Energy Futures Network Paper No. 15

Transcription

1 Stranded Assets a deceptively simple and flawed idea Dieter Helm 22 nd October 2015 The stranded assets argument has an elegant simplicity. Start with a maximum of 2 degrees warming. Work backwards to the total amount of additional carbon dioxide that can be emitted, consistent with this constraint. Compare this with the booked reserves of the fossil fuel companies, and then identify the excess over the constraint as stranded assets. As far as it goes is fine. But that is not very far. It does not tell us anything useful about the value of the oil, gas and coal companies. Nor indeed does it tell us anything of much practical use in thinking about financial risks and instabilities. The valuation of fossil fuel assets on company balance sheets does indeed vary, there are risks (and opportunities), and taxes, subsidies and regulatory controls are important. But then they always have been. The main way in which asset valuations is affected is through price. Assets will be worth less if the price falls, and threat of price falls has got very little to do with climate change, at least in the short to medium term. Price as well as quantity The stranded asset argument in its simple form is all about quantities, and silent on price. Yet the private value of assets is the quantity, multiplied by the price, discounted by the relevant cost of capital. The social value is of course very different, but the lack of any serious efforts to do much about climate change since 1990, and the lack of a serious carbon price now, suggest that in this public policy arena, it is more about hot air than serious action. The Paris COP is all too

2 predictable, in the same vein as Copenhagen and Dublin before it: non- enforceable pledges that do not add up to 2 degrees, on this occasion with China not capping emissions for another fifteen years, and India not capping at all. Investors have noted this inaction. If anything, this further failure to create and enforce a credible global climate agreement should lead to an increase in asset values. Limiting emissions to 2 degrees looks unlikely and hence assets beyond that level are more rather than less likely to be valuable. So lets start with the price. What is the assumed path of oil, gas and coal prices from now to the crunch point when all the carbon that can be emitted under the 2- degree constraint has been? The answer until recently from the climate campaigners is that these prices will go ever higher as peak oil (and peak gas) kick in. We have been repeatedly told that the reason why decarbonisation makes economic sense is that it protects us from high and volatile prices. In Britain, Ed Miliband, Chris Huhne and Ed Davey all sang this song. In Europe we had Connie Hedegaard and Jose Manuel Barroso on the same hymn sheet. They were all convinced that oil and gas prices were a one- way street ever upwards. They were not alone: as I document in The Carbon Crunch, this is what most advocates of renewables and nuclear, and most political leaders in Europe believed for the decade up to the abrupt collapse of the commodity super cycle in Many also believed in the theory of peak oil, as a justification for their certainty about prices. Now note the implications. If this were true and prices were going ever upwards, the assets on the balance sheets of the oil and gas companies would be ever more valuable. On the stranded asset argument, the quantity might nevertheless be limited, but with a positive discount rate, what matters is their value in the short run. Investors should have been piling into, and not out of, fossil fuel companies. This belief held by many of the same people who now trot out the stranded asset argument yields the opposite conclusion on valuation to the one advocated by campaigners

3 The pure quantity- driven peak oil argument is nonsense, with a particular stranded assets twist. There is enough oil, gas and coal to fry the planet many times over. Indeed this massive abundance is a necessary condition of the stranded asset argument. Supply is massively in excess of demand. Shale technology is just the latest addition to the enormous advances in our ability to find and deplete deposits. As a result of abundant supplies, the price should be expected to fall through time, regardless of any carbon constraint. If the long run price of oil (and gas and coal) goes down not up, then over time the value of the company assets on their balance sheets will fall. It has little to do with climate change policy. Indeed this is apparent now: the collapse of oil prices since late 2014 has led to sharp share price falls for the oil companies, and has reduced E&P in the more marginal areas. It is the sort of thing that happens all the time in company valuations: changes in relative prices lead to changes in asset valuations. The value of the oil companies reserves may be overstated but that is because analysts have yet to catch up with the possibility of low and possibly further falls in oil prices whatever the short term blips and volatilities. The discount rate Though there are some in the climate change debate (like Nick Stern) who think that assets should be valued on the basis of zero utility discount rates, investors face a range of alternatives for their funds, with different expected rates of return. They have a cost of capital, and they will discount future earnings. Telling them not to is naïve and pointless and confuses the private with the social. The implications of discounting are obvious and profound: at any reasonable number, investors are not much interested in returns in even 10 years time, let alone in They are quite rational to take this view. Society might take a different view, but the stranded assets argument targets private not public incentives.

