Stranded Carbon: The Alignment of Financial Markets with Climate Science
By Lisa Goldberg, Director of Research, Center for Risk Management Research & Adjunct Professor of Statistics, University of California, Berkeley
Lisa Goldberg is a judge for the Moskowitz Prize for Socially Responsible Investing, awarded annually by the Center for Responsible Business. She wrote the following piece after attending a climate risk event co-hosted by the CRB.
On March 31, ExxonMobil posted a 30-page article, Energy and Carbon – Managing the Risk, on its website. The article speaks to concerns raised by shareholder activists representing $3 trillion in capital and organized by a sustainable wealth management firm, Arjuna Capital, and As You Sow, a non-profit advocacy group. At issue is the potential for ExxonMobil’s hydrocarbon reserves to become stranded as a result of CO2 emission-limiting regulation. A sudden increase in awareness of the risk associated with global warming and ocean acidification could make markets nervous, resulting in a precipitous drop in the value of the shareholders’ equity.
Following an upbeat commentary on the trajectory of world growth and an overview of the close connection between human prosperity and energy production in Energy and Carbon, ExxonMobil draws the following conclusion, “Based on [our rigorous, comprehensive annual analysis of the global outlook for energy], we are confident that none of our hydrocarbon reserves are now or will become ‘stranded’.”
ExxonMobil’s argument rests, in part, on the high price that must be attached to carbon emissions—$200 per metric ton—in order to strand assets. This translates roughly to an increase in price of $2 per gallon of gasoline. As ExxonMobil explains, “Current EU Emissions Trading System prices are approximately $8 to $10 per ton of CO2.”
Five weeks earlier, on February 25, renowned financial economist Bob Litterman shared his views on stranded hydrocarbon reserves at Berkeley-Haas. Under the leadership of Scott Pinkus, who is a Senior Advisory Board member for the Center for Responsible Business (CRB) and Steering Committee Chair of the Master of Financial Engineering Program, the CRB and MFE Program partnered to sponsor Litterman’s presentation. Together, these organizations bring diverse expertise to the problem of understanding the interplay between climate change and financial markets.
Like ExxonMobil, Litterman figures that a high price for carbon emission is needed to strand assets, but that is where the similarity between the two points of view ends. Based on an economically reasonable estimate of the present value of expected future damages, Litterman argues in What is the Right Price for Carbon Emissions that given the uncertainty, “a cautious approach that weighs the cost of catastrophic outcomes above the potential benefits of hedging future economic growth is justified.”
Litterman estimates a high price for carbon emissions and believes that the carbon markets have not yet priced climate risks appropriately. If the price of carbon emissions goes up, the cost of extracting hydrocarbon reserves will exceed any benefit, and hydrocarbon reserves will become a “stranded asset.” In The Other Reason For Divestment, Litterman explains, “Emissions markets have not yet priced climate risk appropriately, but what is not well understood is that today’s equity markets build in expectations that climate risk will not be priced rationally for a very long time.” He continues, “It’s very possible that fear of catastrophic outcomes will lead to rational global pricing of emissions much sooner than the market has built into current prices of stranded assets.”
To illustrate his point, Litterman asks us to imagine ourselves racing down a mountain road when a sharp curve suddenly appears in the distance. If the road is familiar, we may know exactly when to brake and how much. If we have never been down that road before, we instinctively slam on the breaks. In warming the earth with CO2 emissions, we are most certainly traveling on an unfamiliar road.
Litterman concludes, “I think a savvy investor, particularly an educational endowment, recognizes that people do become more rational over time. Such an investor would see the risk embedded in the stranded assets in their portfolio.”
There is growing support for this perspective. A number of non-profit organizations including Responsible Endowment Coalition, Divest-Invest and 350.org are working with students, endowments, foundations and philanthropic organizations around the world to align investment policies with climate science. On April 10, 2014 in an open letter to Harvard’s President Drew Gilpin Faust and the Harvard Corporation, a group of 112 faculty members expressed disappointment in Harvard’s investment policy and called for divestment.
How confident is Litterman that hydrocarbon reserves will be stranded? He is betting on it. Under Litterman’s stewardship as Investment Committee Chair, the World Wildlife Fund has entered into a total return swap to hedge stranded assets its portfolio. WWF agreed to exchange returns on coal and oil from assets embedded in its portfolio for returns to a broad market index. To date, the swap has paid off: it earned an annualized net total return of 21.7% between 1/3/2011 and 1/17/2014. Litterman points out that there is no reason to draw the line at hedging. He explains, “A more sophisticated investor might recognize that an even larger exposure to this stranded-assets swap would create some risk, but would also potentially represent a return-generating opportunity — all while aligning the interest of the endowment with that of the institution and encouraging rational behavior with respect to climate risk.”
For individuals and organizations with a view that climate change may lead to catastrophe, financial markets provide a forum to act. Sustainable investing can lead to incentives for the exploration of clean, renewable energy; the development of affordable carbon sequestration; and the rationalization of corporate behavior. And if hydrocarbon reserves become a stranded asset, sustainable investing might just lead to a profit.
