Assessing the sources of stranded asset risk: a proposed framework

ABSTRACT

Long-term investors, particularly bond investors, do not currently enjoy an efficient framework for assessing where stranded assets (SAs) might arise. Traditional risk categories currently embodied in credit research – Business Risk and Financial Risk – can capture a number of Environmental, Social and Governance (ESG) issues. However, there are some risks that are difficult to assess in this framework, primarily because many ESG categories themselves are not particularly efficient, or even meaningful, as analytical categories. We propose that a better analysis of these risks can be obtained by categorizing what are currently called ESG risks into three specific risk categories: (1) Operational or Management Risk; (2) Climate Risk, primarily related to climate mitigation and adaptation; and (3) Natural Capital Risks, a category intended to capture natural capital depletion, subsidy loss risks, and certain geopolitical risks – risks associated with water resources perhaps being the best example of a Natural Capital Risk. SAs can arise from all three sources, but those arising from Climate and Natural Capital Risk are more likely to be both significant and irreversible.

KEYWORDS:

• Fixed income
• risk assessment
• credit risks
• ESG risks
• stranded assets

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. It should be clear that these analyses generally apply only to public companies for which information on various operating metrics are divulged. This may not necessarily be the case for non-public companies, a constraint that may hamper high-yield investors looking to employ ESG criteria. These investors generally operate in a universe, particularly in the US, populated by a significant number of non-public companies.

2. European Commission, Interim Evaluation: Functioning of the European chemical market after the introduction of REACH, March 2013.

3. These costs represented a spectrum of environmental impacts, including greenhouse generation (carbon dioxide, HFCs, nitrous oxide, methane, perfluorocarbons, sulphur hexafluoride), air pollution, water consumption, waste generation (including land and water pollution).

4. Which turns out to be not difficult at all—after a drilling suspension and the adoption of new regulations, Gulf of Mexico offshore drilling is growing strongly – including for BP, although it took a couple of years.

5. Note that recent commodity price declines, while significant, still leave commodity prices well above levels seen in the 1980–2000 period.