4 Take recent asset valuation changes. Halving the oil price clearly reduces the balance sheet asset valuations of booked reserves. The companies find their dividends exposed to cuts, as their cash flow diminishes and their ability to maintain them in the future is questioned. This could be seen this year: a number of oil companies displayed dividend yields as high as 7%, up to twice that even for utilities. No wonder investors who failed to spot the end of the commodity super cycle and the end of the Chinese growth pattern lost money. But these losses tell them absolutely nothing about the future value of these assets, and the stranded assets argument has nothing to do with these losses. This has not however stopped some of the campaigners claiming that these losses somehow verify the stranded assets argument. They are not stranded: they are simply worth less because the price has fallen in the relevant period that the discount rate dictates. The stranded assets argument and the different fossil fuels The argument tends to focus on the oil companies, but not all fossil fuels are equally bad. It would be nice to think that the stranding will be inversely proportional to carbon emissions. This would mean that coal would be stranded early on, and then oil and eventually gas. Indeed it might be that the value of gas assets would go up, at the expenses of coal, for a significantly long transitional period. But this is not what is happening. Coal companies like the mining sector more generally are valued against the base- line marginal cost of coal. As the demand from China has slowed, and as new mines have come on stream, and as shale gas has displaced coal in the US, the price has fallen. That in turn has reduced the share prices and the asset valuations. It makes little sense to talk about aggregate coal reserves. They are, for all practical purposes, best regarded as infinite. They will go on for another century

5 and perhaps even longer. Not since Stanley Jevons in the nineteenth century worried about peak coal and that Britain would run out and return to its former littleness, has anyone seriously thought we will run out. A meaningful and differential carbon price might make a difference. Regulation would also change the valuations, as would non- carbon emissions prices and controls. Some progress on this front has been made, and much more could be made. Again this will affect company valuations, but it does not strand the assets. On the other hand, the rapid expansion of India s coal- based economy creates extra demand in a non- carbon capped country and the world s appetite for coal continues to expand, having risen since 1990 from less than 25% of world primary energy to 30% of a much- increased total demand. Is investment in a coal company a good idea? It depends upon the future nexus of demand, supply, price, emissions and other energy taxes and subsidies and regulation. Despite the many terrible environmental and health consequences of burning ever more coal, it is not obvious that it will yield poor returns to investors. Private and state owned fossil fuel companies The target of the stranded assets campaigners is the independent oil companies (IOCs) and independent coal companies. Neither is dominant in the world s energy markets. More than 90% of oil reserves are in state not private hands. Assuming that the assets that are supposed to get stranded are uniformly distributed across the industry, the implication on the stranded assets argument is that state owned and state controlled reserves face a write down of value because these countries will not be allowed to burn their fossil fuels or export them. Yet few believe that Russia, Saudi Arabia, Iran, Iraq or Venezuela will shut their industries down in the name of climate change mitigation anytime soon. If nevertheless demand for oil slowly dries up as the carbon constraint bites, then these countries will conclude that oil today is worth more than oil tomorrow. They will then have every incentive to pump more and faster.

6 Furthermore they will have an interest in the largest share of this declining market, and fight for market share as Saudi Arabia is doing now against Iran and US shale oil. This will drive the price of oil down not up, encourage more of it to be burnt, and have the twin impacts of increasing emissions but also reducing asset values. Muddling up social policy with private decision making The great mistake the stranded asset lobby make is to believe that they have come up with a way to mobilise private investors and institutions to do the decarbonisation for them. They think that disinvestment will be a profit maximising strategy. Hence their job is to educate private investors as to how best to make more money. In the process they anticipate that the cost of capital to fossil fuel companies will go up, hence starving them of investment. There are many reasons why investors should recalibrate their valuations for companies in the oil, gas and coal business. The most important is price and the prospect that the price may stay low and even fall for the medium and longer term. Yet price is almost entirely absent from the stranded asset campaigners argument. Much of this adjustment of expectations has now happened. Its impacts have been on E&P investment, and its greatest casualty has already been Arctic oil exploration. If price stay low, the case for Arctic investment is vanishingly small. But that does not mean oil in generally will be left in the ground. Iraq, Iran and Saudi Arabia all have resources which can be developed at less that $10 a barrel- and nobody anticipates that the price will fall that low. What the stranded assets campaigners get wrong is muddling up the private interests of investors with the public interest in mitigating climate change. The great threat of rising temperatures requires public policy setting the social cost of carbon in serious carbon prices, using regulation to get out of coal, and

7 investing in new technologies the sorts of policies advocated in The Carbon Crunch. It is governments that need to look after the social interest, and it is governments that have failed to put a proper price on carbon and spend enough on R&D. Until they do, investors will find it more profitable to concentrate on the price of oil, and they can profitably ignore the stranded asset argument. To the extent that the stranded assets argument distracts attention from these massive failures by governments, it may even be counterproductive. Dieter Helm is the author of The Carbon Crunch Revised and Updated Published in 2015 by Yale University Press For other recent publications visit