In the past couple of years, the concept of stranded assets has become synonymous with the existential threat climate change poses to the fossil-fuel industry. Nowadays, energy analysts cannot ignore these threats, and any credible discounted cash-flow projection must factor them in.
Industry disruption is nothing new. When electricity started replacing oil lamps for illuminating homes in the first half of the 20th century, the incumbent lighting and whaling industries’ assets became stranded almost overnight. Austrian economist Joseph Schumpeter saw this as a natural feature of any market economy, coining the phrase “creative destruction” to describe the phenomenon.
Recent history provides us with a litany of other examples. The emergence of streaming companies like Netflix led to the demise of home-movie rental firms such as Blockbuster, while the rise of digital photography saw Eastman Kodak, the world’s biggest photographic film corporation, filing for bankruptcy protection in 2012.
However, much as the failures of Blockbuster and Kodak were costly for investors in these firms, the losses pale in comparison with those that fossil-fuel companies and others face as the world attempts to combat global warming.
The Intergovernmental Panel on Climate Change (IPCC) in October 2018 said the atmosphere can absorb, calculated from the end of 2017, no more than 420 gigatonnes (Gt) of carbon dioxide (CO2) if the global temperature rise this century is to be kept below 1.5 degrees Celsius above pre-industrial levels. However, since around 42 Gt of CO2 is emitted globally every year, this budget is expected to be exhausted by the end of 2027.
The budget for staying below the Paris Agreement’s two degrees Celsius threshold – signed in 2016 by nearly 200 countries – affords precious little wiggle room either, at approximately 1170 Gts.1 A 2015 study in Nature concluded that on the basis of those estimates of the two degrees Celsius carbon budget, a third of oil reserves, half of gas reserves and more than 80 per cent of known coal reserves should remain buried if temperature targets set under the Paris Agreement are to be met.2
Shift from coal gathering steam
Since coal is the dirtiest of the three main types of fossil fuel – coal-fired power stations emit around double the CO2 per unit of electricity that natural gas plants do – governments in Europe and elsewhere are phasing out use of the fuel. UK-based website Carbon Brief reckons global electricity production from coal is on track to fall by around three per cent in 2019, the largest drop on record, thanks to big falls in developed countries that are not being matched by increases elsewhere.3
This move away from coal has already led to the stranding and closure of many assets across Europe
The European Union has been steadily shifting away from coal generation. According to European energy research firm EnAppSys, coal and lignite power plants produced 95.8 terawatt-hours in the three months to the end of September 2019, almost 30 per cent less than gas-fired stations. By contrast, coal plants produced 31 per cent more than gas in the third quarter of 2018 and 37 per cent more in the same period of 2017.4
“This move away from coal has already led, and will continue to lead, to the stranding and closure of many coal assets across Europe,” says Pedro Faria, strategic advisor to CDP, a not-for-profit organisation that helps investors, companies and cities measure and understand their environmental impact.
Figure 1: Electricity production from coal
Take the case of German utility RWE. With Berlin looking to phase out coal-fired electricity generation by 2038, RWE is trying to reinvent itself as a renewable energy company – it is now the world’s second-biggest producer of offshore wind power and Europe’s third-biggest provider of renewable energy.
However, unlike Danish group Orsted, which in 2017 took big steps towards transforming itself into a pure renewables business when it sold off its upstream oil and gas assets, RWE retains sizeable coal operations.
Although the German government recently agreed to pay it to close them down, Aviva Investors’ European equity portfolio manager Ed Kevis argues there is very little, if any, value ascribed to those assets. “This helps explain why the shares trade on a multiple of just 10 times forecast 2021 EBIT (underlying earnings) when Orsted shares trade on a multiple of 27,” he says.
