Investment in carbon industry increasingly exposed to environmental risks

Investment in carbon industry increasingly exposed to environmental risks

Ignoring environment-related risks could trigger the next financial crisis. Oil companies and other carbon industry investors are exposed to some $7 bn in liabilities as a result of investing in “stranded assets.”

Environment-related risks such as climate change have traditionally been poorly integrated into investment decision-making. This is about to change, however, with ever more asset owners and managers realising the harmful effects of global warming on their fossil fuel based-investments, that is investments into CO2-intensive production.

A worrisome scenario – the “carbon bubble” – is set to occur if capital markets take no action to stop mispricing carbon, a by-product of energy production that has been merely seen as an “external cost” in most contemporary economic models.

If the world were to adhere to its goal to reduce green house emission by 2 percent by 2050, most of the world’s total oil, gas and coal reserves would be deemed unburnable. Listed companies would see their carbon budget shrink to roughly one fourth of its current size of 762Gt CO2, rendering most of their assets worthless and causing a massive market loss of $7bn due to overvaluation of asset prices.

While a bursting carbon bubble could pose a serious threat to the owners and managers of environmentally unsustainable assets, investors have yet to start shifting money out of the sector. Instead, the industry continues to pour large amounts of money into exploiting new reserves, which they believe could amount to roughly four times the reserves that are currently listed.

The reason for why companies hesitate to shift strategy might lie in the fact that markets seem to bet against the world’s ability to place binding restrictions on greenhouse gas emission. In fact, last week, the European Commission announced its plan to revise its green energy targets, allowing member states to set their own goals for promoting renewable energies.

However, non-performing assets, or “stranded assets”, in oil, gas and coal companies could force down stock prices and thus cause losses to investors holding positions in these companies.

The consequences of future losses are already being felt in countries with a traditionally vast coal industry, such as Australia. The country is increasingly exposed to demand-side changes, which are directly linked to environment-related factors. Exports to China, the main buyer of Australian coal, have declined steadily over recent years, pushing prices down and costs up, and further worsening the outlook for the country’s mining sector.

Large institutional investors, such as pension funds, are particularly exposed to carbon asset risk. As these investors usually deploy passive index tracking strategies as part of their investment rationale, stranded assets could make up 10 to 30 percent of portfolio risks. Fortunately, there is a way to avoid a potential financial crisis.

Regulators have called on large asset managers to fulfil their fiduciary duty and minimise their exposure to environment-related risks by pulling their customers’ money out of risky assets and investing into clean energy companies instead. At a UN summit held in New York last week, representatives of the wealth management industry announced their goal to promote annual investments into the green economy by $1bn – notwithstanding the recent decline in renewable investments. Bankers have also stressed the need to develop financial vehicles, which would allow both institutional and retail investors to fund green projects.

Such steps are crucial – and there is light at the end of the tunnel. According to MSCI, a US-based investment provider, integrating environmental, social and governance (ESG) analysis into the investment process has become a major theme in the industry and is set to gain in importance over the next years. Alternative fixed-income products, such as green bonds, could even be the trend for 2014.

About Author