An IHS Energy Strategic Report
by Daniel Yergin and Elena Pravettoni
Since 2014, some central banks and financial regulators have raised concerns that climate change may pose "systemic risk" to the financial system. This view was notably articulated when Mark Carney, Governor of the Bank of England, declared in a September 2015 speech that climate change—in particular "transition risk"—could threaten financial stability via a sudden and significant collapse in asset values. In response, the Financial Stability Board, which reports to the G20 governments and is chaired by Governor Carney, launched a task force to develop a climate risk disclosure framework for market participants.
The task force is set to release its voluntary, unified guidelines for climate risk disclosure in December 2016.
A key consideration in this debate is the valuation of oil and gas reserves. In the September 2015 speech, Governor Carney cited the "carbon bubble" thesis, stating that a key risk to financial stability could come from potential sharp drops in the valuation of oil, gas and coal companies, owing to stranded reserves that may never be produced.
However, IHS Energy analysis demonstrates that oil and gas company valuations are primarily based on reserves that will be produced and monetized over a 10–15 year period—a relatively short time frame in which an energy transition is unlikely to unfold.
The analysis1 found that about 80 percent of the value of most publicly traded oil and gas companies is based on their proved reserves, which accounts for roughly 20 percent of the resource base of global international oil companies by volume. Their valuation is based on the present worth of expected cash flow from projects and reserves that will be produced in the short to medium term and are consequently at minimal risk of being stranded.
Therefore, there is little risk of oil and gas companies being overvalued by potential climate policy restrictions.
Furthermore, the recent oil price collapse has proven to be a high-stress "stress test" for the oil and gas sector. According to IHS Herold, 82 global oil and gas companies lost 42 percent of their market value from June 2014 to December 2015—equal to $1.4 trillion in market capitalization. Yet, this fall has had minimal systemic impact on the global financial system thus far. Since oil prices fell below $100/bbl in September 2014, the Dow Jones Index has risen 6 percent.
The history of past transitions suggests that the unfolding of a lower-carbon energy economy, possibly supported by carbon capture, will also be a gradual process, and can be priced in by markets over time. The energy economist Vaclav Smil, an expert on energy transitions, has noted that "even a greatly accelerated shift towards renewables would not be able to relegate fossil fuels to minority contributors to the global energy supply anytime soon, certainly not by 2050."
Overall, an energy transition that unfolds over decades does not constitute abrupt systemic risk to the financial system.
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1. See the IHS Special Report Deflating the Carbon Bubble