By Angus McCrone, Chief Editor
and Nathaniel Bullard, Director of Content
Bloomberg New Energy Finance
Market economies have two, apparently contradictory, characteristics. One is the ability to prosper despite periods of hectic transition. The other is to slip on banana skins on a regular basis.
Frequently, those banana skins can be spotted in advance but the markets slip on them anyway. During the course of 2014, a view has begun to take hold that the current configuration of the energy sector may be a sizeable banana skin, waiting to ambush the world economy. At best, the crash is a decade or so away, say proponents of this view, at worst, it may already be right under our feet.
We are talking about the coming transition away from fossil fuels. No one is suggesting that the world is about to do an “emergency stop” when it comes to burning coal, or oil and gas, but the environmental and technology-cost pressures are all working towards limiting, and then reducing, their use. The impact on capital markets is hard to forecast with any certainty.
If it is going to be tough for utilities, industry and the transport system to wean themselves off coal, oil and gas, it will be just as hard for investors. As Nathaniel Bullard argued in a Bloomberg New Energy Finance White Paper in August, Fossil fuel divestment: a $5 trillion challenge, world stock markets are sitting on investment in quoted fossil fuel companies worth $4.9 trillion. Even if you want to pull that money out of those companies, there are few if any alternative sectors that offer the same combination of scale and yield in which you can invest.
So how might the rebalancing of energy investments play out?
There are three big questions. The first is how quickly and violently the transition to a cleaner, more distributed, more resilient, smarter energy system will happen. The second is whether investors get ahead of this transition and protect themselves from risk, or whether they lag it and end up writing off stranded assets. The third is whether significant collateral damage is visited on the world economy, as it was when dotcom euphoria died in 2000-02 or (an extreme case) when the subprime bubble burst in 2007-08.
The bearish thesis rests on the idea that the world can burn only a small part of the known deposits of fossil fuel if it is to avoid a temperature increase of more than two degrees Centigrade. The Intergovernmental Panel on Climate Change said earlier this month that to keep a good chance of staying below a two-degree increase, and at manageable costs, “our emissions should drop by 40 to 70% globally between 2010 and 2050”.
If this happens, the giant corporations that operate in fossil fuel extraction – from ExxonMobil to Shell, Saudi Aramco to Gazprom, and Shenhua to Coal India – are sitting on reserves that they will never extract (at least in the absence of an increasingly implausible acceleration of progress in carbon capture and storage). The Carbon Tracker Initiative estimated in 2013 that while the top 100 coal companies and the top 100 listed oil and gas companies own just 25% of global reserves (the rest being held by state or state-owned organisations), the reserves on their balance sheets would generate almost the entire remaining “carbon budget” up to 2050 for the whole world.
Just how high the stakes are was articulated by former BP chief executive Lord John Browne, who warned last week that energy and mining companies are ignoring an “existential threat” from climate change and must change the way they operate.
If these companies are not going to produce these emissions, it means they will be unable to exploit the reserves on their balance sheets, and these will need to be written down, perhaps substantially. The more the big corporations in this sector plough on with heavy capital expenditure programmes, the more investment they will put at risk as their market disappears and their activities are cut short. Note that it does not matter whether they leave their reserves in the ground because of regulations, or because clean energy technologies become more competitive. The impact on their balance sheets would be the same.
Sadly, here at Bloomberg New Energy Finance we cannot yet see emission reductions consistent with two degrees Celsius being achieved. Our 2030 Market Outlook, published in June, predicted that fossil fuels would still make up 65% of world generation in 2030 and that oil would still power the majority of the transport system. To a large extent, this reflects cumulative investment to date – there is a huge amount of coal and oil capacity and infrastructure existing now, and it will continue to operate for a long time yet. Despite our bullish forecasts for the full cost-competitiveness of onshore wind and PV within a few years, we calculate that world emissions will not peak until the late 2020s at the earliest and the world looks likely to miss the two-degree target.
So what does that mean in terms of the effect on investors? If we are right that the two-degree carbon budget will be burst, the impact on quoted fossil fuel stocks may be less dramatic than if the world actually did what was necessary to meet the budget. And if the driver is cost competitiveness, rather than a dramatic new and swingeing climate deal, as we believe, then the adjustment should take place progressively over time.
Even before the recent drop in the oil price, quoted oil and gas companies were being pushed by their investors to scale back investment and focus on improving returns from their legacy assets. Coal companies have received even more dramatic signals from the market, with thermal coal prices 44% less than they were four years ago and investors pruning their exposure.
In the most likely scenario for energy investors, they will make good returns out of fossil fuel companies for some time yet, as long as they are not profligate with new capital. Tobacco stocks have out-performed wider market indices several times over since 2000, despite the steadily-tightening noose of regulation and tax on demand for smoking products, particularly in developed economies.
