How to deal with worries about stranded assets

IN SEPTEMBER 2015, at a candlelit dinner at Lloyd’s of London, Mark Carney, the governor of the Bank of England, addressed the insurance industry on climate change. He gave warning in advance that there would be no jokes. Then he dropped a bombshell on the oil industry.

His message was twofold. First, if the world seriously intended to limit global warming to 2ºC, most of the coal, oil and gas reserves in the ground would be left “stranded”, or unrecoverable. Such “transition risk” could jeopardise financial stability, he argued. Second, a task force would be set up to prompt companies to disclose how they planned to manage risks and prepare for a 2ºC world, similar to the one created to improve risk disclosure by banks after the financial crisis.

Ever since that speech, oil companies have been incensed by the idea that they may be the next Lehman Brothers. Ben van Beurden, chief executive of Royal Dutch Shell, talks of financial regulators trying to “weaponise financial markets against oil and gas”. Patrick Pouyanné, the boss of Total, has urged Mr Carney to “take care of the pound, not the oil industry”.

But Mr Carney’s remarks presaged a change in attitude towards oil companies by governments, financial regulators and investors that has become clearer since the Paris climate-change agreement last December. The Securities and Exchange Commission, America’s stockmarket regulator, is investigating whether ExxonMobil, the country’s biggest oil company, values its untapped reserves appropriately in light of the recent halving of oil prices and potential regulatory action on climate change. In October it said it might write down about one-fifth of its reserves. The company has faced related probes by New York’s attorney-general, Eric Schneiderman.

Activist shareholders have had unprecedented support from mainstream investors for their efforts to force oil companies to explain how their businesses would be changed by full-scale decarbonisation. Total, Shell and BHP Billiton, a coal and oil company, were ahead of the field, issuing reports in the past 12 months that outlined scenarios for a move to 2ºC warming.

American oil firms prefer to dig in their heels, arguing that market forces are a better way to reduce emissions than “international accords or government initiatives”. They note that thanks to the shale-gas revolution in America, emissions last year were 12% lower than a decade earlier. Such attitudes risk causing more of a backlash towards the most resistant companies. BlackRock, a big asset manager, estimates that more than 500 investment firms, with assets of $3.4trn under management, have pledged to divest from fossil-fuel companies. It says that when financial fiduciaries decide where to invest, they should now consider the climate impact as well as the likely returns.

Bevis Longstreth, a former SEC commissioner (and climate activist), says such exhortations can have a ripple effect throughout the investment community. Local governments are beginning to unwind their oil and gas investments. It reminds him of the rush to disinvest from big companies that traded with South Africa under apartheid in the 1980s. “It’s like getting out of the theatre when you smell smoke.”

Stranded by guesswork

Yet the industry’s tetchy reaction to the questions raised over the value of its reserves is partly justified. Mr Schneiderman’s probe of ExxonMobil has cast this way and that, like a wildcatter desperately looking for oil. Because oil prices go up and down so much, estimating and valuing reserves is fiendishly hard. It is even harder to predict what regulators might do to counter climate change.

As for Mr Carney’s worry about stranded assets, the industry argues that it is premature. Countries like Saudi Arabia may have reserves estimated to last 70 years, but oil companies’ proven reserves are much shorter-range, typically 10-15 years. IHS, a research firm, estimates that about 80% of the value of most listed oil companies is based on proven reserves that will be used within that time frame. Daniel Yergin, IHS’s vice-chairman, also points out that the recent collapse in oil prices posed no threat to the stability of the financial system, even though the shock was more abrupt than climate change is likely to turn out. He thinks Mr Carney has overstepped the mark.

If measures to stop global warming are fully implemented, oil-company revenues could fall by more than $22trn over the next 25 years

All the same, the industry may come under further pressure. Under the aegis of the Financial Stability Board (FSB), a body administered by the Group of 20 that monitors the global financial system (and is chaired by Mr Carney), the Task Force on Climate-related Financial Disclosures is drawing up global guidelines, due to be presented to the FSB in December, for voluntary disclosure on how to manage climate risks. Members of the task force acknowledge that these risks may be tricky to account for on the balance-sheet, especially as it is not clear what future regulations governments will impose. IHS argues that such rules could harm fossil-fuel companies by putting off lenders and giving an advantage to state-owned rivals that would not face the same pressures from investors.

One of the advisers to the task force, Mark Lewis, of Barclays, says that if measures to stop global warming are fully implemented, oil-company revenues could fall by more than $22trn over the next 25 years, more than twice the predicted decline for the gas and coal industries combined. Mr Lewis sees a cautionary tale in the woes of European utilities, hit by government action to penalise coal and nuclear power. They have suffered such a devastating collapse in their share prices in recent years that some of the biggest, including Germany’s E.ON, have been forced to split off their fossil-fuel businesses. If the big oil companies are encouraged to discuss climate-change risks openly, they will have a better chance of avoiding such a fate.