The Challenge of Stranded Asset Risk
By Lauren Morrell
What is the future of investing in fossil fuel extraction companies? How are investors choosing to proceed? What tools are helping investors make decisions on investments with fossil fuel exposure? A panel of investment experts grappled with these questions and more at the 25th annual SRI Conference. For now, let’s focus the discussion on one specific risk in this category: stranded asset risk.
To help asset managers and investors understand the impact of their investment decisions, Sustainalytics attempts to identify the fossil fuel (coal, oil, gas) extraction companies that will be impacted the most by the risk of stranded assets. What then are “stranded assets?” Currently, the stock market price of fossil fuel extraction companies is based on how much coal, oil, or gas each company has access to—their “proved reserves.” However, if a carbon tax or other political measure makes it impossible for them to dig up and burn everything currently on the books, what will happen to their stock price? Surely, it will drop, because the value will be proven to be overstated.
While Sustainalytics is attempting to identify which companies will potentially be impacted the most by future stranded assets, they are the first to admit that it’s difficult, because public companies are not required to report much data on reserves, finances, and other factors needed to properly evaluate potential risks related to stranded assets.
Kevin Ranney, Director of Advisory Services at Sustainalytics, described how his team uses three key variables to assess exposure to carbon asset risk: the overall carbon intensity of extraction methods, the fuel mix itself, and the capital cost of projects which increases vulnerability to declining prices and demand. They also assess management action on incorporating carbon-related discounts into their business strategy. Ranney explained that “companies cannot manage [stranded asset risk] away, but how they are thinking about these issues, integrating these considerations into their CAPEX decisions does provide an important signal to investors as to how well [they] are likely to manage this over time and be prepared for a more carbon-constrained future.”
What are investors doing about the somewhat incalculable risk of stranded assets? Tim Brennan, CFO of the Unitarian Universalist Association, detailed the divestment resolution passed by the General Assembly of the Unitarian Universalist Association (UUA) in June 2014. The UUA resolution was “widely characterized as a vote to divest, but it is more nuanced than that,” Brennan said. “The proponents of the resolution started off basically putting forward exactly what [350.org] had asked for; and ended up with an appreciation of the importance of engagement.” Citing a blog from carbon tracker, Brennan emphasized the “dual approach” where the divestment movement brings the issue to the table, and stakeholders engage companies with detailed analysis and with the option for divestment.
As coal, oil, and gas become increasingly difficult to find and extract, the base of proven reserves is becoming increasing expensive to find and are in increasingly environmentally-sensitive areas. The costs of exploration and drilling are higher than ever—both in dollar and environmental terms—and generally require extreme energy- and water-intensive practices. Not to mention the effect on the environment of burning coal, oil, and gas once it’s been extracted.
Sonia Kowal, President of Zevin Asset Management, believes that carbon tax regulation will be vital to limiting future environmentally-questionable investments, but also believes that the stalemate on climate legislation is likely to continue due to lobbying efforts by energy companies and related interest. Her belief is not unfounded. We know, for example, that $721 million was spent by fossil fuel extracting companies on the recent midterm elections, but that’s only the publicly disclosed amount. Super PAC donations are not disclosed, so the $721 million figure is likely just the tip of the iceberg.
Though many fossil fuel extraction companies acknowledge the probability of a price on carbon in the future, the issue is seen as beyond the current planning horizon and therefore not a risk to their current assets. “Essentially, we feel like these guys are little kids that just love to dig holes,” Kowal mused. “Fossil fuel companies do not like to be told that playtime is over, and they’re going to do anything they can to make sure that it’s not.” For now, it’s up to investors to press the issue of stranded asset risk and incorporate it into pricing models and investment decisions.
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Posted: January 7, 2015