We also think that the impact on investors will be different, depending on whether their holdings are in coal, oil or gas stocks. Gas has huge advantages, with lower emissions than coal (as long as fugitive emissions are closely controlled), it offers fast-ramping technologies to balance variable wind and solar generation, and it does not produce the sort of air pollution that is crippling so many developing world cities. Gas benefits in all of the future scenarios we model – largely to the detriment of coal.
Our 2030 Market Outlook’s central scenario sees global coal capacity rising by 18% in the next 16 years, with most of the addition coming in this decade. World gas-fired power capacity increases by 55%, nearly three times as much.
Oil, unlike gas, has no role as part of the answer to the carbon bubble problem. The International Energy Agency warned this month that the current crude price, down 25% from earlier in the year, might deter investment in new capacity and lead to much higher prices in the 2020s. However, policies to address climate change will have to address oil use. Whether it is death by technology (competition from electric vehicles, gas-fuelled vehicles, much greater fuel efficiency) or death by regulation, oil will eventually see its market shrink.
Alternatives for investors
Whether fossil fuel companies are humbled by stranded assets, or manage to turn themselves into profit machines on the back of legacy assets, the divestment challenge will still be there. The opportunities for quoted equity investors in oil and coal, in particular, will be much more limited than before. As our White Paper argued, fossil fuels have been a pillar of stock market indices and investor portfolios for decades, providing reliable profits, throwing off substantial dividends and excellent liquidity.
Finding other sectors to replace the role of fossil fuel investments in a portfolio will be difficult. Some highly profitable sectors such as IT offer fat profit margins but low dividends, or are on very high multiples of earnings already. Many other sectors are too small in size to absorb the divested cash, or they have profit margins too narrow to be like-for-like substitutes.
You might posit that investors will divest from fossil fuels and invest in clean energy. That will doubtless happen to some extent, but the characteristics of most of the renewable energy sector are very different, with thin, non-existent or highly cyclical profit margins in wind turbine and solar panel manufacturing. Project ownership offers steady, high-yield returns, as long as policy risk is managed.
Efforts to put together institutional money and operating-stage renewable energy projects have been underway for some years, and are bearing fruits. One is the green bond market, on course for a record $37bn of issuance this year. Another is the US yieldco and its UK equivalent, the quoted project fund. These have raised nearly $7bn in new equity from stock market investors in the last year and a half.
But the total free float of the 106 companies that make up the NEX index is just $350bn – an entire order of magnitude too small to absorb money on the scale of the $4.7 trillion valuation of the quoted oil and gas sector. Divestment from coal looks much more practicable on a short timescale than divestment from oil or gas, with quoted coal stocks worth only $250bn.
There are several ways in which a rapid revaluation of oil, gas and coal companies might dent the wider economy. One is via the loss of wealth that could result from the divestment process. The Nasdaq Composite index dropped around 80% between March 2000 and October 2002, and that had a dampening effect on economic activity, particularly in the US. Something similar could result from a de-rating of fossil fuel stocks, and the resulting effect on portfolios. Indeed it could have a much bigger impact, given the scale of the sector. On the other hand, if the re-rating is drawn out over a longer period, its influence would be diluted by other financial market developments.
Another possible impact on the world economy could come via budgetary crises in countries that have become overly reliant on the fossil fuel sector. Russia is already suffering significant damage from the recent fall in the oil price from $116 to $79 a barrel – combined of course with the impact of sanctions. Persistently low oil and gas prices would wreak havoc with the economies of Venezuela, Iran, Nigeria and eventually even Qatar and Saudi Arabia, and might result in a surge in geopolitical instability. Received wisdom may be that oil prices will rise once again when Saudi Arabia has inflicted enough pain on US shale oil producers. But a slow world economy, combined with a transition to cleaner transportation might change the equation – remember it was only 11 years ago that oil was $28-a-barrel and the leading forecasters thought it would settle around $40.
A third, more localised, macroeconomic impact could take the form of job losses and business closures in oil- and coal-producing regions of the G20 such as Queensland in Australia, Mpumalanga province in South Africa, Texas in the US, Alberta in Canada or Shanxi province in China. At an international scale, coal in particular is not an enormous employer. US government data show fewer than 90,000 people employed in US coal mines and basins in 2012 – and that number is declining not just due to mine closures, but due to automation. That same year, the solar sector employed 119,000 in manufacturing and installation; last year, 143,000; this year, an estimated 165,000. But, locally, coal is important.
You could see the problem hitting some overly-exposed banks, and some financial centres, and their local pension funds and long-term institutions could suffer if they unduly exposed to fossil fuels. This could be a worry for London, where international oil, gas and coal exploitation accounts for 20% of the total market capitalisation of the FTSE100 index.
In summary, the shift away from fossil fuels – whether driven by regulation, economics or the divestment movement – may not be as obvious an economic and financial market banana skin as China’s slowdown, Russian adventurism, turmoil in the Middle East or euro area austerity.
But that is the thing with banana skins: you only find out how slippery they are when you step right onto them.