What are stranded assets?
Reaching a goal of limiting climate change to less than two degrees of warming would require us to keep a large proportion of existing fossil fuel reserves in the ground. According to a 2015 study in Nature, an estimated third of oil reserves, half of gas reserves and more than 80% of known coal reserves should remain unused in order to meet global temperature targets under the Paris Agreement. The value of ‘stranded assets’ might not be fully reflected in the value of companies that extract, distribute, or rely heavily on fossil fuels, which could result in a sudden drop if this risk were priced in.
How could assets become stranded?
A variety of factors could lead to assets becoming stranded. These include: new government regulations that limit the use of fossil fuels (like carbon pricing); a change in demand (for example, a shift towards renewable energy because of lower energy costs), or even legal action.
Who’s exposed to the risk of stranded assets? And how much could they lose?
Primarily, those who have invested in the company, including people who have bought the company’s stocks or bonds. This can include a wide variety of people and institutions such as individual investors, banks, pension funds, insurance companies, and universities, among others.
The size of potential losses is difficult to estimate because it depends on different scenarios about the future and how they would affect the value of the underlying assets. For example, an oil company could diversify its portfolio to include renewable energy, or a coal company might be surprised by how quickly technology shifts towards other forms of power production. To get a rough idea of the scale, Weyzig (2014) estimated that the exposure of the European financial sector (banks, insurance companies, and pension funds) to high-carbon assets was over €1 trillion.
Although the ‘stranded assets’ discussion often focuses on fossil fuels, it’s not just companies extracting oil, gas, and coal that could be affected by transition risk. Other companies that use fossil fuels as inputs for production, or are otherwise energy- or carbon-intensive, could also be affected by new climate legislation, technological advances, or a shift in demand.
That’s why international bodies like the Financial Stability Board are encouraging firms to increase their disclosure about climate-change related risks, and why it’s important that to make sure this disclosure is done effectively.
Can stranded assets create a financial crisis?
While we don’t have enough information to say for sure, many supervisory authorities are considering this question and concluding that there is a potential risk of an abrupt transition having destabilizing effects on the financial system. This is less about the shift away from fossil fuels than about how smoothly it’s done – for example, credible climate policy can help firms put into place long-term strategies for a slower and smoother adjustment that would avoid sudden shocks.
What can be done about stranded assets?
Individuals concerned about stranded asset risk could talk to their pension funds or asset managers about reducing portfolio exposure to carbon-intensive assets, or increasing investment in low-carbon assets such as renewable energy.For regulators and supervisory authorities who are monitoring the financial system as a whole, the main focus at the moment is on encouraging greater disclosure, so that investors are better aware of the risks and can make more informed decisions. Regulators can also try to better understand the potential risks, for example by developing dedicated ‘carbon stress tests’ to test the resilience of financial institutions under different scenarios.
