Will the carbon-bubble explode? – An insight into fossil fuel assets as a leverage point of climate change

Aug 7, 2019 by

Armon Rezai is a professor at the WU Vienna University of Economics and Business. They mainly employ a macroeconomic approach on dealing with climate change and connected distribution issues, environmental policy and financialization.

At the core of the lecture were the financial implications of climate policy on fossil-fuel assets linked to a carbon budget which is determined by temperature targets.  The carbon budget can be understood as a “CO2 budget constraint” that, according to the Paris Agreement, amounts to 0.5 trillion tons of CO2 equivalent in order for global temperature rise to stay below 2°C this century. The carbon budget is defined as the total amount of carbon emitted since the industrial revolution, independent from the emitters themselves or the point of time of the emission.

 The urgent need of rapid decarbonization bears transition risks for financial markets that differ between countries. Emission cuts affect governments differently, depending on whether they own fossil fuel or company assets which are linked to CO2 emissions (sovereign risks).

Moreover, stranded assets play a crucial role in this topic. An unanticipated drop in profitability and valuation of such an asset, as a consequence of a drop in demand can transform these formerly highly profitable assets into liabilities. In this sense, he stresses that the fossil-fuel industry is threatened by the climate policy resulting from the Paris Agreement and technological change that will promote the “renewable revolution”. In contrast to this common narrative, we have to bear in mind that the biosphere is actually the one to be threatened by the fossil-fuel industry in an economy based on capitalist norms. Dietz (2017) differentiates between unburnable fossil fuels on the one hand and an insecure valuation (pricing) of fossil fuel assets on the other hand in response to climate policies.

Armon Rezai repeats that not mitigating climate change will have tremendous implications for our society. They pointed out that the strongest climatic variations in the past 7000 years were around ±1.5°C while humans settled down 12000 years ago. Today, we have already reached a temperature increase of +1.3°C, compared to the status at the beginning of the  industrial revolution, with an atmospheric CO2 concentration of more than 400 ppm. This means that we have already reached a temperature increase that represents the maximum amplitude of temperature volatility that humanity has experienced since then.

Additionally, according to IPCC projections, this will definitely increase further. In the Stern Review on the Economics of Climate Change (2007), it has been calculated that the financial costs of ongoing climate change will exceed the transition costs for reaching the Paris Agreement. In other words internalizing these “externalities”, like their impacts on the environment or society in the long-term,  would enable a more true evaluation of these assets, which is up for grabs (“efficiency gains”).

However, the economy is doing business as usual, expecting the fossil fuel market to continue increasing as if there was no need to restrict carbon emissions. This can be represented by a “carbon bubble”:

This bubble results from imperfectly anticipated climate policy and the irreversibility of costs for adjusting investment in dirty capital stocks. Such investment will inevitably evoke a crash in the share prices of carbon‐based industries as well as on other assets (“stranded assets”). A lack of divestment will most likely result in a total financial crash. It is important to bear in mind that 20-30% of the market capitalization of stock exchanges are fossil fuel based and that financial implications on assets are contagious (systemic risks). The impact of such a crash depends on the level of global integration of countries, the share of energy-use and the respective currency. Fossil fuel exporters will suffer more from committing to the Paris Agreement than other economies (e.g. Russia).

According to Rezai, the other crucial tipping point is the declining costs of renewable energies that lie, at least in some parts of the US, below the costs for coal energy. Even though the EROI (energy returned on energy invested, defined as the net energy of the energy in process itself) of renewable energies is low, the EROI of oil is plummeting. This results mainly from the innovations fueled by German and Chinese green-energy subsidies and innovations.

Personally, we feel that Rezai’s ideas of an energy transition are mainly based on the current financial system without showing optimism for a systemic change. They put hope in the power of the market incentivizing the development and cost-reduction of renewable energies and carbon capture and storage (CCS) known as negative emissions technologies. Nevertheless, they stress the importance of identifying long-term winners and losers as a leverage point of this transition.

Written by: Carolina Ortega Guttack & Florian Döhle

Based on the lecture “Sustainability transition” held by Armon Rezai during AEMS 2019.