As reported by Reuters, Hurricane Harvey, which hit southern Texas on August 25, 2017, killed as many as 60 people, dumped more than 50 inches of rain and caused damages as high as US$180 billion.
Harvey shut down, damaged or destroyed Texas energy operations and related businesses. Only a few days later, as some business leaders estimated that Harvey’s financial effects could result in U.S. GDP losses of up to 1 percent, record-breaking Hurricane Irma aimed for Florida’s high-growth areas. In addition to direct financial losses, these multi-billion-dollar weather events may result in additional losses for traditional energy producers by fostering the movement from conventional to renewable energy. The financial assessment of Harvey and Irma brings the question of stranded assets to the forefront.
Stranded assets, although lacking a precise technical meaning in accounting terms, are broadly defined as “assets that have suffered from unanticipated or premature write-downs, devaluations, or conversion to liabilities which can be caused by a variety of risks,” according to Ben Caldecott and a team of leading researchers on the subject at the Smith School of Enterprise and the Environment at the University of Oxford.
The term is often associated with financial losses related to the diminished value of energy producers’ reserves of coal, oil, gas and similar hydrocarbon properties. Today’s increased competition for cheaper and cleaner low-carbon or renewable fuels to avoid the collective costs of climate change, including catastrophic weather events, raises stranded asset risks that can affect the value of energy organizations at every point in the supply chain.
Importantly, the assets listed on the financial statements of energy producers reflect only a portion of the value that is subject to potential devaluation. Another portion, which represents expectations about cash flows from future production, is not reported on the balance sheet. This expectation, however, is reflected in the price of the energy producers’ securities. As expectations of future profitable production diminish, properties become subject to impairment and abandonment, and investors may incur financial losses.
Harvey and Irma made it clear that stranded asset risk is no longer hypothetical. Investors must consider the potential for financial losses previously unforeseen in the energy industry.
Continued depressed oil prices could lead to stranded assets
Over the last decade, the overall market price of fossil fuels has declined for a variety of reasons, including efforts to increase efficiency and respond to climate change through the reduction of greenhouse gases. Reduced demand affects the long-term market price and the viability of conventional energy-producing assets. If prices remain at historic lows, the investments may increasingly be at risk.
Market price declines squeeze the margins that producers can expect to realize from the extraction, delivery and refining of hydrocarbon-based fuels. Looking to the future, an expectation of an ongoing, low-price environment may make new investment in certain energy properties unrecoverable. Rather than explore, develop and produce in an era of historically low prices, certain projects may be economically unrealistic and not receive capital investment.
A call to action
Given the risks, investor groups, non-governmental organizations (NGOs) and certain government and banking entities around the world have begun to sound alarms. Using the phrase “un-burnable carbon” in 2013, the Carbon Tracker Initiative (CTI) concluded worldwide efforts to limit global warming to 2 degree Celsius could result in significant losses to global investments in traditional energy producers, estimated at US$4 trillion in market value of equity and US$1.27 trillion in debt. Financial leaders including Henry Paulson Jr., former Secretary of the Treasury, and Mark Carney, Governor of the Bank of England, began warning the financial markets to pay attention. The actions taken toward meeting or exceeding the 2015 Paris Accord targets could accelerate impairment. More recent publications by CTI, moreover, alert investors not only about existing operational assets, but also hydrocarbon production projects that are planned but not needed.
Hurricanes like Harvey and Irma demonstrate the larger question for market decision makers. Moving toward low- and carbon-free energy sources more quickly can result in increased risks of losses related to the abandonment of conventional assets. Alternatively, a series of high-cost events, with unpredictable timing, can create immediate financial losses and incentives for more imminent transformation.
How information can help identify stranded asset risk
Estimating potential stranded assets and related losses is a challenge. It requires assessing expectations about future energy use, prices and regulatory initiatives. These drivers affect projections of not only the amount but also the timing of when particular fossil-fuel assets may lose viability.
The Financial Stability Board has established a Task Force on Climate-Related Financial Disclosures, which is developing enhanced disclosure guidelines regarding climate change. Sensitivity analyses that reflect a range of scenarios, including a 2 degree Celsius limit, are described as critical for identifying stranded asset risks.
Risk across the energy supply chain
The need for these stress tests is not limited to energy producers. Entities up and down the energy supply chain, such as equipment and transportation companies and utilities, are similarly at risk. A broad range of other industries, such as agriculture, leisure and retail, may also be climate-dependent or have operations concentrated in energy-producing regions. Data-based stress tests can help companies meet increasing demands for climate-risk disclosure, which will enable investors to make informed decisions.