Get ready for the carbon bubble

20 February 2012

Remember the sub-prime mortgage bubble? The next economic bubble could be caused by investing in the unsustainable fossil fuel industry. The idea might sound incredible, but it results from our failure to seriously address the science of climate change.

The science tells us we can’t burn all fossil fuels

Fossil fuels formed over millions of years from dead plants that were quickly buried, removing carbon from the atmosphere in the process. Thus fossil fuels contain carbon which has been out of circulation for up to hundreds of millions of years. Yet humans are digging up this carbon and burning it in the space of a few centuries. When carbon (C) is burned, it reacts with oxygen to produce carbon dioxide (CO2), a heat-trapping greenhouse gas.

Carbon dioxide from fossil fuel burning is the main cause of anthropogenic global warming, now far outstripping natural influences on climate. Carbon dioxide in the atmosphere is like radioactive waste: much of it hangs around for a very long time. As long as humanity continues to burn fossil fuels, carbon dioxide will continue to accumulate in the atmosphere and the Earth will continue to warm. The urgent need to prevent further warming leaves us with no choice but to phase out fossil fuels as rapidly as possible.

In the words of NASA climatologist James Hansen, saying what other scientists have generally failed to communicate, “we cannot burn and emit to the atmosphere most of the remaining fossil fuels”. If we wish to avoid unimaginable global catastrophe – or to meet the target the world’s governments have agreed to – let alone to limit global warming to a level anywhere near what scientists consider safe – we must leave the vast majority of the planet’s fossil carbon in the ground.

Let’s begin with the most extreme scenario: burning not only all existing reserves but all fossil fuels. Just how much fossil fuel is there? As shown in Figure 1, we’ve already burned a few hundred gigatonnes (Gt) of carbon, but the total amount may be more than 10,000 Gt. Note that potentially recoverable coal may extend ten times the height of the graph:

Figure 1: CO2 emissions to date (purple) compared to estimates of possible future emissions from burning all reserves (blue) and all potentially extractible fossil fuels (blue + yellow). (Hansen et al., in press)

About half of the carbon we’ve already emitted has been absorbed by the ocean and land vegetation, but they can’t take thousands of gigatonnes. Therefore burning it all could increase the atmospheric concentration of CO2 to ~6,000 ppm (compared to the preindustrial 275 ppm and present 392 ppm). Luckily, the warming effect of CO2 diminishes as you add more, but still this would increase the present forcing by a factor of nine. The resulting amount of global warming depends on the assumptions you make about climate feedbacks, but suffice to say it would be higher, perhaps far higher, than even the worst-case projections for 2100. Geologic events when the Earth warmed by 5-9°C, apparently at a far slower rate, are associated with mass extinctions. Rapid global warming of >10°C would be unprecedented in the history of the Earth. It is virtually impossible to imagine how human civilization could survive a calamity of such magnitude.

What about peak oil? Indeed, production of cheap “conventional” oil is arguably at its peak, having plateaued in the last few years. According to Figure 1, we have already burned about half the global supply of conventional oil. The reasonable response to peak oil would be to switch to renewable electricity. Unfortunately governments are generally intending to switch to unconventional oil and gas, which are harder to get, more carbon intensive, and (as also shown in Figure 1) very extensive. So there is undoubtedly too much fossil fuel left, not too little. The question is the rate at which these enormous reserves of carbon can be economically extracted, and whether we’re reckless enough to try.

Now let’s consider the globally agreed goal to hold warming below 2°C above preindustrial temperatures. The Carbon Tracker Initiative, a non-profit organization aiming to “align the capital markets with efforts to tackle climate change”, estimate proven conventional fossil fuel reserves total 762 Gt C (2,795 Gt CO2). In contrast, scientists at Germany’s Potsdam Institute estimate that to have an 80% chance of limiting warming to 2°C, we can only emit 154 Gt C (565 Gt CO2) between now and 2050 (currently on track to be used up as soon as 2024). Dividing the latter number by the former, Carbon Tracker concludes only 20% of those reserves can be burned; the rest are “unburnable carbon”.

