In their Wall St. Journal op-ed
this week, Al Gore and one of his business partners characterize
the current market for investments in oil, gas and coal as an asset
bubble. They also offer investors some advice for quantifying and
managing the risks associated with such a bubble.
Their article is
timely, because I have been seeing references to this concept with
increasing frequency, including a recent article in the Financial Times, as well as in the growing literature around sustainability investing.
Although bubbles are best seen in retrospect, investors should always
be alert to the potential, particularly after our experience just a few
years ago. In this case, however, I see good reasons to believe that
the case for a “carbon asset bubble” has been overstated and applied too
broadly. The following five myths represent particular vulnerabilities
for this notion:
1. The Quantity of Carbon That Can Be Burned Is Known Precisely
Mr. Gore is careful to differentiate uncertainties from risks, which
he distinguishes for their amenability to quantification. For
quantifying the climate risk to carbon-heavy assets, he refers to the
widely cited 2°C threshold for irreversible damage from climate change,
and to the resulting “carbon budget”
determined by the International Energy Agency. As Mr. Gore interprets
it, “at least two-thirds of fossil fuel reserves will not be monetized
if we are to stay below 2° of warming.” That would have serious
consequences for investors in oil, gas and coal.
The IEA’s calculation of a carbon budget
depends on a parameter called “climate sensitivity.” This figure
estimates the total temperature change resulting from a doubling of atmospheric CO2 concentrations. The discussion of climate sensitivity in the recently released Fifth Assessment Review
of the Intergovernmental Panel on Climate Change (IPCC) sheds more
light on this parameter, which turns out not to be known with certainty.
Their Summary for Policymakers
includes an expanded range of climate sensitivity estimates, compared
to the IPCC’s 2007 assessment, of 1.5°-4.5°C with a likelihood defined
as 66-100% probability.
It also states, “No best estimate for equilibrium climate sensitivity
can now be given because of a lack of agreement on values across
assessed lines of evidence and studies.”
The draft technical report that forms the basis for the Summary for Policy Makers provides more detail on
this. It further assesses a probability of 1% or less that the climate
sensitivity could be less than 1°C. That shouldn’t be surprising, since
temperatures have already apparently risen by 0.8°C above pre-industrial
levels. At the same time, the report indicates that recent observations
of the climate — as distinct from the output of complex climate models —
are consistent with “the lower part of the likely range.”
In other words, while continued increases in atmospheric CO2
resulting from increasing emissions are widely expected to result in
warmer temperatures in the future, the extent of the warming from a
given increase in CO2 can’t be determined precisely before the fact. For
now, at least, the CO2 level necessary to reach a 2°C increase would be
consistent with calculated carbon budgets both larger and smaller than
the IEA’s estimate. That means that the basis of Mr. Gore’s suggested
“material-risk factor” — as distinct from an uncertainty — is itself
uncertain.
2. The Transition to Low-Carbon Energy Is Occurring Fast Enough to Threaten Today’s Investments in Fossil Fuels
There is no doubt that renewable energy sources such as wind and solar power are growing at impressive rates. From 2010 though 2012
global solar installations grew by an average of 58% per year, while
wind installations increased by 20% per year. Yet it’s also true that
they make up a small fraction
of today’s energy production, and that the risks for investors of
extrapolating high growth rates indefinitely proved to be very
significant in the past.
For some clarity on this, consider the IEA’s 2012 World Energy Outlook,
the agency’s analysis of global energy trends. (The latest annual
update will be published on November 12.) As of last November, the IEA
expected global energy consumption to grow by 35% from 2010 to 2035 in
its primary scenario, which reflected an expansion of environmental
policies and incentives over those now in place. In that scenario, the
global market share of fossil fuels was expected to fall from 81% to
75%, but with total fossil fuel consumption still growing by 25% over
the period. Only in their “450″ scenario, based on similar assumptions
to its carbon budget, would fossil fuel consumption fall by 2035, and
then only by 10%.
Moreover, in its April 2013 report on “Tracking Clean Energy Progress,” the IEA warned, “The drive to clean up the world’s energy system has stalled.”
This concern was based on their observation that from 1990 to 2010 the
average carbon dioxide emitted to provide a given unit of energy in the
global economy had “barely moved.” That’s hardly a finding to be
celebrated, but it serves as an important reminder that while some
renewable energy sources are growing rapidly, fossil fuel consumption is
also growing, especially in the developing world — and from a much
larger base.
The transition to lower-carbon energy sources is inevitable. However,
it will take longer than many suppose, and it cannot be accomplished
effectively with the technologies available today. That’s a view shared by observers with better environmental credentials than mine.
3. All Fossil Fuels Are Equally Vulnerable to a Bubble
As Mr. Gore correctly notes, “Not all carbon-intensive assets are
created equal.” Unfortunately, that’s a distinction that some other
supporters of the carbon asset bubble meme don’t seem to make,
particularly with regard to oil and natural gas. The vulnerability of an
investment in fossil fuel reserves or hardware to competition from
renewable energy and decarbonization doesn’t just depend on the carbon
intensity of the fuel type — its emissions per equivalent barrel or BTU —
but also on its functions and unique attributes.
The best example of this is coal, which was in the news this week for a major transaction involving the sale of a leading coal company’s mines. What’s behind this isn’t just new EPA regulations
making it much harder to build new coal-fired power plants in the US,
but some fundamental, structural challenges facing coal. Power
generation now accounts for 93% of US coal consumption, as non-power commercial and industrial demand has declined.
