Aligning Flows of Capital with Tackling Climate Change

The Carbon Tracker Initiative (CTI) was set up a few years ago to investigate what levels of future carbon emissions were being financed. By comparing the stocks of carbon in the form of coal, oil, and gas in the ground with carbon budgets that equate to degrees of warming, we have demonstrated the huge overhang of carbon in our energy system – what we refer to as “unburnable carbon.”

This approach has proved valuable in being able to link together the worlds of the environment, energy, and finance sectors. As a result, the implications of having an excess of fossil fuel resources and infrastructure are being addressed by a wide range of institutions, including the International Energy Agency, the World Bank, the Organisation for Economic Co-operation and Development, and the United Nations Framework Convention on Climate Change, as well as coalitions and individual companies in the energy and finance sectors.

Behind all of this is a desire to facilitate the energy transition. We know that we will not be able to deliver a low-carbon future without having the capital to pay for it. Unless we have a financial system that is able to address climate risk, this is unlikely to happen. It is clear that the past will not be repeated, due to both the changing climate and a changing energy system. We therefore need a financial system that can deal with sectors that do not just repeat historical performance.

CTI’s macro-level analysis has made it clear that there is a journey we need to take. Everyone needs to refocus on the ultimate destination in terms of cumulative emissions. Our discussions have made it clear that this journey will not affect everyone equally – impacts will vary from region to region and depend on which fossil fuels are used. Investors will want to know who the winners and losers are going to be along the way, and how long it is going to take to get to the different stages.

It is essential that analysts be willing to challenge their assumptions in order to entertain this alternative scenario. The fundamentals of demand and price need to be reconsidered. In order to stay within a certain carbon budget, it is clear that the demand for carbon-intensive fuels will have to fall. This may then have price impacts on those commodities. Depending on the time horizon, this will affect the future revenues of companies selling those products, which feeds into valuations and credit ratings.

This has already started to happen in some markets, with the US coal sector offering a prime example. Due to cheap gas as well as air quality standards, the US domestic market for coal has declined. The largest coal-producing companies lost half of their value in the first six months of 2012, with credit downgrades following. As a result, some of those companies are looking to enter other markets – leading to oversupply in the seaborne coal market – whereas others are filing for bankruptcy.

Some analysts are starting to wake up to the fact that China’s coal consumption may peak in the next couple of years. China has proven very effective at meeting the targets set in its five-year plans, and improving air quality and reducing carbon intensity are high on the political agenda. This is now the base case-scenario for some analysts – that the coal market is in structural decline. This makes the economics of new export mines very challenging, as they will not provide a return on investment if demand and prices collapse. Challenging assumptions is critical – using last year’s coal price and demand to predict future revenues may no longer be valid.
It is worth noting that we are not framing these developments as a global deal or carbon price, or as pure climate regulation. There are a range of market factors at work – items labeled “climate regulation” are just one element. What is clear is that there are a growing number of factors that are acting to constrain high-carbon activities; as this continues, alternatives will become cheaper. However, it may be something as fundamental as adjusting the economic growth rate for China, which is as significant as a specific carbon policy for reducing demand.

CTI has tried to frame its analysis in ways that fit with the market view. Our latest research – a carbon-supply cost curve for the oil sector – shows that the world’s expensive oil may not be needed over the next few decades if we are serious about reducing emissions. Our analysis shows how high-cost oil projects are surplus-to-demand and will require that high oil prices be maintained to deliver returns.

It is also clear that different companies have varying degrees of exposure to the high end of the cost curve. The entire business model of some oil companies is betting on high oil prices to justify technically challenging, high-risk, high-cost projects such as ultra-deepwater, oil sands, and Arctic developments. This is where shareholders need to be more active in challenging the capital expenditure plans of the companies to ensure that they are focusing on shareholder value, rather than the endless pursuit of oil volume.

CTI believes it is better to be prepared for the energy transition than to wake up to a sudden shock. Many industries have gone through changes, and not all have survived. Most recently, we saw the CEO of a European utility acknowledge that his company invested in renewables too late. If the energy sector does not take this on board, then we will be left with more stranded assets that are no longer economical to run.

The world of energy is moving fast, and the operating environment of 2020 and beyond is likely to look very different from yesterday’s markets. That is why CTI is getting investors, governments, and boards to think about how the capital investment decisions made today will play out in a future where there is a lower demand for fossil fuels than in the business-as-usual scenarios that many are banking on.