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An emerging challenge for investors is to figure out the extent to which action (or inaction) on climate change will impact their portfolios.
Regardless of one’s personal views, company valuations are already being affected as Superannuation funds and other major investors respond to climate change. Investors need to be aware of some key issues, anticipate future developments, and develop appropriate strategies.
The carbon bubble
An investment bubble occurs when investors pay highly inflated prices for an asset.
The prevailing view of climate scientists is that, to have a reasonable chance of limiting global warming to no more than 2oC, most fossil fuel reserves will need to be left in the ground. Oil, gas and coal companies are valued on their potential future earnings, which in turn are based on the resources to which they have extraction rights. If a global agreement is reached that significantly reduces the amount of coal, oil and gas that those companies can produce, then they are worth a fraction of present valuations, and are currently in a ‘carbon bubble’ situation.
The other threat to fossil fuel companies comes from renewable energy. The cost of wind and solar power has fallen dramatically in recent years. While they still have some hurdles to overcome, renewable energy technologies are already reducing the demand for fossil fuels, and in many countries make up the majority of new electricity generation capacity.
Divestment has two main aspects to it.
On one hand the ‘divestment movement’ seeks to encourage individuals and institutions to sell their holdings in fossil fuels, primarily on moral grounds. Many churches, universities and investment funds are divesting themselves of these shares. A notable example is Rockefeller Brothers Fund, a fortune originally built on oil.
There is also a purely economic reason for divesting. If the carbon bubble theory is correct, and if companies are prevented from exploiting most of the fossil fuel reserves, it makes sense to get out of the sector before prices plunge.
Norway has the world’s largest sovereign wealth fund, also built on oil revenue. Its government is a major shareholder in many of the world’s biggest mining companies and has written to these companies to raise the issue of them spinning off their coal mining activities. While politics may be involved in this action, the future performance of the fund is the primary concern.
Assets become stranded when their working life ends prematurely, and their owners don’t receive the expected returns on their investment.
Fossil fuel reserves that can’t be extracted, for either political reasons or because new technologies render them obsolete, are one type of stranded asset. Fossil fuelled electricity plants also face the risk of becoming ‘stranded’ if they are unable to operate and have no chance of being sold.
So it isn’t just coal, oil and gas companies that investors need to watch, but also utilities and other industries that are highly dependent on fossil fuels.
Global energy markets may be facing an economic disruption greater than that endured by telecoms and IT companies in the last 30 years. For investors, both opportunities and threats will emerge. The challenge will be to recognise which is which. But with Saudi Arabia investing heavily in solar power it may be wise to heed the words of former oil minister, Ahmed Zaki Yamani: “The stone agecame to an end not for a lack of stones and the oil age will end, but not for a lack of oil”.