Predictions of a coming carbon asset bubble overstated

Lately, it has been fashionable to talk of “stranded carbon assets” that will emerge as a risk to investors as pressure to mount a serious global climate policy increases. The thinking behind the carbon bubble analysis, recently presented by Al Gore, is that up to two thirds of fossil fuel reserves will not be monetized if the world is to remain below the 2 degrees increase in the global temperature that scientists say is the limit before the planet suffers devastating and irreversible damage.

In light of a possible carbon asset bubble risk, former Vice President Gore suggests “investors should determine the extent to which carbon risk is embedded in current and future investments.” In the first academic foray on the topic, my colleagues and I at UC Davis Graduate School of Management and University of Otago have done just that. In our new study, “Science and the Stock Market: Investors’ Recognition of Unburnable Carbon” we found that investors did have a detectable market response to the initial scientific disclosure on the implications for fossil fuels regarding the need to stay below 2 degrees of warming. In fact, some 63 American oil companies shed $27 billion in market capitalization in 2009 in the immediate aftermath of publication of the findings reported in a 2009 article in the prestigious Nature journal of science that only a fraction of the world’s existing oil, gas, and coal reserves can be emitted if global warming by 2050 is not to exceed 2 degrees above pre-industrial levels.

Our findings show that markets may not be “irrational” where carbon emission limitations are concerned. In a recent report, The Carbon Disclosure Project (CDP) recently noted that five major oil companies –Shell, Chevron,ExxonMobil, ConocoPhillips and BP -are starting to account for coming carbon limits in their business plans.  Fuel fix reported last week that ExxonMobil disclosed in its briefings on its highly regarded World Energy Outlook that it was factoring in a carbon cost of $60/ton in the future, based on scenarios that take into account existing and looming climate regulations worldwide. Refiners are already taking greenhouse gas emissions reducing steps in California which launched a carbon cap and trade and low carbon fuel standard this year. And some companies, notably Shell and Chevron, have announced new carbon capture and sequestration (CCS) additions to major long term mega projects in Canada and Australia. The fact that some oil companies are already embarked on CCS is likely the main reason why investors do not consider oil and gas reserves as “stranded” or “unburnable” and why oil company stocks are not being shunned by institutional investors. There is likely a general presumption that when tighter regulation comes in place, CCS will be deployed widely and therefore massive oil and gas reserves on balance sheets will still be able to be monetized.

Under its 2 degrees scenario, the International Energy Agency (IEA) estimates that CCS will provide 14 % of cumulative emissions reductions between 2015 and 2050 compared to a business as usual scenario. Under the 2 degrees IEA scenario, CCS represents one-sixth of the required reduction in emissions from fossil fuels in 2050. Globally, approximately $23.5 billion in public support has been made available for CCS demonstration to date. CCS uses a combination of technologies to capture the CO2 released by fossil fuel combustion or an industrial process, transport it to a suitable storage location and store it in a manner that prevents it from entering the atmosphere and contributing to climate change. Such storage to date is typically in underground formations or structures, like depleted oil fields or saline formations. The implementation of CCS is expected to raise considerably the investment costs for fossil fuel production and use. However, on a percentage basis, given today’s high global oil and gas prices, the added costs for implementation of CCS is relatively small. For example, in Australia where the carbon tax was imposed in the same time frame as the science articles from Nature, the added costs for the addition of CCS to the major Gorgon LNG project was less than 2% of the total capital costs of $55 billion. The Gorgon natural gas project includes the world’s largest carbon dioxide injection and sequestration facilities, sequestering 3.5 mtpa of CO 2 deep below Barrow’s Island in offshore Western Australia and adding $1 billion to the project’s total cost of $55 billion, or a very small percentage increase of 1.81% (in total costs run roughly $3,500 per installed ton per year of liquefied natural gas production capacity of 15.6 mtpa). Australia’s $23/ton tax on carbon was projected to add about $0.20 to $0.25 per MMBtu to the cost of delivered natural gas for various new projects such as Wheatstone and Ichthys. This would represent a manageable cost escalation if prices for Asian LNG remain in the $12 to $18 per MMBtu range seen in that market since the Fukushima nuclear accident increased spot prices for Asian LNG dramatically since 2011, but would have been a competitive burden were LNG prices to fall significantly.

There are also indications that governments will share a high proportion of the costs for CCS in some places. In Canada, which would not like to see its massive oil sands reserves wind up as stranded assets, government subsidies will cover 65% of the $1.35 billion costs to add CCS to a Royal Dutch Shell, Chevron and Marathon Oil oil sands production project. The $1.35 billion CCS project called Quest that will gather carbon dioxide emissions from an oil sands upgrading project in Canada and pipe the carbon to a site 80 kilometers away for storage underground. Government subsidies will cover the majority of the project cost, with the industry partners covering only $485 million of the cost of construction of the CCS facilities. Over a 25 year period, Quest will cost $72 a ton for the carbon it stores.

Oil from Canadian oil sands is considered among the most vulnerable reserves as unburnable carbon because production of the hard to exploit oil emits 20 percent higher life-cycle CO2 emissions than low-sulfur, light crude oils. Estimates about CCS costs for oil sands vary based on assumptions. RAND Corporation calculates that CCS costs for oil sands will likely range between $3.71 to 7.88/bbl for shallow projects (about 5 to 10% at today’s prices) and $5.77 to $10.80 for deeper projects. Those costs could go down to $2.86 to $6.39 and $4.36 to $8.73, respectively, by 2025, according to RAND.

Given the long time frame for the cumulative carbon problem of over 50 years and the relative unpredictability of long term oil and gas, investors may feel that the risks associated with unburnable carbon –that is, the need to add CCS technologies to monetize reserves and the possibility that carbon pricing will lower demand for oil and gas and thereby the prices for those commodities – are too uncertain to ascertain amid other equally uncertain factors that might influence the price of oil and gas over the long run. And, the present value of such future CCS costs can be quite small relative to the present value of current or near term operations.

In light of these trends, former Vice President Gore may not actually be asking the correct question when he queries whether investors have taken carbon risk in mind. Our findings would suggest that investors have taken at least an initial assessment on carbon risk into account for American oil company shares.  

Longer term, however, maybe the more correct question investors and companies themselves need to be asking themselves is this:

How realistic is it to have CCS utilized all over the world in all oil and gas operations? Will local communities agree to the storage of so much sequestered carbon?

Oil company carbon contingencies rely highly on the premise that CCS, with some government subsidization, will allow them to monetize all the reserves on their balance sheets, and shareholders are drinking that Kool-Aid.  The question will be – Is that actually a realistic scenario?