This leaves coal producers increasingly reliant on a utility market
that has many other (and cleaner) options for generating electricity.
That’s particularly true as the production of natural gas, with lower lifecycle greenhouse gas emissions per Megawatt-hour of generation, ramps up, both domestically and globally. Coal accounts for about half of the global fossil fuel reserves that Mr. Gore and others presume to be caught up in an asset bubble.
Compare that to oil, which at 29% of global fossil fuel reserves,
adjusted for energy content, still has no full-scale, mass-market
alternative in its primary market of transportation energy. Despite a
decade-long expansion, biofuels account for just over 3% of US liquid fuels consumption, on an energy-equivalent basis. They’re also encountering significant logistical challenges and concerns about the degree to which their production competes with food. This has contributed to recent efforts in the EU to limit the share of crop-based biofuels to around 6% of transportation energy.
Biofuels have additional potential to displace petroleum use,
particularly as technologies for converting cellulosic biomass become
commercial, but barring a prompt technology breakthrough they appear
incapable of substituting for more than a fraction of global oil demand
in the next two decades.
Electric vehicles offer more oil-substitution potential in the long
run, though they are growing from an even smaller base than wind and
solar energy. Their growth will also impose new burdens on the power
grid and expand the challenge of displacing the highest-emitting
electricity generation with low-carbon sources.
Meanwhile, natural gas, at 20% of global fossil fuel reserves,
offers the largest-scale, economic-without-subsidies substitute for
either coal or oil. In any case, it has the lowest priority for
substitution by renewables on an emissions basis, and so should be least
susceptible to a notional carbon bubble.
4. A Large Change in Future Fossil Fuel Demand Would Have a Large Impact on Share Prices
Although Mr. Gore’s article includes a good deal of investor-savvy
terminology, it is entirely lacking in two of the most important factors
in the valuation of any company engaged in discovering and producing
hydrocarbons: discounted cash flow (DCF) and production decline rates.
Unlike tech companies such as Facebook or even Tesla, the primary
investor value proposition for which depends on rapid growth and
far-future profitability, most oil and gas companies are typically
valued based on risked DCF models in which near-term production and
profits count much more than distant ones.
At a conservative discount rate of 5%, the unrisked cash flow from
ten years hence counts only 61% as much as next year’s, while cash flow
20 years hence counts only 38% as much. Announced changes in near-term
cash flow due to unexpected drops in production or margins would
normally be expected to have a much bigger impact on share prices than
an uncertain change in demand a decade or more in the future.
This is compounded by the decline curves typical of many large
hydrocarbon projects. If the first 3-5 years of a project account for
more than half its undiscounted cash flows, it won’t be very sensitive
to long-term uncertainties, nor would a company made up of the
aggregation of many projects with this characteristic. This is even
truer of shale gas and tight oil production, which yield faster returns
and decline more rapidly.
I can’t speak for oil and gas analysts, but I’d be surprised based on
past experience in the industry if the risk of a 10% or greater drop in
global demand for oil or gas in the 2030s would have much of an effect
on their price targets for companies — certainly not enough to qualify
as a bubble.
5. Fossil Fuel Share Prices Don’t Already Account for Climate Risks
The assertion of a carbon bubble in fossil fuel assets ultimately
depends on investor ignorance of climate-response risks, presumably
because companies haven’t quantified those risks for them. To the extent
the latter condition is true, it represents an opportunity for
companies seeking to capitalize on the boom in sustainability-based
investing.
However, you needn’t be an adherent of the Efficient Markets Hypothesis for which Eugene Fama was just named as a recipient of this year’s Nobel Prize in Economics
to realize that thanks to the Internet, average investors have access
to most of the same information on this subject as Mr. Gore and his
partners. Institutional investors, who make up the bulk of the
shareholding for at least the larger energy firms, along with the
analysts who follow these companies, have the resources to access even
more information.
Nor is the idea of a carbon bubble exactly new. I’ve been following
it for a couple of years, as it took over from waning interest in Peak
Oil. It’s not an obscure risk, either, in the sense that sub-prime
mortgages and credit default swaps were in the lead-up to the failure of
Lehman Brothers in 2008. It’s becoming more mainstream every day,
but the burden of proof that this risk is mispriced rests on those
advocating this view.
Conclusions – A Real Bubble, Or An Attempt to Project One?
Before concluding, a word of disclosure is in order. As you may
gather from my bio, I spent many years working with and around fossil
fuels, though my ongoing involvement in energy is much broader than
that. As a result of that experience, my portfolio includes investments
in companies with significant fossil fuel holdings. I strive for
objectivity, but I can’t claim to be disinterested. However, neither can
Mr. Gore. As a major investor in renewable energy and other
technologies through the firm cited in the article and other roles,
he has as much at stake in promoting the idea of a carbon bubble — and
on a very different scale — as I might have in dispelling it.
The carbon bubble is an interesting hypothesis, even if I don’t
yet find the arguments made in support of it convincing. Despite that, I
see nothing wrong with investors wanting to track their carbon
exposure, consider shadow carbon prices, or ensure they are properly
diversified. However, the biggest risk I see that might eventually warrant
considering divestment isn’t based on the merits of this analysis, but
on the possibility of creating a self-fulfilling prophesy by means of
drumming up social pressure on institutional investors. You might very
well think that applies to this Wall St. Journal op-ed. I couldn’t
possibly comment.
http://www.energytrendsinsider.com/2013/11/01/five-myths-about-the-carbon-asset-bubble/
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