The research is clear on stranded assets, but how will the finance sector respond?

The latest research reveals transitioning to low carbon economies could see a loss of US$1.4 trillion in stranded fossil fuel assets with a particular impact on OECD countries. Meanwhile, BP’s Energy Outlook cut projected global oil and gas demand for 2035 by 5%, and brought forward the expected year of peak oil. Sustainable Investment Manager János Hidi argues that in light of this research and announcements, governments and the private sector should work together with the finance sector for a successful capital reallocation towards net zero.

Transitioning to a low-carbon economy will have far reaching consequences on both the real economy and finance sector.

In the real economy the impact is dominated by the need for large investments in low-carbon solutions, and a move away from fossil fuels as energy sources with strong implications on the extractive sectors and the international oil and gas trade. Fresh recognition of the future of fossil fuels was made with BP’s Energy Outlook bringing forward the expected year of peak oil, which has large implications on several sectors, from the oil and gas industry to mobility, manufacturing, raw materials, and the supporting infrastructure development.

In the finance sector, these complex changes will be the main drivers of capital reallocation in the coming decades. Current asset pricing will need to reflect these changes in time to avoid a disorderly financial shock.

The research is clear

A recently published study in Nature Climate Change quantifies the financial impact likely to be caused by the stranded fuel assets, which will lose their value along the transition to low-carbon economies.

Based on E3ME macroeconomic modelling, it concludes that financial risks related to the value loss of stranded fossil fuel assets is substantial, worth US$1.4 trillion, and the majority of those risks fall on private investors in OECD countries, including pension savers, due to financial investments in those impacted oil and gas assets around the globe. (See also our blog post ’Global warming could melt our pension savings’.)

The largest losses are expected in oil and gas fields located in Russia, the United States, Canada and China, but when the financial ownership is taken into account, the size of ultimate loss to owners is reallocated to governments and individual investors around the developed world, especially to the United States due its large financial market.

As a percent of GDP, however, these losses are the largest in Qatar, Turkmenistan, Russia and Norway.

The findings are a major turning point

The findings of this research should be considered a turning point in how the finance sector approaches the global transition to a low-carbon economy that is already starting to surface in the real economy now.

A prudent approach to this challenge is a managed phase-out of fossil based assets, similarly to a report by the Glasgow Financial Alliance for Net Zero, which argues that instead of divesting we should follow an approach which is aligned with a net zero target without making the transition financially disorderly.

This approach focuses on encouraging decarbonisation, providing finance to a managed replacement of the stranded assets, making an orderly and just transition possible.

Such an approach requires governments and the private sector to act now in a co-ordinated way, implementing the required policy changes and investments, limiting economic disruption related to the transition.

If the finance sector does not gradually price and walk at the pace of the real-economy, adapting and transitioning at the same time, we could see an even more turbulent transition to net zero than it will already be.

The finance sector has a choice to make

With investor short-termism so prevalent, it is easy to imagine a transition scenario in which the long-term consequences of decarbonisation are not priced in gradually by the financial markets, as it would be desired, but instead a sudden recognition of the new reality – a Minsky-moment of the financial markets – may lead to a disorderly transition to net zero.

In this scenario the adjustment needed in the real economy, which in itself is disruptive, will be exacerbated by the sudden re-pricing of financial assets. The accumulated level of mispricing will only grow in time, along with the required size of realignment.

The financial crisis of 2007-2008 was triggered by a similar realignment, where the financial markets realised the extent of mispriced subprime mortgage assets, leading to an unprecedented shock to the real economy. That subprime mortgage crisis was caused by an estimated US$250-500 billion worth of mispriced financial sector asset base.

The recent Nature Climate Change study quoted above estimates that the transition to a net zero economy can lead to a US$681 billion worth of losses on financial institutions’ balance sheets, potentially leading to a bigger disruption than in 2007-2008.

Given the many unknowns in the process, including the uncertainties in the climate and economic models themselves, we should not make things worse by adding an otherwise avoidable financial layer to the layers of uncertainties.

There is a considerable amount of research available, including climate scenario analysis and stress testing which can help guide the finance sector to get prepared and follow the path of an orderly and just transition to net zero.

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