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Terms List

As pioneers in bridging the gap between capital markets and tackling climate change, we have developed several key terms to explain some of the concepts that have arisen. Here we define and clarify some of these key terms.

Unburnable Carbon

Unburnable Carbon refers to fossil fuel energy sources which cannot be burnt if the world is to adhere to a given carbon budget. Some aspects to consider:

  • Some fossil fuels may be used for other purposes which do not involve combustion, eg as petrochemical feedstocks. Hence we use the term unburnable rather than unusable.
  • There are a number of pilot Carbon Capture and Storage (CCS) projects now operating. Further deployment in decades to come could extend the carbon budget if the technology becomes commercial at scale.
  • Different organisations may apply a range of carbon budgets, meaning the precise amount of unburnable carbon cited varies. However there is a consensus that there is a clear overhang, and the level of potential carbon emissions exceeds any reasonable carbon budgets

Carbon Tracker has produced a series of reports themed on Unburnable Carbon which have prompted a new debate around the future of energy and investment. This has prompted organisations ranging from the IEA, oil companies, NGOs, accountants, investors, the OECD and investment banks to consider the issue. Given that the IEA and even oil companies such as BP and Shell have confirmed that burning all known fossil fuels would result in more than 2°C of warming, we feel there is reasonable consensus around this issue.

Our carbon supply cost curves research is a response to demand from investors to understand which projects are less likely to be developed in a world where global warming is limited to 2°C. This determination is made on economic grounds, with the most competitive oil, gas and coal projects being assumed to go ahead in preference to high-cost alternatives.

Useful links:

IEA: “No more than one-third of proven reserves of fossil fuels can be consumed prior to 2050 if the world is to achieve the 2 °C goal, unless carbon capture and storage (CCS) technology is widely deployed.”

Shell: “The issue of the bubble arises because the combined proven oil, gas and coal reserves currently on the books of fossil fuel companies (and governments in the case of NOCs) will produce far more than this amount of CO2 when consumed.

BP:  “We agree that burning all known reserves would probably cause global temperatures to rise by more than 2°C – and that addressing this issue will require the efforts of governments, industry and individuals. However, we believe that the unburnable carbon approach to assessing the impact of potential climate regulation on a company’s value oversimplifies the complexity of the issue and overstates the potential financial impact.

Carbon Budgets

At the 2015 UNFCCC Paris COP, world governments confirmed their intention to limit global warming “well below 2°C” and pursue efforts to “limit the temperature increase to 1.5°C”. The upper limit of 2°C is a frequently used reference point for delineating a carbon budget. The nature of climate science means that the probabilistic scenarios used produce a range of budgets depending on the parameters applied to the models. In selecting / using a budget, people should be aware of:

  • What the probability of the delivering the desired global warming outcome is: 50%, 66%, 80%? The more likely the scenario is to achieve the outcome, the smaller the carbon budget will be.
  • What time period is covered: The IPCC AR5 budgets start in 2011, meaning some of those budgets have already been used up.
  • What assumptions are made for certain climate variables: Climate sensitivity is one variable that can significantly impact the size of the carbon budget. As is the degree to which net-negative emissions are deployed.
  • Does the budget cover just energy-related emissions, such as those used by the IEA, or are other industrial, agricultural, landuse change, etc. emissions covered as well?
  • Is the budget for CO2only or all greenhouse gases? Some budgets are just for carbon or carbon dioxide (check the units); others cover all 6 greenhouse gases and are expressed in CO2e (equivalent). Does a CO2 only budget assume a high or low effort to reduce other greenhouse gases?

Our first analysis applied the Meinhausen et al. paper (2009) (Potsdam Institute) published in Nature which was peer reviewed research comparing a carbon budget based on a synthesis of the latest climate models available at the time. In response to feedback, our second analysis included some updated carbon budgets developed by the Grantham School of Climate Change and the Environment at LSE, led by Lord Stern. These provided carbon budgets which varied some of the factors in the bullet points above to test different levels of global warming (1.5 – 3°C).