The UK government is looking to phase out coal-fired generation by 2025
In the UK, the government is looking to phase out coal-fired generation by 2025, with the inevitable result of power generation assets becoming stranded. Shares in Drax Group have lost more than two thirds of their value over the past six years as profits plunged after the electricity producer shifted away from coal to biomass.5 Rival SSE is to abandon the last of its remaining coal-fired plants by March 2020 after it racked up annual losses of £40 million.
“As national and international policies focus on promoting lower-carbon forms of power generation in a bid to tackle climate change, the economics of coal-fired stations have become increasingly challenged,” SSE said in June 2019.6
Even where governments are reluctant to close coal-fired power stations, the decision is being taken out of their hands by economic forces. Recent advances in technology have helped drive rapid falls in the cost of both generating electricity from renewables, such as solar and wind, and storing it. According to an October 2019 report by Bloomberg New Energy Finance (BNEF), solar and onshore wind are now the cheapest way of generating electricity across more than two thirds of the world, with solar costs having plunged 85 per cent and wind 49 per cent since 2010.7
Coal-fired power plants are being driven out of business across the US
The plummeting price of renewable energy, combined with bountiful supplies of fracked gas, has been driving coal-fired power plants out of business across the US. In November, two of the country’s biggest, which in combination emitted 258 million tonnes of carbon between 2010 and 2017, shuttered operations.8 That is, in turn, stranding a growing number of mines, scuppering President Trump’s efforts to rescue the US coal industry by easing environmental regulations.
On October 8, Blackhawk Mining LLC said it would idle three mines and two processing plants in West Virginia.9 A week later, Peabody Energy said it will close a southern Illinois mine and a nearby coal-processing plant.10 A fortnight after that, Murray Energy became the eighth coal company in a year to file for bankruptcy protection.11 The US Energy Information Administration expects coal output to drop eight per cent in 2019 and 13 per cent this year.12
Although BNEF reckons renewables are set to undercut commissioned coal plants almost everywhere by 2030, the amount of electricity generated globally from coal is not set to peak until 2026 as new power plants open in China, India and elsewhere. As a result, and despite the threat of stranded assets, new coal mines continue to open in other parts of the world, at least for now. For instance, the government of the state of Queensland, Australia, in June gave the go ahead for construction of the Carmichael coal mine. It promises to be one of the world’s biggest. Indian company Adani, which owns the site, plans to produce 2.3 billion tonnes over 60 years.13
The mine threatens to open up the Galilee Basin, one of the world’s largest untapped reserves of thermal coal – the type used in power plants. But the controversial project has run into trouble. Under pressure from environmental activists and concerned over the threat of being left with a stranded asset on their books, over 30 of the world’s financial institutions have refused to lend to Adani. As a result, the Indian group is having to fund the first A$2 billion phase itself.14
Pressure on Australia’s coal industry, the country’s biggest export earner, is also coming from other quarters. In February, a judge in New South Wales banned a bid by Gloucester Resources to mine 21 million tonnes of coal over 16 years because it would have contributed to climate change.15 The same month, Glencore, Australia’s biggest coal miner, announced it would cap production at current levels. Though the Swiss-based company is not abandoning coal, it is steering investment towards commodities such as cobalt, copper and nickel, which underpin a lot of the transition to renewable energy. Pressure from Climate Action 100+, a group whose affiliates include several Australian pension funds that want to support cleaner energy, undoubtedly played a part.16
The global market for coal will remain under extreme pressure
Casey Merriman of Energy Intelligence, a leading provider of analysis and data on the global energy industry, says although demand from China, India and other Asian nations may be growing for now, the global market for coal will remain under “extreme pressure”.
“Maybe demand from these countries can slow the death a little bit, but even miners with the lowest production costs need to factor in falling prices and a struggle to find a market for their product beyond the next decade,” she says.
Faria agrees, arguing that even though China and India may be continuing to build new coal-fired power stations, that policy is at risk of being rapidly reversed given worsening pollution in both nations has led to social unrest.