The target 2°C was recommended by climatologists a few years ago, but many no longer consider that target to be remotely safe. To avoid passing tipping points, humanity must return the Earth to energy balance, which means reducing atmospheric CO2 to ~350 ppm. Because of the long lifetime of CO2 in the atmosphere, to reduce its concentration humanity must stop emitting so the oceans and vegetation can start absorbing. In practical terms, everybody needs to cut fossil fuel emissions to zero or near-zero within a couple of decades. So the fraction of fossil fuel reserves that can be safely burned is even smaller than Carbon Tracker estimates.

“Carbon capture and storage” currently does not exist. Despite being heavily promoted by governments desperate to rescue the fossil fuel industry, it has as yet failed to deliver and even adherents admit it may not work for at least two decades. The only known safe method of storing carbon is to leave it in the ground.

The market assumes we will burn all fossil fuels

Government positions and policies are probably representative of market expectations.

There is a colossal contradiction between the stated aims and actual consequences of government policies. While governments have agreed to limit warming to 2°C and claim to be making progress toward that goal, the policies implemented to date have been so ineffective that CO2 is skyrocketing. 2010 broke records not only for atmospheric CO2 (392 ppm) but also emissions (37 Gt/yr) and even the rate of increase in emissions (6%/yr)! This is at a time when we should be cutting emissions 6%/yr, so that emissions can start falling and reach 0 Gt/yr as soon as possible, so atmospheric CO2 can in turn decrease and reach 350 ppm as soon as possible.

Most governments not only have no plans to phase out fossil fuels; they are enthusiastically expanding their fossil fuel industries and even exploring for new reserves. I suspect some industry leaders realize their days are numbered and are scrambling to extract as much as possible before someone stops them. Even as I was writing this article, Geoscience Australia announced that coal exploration in Australia grew 62% in 2011. It seems like almost every day a massive expansion of fossil fuel use is announced – another coal mine, another gas pipeline, another export plan.

The International Energy Agency (despite being pro-fossil-fuels) predicts by 2017 we are on track to build enough carbon-intensive infrastructure, if it lasts for its intended lifetime, to lock in enough emissions to miss the 2°C target (let alone 350 ppm). Worse, 80% of those emissions are already locked in by the lifetime of existing infrastructure.

Tellingly, national positions in UN negotiations are correlated with fossil fuel reserves. Most supportive of an ambitious global agreement in Durban were the EU, the Africa group, and the Alliance of Small Island States, who collectively own a mere 10% of fossil carbon. In contrast, the biggest blockers – the US, Russia, China, Australia, India, Saudi Arabia, and Canada – own 65%. (The data used to draw this conclusion don’t precisely match up to the other numbers I have cited, but are probably accurate enough to give a general idea.)

Australia, with 7% of fossil fuel reserves, is a case in point. The Gillard Labor Government says it accepts the science of climate change, but effectively denies the implications by playing an obstructive role internationally, implementing insufficient policies at home, continuing to expand fossil fuel exports which are already monstrous in scale, and even openly insisting fossil fuels will and should have a future:

  • Greg Combet – our Climate Change Minister! – said in March 2011: “the Government is extremely committed to ensuring that we’ve got a vibrant coal industry in the future and that our industries are competitive so we will discuss the details of any [policies] with the industry itself.”
  • Combet went further in June: “Let’s not forget in the resources sector there’s a massive pipeline of investment in coal and LNG at the moment and a carbon price is not going to materially affect that in our judgement.”
  • In July, Prime Minister Julia Gillard pointed to a coal company takeover bid as evidence that investors “see a good future in coal mining in this country”.
  • A week later Combet said: “The Prime Minister is up here in the Hunter region today with me; this is my local region that I represent; coal mining, for example, is a very important industry here and the Government is strongly supportive of it. [Liberal Party leader] Tony Abbott has been running around up here in the past claiming the coal industry will be destroyed and all the jobs will be lost, all of which is complete rubbish, but it has engendered apprehension in people’s minds. The Prime Minister and I will be explaining to people that the coal industry has a very strong, positive future. There is $70 billion of investment coming in; 19 new mines committed or under construction.”

Yes, you did read that correctly: the Australian Government believes it would be scary if coal is phased out. The only word that adequately describes the situation is “insanity”.

