TODAY’S STUDY: THE DIFFERENT WAYS TO MAKE THE TRANSITION TO NEW ENERGY

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.

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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

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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.

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• 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.

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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.

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• 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.

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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.

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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.

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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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