September 29, 2019

Stranded Assets, Policy Uncertainty, and the Threat of Adverse Exposure

By Shubhankar Dharmadhikari

With the ever-growing noise regarding the dangers of climate change, new climate legislation, and financial dynamics, the potential macroeconomic impacts of the changing environment can be hard to disentangle. While many countries continue to grapple with balancing economic and environmental concerns as they pass legislation to begin the transition to renewable fuel sources, the issue of stranded fossil fuel assets continues to metastases as a macroeconomic risk. Long term capital misallocation by large fossil fuel companies and fossil fuel reliant countries, short-sighted risk models, and policy volatility has led to a dangerous mispricing of fossil fuel assets and the formation of a carbon bubble, creating compounding adverse exposure as companies, countries, and the market continue to underestimate the structural risk posed on the economy.

Although much analysis exists on the subject already, we uniquely adopt a risk impact forward framework that connects together both qualitative theoretical work done within the academic space with more quantitative modeling and insight construction conducted by financial firms to analyze portfolio risk and process trace how (and why) certain impacts could manifest. By further contextualizing the analysis by looking to recent policy uncertainty and the relationship that exists between that uncertainty and the decision-making calculus utilized by investors and fossil fuel companies in choosing to continue to deploy further long-term investments, we can more accurately map potential triggers that could pop the carbon bubble and cause an adverse hard landing scenario.

We first move to risk identification by looking to recent market developments and track long-term asset commitments made by fossil fuel companies and develop a picture of financial risk as understood by the current literature on stranded assets. Here, we look not only to first-hand sources in the form of 10-K annual filings by fossil fuel companies to better understand the forms of noncancelable assets[1] they will continue to possess, but also utilize qualitative analysis regarding dynamic policy uncertainty that directly develops an understanding of where potential risks lie. Second, we analyze the potential propensity of these risks to manifest and cause a networked or cascading macroeconomic impact and understand why (and under what conditions) those effects could manifest and/or overlap. This portion of the analysis primarily draws on quantitative modeling strategies developed by financial firms and fossil fuel companies to understand macroeconomic risk. Finally, the degree of financial risk and impact posed by asset stranding is considered within through the lens of timeframe and magnitude posed by the risks. By connecting these broader frameworks, we can see that a more flexible categorical understanding of financial risk is necessary as policymakers and investors move forward in designing climate policies, constructing portfolios, and navigating systemic risk contagion.

Understanding Where We Are and Where We’re Headed

With the withdrawal from the Paris Agreement by the United States, policy uncertainty became an operational curveball for ongoing financial management, creating qualitative misalignment that directly impedes low-carbon transition efforts while simultaneously sufficiently reducing the risk premium profiles of ‘dirty’ investments that companies such as Exxon and Chevron can afford to internalize short term negative externalities. Further compounded by long term noncancelable exploration asset holdings, market signals to secondary asset evaluations have become also become inflated and mispriced. This not only creates conditions for adverse exposure through massive asset devaluation, as other countries will be forced to make more stringent and sudden climate policies down the line – triggering the exact sort of abrupt transition that could lead to a ‘hard landing’ scenario – but also leads to further weakness within the market as fossil fuel firms and large scale economies become locked in the short term, and stay afloat by taking on more debt and increasing downstream market exposure within the emerging markets theatre (i.e. countries that require much longer to transition to a low carbon economy/are more prone to staying reliant on fossil fuel sources).

Furthermore, the uncertainty is compounded through the generation of unreliable market signals without proper attribution as financial institutions no longer have proper metrics to value their exposure, which means firms would and could face the sort of direct exposure by running to funding and liquidity problems as they did during the 2008 Financial Crisis. Liquidity risks, which can be considered as the likelihood of failing to meet a fund capital call or on other obligations as the firm is covering losses for a downturn, can directly implicate other portions of a firm’s bundled portfolio. This itself presents an opaque risk of blooming losses and equity exposures that could spill over and undermine other portions of tranche assets and magnify the losses not only on equity but also on bonds and loans for government-backed companies.

Moreover, as investments within and by fossil fuel companies approach more $1 trillion by 2030 and firms see the reduced risk premium from policy uncertainty, the potential for systemic risk and second-round contagion grows through market distribution and propensity (i.e. the potential of cascading impacts to manifest as more portfolios become tied to high-risk fossil fuel assets) of adverse exposure to increase to estimates of $25 trillion, with 80% failing on governments. As we will see in the next section focusing on risk analysis, the way that firms’ price in the probability, timeframe, and magnitude of this future risk could also be distinctly misplaced, and further compound the problem.

