Moving to a Low-Carbon Economy: The Impact of Policy Pathways on Fossil Fuel Asset Values Climate Policy Initiative David Nelson Morgan Hervé-Mignucci Andrew Goggins Sarah Jo Szambelan Thomas Vladeck Julia Zuckerman October 2014 CPI Energy Transition Series Descriptors Region Global, United States, European Union, China, India Keywords Stranded assets, low-carbon, finance, renewable energy Contact David Nelson, [email protected] Acknowledgements The authors thank Alexander Pfeiffer for analytical contributions to the paper. They also gratefully acknowledge input and comments provided by Michael Schneider of Deutsche Bank and Nick Robins of UNEP. The perspec- tives expressed here are CPI’s own. Finally, we thank CPI colleagues who reviewed the paper and provided publication support, including Ruby Barcklay, Amira Hankin, Elysha Rom-Povolo, Dan Storey, and Tim Varga. About CPI Climate Policy Initiative is a team of analysts and advisors that works to improve the most important energy and land use policies around the world, with a particular focus on finance. An independent organization supported in part by a grant from the Open Society Foundations, CPI works in places that provide the most potential for policy impact including Brazil, China, Europe, India, Indonesia, and the United States. Our work helps nations grow while addressing increasingly scarce resources and climate risk. This is a complex challenge in which policy plays a crucial role. Copyright © 2014 Climate Policy Initiative www.climatepolicyinitiative.org All rights reserved. CPI welcomes the use of its material for noncommercial purposes, such as policy dis- cussions or educational activities, under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported License. For commercial use, please contact [email protected]. October 2014 The Impacts of Policy Pathways on Fossil Fuel Asset Values Executive Summary Energy plays a central role in the global economy, and by comparing two extreme scenarios — one where no for more than a century one of the cheapest and most action is taken on climate change and one where the prevalent sources of energy has been fossil fuels — coal, IEA’s low carbon goals are achieved — to quantify risks oil, natural gas, and the power that has been generated and assess how they may be allocated between various from these fossil fuels. Unfortunately, fossil fuel use groups and investors.2 Actual risks are lower, as markets has also been a major source of carbon emissions; in have built in expectations for climate action, but these 2010, fossil fuels burned for energy contributed close to two scenarios provide benchmarks for comparison. two-thirds of anthropogenic greenhouse gas emissions.1 Addressing climate change will invariably reduce or Our analysis finds the following: change fossil fuel use, and in all likelihood reduce the Governments, their citizens, and taxpayers, rather value of fossil fuel resources. than private investors and corporations, face the Some observers worry that a switch away from fossil majority of stranding risk. This risk is concentrated fuels will not only have a significant cost to the global in resource-owning and producing countries, partic- economy, but could also absorb the investment capacity ularly major oil producers. Governments own 50-70% of the financial system and even undermine the finan- of global oil, gas, and coal resources and collect taxes cial system if investors were burdened with worthless and royalties on the portion they do not own. Thus, it is fossil fuel investments. We examine the impact of a unsurprising that governments would bear close to 80% low-carbon transition on the investment capacity of the of the $25 trillion of value difference for producers under global financial system in a companion paper, “Moving our two scenarios. to a Low-Carbon Economy: The Financial Impact of the Only some of the value at risk would actually be lost Low-Carbon Transition.” That paper shows that the in the transition — most of the value would be trans- increase in financial capacity due to reduced invest- ferred from one economic actor to another, or one ment needs and operating costs for fossil fuel assets country to another. For example, a falling oil price may more than offsets the increased investment required for hurt producers but benefit consumers. lower carbon investments, even when “stranded assets” (investor losses in existing fossil fuel assets) are taken • Some of the lost value represents lost revenue into account. collected by fossil fuel-producing governments from their own citizens. When these transfers In this paper, we examine the question of stranded are excluded, the total value at risk falls from assets: What impact would a low-carbon transition $25 trillion to $15 trillion. Almost half of the have on the value of investor portfolios when: potential stranding for governments represents • Some fossil fuel assets become valueless as lost