Carbon budgets continue to be a popular approach to frame the challenge of keeping global warming to ‘acceptable’ levels. The IEA regularly publishes ‘energy-sector only’ carbon budgets to deliver 2C and well below levels of warming in its World Energy Outlook. Carbon Tracker has applied these in its scenario analysis, as they provide a detailed demand picture. The IPCC AR5 (2013) is now the most cited ‘total’ carbon budgets – meaning energy sector emissions plus land use, land use change and forestry plus industrial sector emissions. Our carbon supply cost curves use the IEA 450 scenario allocation of the budget to each fuel – coal, oil and gas – to test which projects are within the budget.

Carbon Bubble

In our first report we asked the question: are the world’s capital markets were carrying a carbon bubble? This question related to the fact that there is unburnable carbon, and some of that is owned by listed companies. In terms of carbon there is a clear overhang of fossil fuels beyond what can be burned in a 2°C scenario; there is a lively debate about the financial implications. Some of the issues that have arisen include:

  • Are there assets which are being valued in a manner inconsistent with the expected future scenario?
  • Does the short-term bias of valuation models mean that the impact of lower-than-expected future demand is largely discounted out at present?
  • Is the market capable of pricing in the complex set of factors which could affect demand and price?
  • Do large diversified companies (eg mining stocks or oil majors) dilute the impact of a reduction in coal or oil revenues?
  • Do current accounting rules capture the value and any potential impairment of assets in a consistent and useful manner, (eg compare mining vs oil; contrast IFRS and US GAAP)?
  • If capital expenditure continues to be used to replace reserves could this lead to the inflation of a carbon bubble which would have to be corrected in a scenario of sudden drastic action to prevent dangerous climate change?

Although it is well established that there are greater amounts of fossil fuels available than can safely be burned, it does not necessarily follow that there are material valuation implications for most listed companies at present. Valuations tend to be based on near term cashflows, which are less likely to be affected by climate-related factors. However, exposure will vary and some companies will be better positioned to withstand weak future demand fossil fuels than others. A significant proportion of fossil fuel projects outside the carbon budget are related to future projects, which companies still have time to cancel – the less that energy transition risks are factored into company planning now, the greater chance of value impacts in the future.

A number of financial institutions have published research on this issue, including HSBC, Citi and Morgan Stanley. We encourage further research in this area to ensure that the market understands the different scenarios and prevents a carbon bubble being inflated.

Stranded Assets

Carbon Tracker introduced the concept of stranded assets to get people thinking about the implications of not adjusting investment in line with the emissions trajectories required to limit global warming. There have been a number of interpretations, including:

  • Regulatory stranding – due to a change in policy of legislation
  • Economic stranding – due to a change in relative costs / prices
  • Physical stranding – due to distance / flood / drought

The concept has initiated a new programme at the Smith School of Oxford University which considers stranded assets across a range of sectors from an academic perspective. From a financial perspective, accountants have measures to deal with the impairment of assets (eg IAS 16) which seeks to ensure that an entity’s assets are not carried at more than their recoverable amount.

Stranded assets are now generally accepted to be fossil fuel supply and generation resources which, at some time prior to the end of their economic life (as assumed at the investment decision point), are no longer able to earn an economic return (i.e. meet the company’s internal rate of return), as a result of changes associated with the transition to a low-carbon economy.

For existing assets, our research can highlight which ones are more at risk of becoming stranded under a lower demand scenario – for example one that restricts anthropogenic warming to 2°C. There are already examples of coal mines, coal and gas power plants, and hydrocarbon reserves which have become stranded by the low carbon transition.

For potential new investments, our research aims to prevent stranded assets arising by identifying where capital expenditure may be allocated to investments which may not yield the expected returns as the world decarbonises. Our focus is therefore on the stewardship of capital, with the intention of preventing it being wasted.

Investors have recognised the value of companies considering a range of scenarios, including a 2°C scenario, by supporting initiatives and resolutions which ask companies to report on the implications of this future for their business. Financial regulators have also endorsed the importance of scenario analysis for assessing climate risk through the Financial Stability Board Task Force on Climate-related Financial Disclosures. Mark Carney, the FSB chair stated that a carbon budget consistent with a 2°C target “would render the vast majority of reserves ‘stranded’ — oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics”