Investors face up to a future of stranded assets

Recent studies have warned that a range of fossil fuel assets could become 'stranded' because of high extraction costs or regulations to curb climate change. In this round table, organised by Environmental Finance, with support from HSBC, the Carbon Tracker Initiative and Climate Change Capital, participants discussed the risk to investors.

Peter Cripps: Perhaps we should start with the basics of the stranded assets debate and who better to do that than James Leaton of the Carbon Tracker Initiative.

James Leaton: I am going to try and boil it down into something very simple which, essentially, is around demand and price.  Obviously, if the fossil fuel sector is not adjusting supply in line with demand, that is going to affect prices going forward. 

So this is really about challenging assumptions.  It is very common and easy to predict the future based off last year or the last three years but, with climate change, the one thing we know is that it cannot be the same. Either we have to reduce emissions or there are going to be increasing physical impacts. 

This year, therefore, we started doing cost curves for each individual fuel.  We started with oil and highlighted some high‑cost, high‑carbon projects that needed more than $95/barrel to give more than a 15% rate of return. 

Since then, the Brent oil price has gone down to around $80.  So that already demonstrates the value of stress‑testing projects against a range of prices. 

We then moved on to coal. It is not in a great state.  Maybe a third of production for export is not even covering its costs at the moment.  Obviously, the diversified companies have other commodities they can focus on and have already cut back a lot of their thermal coal investments.

But some of the pure‑play operators in the coal or unconventional oil sectors do not have the options that the diversified mining companies or the oil majors have.  I also think they are underestimating the pace of development of alternative technologies, and how quickly the costs are coming down.

Peter Cripps: Do you buy into that, James and what will be the implications for investors?

James Cameron: My way of looking at the stranded assets debate is similar but it is to do with properly understanding the systemic risk and accepting that it is very likely to be non‑linear, both in a climate sense and in a financial sense.

That is really what a stranded asset looks like: it is what has happened when there has been a non‑linear shift and you are not ready; you have not managed it properly: it is just sitting there and it is worthless or is worth so much less that it has damaged your portfolio. 

When thinking about stranded assets and your asset‑allocation plans, you have to ask yourself: 'Will there be a significant regulatory or public policy change that will alter the market conditions for the use of this commodity?' 

At the same time, you have to find alternatives.  It is unreasonable to expect large institutional investors to switch out of something into nothing.   The right conversation when you are talking about alternatives is, 'Can you deliver the essential service that human beings need?'  And, 'Can you do it in a way that makes it rational for a re‑allocation to take place so there is no damage to the yield?' 

The issue is not about the cost of the alternatives; the issue is about the cost of the transition; it is the infrastructure you have to build to make the alternatives really thrive, given the power of the incumbents. 

The big fossil‑fuel companies still command, not just enormous power in markets, but in our own consciousness about how energy is produced, how the things that we use every day are made. 

Peter Cripps: Do people feel that stranded assets are already here, or is this just a concept for the future? 

Miguel Santisteve: The view from companies is that we could be being over-optimistic on what can be done in the short term in terms of transitioning from fossil fuels into alternative energies, even though they accept that there is a need for such a transition. And, in many cases, they would disagree with the figures being used as proven reserves by Carbon Tracker.

I think we all love the idea of renewable energy, but we need to realise that solar and wind energy currently represent only 1% of global energy production. And, unfortunately, I do not think the technology is there yet to replace the use of oil in areas such as transportation, farming, mining, plastics etc.

Solange Le Jeune: I think stranded assets is just a new term for a lot of thinking that has been going on for a long time. But also it is really a risk‑management tool. It says, 'We have these assets here, what are the best ones?  Which are the ones I really need, which ones are at risk?'

But it is not something we necessarily need to look at in the short term; it is a debate for the medium‑to‑long term

Cathrine de Coninck-Lopez: I think some oil assets are stranded, right now. You look at the oil sands stocks and the situation is really quite bad.  However, the market does not necessarily look at longer‑term trends.  Therefore, if the oil price goes up in the next couple of months, there may be a buying opportunity for oil sands.

So, I agree there is a timing issue.  It is such an interesting time for the oil majors; why would you divest when the price is so low?  If you really believe in the long‑term sustainability of your assets, you should be buying them, right?  However, they are not.  So that is the real question for me: why are they not buying those assets?

Miguel Santisteve: Some of them already see the opportunity of investing in renewables.  For instance, Total, the French oil & gas producer, is now the second‑largest producer of solar panels in the world through the acquisition of SunPower back in 2011.  They are therefore getting ready for the transition.

Geof Stapledon: We are a diversified mining company, so we have oil, gas and coal in our portfolio but we also have uranium and copper with the latter being used extensively in renewables infrastructure.  So, in our portfolio, demand for some of our commodities will increase in the transition away from fossil fuels.

