The carbon bubble is soon here - can we prevent its burst?

Esther Bijl is Project Manager at Debating Europe

In the Copenhagen Climate Conference in 2009, the international community made history: for the first time ever it set a measurable target in the fight against climate change.

As many as 193 countries committed to stay well below a global temperature rise of 2°C compared to pre-industrial levels in order to prevent “dangerous anthropogenic interference with the climate system”. Since then, governments worldwide have made serious steps to put a cap on rising temperatures and to regulate the amount of CO² that is emitted into the atmosphere, mostly through burning of fossil fuels, such as coal, oil and natural gas.

Environmental legislation, such as carbon tax and air pollution regulation, will therefore have a major impact on the global fossil fuel industry. It will not only make the exploration of fossil fuel reserves more expensive at a time when renewables are becoming cheaper, commitment to the 2°C target will also make it impossible to burn all the fossil fuel reserves that we have. As pension and retirement funds, banks and insurance companies around the world have major investments in fossil fuels, this could have a massive impact on the financial sector in general, and on pension and retirement funds in particular.

In order to have a reasonable chance to meet the 2°C target, we can emit no more than another 565 gigatonnes of carbon by 2050. This is called our ‘carbon budget’ and equals the burning of about one third of all Earth’s proven fossil fuel reserves. Our scarce resource is therefore no longer fossil fuels, but the capacity of the atmosphere to absorb emissions. And with the 2°C target, we have more fossil fuels than we are ever going to need.

However, major fossil fuel companies still use their proven fossil fuel reserves as assets on the stock market and continue to raise money from pension funds, lenders and investments to develop more reserves. This increases their company value and attracts more investors who believe that supply and demand of fossil fuels will remain high. Between 2014 and 2016, banks alone invested $105.61 billion into Arctic oil drilling, tar sands and ultra-deep offshore oil exploration. Globally, companies spent more than US$674 billion on developing new reserves in 2012.

The carbon bubble is not just a green issue, it’s an economic one
When markets think that assets are more valuable than they really are, this results to a stock market bubble. This happened in the 1990s when large investors overestimated the value of many internet-based start-ups, creating the “dot-com” bubble, followed by for example the US housing bubble in the early 2000s. After the dot-com bubble and the housing bubble, we are now facing a carbon bubble. The longer we wait for perceptions to pop and the bubble to burst, the more serious the panic this will cause on the financial markets. Barclays projects that with a 2°C scenario, the oil industry will lose more than $22 trillion of expected revenue, the coals industry would lose $5.8 trillion and the gas industry would lose $5.5 trillion. According to Citigroup, continued investment in unconventional oil and gas exploration in a 2°C scenario with a drop in crude oil prices could lead to a financial loss of just over US$100 trillion in the next 35 years.

These numbers suggest that the collapse of the carbon bubble can lead to a financial crisis of a similar size to the one caused by the collapse of the housing bubble in 2007. Much of this money comes from banks and insurance companies, but also from retirement funds, universities and other public funds. The collapse of the bubble will therefore not only damage actors in the financial sector, but also citizens’ pensions.

Whether and when this bubble bursts has much to do with the perception of investors about the future of fossil fuels. As long as markets believe that supply and demand of fossil fuels will not decrease, the value of shares will remain high. When this perception changes, the value of the shares will decrease, shareholder wealth will go lost and the bubble will burst.

How likely is it that the perception of investors will change?
It is likely that renewables will soon be the cheapest option for energy. The costs of low-carbon technology are not only overestimated in many cases, they are also expected to decline in the next years. Between 2010 and 2015, the costs of onshore wind generation fell by 30% and the costs for solar energy by 66%. In fact, solar power is projected to cost no more than fossil fuel power by the end of this decade. Globally, renewable electric capacity has already overtaken coal as the world’s largest installed power source.