Finally, the existence of propped up oil industries through government subsidies in key (and particularly vulnerable) markets/geographic regions and the fact that fossil fuel firms are substantially debt-financed only further incubates the risk profile of stranded assets. So where does this leave us? Privately-owned companies, as well as government holdings, become linked through indirect asset holdings that amplify shocks, generating a dangerous structural feedback loop. The contributions of policy volatility and its impact on fossil fuel firm decision making frames the next sections discussion on risk evolution, mispriced risk within the sector, and how these directly create the conditions for a macroeconomic hard landing scenario and high magnitude financial impacts.

Second-Order Financial Risk Assessments and the Need to Do Better

As described above, the risk of certain financial institutions losing credibility in their risk assessments rises out of associated losses as a result of asset stranding impacting the market values of fossil fuel firms. This problem becomes even more pronounced when we see that a large portion of financial disclosure statements are largely backward-looking which means more often than not, they fail to consider long-term climate risks that are emerging and price those in. This static frame of reference lends itself to facilitating carbon lock-in, as planned capital expenditures combined with lowered risk premiums from Paris withdrawal specifically implicate how analysts understand exploration investments, as “…cancelling an announced tightening of climate policy immediately boosts the scarcity, rent, and market capitalization of fossil fuel companies, leading to an investment boom in exploration and a surge in discoveries…”[2]. With organizations such as Exxon holding around $6 billion in noncancelable leases and charters, and new projects continuing to be approved, the magnitude of real asset (either capital or reserves) and financial assets (with a variable price) devaluation exposure is not only not large, but also not captured within current investment decision making calculus, (especially the indirect risk exposures to other economic sectors). If more stringent policies in line with global climate targets become a reality, approximately $12 trillion of financial value could disappear within the form of stranded assets.

Paradoxically, while a broad variety of research agrees that a transition to renewables is inevitable, the rate of the transition to the low carbon economy is a key determinant in a ‘soft landing’ versus a ‘hard landing’ scenario. Whether adverse exposure to other scenarios is contained, the current policy and economic environment have created conditions ripe for a hard landing scenario to be triggered. Within this environment, financial decision-makers in failing to assess the impact of carbon exposure that are built off long-term investments (which are the most vulnerable) mystify risks through variable expected return assessments, which again, fail to capture intertemporal adjustments which are necessary as key first-order assets (and the financial variable assets dependent upon them) such as exploration instruments react to expectations about future changes in policy. Additionally, the development of new investment vehicles such as long-horizon private capital funds creates new tranches of private equity investment which further blend portfolio composition and systemically relevant second-round effects even further[3]. Escalation triggers for the hard landing scenarios and the magnitude of the market impact become harder to trace and predict as more complex formations and cascades of indirect assets become implicated through macro-financial channels[4].

A final key component of situating this impact analysis also requires understanding the risk posed to governments and emerging markets that rely on (and will continue to be locked into) support for coal and oil production. G20 governments continue to prop up coal production through a wide range of financial instruments, with an increase in support in recent years[5]. Subsidies of this sort and magnitude not only create structural path dependencies (and lend to the dangerous feedback loop implicating macroeconomic channels) for fossil fuels, but also hide the true cost of coal infrastructure by driving investments into non-economic coal infrastructure which creates new first-order stranded assets (new coal plants, mining facilities, and an economic path dependence). Artificially extending the life of high-carbon assets that are structurally at risk directly positions them to be vulnerable to be even more adversely impacted (and moreover contribute to) hard landing impacts.

As key decision-makers consider enacting stringent climate policies or taking on carbon assets, understanding these market perception factors, structural path dependencies, and interactions between adverse exposure channels along macro-financial channels frames how the potential magnitude and likelihood of a hard landing scenario can manifest[6], a scenario becomes more likely with each passing day.

