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Stranded Assets Of The Carbon Bubble

I attended a Climate One talk at the Commonwealth Club this week about how an alleged carbon bubble in the valuation of oil and gas companies will eventually lead to stranded assets remaining unextracted.  I am no stranger to this subject since I blogged about another Commonwealth Club session on natural resources in June 2014.  It's a complicated argument with more than one side.

The Carbon Tracker Initiative's Carbon Bubble report is one renowned reference for the pro-bubble case.  Here's the theory in a nutshell.  The argument contends that burning hydrocarbons raises the earth's carbon budget beyond a threshold that human civilization can tolerate.  Avoiding this threshold and the climate catastrophe it will cause requires sequestering discovered hydrocarbon energy reserves in the ground forever.  These reserves thus become stranded assets that cannot contribute economic value to an energy company's balance sheet.  The financial markets' expectation that these unavailable assets will still become available implies that energy companies' stocks trade at an unsustainable "carbon bubble" valuation.

A contrary analysis in the Wall Street Journal from January 2015 argues that the world economy will still need significant hydrocarbon energy for the foreseeable future.  I have enough financial expertise to see wisdom in realistically calculating economically recoverable energy reserves.  Energy and mining companies are always engaged in a complex pursuit of exploration, discovery, and write-down of reserves that has more to do with local geography and logistics than with global carbon regulation.  Carbon bubble proponents should remember that when they estimate large amounts of uneconomical reserves.  They should also remember than even the IPCC caveats its climate warnings with probabilities, not certainties.

Some of the carbon bubble logic falls apart in the face of project economics.  If energy company executives are truly incentivized to replace depleted reserves as the driver of share price, and if difficult projects are indeed only profitable at higher energy prices, then it follows that stringent carbon controls that drive up oil prices will revive those abandoned projects that have unfavorable break-even points.

Carbon bubble proponents and critics need to revisit the US DOE EIA's Annual Energy Outlook.  Consider that population growth, energy use per capita, and energy use per dollar of GDP are all very relevant in forecasting the amount of reserves the energy sector must discover and develop.  Tighter carbon rules will make less energy available in the short term before any dramatic supply increase from renewables comes on line to save us.

The financial sector has begun pricing securities that make lower contributions to the world's carbon budget.  Fossil Free Indexes has made a stab at finding benchmarks for portfolio managers.  Clean Energy Victory Bonds are a proposed category of US Treasury Bonds that individual investors could buy.  The victory bonds' emphasis on funding widely available technology distinguishes them from the Clean Renewable Energy Bonds (CREBs) that public utilities have issued to develop specific commercial-scale projects.

The movement encouraging divestiture from energy companies should not concern long-term value investors.  It is music to the ears of bargain hunters who seek undervalued securities with reduced demand.  Thank institutional investors for making energy stocks cheaper.  We can also thank the water-energy-food security nexus for making those three inputs more expensive, and thus more profitable for natural resource companies developing new projects.

The World Bank's World Development Report (WDR) from 2010 is a good reference for analysts pursuing insights into how the energy sector will change, with or without carbon bubbles.  Analysts must also compare the competing market valuations of the sectors for oil/gas, coal, nuclear, and renewables both inside and outside the US.  The ongoing WDR series reveals opportunities for direct investment and portfolio rebalancing.  The energy sector's component valuations will reveal opportunities for arbitrage.  Count on Alfidi Capital for continuing insights into companies that deliver ROI, with or without carbon limitations.