Financial Advisor contributor Paul Ellis recently interviewed Anthony Hobley, chief executive officer of Carbon Tracker, to discuss their mission for a climate-secure global energy system.

Ellis: Anthony, let’s begin with the carbon budget. What is the carbon budget and why should an advisor in the U.S. care about it?

Hobley: Well, we should all care about the carbon budget, because the carbon budget is what climate scientists tell us is the amount of carbon we can put in the atmosphere, while having a reasonable chance of keeping a stable climate. This means keeping global average temperature rises below 2 degrees Celsius, and that means we can effectively put 2,000 gigatonnes of carbon dioxide into the atmosphere against a pre-industrial CO2 baseline measurement. When we did our original report in 2011, we only had 900 gigatonnes left in that budget. Under current business-as-usual trajectories we will burst through that 2 degrees budget by the mid 2030s. So, we must bend that curve that tracks CO2 emissions down quickly during the next 15 years.

As a financial market professional, you may or may not care about climate change and the physical impacts that going above 2 degrees will have, but how you translate that information into assessing risk and reward around investment decisions is important to your clients’ portfolios. That’s the interesting thing that Carbon Tracker has done. We’ve taken that carbon budget and overlaid it onto real world assets, particularly the assets and resources of the fossil fuel companies, out to 2050. There is about 3,000 gigatonnes of carbon dioxide locked up in oil, gas and coal reserves and resources, yet we can only burn 900 gigatonnes of it.

Ellis: What is Carbon Tracker’s focus as an organization and how is your business organized?

Hobley: We’re a not-for-profit, philanthropically funded organization. What’s unique about us, though, is that we’re all former financial market professionals, which is quite unusual for a philanthropically funded NGO. We’re mission-driven, and our mission is a climate-secure global energy system, which in effect means net zero emissions by 2050.

Our vision is to align financial capital market risk with climate risk and energy transition risk. Put another way, we use financial analysis to demonstrate that there is real financial risk tied up with climate risk and the energy transition. There is also opportunity on the other side of that equation.

Ellis: The fossil fuel reserves and resources you’ve talked about are in the ground, but also on the balance sheets of companies in the energy sector, is that correct?

Hobley: To some degree. We talk about reserves and resources out to 2050, and there are different types of reserves—proven reserves (P1), probable (P2) and possible (P3)—and then there are future resources. The P1s are the ones that are being proven and used now, so they are going to have greater value. Those P1 reserves have a life of eight to 10 years, and the companies must develop more reserves if they anticipate being in business beyond that. Their future business model depends on all of the reserves and resources if they want to be around three decades from now.

Some investors say, “well, in the current world of short-term investment horizons, we can worry about that tomorrow.” The problem is that companies are taking revenues from the currently-producing reserves, and they’re projecting those forward up the cost curve into ever more expensive exploration and development, like the Arctic, tar sands and deep ocean resources. At Carbon Tracker, we believe that is destroying value today within those companies, which makes neither climate nor financial sense.

Ellis: What kinds of questions should financial advisors, who are working with long-term investment strategies for their clients, be asking companies in the oil, gas and coal industries about these firms’ assets?

Hobley: They should be asking those that are managing their clients’ money the extent to which they understand the business of those oil, gas and coal firms. At Carbon Tracker, what we’ve increasingly found is that many shareholders, the asset-owners of those companies, have been asleep at the wheel for years.

We understand that for decade after decade, coal, oil and gas companies produced a great return with a low risk and low beta, but that has changed dramatically. The return on capital being produced from oil and gas companies has been going in one direction, down, over the last few years, certainly the last five years. I think many shareholders thought they didn’t need to understand the business model of these companies. The share price of all oil and gas companies would go up if the oil price went up, and the share price would go down if the oil price went down. No one fully understood which companies were better run, had a better return on capital, were more efficient in employing capital, and so on. 

Ellis: You spoke earlier about the carbon budget. What should financial advisors know about another term Carbon Tracker often refers to, which is stranded assets. When you use that term, what are you referring to?