“Even in the absence of pressure from governments and other regulatory bodies, it makes sense for long-term investors to encourage miners to keep coal underground. While it might seem like a strange thing to do, it is increasingly apparent climate change is having a devastating impact on other parts of the portfolio and this threatens to get even worse,” he says.
Will oil and gas go the same way as coal?
Trevor Green, UK equity portfolio manager at Aviva Investors, says the problems facing coal look to be a foretaste of what is in store for oil and gas explorers. With more and more investors calling into question the long-term investment case, Green believes there is already clear evidence oil and gas companies’ cost of capital has begun to rise.
“Investors are demanding greater compensation for taking on the risk of investing in these assets. If you perform a discounted cash-flow analysis of the fossil fuel sector, it suggests the market is pricing in flat earnings up to around 2030, beyond which point companies will be worthless,” he says.
Green says it is damning that the combined US energy sector is worth less than Apple after losing more than 40 per cent of its value since the middle of 2014. “While much of that is explained by a 40 per cent drop in oil prices, it is telling that oil majors’ dividend yields have risen,” Green says.
Figure 2: Apple’s value surpasses US energy sector
According to Martijn Rats, head of European oil and gas equity research at Morgan Stanley, while it may be too pessimistic to suggest oil majors will be worthless in a decade, it is true the market is either already, or very close to, pricing in no dividend growth for European oil majors into perpetuity. He describes this as “a remarkable change” for companies that have been growing their dividends for decades.
Oil companies are under pressure to transform their businesses in line with climate goals
Pressure on oil companies to transform their businesses in line with climate goals is coming not just from environmental groups but large institutional investors too. With many countries indicating they intend to electrify their transport networks at an accelerating pace as climate change rises to the top of the political agenda, oil companies are being stung into action.
On December 2, 2019, Repsol embarked on the most ambitious attempt yet by an oil major to wean itself off fossil fuels. The Spanish oil group, which took a €4.8 billion charge as it wrote down the value of oil and gas assets, said it will eliminate all greenhouse-gas emissions from its own operations and customers who use its products by 2050.17
Interestingly, Repsol’s shares as of January 17 were largely unchanged in the wake of the announcement. Rats says while that is partly because it was no more than an “extension” of previous guidance, it also reflects the difficulty the market is having in gauging what such statements actually mean.
“The industry at the moment is in a position where doing nothing is not an option because simply betting on oil and gas for the next 20-30 years looks increasingly risky. But the alternatives, such as expanding into renewable energy, are also fraught with uncertainty. The returns on capital from doing that may not be very good at all,” he explains.
Rats adds rising uncertainty is making it increasingly difficult to value shares, meaning investors are building in larger and larger margins of safety, resulting in share prices performing poorly.
Similar trends are starting to emerge in bond markets. Tom Chinery, investment grade credit portfolio manager at Aviva Investors, argues investors’ nervousness can be seen in a shortening of debt maturities for oil and gas companies.
While ExxonMobil has 30-year debt, there’s nothing issued by BP with a maturity over 15 years
“The market is changing dramatically. While ExxonMobil has 30-year debt, there’s nothing issued by BP with a maturity over 15 years. Investors are still buying these companies’ bonds, but visibility and confidence in their long-term prospects is diminishing,” he says.
Although Chinery concedes it is hard to detect any appreciable widening of credit spreads on debt issued by oil majors, in 2017 Moody’s warned the oil and gas industry faced significant credit risks from the carbon transition. The credit ratings agency said the potential for oversupply as demand falls is likely to put pressure on margins and cash flows, which could lead to assets being stranded.18
Projects most at risk include those with high operating costs or a high carbon intensity of production; large upfront capital commitments and long investment lead times; and a higher carbon content. These include oil sands, shale and extra-heavy oil, as well as reserves of higher-grade oil and gas in deep waters and other hard-to-access sites like the Arctic. In December 2019, US investment bank Goldman Sachs ruled out financing oil drilling or exploration in the Arctic in future, adding it would not invest in new thermal coal mines anywhere in the world.19
Since most companies’ proven reserves are likely to be extracted within the next ten years, Merriman believes there is little risk of them getting stranded. But new projects that are likely to take longer to come to fruition are looking increasingly risky, helping explain what she terms “widespread capital austerity”.
