In our first report we asked the question: are the world’s capital markets 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.