimates by the Intergovernmental Panel on Climate Change (IPCC) Working Group 3, Fifth Assessment, Table 6.2, April 2014.

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