Companies are being much more selective about where their capital expenditure goes
“There is enormous pressure to prioritise free cash flow and turn that into dividends and returns. Companies are being much more selective about where their capital expenditure goes. They’re doing everything they can to prioritise projects with short pay-off periods to bring cash flow forward and I don’t see this changing,” she says.
A fragile bridge? Natural gas’s methane problem
While no company has gone as far as Repsol, its competitors such as Royal Dutch Shell, Total and BP have set their own targets to reduce emissions and are investing in renewable energy, electric-car charging and battery technology. But in all three cases, as with many other oil majors, an even more significant strand of their strategy is to shift the production mix away from oil towards natural gas.
Shell, which acquired BG Group in 2016 to become the world’s top trader of liquefied natural gas (LNG), currently produces around 3.7 million barrels of oil equivalent per day, of which roughly half is natural gas. Chief executive Ben van Beurden said in March 2018 natural gas production could be triple that of oil by 2050 as Shell looks to meet a self-imposed goal to halve the net carbon intensity of the energy products it sells.20
Gas has until recently been seen as a bridge from coal to renewables
As power plants running on gas emit about 40 per cent less CO2 than those running on coal, gas has until recently been seen as a bridge from coal to renewables. However, according to Merriman, this view is being challenged.
“The green credentials of gas have started to come under significant scrutiny due to the amount of methane being released into the atmosphere, in addition to its still-sizeable carbon footprint,” she says. A US government study published in November 2019 corroborated this as it reported atmospheric methane had risen unexpectedly sharply to 1,859 parts per billion (ppb) in 2019, from 1,775 ppb in 2006.21
Compared to carbon dioxide, methane is a relatively short-lived but potent global warming gas. According to the IPCC, over a 20-year period methane’s global warming impact is 86 times that of CO2. The IPCC is calling for natural-gas production cuts of 15 per cent by 2030 and 43 per cent by 2040, relative to 2020 levels.22
The fact natural gas appears to contribute more to global warming than previously realised means various gas assets are in danger of becoming stranded too
A June 2019 report by Global Energy Monitor said the fact natural gas appears to contribute more to global warming than previously realised means various gas assets are in danger of becoming stranded too, not least if the price of renewables continues to fall. The US fracking industry, which has been eating up cash, looks especially vulnerable.23 Fracking is estimated to release 50 per cent more methane into the atmosphere than drilling for gas in conventional ways. A 2018 study by Alvarez et al, published in Science, concluded 2.3 per cent of US gas production was leaking into the atmosphere, 60 per cent more than the US government had assumed.24
Global Energy Monitor warned much of the US$1.3 trillion being invested in developing over 200 LNG terminal projects is also at risk of being stranded. The report’s authors said LNG tends to lead to higher fugitive emissions, as well as requiring significant amounts of energy to ship, liquefy and turn back into gas.
While evidence gas-fired power stations are becoming stranded is inconclusive, they could be at risk further ahead. Worryingly for the US owners of such assets, according to a 2018 report by Dyson et al, clean energy portfolios can often be procured at significant net cost savings, with lower risk, compared to building a new gas plant.25 With about half of the existing thermal generator fleet likely to retire by 2030, US power companies have big decisions to make as they prepare to commit their customers and investors to as much as US$1 trillion in investment and fuel costs over the coming decade.