profits and taxes that countries would raise they are no longer needed and are left unex- from sales to their own citizens at world market ploited as demand falls? prices. In practice, many energy producers subsidize local fossil fuel products compared • Other assets that continue to produce lose to world prices, thus returning some value back value as a result of price declines resulting from to their consumers at the expense of taxpayers lower demand? or service recipients. Even when adjusting for these transfers or potential subsidies, govern- Most importantly, we examine how the decline in value ments still face twice the risk that investors would be spread between governments and investors do. (To put this number in perspective, $15 and among various countries, and how both the level trillion is equivalent to approximately 6% of the of stranded assets and their distribution depends on policy. For this analysis, we have built regional and global economic models for each of the fossil fuel 2 To evaluate and quantify stranded asset risk, we use two scenarios to represent industries — coal, oil, natural gas, and power — as a the extreme outcomes. One is based on business as usual, where no additional climate relevant policy action is taken. The other is based on the IEA’s low carbon tool to assess stranding risks for various assets and scenarios, including the 2DS scenarios from the 2012 Energy Technology Perspec- their owners and investors. These models estimate risk tives (ETP) modelling, the 450 ppm scenario from 2013 World Energy Outlook (WEO), and the 2DS from the 2014 World Energy Investment Outlook (WEIO). 1 Intergovernmental Panel on Climate Change, 2014. Contribution of Working Group Stranding risks are calculated as the difference in the value of specific assets and III to the Fifth Assessment Report: Technical Summary. Available at: http://mitiga- resources between the two scenarios – given the impact on pricing, costs and tion2014.org/report/final-draft production. CPI Energy Transition Series IV October 2014 Moving to a Low-Carbon Economy value of global stocks, bonds, and loans in 2013 higher prices as consumers make investments (not including other assets), or less than 1% of in efficiency, relocate or change consumption projected global GDP from 2015-2035.)3 mix. All of these responses have a cost. In our oil model, when using taxes to increase retail • Net consuming countries would be better prices, the cost to consumers of seeking alter- off with lower fossil fuel consumption, but natives combined with value loss to producers producers would lose value. The benefits of outweighed the benefits to taxpayers through lower prices to consumers in countries like tax receipts, leading to a global net stranding Europe, China, India, Japan and even the U.S., cost of $3 trillion under our two scenarios. On will more than offset the value declines to their the other hand, if innovation, new technology, producers. The net benefit to China and Europe or other policy mechanisms could shift demand will each exceed $1 trillion, but the loss in value without a cost to consumers, there would to some oil-exporting countries could also be a net gain of $7 trillion, despite the lower exceed $1 trillion. government tax receipts. Across the four fossil fuel industries, oil accounts • A combination of innovation and price for the majority of value at risk, but coal holds the policies probably works best. A more realistic largest emissions reductions potential. Even though approach would combine the two, leading to reducing oil consumption makes up less than 15% of the net stranding within the range given above. emissions reductions in IEA’s low-carbon scenario, oil Taxes have an initial advantage because they accounts for close to 75% of the fossil fuel asset value are a more certain policy tool than innovation. at risk in the low-carbon transition, because of oil’s high Tax revenue can then be channeled to support marginal production costs and high profit margins. By further innovation — and the more successful contrast, coal faces lower costs and lower profits, and innovation is, the lower taxes will be needed to so has less value at risk — it accounts for approximately reach a low-carbon trajectory. Moreover, studies 80% of the emissions reductions in IEA’s low-carbon of the price elasticity of demand for oil suggest scenario with just 12% of the asset value at risk. that a good deal of innovation and behavior Policy will determine both the net impact of stranding change is driven by price changes; in fact, it and how the impact is distributed. For many coun- could be argued that prices are the main driver tries, the right policy mix could create a net benefit. of innovation and behavior change. Thus, the Stranding is a function of changed consumption and two policy pathways are not strictly alternatives, expectations, which are in turn affected by changes but could be complementary.