Moving to a Low Carbon Economy: The Impact of Different Policy Pathways on Fossil Fuel Asset Values
David Nelson, Morgan Hervé-Mignucci, Andrew Goggins, Sarah Jo Szambelan, Thomas Vladeck, Julia Zuckerman, October 2014 (Climate Policy Initiative)
Executive Summary
Energy plays a central role in the global economy, and
for more than a century one of the cheapest and most
prevalent sources of energy has been fossil fuels — coal,
oil, natural gas, and the power that has been generated
from these fossil fuels. Unfortunately, fossil fuel use
has also been a major source of carbon emissions; in
2010, fossil fuels burned for energy contributed close to
two-thirds of anthropogenic greenhouse gas emissions.1
Addressing climate change will invariably reduce or
change fossil fuel use, and in all likelihood reduce the
value of fossil fuel resources.
Some observers worry that a switch away from fossil
fuels will not only have a significant cost to the global
economy, but could also absorb the investment capacity
of the financial system and even undermine the financial system if investors were burdened with worthless
fossil fuel investments. We examine the impact of a
low-carbon transition on the investment capacity of the
global financial system in a companion paper, “Moving
to a Low-Carbon Economy: The Financial Impact of the
Low-Carbon Transition.” That paper shows that the
increase in financial capacity due to reduced investment needs and operating costs for fossil fuel assets
more than offsets the increased investment required for
lower carbon investments, even when “stranded assets”
(investor losses in existing fossil fuel assets) are taken
into account.
In this paper, we examine the question of stranded
assets: What impact would a low-carbon transition
have on the value of investor portfolios when:
• Some fossil fuel assets become valueless as
they are no longer needed and are left unexploited as demand falls?
• Other assets that continue to produce lose
value as a result of price declines resulting from
lower demand?
Most importantly, we examine how the decline in value
would be spread between governments and investors
and among various countries, and how both the level
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
industries — coal, oil, natural gas, and power — as a
tool to assess stranding risks for various assets and
their owners and investors. These models estimate risk by comparing two extreme scenarios — one where no
action is taken on climate change and one where the
IEA’s low carbon goals are achieved — to quantify risks
and assess how they may be allocated between various
groups and investors.2
Actual risks are lower, as markets
have built in expectations for climate action, but these
two scenarios provide benchmarks for comparison.
Our analysis finds the following:
Governments, their citizens, and taxpayers, rather
than private investors and corporations, face the
majority of stranding risk. This risk is concentrated
in resource-owning and producing countries, particularly major oil producers.
Governments own 50-70%
of global oil, gas, and coal resources and collect taxes
and royalties on the portion they do not own. Thus, it is
unsurprising that governments would bear close to 80%
of the $25 trillion of value difference for producers under
our two scenarios.
Only some of the value at risk would actually be lost
in the transition — most of the value would be transferred from one economic actor to another, or one
country to another. For example, a falling oil price may
hurt producers but benefit consumers.
• Some of the lost value represents lost revenue
collected by fossil fuel-producing governments
from their own citizens. When these transfers
are excluded, the total value at risk falls from
$25 trillion to $15 trillion. Almost half of the
potential stranding for governments represents
lost profits and taxes that countries would raise
from sales to their own citizens at world market
prices. In practice, many energy producers
subsidize local fossil fuel products compared
to world prices, thus returning some value back
to their consumers at the expense of taxpayers
or service recipients. Even when adjusting for
these transfers or potential subsidies, governments still face twice the risk that investors
do. (To put this number in perspective, $15
trillion is equivalent to approximately 6% of the value of global stocks, bonds, and loans in 2013
(not including other assets), or less than 1% of
projected global GDP from 2015-2035.)3
• Net consuming countries would be better
off with lower fossil fuel consumption, but
producers would lose value. The benefits of
lower prices to consumers in countries like
Europe, China, India, Japan and even the U.S.,
will more than offset the value declines to their
producers. The net benefit to China and Europe
will each exceed $1 trillion, but the loss in value
to some oil-exporting countries could also
exceed $1 trillion.
Across the four fossil fuel industries, oil accounts
for the majority of value at risk, but coal holds the
largest emissions reductions potential. Even though
reducing oil consumption makes up less than 15% of the
emissions reductions in IEA’s low-carbon scenario, oil
accounts for close to 75% of the fossil fuel asset value
at risk in the low-carbon transition, because of oil’s high
marginal production costs and high profit margins. By
contrast, coal faces lower costs and lower profits, and
so has less value at risk — it accounts for approximately
80% of the emissions reductions in IEA’s low-carbon
scenario with just 12% of the asset value at risk.
Policy will determine both the net impact of stranding
and how the impact is distributed. For many countries, the right policy mix could create a net benefit.
Stranding is a function of changed consumption and
expectations, which are in turn affected by changes
in policy, pricing, technology, and behavior. Indeed,
technology and behavior are also likely to be driven by
policy. However, the range of policy options can lead
to different responses from producers, consumers and
investors, affecting the total net stranding cost and how
that cost is spread among different investors, consumers, taxpayers, and governments.
