Future Regulation Makes Fossil Fuel Reserves Wildly Overvalued, Report Claims

A new report that warns of a “carbon bubble” argues that the world’s financial markets have vastly inflated the value of fossil fuel reserves because future regulation will ensure that most of it will remain in the ground.

(July 22, 2011)—Global investors’ portfolios need major adjustment because of incorrect assumptions about the value of fossil fuel reserves, a report by the Carbon Tracker Initiative has contended.

The research by the Carbon Tracker Initiative, a group billing itself as offering a “new way of looking at the carbon emissions problem,” has claimed that a “carbon bubble” has occurred because financial markets have valued known fossil fuel reserves as assets. The report—“Unburnable Carbon – Are the world’s financial markets carrying a carbon bubble?”—argued that valuing fossil fuel reserves as assets is a mistake because future carbon emission regulations will ensure that the bulk of those reserves will remain in the ground or “stranded.”.

As asset owners increasingly look to commodities for inflation hedges and diversification, they may need to reconsider the long-term stability of those investments, the report said. Asset owners need to ask whether their “asset allocation decisions [are] based on obsolete data regarding the full risks facing fossil fuel reserves” and whether a large portion of their investments “may be unburnable carbon.”

“There are more fossil fuels listed on the world’s capital markets than we can afford to burn if we are to prevent dangerous climate change,” read the report. “Now is the time to move into the second generation of investor action on climate change, which tackles the system that is locked into financing fossil fuels. Climate change poses a great threat to the global economy and it is not unrealistic to expect regulators responsible for assessing new systemic risk to address the carbon bubble.”

The report also called for regulators to take action on the problem. “Further regulation, guidance, and monitoring are needed to shift practices across the exchanges.”

Using a baseline of a 2°C increase from pre-industrial levels, the group worked with modeling research by the Potsdam Institute to conclude that only 20% of the world’s known fossil reserves could be burned if the world was to stay within that limit. The 2°C figure comes from the recommendation suggested by the non-binding 2010 Cancun Agreement.

The group also calculated that the stock exchanges of London, Sao Paulo, Moscow, Australia, and Toronto all have an estimated 20-30% of their market capitalization connected to fossil fuels.

Global action on limiting carbon emissions has been mixed. Some, particularly Northern European countries and members of the British Commonwealth, have embraced efforts to reduce carbon output. In Australia, for example, the country’s superannuation funds recently applauded the Gillard Government’s new carbon-pricing scheme, saying that the move had reduced long-term risk. Other countries have been less receptive. In the United States, “cap and trade” legislation has been shelved since the 2010 mid-term election, though private sector efforts to promote environmental, social, and governance (ESG) concerns in investments have been more successful.

<p>To contact the <em>aiCIO</em> editor of this story: Benjamin Ruffel at <a href='mailto:bruffel@assetinternational.com'>bruffel@assetinternational.com</a></p>