When Will the Bubble Burst?

 

Winston Churchill once said “The Americans can always be counted on to do the right thing once every other option has been exhausted.” In this case, the quote may apply not to Americans but to the financial community. A recent bevy of risk assessments and financial analyses is generating concern among fossil fuel investors that substantial amounts of proven fossil fuel reserves will not be mined due to future legislation against crossing a dangerous global warming threshold. According to several sources, a sudden drop in the total extractable carbon fuels in the world would create a price bubble ‘burst’ similar to, but greater in magnitude, than the real estate crash in 2008. Before we get to more of this, let’s get a few definitions out of the way first:

 

  • Proven reserves: Estimates of quantities of fossil fuels yet to be extracted which can be extracted with present-day technology. This is important in this context because proven the value of proven reserves is traded in securities packages on the stock market. That is, the company assumes that the maximum possible quantity of these resources which can be extracted at market cost and sold at market value will be extracted and sold, and this potential for profit is packaged as a security and sold to raise capital to do so. The definition of proven reserves does not anticipate technological or other changes which may increase the amount of carbon reserves in the world; ‘proven’ means it is definitely extractable. The actual quantities of coal, oil, and gas left in the world are probably much higher than the sum of all proven reserves.

  • Securities: In this case, securities are the commodity futures in oil, coal, and gas that are traded by the owners of the proven reserves (fossil fuel companies), as well as the equity in their ongoing assets -- extraction projects. Basically, they are financial products designed to raise capital for fossil fuel companies and their investors. Many laypeople wonder why fossil fuel companies are so determined to extract that they will remove mountaintops, pollute waterways, spend millions of dollars lobbying for special tax and regulatory treatment, and engage in questionable human rights behaviors. A major reason (which avoids moral judgement) is that they are already selling on the value of their reserves as fully extracted, so they will lose out twice-over if the fossil fuels are left in the ground-- partly because the stock price will reflect extraction that can’t be done (creating a mini-bubble for any specific project that is halted), and partly because they can’t actually sell the fuels.

  • Stock market ‘bubbles’: Speculators buy commodities futures (or any asset) anticipating the price to increase. Irrational behavior may cause a runaway inflation of the price of the asset, driven by a mistaken belief that its value is higher than it is.  This can sometimes look very strange; the first stock market bubble in history involved the price of tulips in the 17th century Netherlands. Single bulbs of tulips were selling for enough money to buy small country estates before the ‘bubble’ burst. How does the bubble burst? When enough people realize the assets are overvalued (I wonder when that occurred to them) and begin to sell them. Selling triggers a cascading effect of more selling, as everyone scrambles to sell amidst a plummeting price and no demand to buy. Eventually they are stuck with a worthless asset, or, at best, extremely small returns on their initial investment. Maybe a tulip bulb bought for the price of a small estate sold for a few pennies, or a warehouse full of extra tulip bulbs could not be sold.*

 

*Some disagree that the ‘tulip mania’ in the Netherlands was the result of irrational speculation. Instead, they argue that it was caused by a shift in government regulation, converting futures contracts-- a binding agreement to buy a commodity at present price to be delivered in the future-- to options contracts, which as the name implies are not binding. This explanation may actually more closely mirror the carbon asset bubble, as a future regulation forbidding extraction, or a voluntary divestment from extraction, will also create a price crash without any irrational investor behavior.

 

At considerable risk of oversimplification, bubbles occur when there is a mismatch between perceived and actual value. Smart investors work tirelessly to gain as much information about their assets as they possibly can, in order to avoid these risks. The problem with carbon is, according to the Intergovernmental Panel on Climate Change and the Copenhagen Accord of 2009, the maximum safe level of warming that the planet should undergo is 2 degrees Celsius. It would take approximately 565 billion tons more CO2 emissions to raise the global temperature by these 2 degrees. The problem is, the world’s proven reserves --  again, whose values are traded upon under the assumption they will be extracted -- total 2,795 billion tons. Even the ineffectual Copenhagen Accord agreed that warming beyond 2 degrees is unacceptable, and yet stock prices reflect extraction that simply cannot be done. The assumption that governments -- on every level -- begin to enact legislation to limit carbon emissions is gaining credibility among big investors, an assumption which hasn’t carried much financial weight until very recently. Another small but growing impact on fossil fuel stock values is the divestment campaign originally begun by Bill McKibben’s 350.org, which has met with widely varying success. The campaign encourages stakeholders to petition their institution, company, or government’s boards to divest from fossil fuel assets. Unsurprisingly, UC Berkeley students will have a much easier time talking their board into divestment than fellow graduates of my alma mater, Pitt; deep inside gas country, fracking assets get your college a lot of money.

So what’s going to happen? Investors have begun looking at tools developed by the market research company Bloomberg to help calculate how much value might be lost by fossil fuel stocks, and its not pretty. 20% of investment portfolios are currently in fossil fuel companies, and some estimates have fossil fuel stocks losing 43% of their value due to stranded assets. A shock to stock values of this magnitude would register at least as severely as the housing bubble of 2008, whose effects we are still feeling today. So what can we do to stop it?

Needless to say, a hit at the bottom line seems to be the one thing that motivates a fossil fuel company the most. Their chief investors are beginning to take the threat seriously, as the article about Bloomberg LP shows. Bloomberg’s estimation tool is still in a beta testing stage and stops short of recommending specific countermeasures (beyond divestment to protect one’s own assets, which will also tank the value of fossil fuel stocks given enough people doing it.) Most people can probably think of quite a few possible courses of action - the biggest being investment in renewables.

As I’ve written before, the cost you pay for fossil fuels at the pump or on your electricity bill represents an enormous market failure, defined as an inefficient allocation by the free market (which, with any knowledge of corporate subsidies, you will know is not, and never has been, a truly free market). The costs of fossil fuels in a business-as-usual scenario only reflect capital costs, and completely and utterly ignore the enormous costs of their unmonetized consequences -- global warming, asthma, toxic air pollution, cancer, water pollution from ash, and so on ad infinitum. A market failure is a recipe for a bubble to burst, because real costs are hidden, but still very real. This time, the unburnable assets bubble threatens to make a lot of numbers with dollar signs in front of them a lot smaller than they were before, and that is going to get a lot of otherwise intelligent people thinking.

 

Sources and further reading on the carbon bubble:

 

http://www.bloomberg.com/news/2013-10-24/investor-group-presses-oil-companies-on-unburnable-carbon-.html -Full article on Bloomberg LP’s estimation tool

 

http://www.carbontracker.org/investors-challenge-fossil-fuel-companies and http://www.carbontracker.org/carbonbubble The Carbon Tracker Initiative was the first project to investigate the concept of stranded carbon assets and their possible economic consequences

 

http://insideclimatenews.org/news/20131203/bloomberg-lp-launches-first-tool-measures-risk-unburnable-carbon-assets More information on the Bloomberg tool

 

http://www.rollingstone.com/politics/news/global-warmings-terrifying-new-math-20120719 Bill McKibben’s Rolling Stone article on the carbon bubble, which was the first way I heard about the concept. He’s got a knack for making it easy to understand, filling me with enlightening knowledge and literary envy.

 

http://www.smithschool.ox.ac.uk/research/stranded-assets/SAP-divestment-report-final.pdf For the real wonks out there, here is a report from the Oxford Smith School of Enterprise and the Environment studying the effects of fossil fuel divestment. Impress your parents!

 


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