Why market actors fuel the carbon bubble. The agency, governance, and incentive problems that distort corporate climate risk management

ABSTRACT

Similar to the housing bubble, a carbon bubble is being fueled by misaligned corporate governance structures and market incentives that distort capital allocation. Science indicates that a rapid energy transition is needed. However, oil and gas reserves already vastly exceed what can be consumed and continue to increase. A significant portion of fossil fuel assets will eventually become ‘stranded’ – prematurely obsolete over their expected lives. This article examines the various market actors and motivations that are distorting corporate and financial climate risk management. Incentives and structural impediments among key market participants such as short-termism/myopia, long-term arbitrage costs, agency costs / career self-interest, and analytical and cognitive limitations (e.g. bounded rationality), exacerbate the problem. Recognition of these motivations is a ‘heads up’ for shareholders, investors and others to better manage risk.

KEYWORDS:

• Carbon bubble
• stranded assets
• misaligned incentives
• climate finance

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Malkiel (2010), defined a bubble as a “divergence of asset prices from a valuation that would be determined from rational expectations of the present value of cash flows from the asset.” Some type of near-term carbon reduction via regulations, taxes, etc. is a rationale expectation to include in asset valuation since continued heightened use is unsustainable.

2 A negative externality is a cost imposed as a consequence of an economic transaction by a producer or consumer onto an unrelated third party. The private production and consumption of fossil fuels is implicitly subsidized as it incurs high costs on the rest of the world by releasing greenhouse gases.

3 Roughly 2,910 gigatonnes (“GT”) of potential CO2 is held in reserves (Livsey 2020; Carbon Tracker 2011). For a 50% chance of staying at/below 1.5C degrees of warming, the “carbon budget” is about 20%, or less, of existing reserves. (Estimated carbon budget of 495 GtCO2 (Carbon Tracker 2020) to 580 GtCO2, (Rogelj et al. 2018, Table 2.2)). Further data sources include: (United Nations Environment Programme 2019, 27; Carbon Tracker 2020; McGlade and Elkins 2015). McGlade and Elkins 2017 find that one-third of oil, one-half of gas reserves and 80% of coal reserves are unburnable to keep warming below 2 degrees.

4 The Van Eck KOL ETF with reinvested dividends as of the 10-years ending 12/31/2019.

5 TCFD Final Recommendations Report. https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-2017-TCFD-Report-11052018.pdf

6 For example, no Mortgage Backed Securities experienced downgrades until late 2007, since losses of magnitude had never before occurred, (Naqvi et al. 2017, 23).

7 The total return to shareholders is share price appreciation and dividends paid. Larger dividends, which can reduce share price as assets per share decline, may be in the investor’s best interest. Retaining earnings to reinvest in substandard projects may prop share prices, however, the total return of shareholders is maximized when retained earnings are only invested in superior projects and the remainder distributed as dividends.

8 In fact, as part of the coronavirus economic response, fossil fuel companies and their lenders may receive taxpayer subsidies from the government in the form of debt relief (Stein et al. 2020). Most of these companies were already over levered and experiencing financial strain prior to the Coronavirus. A bailout of this type without “strings attached”, would represent not only a financial “moral hazard”, but also be counterproductive in transitioning away from fossil fuels. If anything government loan subsidies / supports for renewables, not fossil fuels is needed.

9 The Wall Street Journal examined 29 shale companies over the decade ending 2019. Collectively these companies have spent $112 billion more in cash than they generated from operations, according to data from FactSet, a financial-information firm (Olson, Elliot, and Matthews 2019).

10 List of banks which have ended direct finance for new coal mines/plants, Banktrack, https://www.banktrack.org/page/list_of_banks_which_have_ended_direct_finance_for_new_coal_minesplants .

11 https://clcouncil.org/

12 http://www.climateaction100.org/

13 A recent poll undertaken by Republican pollster, Frank Luntz, shows 75% of Republicans under the age of 40 support a Carbon fee with a rebate/dividend (Luntz 2019).