However, even among the fossil‑fuel assets within the portfolio … we look at them asset‑by‑asset and all in the context of careful scenario planning around the way we value our businesses and the way we look at investment decision‑making for the future.

So, for example, we have substantially completed the two major thermal coal projects we had in execution and the focus in our coal business is on continuing to improve the productivity of existing operations rather than investing in new mines. A large part of the coal assets we are keeping (after the demerger we announced recently is completed) is metallurgical coal which is used in steel making … and there will still be a future for steel.

Miguel Santisteve: Oil's 'proven reserves', as opposed to the more uncertain figures otherwise stated as 'probable' and 'possible' reserves, often only cover production of oil and gas companies for the next ten years. But we are talking about a transition that might take 20, 30, 40 years, so to speculate on whether those assets are actually stranded is where, I think, we might disagree.

James Leaton:  If you only look at a company based on their proven reserves, that essentially means they are stopping drilling tomorrow.  But they are not; they are re‑investing the revenues from their proven reserves into new barrels – the unconventionals – which are not delivering the same return.  That is why we have focused more, over the last year or two, on their capital expenditure plans. What they are spending now will not come on‑stream for ten, 15, 20 years so you have to look at the environment that might be in place then. 

Kate Brett: There is a disconnect in timeframes when we look at climate risk in our asset allocation modelling. We have looked at some different climate change scenarios and, actually, a lot of the physical impacts do not play out within the timeframe that investors are looking at.  Investors tend to be focused on more immediate risks.

Peter Cripps: What about the drivers of stranded assets? Many people see regulation as being the key to it. 

James Leaton: But, as we have already heard, we already have stranded oil assets in Canada without a global climate change deal and we already have US coal in decline, without a global deal.

Cathrine de Coninck-Lopez: For the oil producers, in my opinion, it is not about regulation, it is all about price and disruptive technologies.  However, regulations are an issue for the disruptive technologies.  Just look at the US and the Production Tax Credits. It creates so much volatility and that is the real problem. From a regulatory perspective, there is a lack of clarity and a lack of consistent support for the new technologies. 

James Cameron: Every part of the energy sector is subsidised, so the subsidy debate is bizarre.  You talk about subsidies being needed for environmental technologies but we have a totally different conversation about the subsidies that go into the extraction of fossil fuels.

However, we are also seeing that subsidies are not really here for that long because most of the technologies have such low operating costs that the real issue is the capital spend and that is the transitional cost.  The infrastructure is not designed for them, so that is an issue. But once they are built they have extremely low operating costs.

Solange Le Jeune: Yes, regulations are very slow to emerge but companies have to anticipate the shift that will happen at some point. I would like to see more discussions along the lines of: 'yes, the regulations are tightening.  We need more clarity on asset‑allocation decisions; we need more clarity on what the strategy is as a result of, say, the regulatory pressure.' 

Companies know some assets are stranded, such as oil sands, or the Arctic projects… and now they are stepping back because they can see this environment is just too much of a risk.  However, many still say: 'There is no regulation yet, and those alternatives are not making progress so we cannot switch from one to the other.' But there is a risk with not shifting as well. If regulatory change comes more suddenly than they think, they would be in trouble.

Tomas Gärdfors: The new EU goals for 2030 on carbon emissions, renewable energy and energy efficiency are significant moves forward. Alongside this there are new EU regulations to further support the required infrastructure to make it possible to reach these goals and to bring renewable energy to the markets where it is needed.

European transmission infrastructure is a long‑term asset which is well suited to pension funds. This is a fantastic opportunity to invest in lower yielding but stable assets.

James Cameron: I think that is a really interesting question: who is going to supply the capital, operate those assets, deliver clean energy infrastructure and avoid stranded assets as a result?  Who is going to do that work if it is not the European utilities?  At the moment, financial firms are buying assets but will they be operating companies?  Will someone hop across from another sector? Who is going to come across and be both the financier and operator of clean energy infrastructure?

Miguel Santisteve: I think this is a key topic in this debate. National Grid has recently warned us that there is a real risk of blackouts in the UK this winter.  You therefore have to think, 'What have we done in the last 10, 20 years in terms of new investments in electricity generation to get to this point?'

If we send out signals to the oil and gas companies, or the coal companies, saying, 'Reduce capex, do not invest, take it easy,' and we know that, just in the oil sector, the natural rate of decline of oilfields is something like 5–6% every year.  So, if you stopped investing now, in ten years you would have half the oil production you have now. 

We need to have a plan in place because otherwise, in the same way that we see now the risk of an electricity blackout, we could face an oil crunch in 10 or 20 years' time.  I therefore think we need to be careful about the messages we send.

Part 2, reviewing investors' thinking about the relative merits of engagement and divestment can be found here.