With the term carbon bubble, some refer to the financial risk of an overvaluation of fossil fuel reserves on the balance sheet of certain listed companies. The reason they think that they could be overvalued is that they believe the global temperature would rise more than the Paris Climate Agreement agreed two degrees Celsius if all these reserves were actually used. If these companies reported the fair value, the reserves would be written off or devalued. In my view, such a carbon bubble does not exist. Even in the case of a successful (and necessary) transition towards a carbon neutral economy.
A carbon bubble as defined here suggests that the currently existing global reserves of fossil fuels could become worthless, almost overnight. But how realistic is this? To answer this question, I consider previous bubbles on the financial markets, and the expected development of global demand for these fossil fuels. Two examples of earlier bubbles in the financial markets are the housing market bubble and the dot-com bubble. Roughly ten years ago, we saw a bubble in the housing market, both in the US and in Europe. The bubble imploded and prices of houses dropped massively. Nevertheless, the effects proved to be local and temporary. Some may argue that we have entered a new bubble, but it is a fact that house prices have again reached new all-time highs. A similar thing happened with the internet, or dot-com, bubble. Following the listing of World Online, the share prices of listed internet companies dropped extremely fast. Many investors lost a lot of money on their investments. However, here too the trend proved to be temporary. At the time of writing, the share prices of companies like Alphabet (Google) and Apple are at very high, if not record, levels.
The global demand for energy will continue to rise in the coming decennia. A large part of this growth will be met by sources of renewable energy. However, the current energy transition is mainly an electricity transition. With power generation we see that the majority of the gas and coal driven capacity will be replaced by renewable alternatives. For many applications there are no sustainable alternatives, or the alternative is not economically viable. For industry and transportation (mainly heavy road transportation and aviation) in particular, demand for oil related products will continue to rise in the coming years. I focus on global demand as, due to local regulations, some products are no longer allowed, and it is relatively simple to find alternative markets elsewhere globally for these products.
Global demand for fossil fuels will stabilise and even decline at some point in time. Especially with coal we see already the first signs of a slowdown in demand growth and peak-demand will be occur soon. Due to national legislation things can change fast. However, local actions alone are not determining the global trends. Those will change as well, but at a slower pace. The transition risks for companies operating in the fossil fuel spectrum are therefore manageable. These companies will decide for themselves what role they want to play in the energy transition and how fast they will become more sustainable. Too fast, but also too slow would not be in their interest. Nevertheless, this can be seen as a normal business risk on which clients and shareholders will value this company. There might be reserves which will stay in the ground and will thus not be produced and consumed. This is also part of normal business risk and is a risk we know as ‘stranded assets’. This is nothing new and is something every commercial company faces – from a clothing retailer to the greengrocer, and from a bank to an energy company.
A scenario in which global demand for, for instance oil, will suddenly completely disappear is not unlikely, but even impossible. On top of that, shares of listed companies can obviously drop significantly base on misjudged risks. However, by far most reserves of fossil fuels are held by national oil companies, not by the listed international oil companies.
Are there no financial risks at all? Of course there are. I recently wrote a blog regarding the carbon risks for a bank. However carbon risks are something completely different than a carbon bubble, and thus different to stranded assets. This is the difference between complete chaos as a result of a massive bubble, and, from a financial perspective, a well manageable energy transition. I expect the latter, simply because the first option does not exist.
This blog was published earlier on Energiepodium.nl (Dutch version only)