The risks of asset stranding as the world transitions to a low-carbon economy extend far beyond fossil-fuel companies and energy producers. For a start, suppliers to these industries will be affected. A prime example is General Electric, which in 2018 took a US$23 billion charge after writing down the value of power-generation assets acquired from Alstom just three years earlier. That followed a collapse in global gas turbine orders.26
Figure 3: Sharp fall in gas turbine orders
According to Steve Waygood, chief responsible investment officer at Aviva Investors, any company with its own carbon footprint, or whose products create one, must wake up to the threat of the rapid deployment of new technologies, and the speed and scale at which regulations could come into force to deliver the goals of the Paris Agreement.
Auto manufacturing is undergoing a period of especially profound change as companies make their fleets more efficient
Auto manufacturing, for example, is undergoing a period of especially profound change as companies make their fleets more efficient in response to the changing regulatory environment around the world. The EU’s fleet-wide emissions target for new cars will be set at 95 grams of CO2 per kilometre by 2021 and big fines await companies that don’t comply.
Carmakers around the world are rushing out new electric models to meet the new rules, as well as to tap in to growing consumer demand for such vehicles. British-based luxury carmaker Jaguar Land Rover will offer customers electrified options for all new models from 2020, while German rival BMW plans to bring 25 electric vehicles to market by 2025.
Chinery says the electrification of the car industry is likely to produce clear winners within the next decade, with other companies being at serious risk. Since developing new electric vehicles requires significant investment, companies with strong balance sheets should have a major competitive advantage.
“Volkswagen has a massive balance sheet that is allowing it to spend €20 billion building five electric car plants. It can create economies of scale by doing tie ups with weaker companies such as Ford that don’t have the same investment capacity. It should make Volkswagen one of the winners, so long as it gets it right,” he says.
For some, the answer has been consolidation. Fiat Chrysler and France’s PSA, the owner of Peugeot, in December agreed a deal to create the world’s fourth-largest carmaker. The companies hope the merged entity will have the financial firepower to invest in new technologies, notably electric vehicles.27
The extent to which electrification is shaking up the car industry can be seen by comparing the fortunes of Tesla with traditional US auto rivals Ford and GM. As Figure 4 shows, between the start of 2011 – six months after the company floated – and February 13, Tesla’s market value surged 5,740 per cent to US$145 billion. That makes it worth considerably more than Ford and GM, whose combined value sank 29 per cent to US$83 billion in that period.
Figure 4: Tesla worth more than GM and Ford combined
Elsewhere in the transport sector, airlines and aircraft makers are under increasing pressure to curb emissions. Since there is little prospect of the aviation industry electrifying in the foreseeable future, airlines will struggle to grow, and could even begin to see assets becoming stranded if regulators demand sizeable cuts in emissions. As for aircraft makers, Airbus in February 2019 took a €463 million charge after pulling the plug on the A380, in which it had invested around €25 billion. Sales of the superjumbo were undercut by other more fuel-efficient offerings like its own A350 and Boeing’s 787.
Heavy industry is responsible for around 22 percent of global emissions
Meanwhile, heavy industry is responsible for around 22 percent of global CO2 emissions. Roughly 42 per cent of that – just over nine per cent of global emissions – is the consequence of fossil-fuel combustion to produce heat to make products such as cement, steel and petrochemicals. To put that in perspective, industry’s requirement for heat leads to more emissions than all the world’s cars (six per cent) and planes (two per cent) combined.28
Since low-carbon production techniques for steel and cement are scarce and expensive, and outright alternatives few and far between, there may be a relatively low risk of assets becoming stranded in the near term. However, given the scale of emissions generated, it seems quite possible companies will come under intensifying pressure to develop and adopt new technologies. That could offer advantages to first movers. In November, German steelmaker ThyssenKrupp launched the world’s first tests into the use of hydrogen in a blast furnace. The gas will be injected to partially replace pulverized coal at a large scale during steel production.