Sources

  1. Bretschger, Lucas, and Susanne Soretz. “Stranded assets: How policy uncertainty affects capital, growth, and the environment.” CER-ETH–Center of Economic Research at ETH Zurich Working Paper 18/288 (2018).
  2. Carbon Tracker Initiative. “Unburnable Carbon 2013: Wasted capital and stranded assets.” Carbon Tracker and Grantham Research Institute (2013).
  3. Carr, Mathew, “Putting a Price on the Risk of Climate Change,” Bloomberg, 5-29-2019 https://www.bloomberg.com/news/articles/2019-05-29/putting-a-price-on-the-risk-of-climate-change
  4. Curtin, Joseph, “The Paris Climate Agreement Versus the Trump Effect: Countervailing forces for decarbonisation,” 12/3/18, https://www.iiea.com/publication/the-paris-climate-agreement-versus-the-trump-effect-countervailing-forces-for-decarbonisation/
  5. Gros, Daniel, et al. Too late, too sudden: Transition to a low-carbon economy and systemic risk. No. 6. Reports of the Advisory Scientific Committee, 2016.
  6. Harvey, Fiona, “’Carbon bubble’ could spark global financial crisis, study warns,” 6/4/18, https://www.theguardian.com/environment/2018/jun/04/carbon-bubble-could-spark-global-financial-crisis-study-warns
  7. Jackson, Andrew. A stock-flow consistent framework for the analysis of stranded assets and the transition to a low carbon economy. Diss. University of Surrey, 2019.
  8. LaPlante, Alex, “Why banks should care about Trump’s climate-change withdrawal,” 7/14/17, https://www.americanbanker.com/opinion/why-banks-should-care-about-trumps-climate-change-withdrawal
  9. Mercure, Jean-Francois & Pollitt, Hector & Vinuales, Jorge & Edwards, Neil & Holden, Philip & Chewpreecha, Unnada & Salas, Pablo & Sognnaes, Ida & Lam, Aileen & Knobloch, Florian. (2018). Macroeconomic impact of stranded fossil fuel assets. Nature Climate Change. 8. 10.1038/s41558-018-0182-1.
  10. van der Ploeg, Frederick, and Armon Rezai. “The risk of policy tipping and stranded carbon assets.” Journal of Environmental Economics and Management (2019): 102258.
  11. Weyzig, Francis, et al. “The price of doing too little too late; the impact of the carbon bubble on the European financial system.” Green New Deal Series 11 (2014).

[1] “These investments are irreversible so that assets are especially prone to value loss with effective climate policy. The risk of stranded assets then affects those who have invested in the extracting company’s stocks or bonds, which may include individuals, firms, or organizations like pensions funds.5 Risks are often not fully accounted for which has resulted in a high exposure of the portfolios in many economies to carbon-intensive assets…”

[2] van der Ploeg, Frederick, and Armon Rezai. “The risk of policy tipping and stranded carbon assets.” Journal of Environmental Economics and Management (2019): 102258.

[3] “Contagion could extend across the corporate bond and leveraged loan markets, partly reflecting uncertainty as to the extent to which firms of various sectors may be affected directly or indirectly by the initial shock. If some highly leveraged financial institutions were severely hit by initial losses, and exposures throughout the system were opaque and unquantified, market and funding liquidity spirals might significantly amplify the damage to the financial system (Clerc et al, 2016).22” Gros, Daniel, et al. Too late, too sudden: Transition to a low-carbon economy and systemic risk. No. 6. Reports of the Advisory Scientific Committee, 2016.

[4] “However, Battiston et al. (2016) warn that by only focussing on direct exposures, Weyzig et al. (2014) may underestimate the potential losses to financial actors. They point out that links between financial institutions, indirect asset holdings, indirect exposures, and second-round effects can serve to amplify shocks and interfere with estimates of default probabilities. The authors use network analysis to incorporate the exposures that stem from these indirect and second-round effects. They find that while Euro Area financial actors’ direct exposures to ‘climate-relevant sectors’ are small (at 3 – 12% of total assets), their indirect exposures are much larger (at 40 – 54% of total assets). In addition, the authors find that climate mitigation policies increase the volatility on 20 – 40% of investors’ equity assets, 40% of pension fund assets, and 40% of bank assets (which is significantly in excess of bank capital).” Jackson, Andrew. A stock-flow consistent framework for the analysis of stranded assets and the transition to a low carbon economy. Diss. University of Surrey, 2019.

[5] A copy of the ODI report tracking the data can be found here: https://www.odi.org/publications/11355-g20-coal-subsidies-tracking-government-support-fading-industry

[6] “Understanding the dynamic relationship between expectations, portfolio decisions, and policy changes then become crucial for understanding capital accumulation and the various effects of environmental policy.”

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