• Price or tax-based policies that reduce
demand would produce very different results
than innovation-based policies. One policy
alternative would be to rely solely on prices
as the mechanism to shift consumption and
investment — for example through taxes on
energy consumption or reduction of fossil fuel
subsidies. Consumption responds predictably to higher prices as consumers make investments
in efficiency, relocate or change consumption
mix. All of these responses have a cost. In our
oil model, when using taxes to increase retail
prices, the cost to consumers of seeking alternatives combined with value loss to producers
outweighed the benefits to taxpayers through
tax receipts, leading to a global net stranding
cost of $3 trillion under our two scenarios. On
the other hand, if innovation, new technology,
or other policy mechanisms could shift demand
without a cost to consumers, there would
be a net gain of $7 trillion, despite the lower
government tax receipts.
• A combination of innovation and price
policies probably works best. A more realistic
approach would combine the two, leading to
net stranding within the range given above.
Taxes have an initial advantage because they
are a more certain policy tool than innovation.
Tax revenue can then be channeled to support
further innovation — and the more successful
innovation is, the lower taxes will be needed to
reach a low-carbon trajectory. Moreover, studies
of the price elasticity of demand for oil suggest
that a good deal of innovation and behavior
change is driven by price changes; in fact, it
could be argued that prices are the main driver
of innovation and behavior change. Thus, the
two policy pathways are not strictly alternatives,
but could be complementary.
• For global commodities such as oil and the
globally traded portion of gas and coal,
national policies have a global impact. For
global commodities, the policies of one country
spill over to have an impact on other countries.
For example, one nation’s demand reduction
can reduce global prices. Again using oil as
an example, lower price increases would be
required to reach global goals if all countries
participate. However, if only net consuming
countries were to institute price-based
policies, these countries could still achieve
80% of the global target with 95% of the net
benefit of global action — and if they did act,
net producing countries would benefit from
reducing their consumption as well. Innovation
policy would have an equally important
cross-border impact.
• Policies that reduce demand are more effective
than those that restrict supply. We also assessed the costs of supply restrictions or
producer taxes. In our model, these policies only
curtail demand by raising prices to consumers
as in the price scenario. The result is significantly higher costs to consumers without the
offsetting benefit of higher tax receipts, but significantly higher profits and value to producers.
Outside of OPEC, our analysis shows that such
a policy could involve significant losses to the
acting country.
• Delaying policy action can markedly increase
stranding costs. Our analysis is based on the
assets and investments in the ground as of
2014. Investments and valuations change on a
daily basis. Delaying policy action or continuing
with uncertain policy creates the risk that more
investments will be made and that valuations —
and potential stranding — of fossil fuel assets
increase. Clear signals will ensure that the right
investments continue at a reasonable cost while
investments that are at risk of stranding in the
future are avoided.
While policy has an important impact on asset stranding, this impact will be colored by the specifics of the
assets and industry and economy in which it competes. We found several specific factors that need to be
considered, including the physical nature and location
of resources which determine the markets in which
the fossil fuels compete, nations’ growth rates and
asset bases, nations’ energy strategies and resource
endowments, potential substitution of one fossil fuel for
another, and the timing of policy action.
Investors have different options for managing risk.
Financial investors can easily adjust their investment
strategies to minimize the asset stranding risks they
face, while governments play numerous policy levers to
maximize the value of their resources. Fossil-fuel producing corporations face bigger challenges.
Policy Implications
Assessing these risks and minimizing them requires
careful analysis of the policy options available to meet
climate change goals and how these interact with the
specific industry and resources. A wide range of outcomes is possible, and the policy mix chosen will influence not just potential value at risk or potential gain, but
also who the winners and losers are in the transition.
Our analysis of stranding risks offers the following
insights for policymakers:
1. To minimize asset stranding, policymakers could do
well to first focus on reducing coal. Reducing coal
consumption accounts for approximately 80% of
the IEA’s projected carbon emissions savings in the
move to a low-carbon future,4 while representing
approximately 12% of potential stranded asset value
at risk.
2. Phasing out coal depends upon strategies and
policies for power generation and other uses of coal:
• Coal fired power generation in developed
countries can meet most of their goals by
phasing out their plants at the end of their
natural lives and adapting operating modes
to a low carbon weighted system.
• Constraining coal fired generation in
emerging markets in the face of growing
energy demand creates an urgent need to
develop alternative energy solutions and
improved energy efficiency, especially in
China and India (see point 5 below).
• Coal mining will require different solutions
across the major uses of coal in power
generation, iron and steel making, other
industrial usage, and residential and heating
use. Finding alternatives to coal in China and
India is a key challenge.
3. Effective oil paths to a low carbon trajectory include
reducing demand (for example through consumption taxes or the reduction of fossil fuel subsidies)
driven by net consuming countries, investment in
alternative fuels, and innovation. Additionally, there
are policy tools that can reduce undesired distributional effects.
4. Gas has a medium term future as a bridging fuel in
power generation, though to minimize stranding, it
will need to peak around 2030.
5. Financial mechanisms can further reduce the
impact of stranding. In emerging economies,
providing renewable energy subsidies through
low-cost debt or dollarizing renewable energy tariffs
can reduce the cost to governments and energy
consumers by up to 30%. In developed economies,
changing financing and business models can reduce
the cost of renewable energy by as much as 20%,
making it more competitive with fossil fuel electricity generation.
6. Governments need to develop strategies to address
the budget consequences of phasing out fossil fuel
production.
Ultimately, the global economy needs to address century-old imbalances borne from years of structuring the
economy around fossil fuel-derived energy. Policy decisions made today will direct the course of the economy
for years to come.
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