A framework aligning the decisions of financial institutions with long-term climate goals is taking shape, as a recent strain of literature has begun evaluating how the operator’s carbon risk is passed on to lenders and investors with a stake in these companies. Investor’s carbon exposure should be evaluated and managed by a combination of different options ranging from disclosure to diversification, engagement and divestment.
The Paris Agreement allows countries to determine their own contributions to emissions reductions; setting the long-term 1.5°C aspirational limit for temperature increase and requiring actions to evolve and strengthen over time has anchored future expectations for a sound commitment worldwide.
If climate policy is scaled up, the most carbon intense assets may suffer from unanticipated or premature write-downs, devaluations, or conversion to liabilities, that is become ‘stranded’.
The risk of stranded assets for the upstream oil industry
The ‘unburnable carbon’ debate has made clear that to meet a 2°C scenario with 50% probability, 35% of oil, 80% of coal and 50% of gas reserves should not be extracted . Because of high marginal production costs and high profit margins, oil accounts for around 75% of the fossil fuel asset value at risk in the low-carbon transition (1). The main risks for the upstream oil industry are economic restraints – driven by the recent and rapid decline in oil prices, coupled with cost escalation of moving to less productive acreage – and pressures driven by future climate regulation.
Oil producing countries own almost 70% of oil reserves that should remain in the ground . Nevertheless, if we look at the ownership of the riskiest assets, private listed companies are the most exposed to carbon risk, as their current and potential production is positioned up in the cost curve: private oil companies own 65% of oil reserves needing more than USD 100 per barrel (bbl) (2). For the 20 largest private companies, 20-25% of capex to 2025 totaling 540 billion is not needed under the IEA’s 450 scenario (3).
Figure 1 shows production and capex share of undeveloped projects requiring USD 95/bbl to break even in seven major oil companies. The highest potential exposure to climate risk is faced by Shell, both in terms of production and capex. Almost 70% of this high cost production is concentrated in the 10 largest projects, while for the other major risks it is more spread out. Eni presents the lowest exposure as for the size of its reserves at risk.
Larger companies with a diversified portfolio can carry on expensive projects, whereas smaller players concentrated in high cost activities are remarkably more challenged. When funding has been committed companies will seek cost deflation, while expensive non-sanctioned projects are likely to be delayed or cancelled to maintain acceptable shareholder returns.
Divestment campaign: growing momentum towards effective impacts
At COP21 it was announced that more than 500 institutions representing over $3.4 trillion in assets have made some form of commitment to divest from fossil fuel based operations. Strategies can range from a 100% portfolio divestment to partial divestment (tilting) . Despite action from early movers, university endowments, public pension funds or institutions such as cities have been considered more successful in raising public awareness than in impacting the targeted industries.
A further phase would take off if very large pension funds and other institutional investors join the momentum, eventually pushing a change in market norms. Signals tend to point towards this direction (4), but economic considerations will need to fully take over moral or ethical incentives only as the research on climate and stranded asset risk evolves, as climate policy is scaled up and as investors realize that early action might entail also a first-mover advantage, rather than simply risk minimization.
Recent research by the University of Cambridge  finds that slightly less than half of the returns impacted by climate change could be hedged by investors through cross-industry and regional diversification and divestment.
(1). A 10% reduction in demand would cause significantly more stranding in oil than in coal, because of oil’s steeper supply curve.
(2). Which embed roughly 90GtCO2 and could satisfy 15-18 MBPD.
(3). 450 Scenario sets out an energy pathway consistent with the goal of limiting the global increase in temperature to 2°C by limiting concentration of greenhouse gases in the atmosphere to around 450 parts per million of CO2.
(4). For instance the Norwegian Government Pension Fund Global requires companies to develop strategies for handling climate change risk, is a member of the Carbon Disclosure Project (CDP) and recently ditched USD 8 billion of assets of companies that source more than 30% of their revenue from coal.
 Photo: Joe Brusky (2014) Divestment Wave Around the Nation.
 McGlade, E. P. (2015) The geographical distribution of fossil fuels unused when limiting global warming to 2°C, Nature, Letter 517, 187–190.
 Climate Policy Initiative (2014) Moving to a Low-Carbon Economy: The Impact of Policy Pathways on fossil fuels asset values.
 Carbon Tracker Initiative (2014) Oil and Gas Majors: Fact Sheets (August 2014).
 HSBC (2015) Stranded assets: what next?
 Cambridge (2015) Institute for Sustainability Leadership: Unhedgeable Risk.
This article was first published on ICCG’s International Climate Policy Magazine n. 39
(Image: pro-divestment messages at COP21, Paris, December 2015. Photo credit: Takver/Flickr)