An existential threat
In April 2019, the Bank of England warned up to US$20 trillion of assets were at risk of being stranded globally if the climate emergency is not addressed effectively.29 In terms of fossil fuels specifically, a 2018 study in Nature said, regardless of the decisions policymakers take, at least US$1 trillion of assets will be stranded in the near future as the “overwhelming” momentum behind technological change in the global power and transportation sectors leads to a dramatic decline in demand for fossil fuels. Should more stringent climate policies be enacted by governments, the value of stranded assets could swell to US$4 trillion.30
The need to transition to a low-carbon economy will present an existential threat to fossil-fuel companies
Waygood believes the need to transition to a low-carbon economy will present an existential threat to fossil-fuel companies that resist pressure to transform their businesses. “Projected capital expenditure over the next ten years is about US$4.7 trillion. I think much of it is going to be wasted,” he says.
David Cumming, Aviva Investors’ chief investment officer for equities, says it is imperative oil companies set out a clear strategy in view of the long-term trend towards low-carbon energy and renewables.
“While this does not necessarily mean they should stop investing in developing new fossil-fuel reserves altogether, we’re encouraging companies to scale back investment. The risk of assets being stranded means they need to apply a much higher cost of capital,” says Cumming.
While Morgan Stanley’s Rats agrees oil companies need to apply stricter criteria when deciding where to explore for oil, he does not believe exploration will dry up overnight, as without it supplies would fall too fast.
“Even the most hardened clean-energy proponents would agree we need to develop more fields under almost any scenario.”
Rats explains there are two reasons to do more exploration. “We are still finding new oil that is cheaper than the oil we already have,” he says. “So, if you look at what Exxon has done offshore in Guyana for example, those are really very good discoveries and they make economic sense at much lower oil prices than fields other companies might have developed if they had not been found.”
If it takes 50 to 100 years rather than the 20 to 30 years we want it to take, we’ll have to use more oil and gas
New oil supplies are also needed as insurance against the risk the world takes longer than expected to decarbonise. “If it takes 50 to 100 years rather than the 20 to 30 years we want it to take, we’ll have to use more oil and gas. We need an inventory of reserves,” Rats says.
Nonetheless, Cumming believes over the long term fossil-fuel companies need to adopt one of two approaches. They could choose a “managed decline”, focusing on maximising returns from their existing portfolio while refraining from sanctioning new projects that fail to fit into a given carbon budget. As a result, upstream production would gradually diminish, with excess cash being returned to investors. A second option would be to use free cash flow to diversify into other sectors, such as the provision of renewable energy, or developing carbon-capture technologies.
“Either way, companies need to outline a credible strategy. Those that don’t are starting to get punished. It’s hard to believe this trend won’t accelerate,” Cumming argues.
While the transition to a low-carbon economy threatens the existence of many companies and whole sectors, Tesla has shown that for others the potential rewards on offer are huge.
Kevis says Orsted is a company that has shown how tackling climate change head on can create value for investors. “The transition to renewables has done wonders for its shares. Investors will be on the lookout for other utility companies contemplating similar moves.” The Danish company’s share price has soared 132 per cent since it sold its oil and gas assets in May 2017.
The investment industry has never had a more important role to play
As for Green, he says engaging with a whole range of companies is helping create shareholder value at the same time as aiding the process of decarbonisation. “If you take the packaging sector, it’s a big energy user. In the past five years, we’ve seen companies such as DS Smith making big strides to becoming more efficient by using less energy and recycling more to keep investors like ourselves happy. It makes the business more efficient so it’s a win-win,” he says.
Waygood believes the investment industry has never had a more important role to play. For so long in an unenviable position of trying to maximise returns for investors while safeguarding the livelihoods of future generations, suddenly the two objectives are beginning to align.
“Asset stranding isn’t a new concept. It is the fact that it is fossil fuels that makes it unique. There is no denying governments need to get their acts together and take a lead. But the fact financial markets are suddenly waking up to this threat gives me hope we as an industry can play our part in averting a disaster, the consequences of which are hard to overestimate,” he says.