HSBC says fossil fuel companies, or some of their assets, will become “non-viable” or “unburnable”.
That’s not just because of climate action, it is also due to changing economics and the impact of new technologies, such as solar and storage.
Fossil fuel companies face an increasingly “acute” risk of becoming “stranded assets”, as a result of climate change policies, changing economics such as plunging commodity prices, and the impact of new technologies such as solar and storage.
That’s the assessment of global investment bank HSBC in a new report titled “Stranded Assets, what next?” The report notes that the concept of stranded assets has been developed because climate science and the development of carbon budgets would make those companies, or some of their assets, “non- viable or unburnable.”
This risk is now being accelerated by a number of factors. One is the dramatic fall in energy commodity prices, in particular oil benchmarks, which means that many fossil fuel assets and fossil fuel reserves are becoming increasingly unprofitable and uneconomic.
And there is also the threat from changes to technology. This includes gains in energy efficiency, and other technology drivers such as solar and battery storage that increase supply and reduce demand from fossil fuel assets.
“Climate science and the launch of a carbon budget fuelled the first wave of discussion around the risk of stranded assets,” the HSBC analysts write.
“The concern was that assets would be stranded by climate change regulation, which has already been witnessed to an extent, for instance with coal-fired power in some geographies.
“Oil price falls turned the debate from policy to economics, as many unconventional oil sectors, such as oil sands, shale oil and Arctic drilling, have become loss-making in a relatively short period of time.
“We expect innovation in efficiency and technological advancements, including in renewables, battery storage and enhanced oil recovery, to alter the energy mix and pricing in the energy economy, potentially resulting in further stranding of high carbon and high cost fossil fuels.”
HSBC notes that climate policies have been accompanied by tough new regulations, in the US and Europe with the EU Plant Combustion Directive and the US Clean Air Act, which have targeted coal-fired power generation, and also in China, as it seeks tor reduce levels of pollution.
The carbon budget, which would limit the amount of fossil fuels to be burned, is becoming an increasingly important measure as the world moves towards a global climate agreement in Paris.
The plunge in oil prices have given producers a choice between operating and taking losses in the hope that prices will recover, or cut losses and shut down facilities. Oil types such as oil sands and shale oil break even at $US80 per barrel or higher and the market value of oil and gas companies has dropped by over $US580 billion in the last nine months.
“The ability and timeframe to withstand losses will depend on the type of producer (e.g. state owned or private) and diversification of reserves across the cost curve,” the report says.
“Where the decision is taken not to produce from a proven reserve or to cease production which was underway, then the asset can be said to be economically stranded - non-viable given the current energy economy. Whether assets are stranded permanently or only in the short term depends on the costs of mothballing versus abandonment.”
HSBC notes that renewable energy costs have come down and contrasts the trend with oil, where harder-to-access reserves are more costly to develop.
“If this trend continues or were to accelerate dramatically, this would trigger an economically driven decarbonisation of the power sector, the section of the energy economy which contributes most towards carbon emissions,” it writes.
HSBC notes that onshore wind is already competitive with fossil fuels in some regions and its costs are still coming down, driven by technological advances including the size of wind turbines, cables and offshore substations.
Solar prices have also fallen quickly in recent years and further cost falls in renewables would be positive for more widespread adoption. “In our view, increasing the share of renewables in the energy mix also largely separates the cost of energy from the volatility of energy commodity markets, which is attractive to energy importing nations in particular. “
But it notes that the energy economy could be completely transformed given a dramatic advancement in battery technology, such as more efficient use of lithium or advances in aluminium battery technology.
“Storage also has important implications for the transport sector. Currently, batteries are an expensive and bulky component in electric vehicles (EVs). A step-change would clear an important hurdle in their ability to take significant market share from traditional petroleum-burning engines, would significantly change the demand profile for oil (the transport sector currently uses oil for 95 per cent of its energy). “
Another interesting technology the report cites is enhanced oil recovery, where new technologies allow more than 60 per cent recovery from an oil well. This includes gas injections involving pumping CO2 from industrial processes into wells.
Up till now, this has been very expensive. But should it become cheaper, then this would in turn increase the stranding risk for higher breakeven oil categories.
So what should investors do about the risk of stranded assets?
HSBC argues that identifying assets most at risk from stranding would be the first step in devising an investment strategy. Then there are two options.
One is divesting fossil fuel stocks. This removes assets but dividend yields may suffer and portfolios could become more concentrated.
The second option is to hold onto stocks, allowing investors to engage with companies and encourage best practice. But the flip side here is that there are reputational as well as economic risks to staying invested.
“Coal assets face the greatest regulatory risks, given the high associated emissions and substitution possibilities. Oil reserves with a high breakeven oil price are also at risk - oil sands, shale oil, Arctic and some offshore assets".