Hobley: A stranded asset is an asset that is not going to produce the financial return anticipated. It doesn’t necessarily have to be as black and white as an asset that stops production and has been completely mothballed. It can be something like the Kashagan Oil Field, which has taken many years to develop, has gone massively over budget, and probably will never return the investment on capital that has been poured into it. It may end up producing oil, and for years, but it has destroyed a significant amount of the capital that was put into it.

Ellis: In the last couple of years, we’ve seen a significant decline in the price of oil, which had a negative effect on the valuation of oil and gas stocks. In this new report that you’ve just released in the U.S., you warn of risks to shareholder value over a longer trajectory. Say more about that report.

Hobley: Yes, let’s run through some of our research history. When we did our original stranded assets and carbon bubble work, in 2011 and 2013 it got a lot of traction. People understood there’s a risk here, but the response, probably quite rightly, was the devil’s in the details. What that means at the individual project and company level is why we then raised capital, employed a team of former investment bank analysts, bought the commercial data on all of the world’s oil, gas and coal projects, started looking at the financials of all the oil, coal and gas projects, and produced carbon supply cost curves.

We found that there was a very high correlation between high-cost projects and high-carbon resource content. What we also found, which surprised us, was the sheer number of projects being sanctioned that would need a high oil price to ever turn a profit, somewhere between $100 and $150 a barrel. 

One of the key justifications for that capital expenditure was the energy demand models being produced by the companies themselves and even the IEA. We looked at those models and did a piece called “Lost in Transition,” which looked at the assumptions that underlined the energy demand models.

We concluded there was a degree of group think, where companies would pick assumptions for GDP growth or population growth that were at the highest end of the spectrum. Yet at the other end of the spectrum, they would pick the most pessimistic projections for the growth of technologies that would destroy demand for their products, like solar, electric vehicles, storage and wind.

 

What came out of these models was demand for oil is going to grow, and grow dramatically and consistently, on a straight-line basis, like it has done for the last 80 years. They completely missed the growth of solar, for example. They didn’t just get it wrong once, and every year solar kept growing.

Carbon Tracker concluded there was a big problem with this demand model. We said “How do we model this in a smarter, more effective way using a more realistic set of assumptions?” We worked with Imperial College in London, which does the energy demand models for the UK Government, and updated a lot of those assumptions, particularly the price data.

This was in our “Expect the Unexpected” report, where we concluded that the likely growth of solar and electric vehicles would be much more robust than the fossil fuel industry would have you believe, and that would have quite an impact on demand for oil, gas and coal, or fossil fuels in general. It would create demand destruction and we concluded would lead to a peak in demand for coal in 2020 and probably a peak in demand for oil in 2020 that would plateau to 2030 and then drop off dramatically. It will be bit further out before gas peaks.

This means that these companies still have a big business going forward for the next 30 years, but it’s an ex-growth business. It will no longer look like it has before. And there’s a very high risk that these companies will get in financial difficulties and effectively destroy value if they continue in this growth mindset.

We believe something quite dramatic has happened, which is that fossil fuels have lost their monopoly on energy generation. We’ve been in these technology transitions before and the incumbents never understand how to make the leap forward. They resist and lobby, and they probably slow the process down, but they can never stop the transition once a new technology is out of the bag.

Ellis: Carbon Tracker’s latest projections for the future demand and supply of energy is focusing on how projected growth in solar PV resources and electric vehicles could affect the supply/demand factors, is that right?

Hobley: The changes in demand don’t have to be big to have a massive financial impact on the companies. For example, a 10 percent drop in demand for coal has pretty much wiped out the coal industry in the U.S. and caused 30 coal companies to go into bankruptcy. This hasn’t necessarily registered across the big portfolio players, because coal as an industry is quite small, so it’s only a small percentage of the portfolio.

Oil and gas, however, are a big percentage of portfolios and would have a much bigger impact on investment portfolios. There was only a 2 percent increase in the supply of global oil that led the oil price to come down from $125 to $26 two years ago. Global growth in demand for energy is 1 percent annually, and already clean energy and non-fossil fuels have half of that growth and are poised to produce 60 to 70 percent of that growth over the next few years. There is very little global growth left for fossil fuels.

Paul Ellis founded Paul Ellis Consulting to work with financial advisors who want to integrate sustainable and impact investment strategies for their clients.