Around two-thirds of the world’s GDP is now under a net zero target, with COP26 potentially ushering in even more ambitious carbon goals. To achieve existing goals, finds a recent study from University College London, 90% of coal reserves must stay in the ground, along with nearly 60% of oil and gas reserves.
This will once again raise investor disquiet over “stranded assets” for oil and gas companies. For the International Energy Agency, these are “investments which have already been made but which, at some time prior to the end of their economic life, are no longer able to earn an economic return”.
It is difficult to quantify the level of stranded assets for fossil fuel companies, because it depends partially on the unpredictable price of oil. However, it is clear that it is likely to get worse the longer the sector puts off addressing the problem. Oxford University and University College Cork research showed that any delay increases the cashflows that needs to be reinvested to compensate for the lost cashflows from stranded assets. It estimates those lost cashflows at around €114 billion if power companies stop using fossil fuel power plants by 2040.
Dr Ben Caldecott, a co-author on the report, said: “To avoid negative impacts on share prices, credit ratings, and financial returns, we find that European power companies should increase spending on green technologies early on, to generate new income streams that will mitigate future stranded fossil fuel assets.”
Oil and gas companies in Europe and North America saw write-downs of $145bn in the first three quarters of 2020, according to analysis from the Wall Street Journal. That is the most since 2010. US accounting rules require companies to write down an asset when its projected cash flows fall below its current book value. Part of this is due to the oil price, but it is also a recognition that many assets will be uneconomic in a low carbon world. It is also clear that many companies are not making sufficient investments in green technology to compensate.
Coal is an Obvious Choice
The M&G bond team has spoken about the difficulties of calculating “transition risk” in the oil and gas sector, independent of term and cyclical factors. Some fund managers are simply divesting from companies with meaningful allocation to the most obvious areas of stranded assets, such as coal. Axa Investment Management, for example, took the decision to divest from coal assets in 2017, believing current valuation models don’t account for stranded asset risks adequately.
Oil and gas is not the only industry at risk. In some cases, whole sectors are at risk of being stranded. Tobacco may be the best example. The rules around fiduciary duty for pension investors make it difficult to justify investment in obviously harmful areas such as tobacco. Increasingly, these companies lack an all-important social license to operate. For bond and equity investors, there is a danger it becomes a little like playing pass the parcel with an unexploded bomb. No-one wants to take the risk of being left holding it when the music stops.
While the problem of stranded assets in oil, gas and tobacco has been well-flagged, there are also considerable risks in real estate. Stranded real estate assets could be buildings that are old and poorly insulated and therefore uninsurable – or, with a generation of companies increasingly concerned about their carbon footprint, un-lettable. It may also be because they are in a region potentially affected by climate events.
A recent report from UN environment programme and Henley Business School “Climate Risk & Commercial Property Values” said: “If real estate cannot be insured against adverse events and cannot be used as loan security, it will lose value and potentially become ‘stranded’. The research has uncovered some evidence of this, either in terms of actual value loss or, as a lead indicator, lack of liquidity … Evidence is starting to emerge that buyer demand has shifted in response to climate risk exposure.” The report showed that commercial property could see a thinning of buyer interest in “at risk” assets.
Property's Role in Net Zero
Tom Walker, co-head of global real estate securities at Schroders points out that between 30-40% of all greenhouse gases come from the property sector and it therefore has a significant role to play in trying to achieve net zero around the world. He says that stranded assets are those buildings where the cost of retro-fitting them so they comply with legislation is greater than the value of the asset itself. He believes this is a significant risk for real estate owners that have been slow to ensure their assets are operationally efficient.
Another concern for Walker is that some of the current measures of sustainable property – such as the "green building certificate" do not take into account of embodied carbon – i.e. the carbon footprint of the steel and concrete used for any new development – but instead focus too much on operational carbon, the cost of running the building. As such, the full carbon footprint may not be reflected in a building’s valuation.
Decarbonisation is a necessity, but there is collateral damage. It is likely to leave a range of assets value-less. These are assets that companies have paid money for and may still be reflected as an asset on their balance sheets. Investors don’t want to be the ones left holding the bomb.
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