Issue: December 2011 / February 2012


Assets that arenít. The next bubble?

As one financial crisis follows another, each is met with surprise and shocks to the system. When it comes to carbon emissions, pension funds and other institutional investors are forewarned. Regulators are too.

What a yawn for investors are climate change and carbon emissions. Admit it. This is despite them being essential considerations in the environmental aspects of the criteria that Regulation 28 insists be taken seriously.

For good reason. Consider this quote: “Financial markets have an unlimited capacity to treat fossil fuel reserves as assets. As governments move to control carbon emissions, this market failure is creating systemic risks for institutional investors, notably the shift of fossil-fuel assets becoming stranded as the shift to a low-carbon economy accelerates.”

It’s from a report by Carbon Tracker, an initiative of non-profit company Investor Watch which seeks to align capital markets with efforts to tackle climate change, prepared for the official Financial Policy Committee in the UK. The purpose of this government committee, newly-established in the face of financial crises, is to monitor risks and bubbles in the financial system.

The report argues that the committee must urgently address the “carbon bubble”. Further, it must ensure greater disclosure by companies on reserves and carbon emissions in order that this material risk to financial stability can be properly assessed. Otherwise, yet another market failure looms.

At present, the report points out, governments and global markets are treating as assets the fossil-fuel reserves equivalent to five times the carbon budget for the next 40 years. The investment consequences of using only 20% of these reserves have yet to be assessed.

Only this 20% can be used to keep global warming below an increase of two degrees centigrade, a target presumably to be rigorously applied. It implies that up to 80% of declared reserves – owned by investors in the world’s largest stock exchange-listed coal, oil and gas companies – would be subject to impairment should these assets become stranded.

As at February 2011, the report finds, the top 100 coal and top 100 oil & gas companies had a combined market value of $7,42 trillion. The countries with the largest greenhouse gas potential in reserves on their stock exchanges are Russia, the US and the UK. The stock exchanges of London, Sao Paulo, Moscow, Australia and Toronto all have an estimated 20%-30% of their market capitalisations connected to fossil fuels.

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Just one of the largest companies listed in London – say Shell, BP or Xstrata – already has sufficient reserves to use up the UK’s entire carbon budget to 2050. Thus, with about a third of the FTSE 100 total value represented by resource and mining companies, it warns that “London’s role as a global financial centre is at stake if these assets become unburnable en route to a low-carbon economy”.

For SA, such a warning would be even more acute as the JSE’s top 40 index is heavily resource-reliant. All the while, new fossil-fuel companies (Glencore being a prominent example) continue to list on world markets “with no consideration by the regulators of potential systemic risks” to financial markets from increased exposure to climate-change factors.

The strategic challenge for fossil-fuel companies, argues Carbon Tracker, is the emissions associated with their products that are currently locked into their reserves. Investors will only be able to understand them not by annual reporting of the past year’s emissions but, critically, forward-looking analysis of carbon stocks becoming integral to financial reporting.

For their own protection, asset owners like pension funds must establish the proportions of their investments exposed to unburnable carbon. And regulators should:

  • Require listed companies, and companies applying to be listed, to report on their fossil-fuel reserves and potential emissions of carbon dioxide;
  • Aggregate and publish the levels of reserves and emissions, using appropriate accounting guidelines;
  • Assess the systemic risks posed to capital markets through the overhang of unburnable carbon;
  • Ensure that financial-stability measures are in place to prevent the bursting of a carbon bubble.

It isn’t a problem for tomorrow.