At the same time, the cost of fossil fuel production is increasing as traditional reserves are depleted and companies now need to extract oil and gas from places that are hard to reach. Between 2000 and 2014, total capital expenditure for fossil fuel exploration grew from $41 to 166 billion while production decreased 1.7% over the same period. New methods like oil sands and deep sea drilling are also much more damaging to the environment, making the production more prone to environmental legislation.

Unconventional exploration therefore only pays off as long as the price of fossil fuels will remain high. Yet, these prices fluctuate, making these methods financially risky. For instance, the average break-even costs of oil sands projects is US$75 per barrel compared to US$27 for Middle East and UD$50 for Russian onshore drilling. Currently, the price of crude oil is as low as US$48 a barrel.

Investor’s anticipation of government regulations can also alter perceptions. Many investors believe that tax on emission, or “carbon-pricing”, will come sooner and will be higher than previously anticipated. Fossil fuel companies such as BP and Shell are expected to lose between 40% and 60% of their market value due to carbon emission regulation. To maximise their return on investment, investors will change their investments to less risky businesses.

This can already be seen in the coal industry. Although a coal tax has not yet been introduced, anticipation of government regulation under the Obama administration turned investments in the coal industry into high-risk investments. Between 2010 and 2015 the U.S. coal sector lost 76% of its value. Peabody Coal, the U.S.’ largest coal mining company, lost 80% of its share price when investors recognized that these became stranded assets. It filed for bankruptcy in early 2016.

Divesting from fossil fuels
Once investors no longer see the added value of unconventional fossil fuel exploration, the perceived value of shares in these reserves will drop, assets will go lost, and the bubble will collapse. This can happen even when companies are still selling their coals, gas and oil.

Since 2011, citizens around the world have started to join divestment movements that call on pension funds, churches, universities and local governments to remove all investments in companies involved in the extraction of fossil fuels, and reduce the risks for both investors and the planet.

And with success: a good number of European cities has committed to pulling out of fossil fuels completely, including Berlin, Copenhagen, Lille, Malmö, Oslo, Paris, Stockholm and Stuttgart. More than 30 cities in France have pledged to divest. Likewise, more than a 100 universities have fully or partially divested following the University of Glasgow’s pledge to divest three years ago.

The movement is getting support from the financial sector. Prominent investors such as Jeremy Grantham and Bob Letterman, former head risk manager at Goldman Sachs, have started to sell their shares in companies that have invested in unconventional fossil fuel projects in last years. Profit-driven institutions, including insurance and asset management companies such as AXA and Aegon and the financial services giant Allianz SE, represent close to US$5 trillion in assets divested. Even the Rockefeller Brothers Fund, the philanthropist arm of the Rockefeller family that has made a fortune in the oil refinery business, announced that its exposure to coal and tar sands oil was less than 0.1% of its portfolio.

What can we do to prevent the carbon bubble to burst?
But it is not yet enough. Fossil fuel companies are the biggest deniers of the stranded assets theory. As long as the perception that supply and demand of fossil fuels will remain high persists, these companies will continue to receive billions in money, subsidies and loans and maintain a high valuation on the stock market. This means they will also continue to have strong ties with politicians, lobbying local, national and European decision makers to slow down the introduction of government regulations.

Divestment from these assets can reduce the risk for investors and help to avoid another financial crisis in which millions – if not trillions – of public money could be lost. The longer we wait, the larger the amounts of capital will evaporate when the bubble bursts – capital that, in addition, could otherwise have been invested in the clean energy sector.

More public pressure and stigmatisation can speed up the process of divestment. It is the pension funds, the university funds and the individual investors that gave value to assets in fossil fuel companies. They can also take it away.

Debating Security Plus – the global online brainstorm on security

This and other security issues – including terrorism, climate change, nuclear proliferation, cyber defence, security and development, climate change – will be discussed on the occasion of Friends of Europe’s online global brainstorm Debating Security Plus. It starts on 26 September at 13:00 CEST and finishes at 14:00 on September 28.

Registration is free and quick, click here.