Sunk costs are those that have already been incurred and cannot be recovered. They often stop people from thinking logically. Investing significant time and money into something creates a tendency to continue to pursue it rather than cutting losses, even when that is the most responsible decision to make. While sustainable investing is very much in the spotlight with investors wanting to integrate ESG considerations into their decision-making, strong returns remain the bottom line. Typically, investors care more about how much is made rather than how it’s made – ignorance is often bliss.
According to the University of Oxford, where they have a specific stranded assets programme, stranded assets are defined as “assets that have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities. They can be caused by a range of environment-related risks and these risks are poorly understood and regularly mispriced, which has resulted in a significant over-exposure to environmentally unsustainable assets throughout our financial and economic systems.”
Numerous risks are associated with stranded assets. For example, changes to existing laws or the introduction of new legislation that potentially renders infrastructure obsolete, reduced costs of renewable energy making it far more competitive or changes to consumer behaviour that moves towards more mindful consumption.
A 2015 study in Nature found that to limit warming to 2C (and therefore achieve the ambitions of the Paris Agreement), a third of oil reserves, half of gas reserves and over 80% of coal reserves must remain unused. For companies and investors involved in those industries, leaving such vast quantities of reserves untouched when such expensive infrastructure (mining operations, oil rigs, pipelines etc) remains functional is a huge trade off, which many are unwilling to make.. The difficulty for investors and companies lies in weighing up the potential financial loss of stranded assets versus the potential future loss associated with climate risk if such assets are to continue operating.
The Financial Times recently estimated that around $900 billion in stranded assets exist in energy alone while a 2014 paper found exposure of the European financial sector topped 1 trillion euros. However, this pales in comparison to the $7.9 trillion expected cost of climate change by 2050 if we do not take significant action. Worryingly, this figure is also thought to be extremely conservative, with researchers from LSE noting how difficult it is to accurately capture all possible risks into financial estimates. They say that “economic assessments of the potential future risks of climate change have been omitting or grossly underestimating many of the most serious consequences for lives and livelihoods because these risks are difficult to quantify precisely and lie outside of human experience.”
Some companies (and their investors) are more vulnerable than others. A recent report by Carbon Tracker found that major US oil companies are lagging behind European competitors in their transition to a low-carbon future, therefore increasing their exposure to climate risk. The study showed companies like BP have a portfolio of around 50-60% of projects that are inconsistent with climate goals compared with 80-90% for ExxonMobil. Interestingly, they also found that emissions ambitions, scale of capital expenditure at risk and internal oil price assumptions for impairment tests are correlated, meaning either all three are being addressed together or all three are getting left behind. Minimum oil price assumptions for 2020-2050 also vary widely, from $60 to $82, both well above current market price around $42. COVID-19 exacerbates this and could force energy companies to rethink their strategy. Indeed, several oil giants have already announced that they expect assets to fall significantly this year. Shell announced that their assets might tumble by as much as $22 billion while BP expect a loss of $17.5 billion in assets, and recently sold their petrochemicals business to pursue low-carbon alternatives (and rebuild their image).
Equally, investors’ expectations may be misguided. A 2020 study by Sen and von Schickfus explored the development of a climate policy in Germany aimed to reduce reliance on coal and the impacts on the valuation of energy companies. They found that investors believe they will be compensated for their stranded assets, which was incorporated within the companies’ valuation. The researchers say, “this finding implies that investors do care about stranded asset risk, but because of the expectation of compensation, they do not believe that they will be financially affected – neither by general unburnable carbon risk nor due to specific policy proposals implying the stranding of assets.” This is dangerous for investors to believe because it removes proactivity in reducing climate risk and, in general, is pretty wishful thinking. While some individual companies may be able to work out deals that limit their risk, the expectation that the loss of all assets will be reimbursed is highly unlikely.
It’s important to realise that these risks are not just for big companies and wealthy individuals. According to 2019 figures from the OECD, global pension assets total around $32 trillion. For many years, fossil fuel giants have been staples in pension funds, therefore opening up individual, non-professional investors to stranded asset risk. This is a major reason why calls for divesting from fossil fuels are largely aimed at pensions, and why people wanting to integrate ESG considerations into their investments should talk to their providers about current and future climate risk exposure. A key area of recent focus is increasing disclosure surrounding climate risk to enhance transparency. Organisations like the UN Principles for Responsible Investing, the Financial Stability Board and the Task Force on Climate-related Financial Disclosures all encourage publishing vital information to increase resilience. The Climate Action 100+ group is an investor initiative with over $47 trillion in combined assets under management that focuses on addressing climate change through improved governance and strengthening climate disclosures relating to finance. With such financial heavyweights on board, others will likely follow.
Changing operations and speeding up the transition to low carbon is a daunting task for many companies, but it can be done, and they can achieve significant success. Take for example, Danish wind energy provider Ørsted. For decades they were entrenched in oil and natural gas production but transformed the company within a decade to focus on clean energy. Now, they are an industry leader while investors have enjoyed a nearly 300% increase on their shares since June 2016.
Stranded assets must be seriously taken into consideration when making investment and company expansion decisions. The relative infancy of low-carbon industries provides enormous opportunities for companies to change path while benefitting investors with portfolio growth and favourable returns.