This means there’s a carbon bubble

Gillard and Combet are in for a fright. The fact that most fossil fuels are unburnable means the market contains a “carbon bubble” of high-carbon investment, and it is inevitable this bubble will burst. It’s only a matter of time.

British economist Nicholas Stern recently joined Carbon Tracker in speaking out against the “profound contradiction at the heart of climate change policy”: between the globally agreed 2°C target and the astronomical value of fossil fuel reserves. Global carbon reserves are valued at $27 trillion (including $7.42 trillion on the market). This value assumes the carbon will be burned, but >80% is unburnable under a <2°C regime. Reserves account for the majority of a fossil fuel company’s value, plus an even larger amount of unproven reserves also contribute value. When the bubble bursts, more than $20 trillion worth of reserves will become stranded assets and the value of fossil fuel companies will plummet.

The bursting of the bubble will not only affect energy and mining companies: it is a systemic risk to the entire economy. The fossil fuel industry represents a large share of stockmarkets, and stock exchanges continue to compete for new fossil fuel companies entering the market. The valuation of these companies flows through to shareholders, trust funds, banks and other lenders, and so on throughout the economy. Many reserves are government-owned, and fossil fuel profits are a major source of revenue for many governments. Investors tend to focus on short-term returns and continue to pour money into unsustainable industries, as they did in financial derivatives leading up to 2008. Many investors are probably unaware of their exposure, as some superannuation funds are not transparent and some financial products blindly follow the sharemarket.

Carbon Tracker recommends measures be taken to ensure the inevitable adjustment causes as little damage as possible. Arguing investors have a right to know the risks, they say intermediaries should take more responsibility for long-term risk, and regulators should mandate “integrated” reports summarizing the future prospects of each company. They note it is already common to report “carbon flows” (ie. emissions), but more important to the future of a business are “carbon stocks” (ie. reserves and their potential future emissions). Regulators could add up the carbon reserves reported by individual companies to more accurately assess the total risk in the market. Investors could then consider the risk and act accordingly.

As well as fossil fuel reserves, I think a similar carbon risk exists in infrastructure. The International Energy Agency analysis makes clear that in order to keep warming below 2°C we cannot build much more high-carbon infrastructure. Presumably, some infrastructure will have to be retired early to meet a 350 ppm target. In some cases that may open up thorny legal issues of property rights and compensation, but I expect these are relatively resolvable: laws can be changed or reinterpreted, but science cannot.

How and when might the bubble burst? Former head of Greenpeace Paul Gilding and Commonwealth Bank risk expert Phil Preston argue that instead of waiting for governments to act decisively, at some point the market will price in the risk of them doing so. Within the next few years, they predict investors will wake up and abruptly revalue and shift investment. The adjustment will have to be soon and abrupt because of the need to cut emissions rapidly before we blow the budget. They point out how rapidly the fortunes of financial businesses changed in 2008. And if investors believe humanity will fail to act in time, why are they not planning for the impacts of dangerous global warming?

Why has the market not yet moved? Evidently investors do not appreciate the implications of climate science. Recently, a coalition of environmental and investment organizations wrote an open letter advising the Bank of England to review its exposure to carbon-intensive investments. The bank responded that it would look into the matter, but expressed skepticism that it is a serious problem, citing three factors necessary for a financial risk: that the exposure is large relative to other assets; that the risk is not already accounted for by the market; and that the bubble will burst abruptly.

In my assessment the carbon bubble meets all three conditions. Firstly, as I alluded to above, fossil fuels are big business, and the exposure to them is massive. Secondly, the impact is decidedly not already priced into the market: governments still assume all reserves will be burned, and judging by the financial press the market agrees. Carbon pricing should lessen the impact of the bubble bursting, but only slightly because the true cost of CO2 pollution is probably far higher than any price a government has yet put on it. Thirdly, the adjustment must be sudden: when we finally realize how serious the climate crisis is, we won’t waste any more time procrastinating. Remember, bubbles don’t deflate in a orderly fashion – they burst.

I am convinced that sooner or later humanity will wake up and act on climate change; the issue is really whether it will be soon enough to preserve a climate that can be reasonably considered safe and stable. Even if we forge ahead with our fossil fuel economy, recklessly burning our way to dangerous global warming and a high risk of feedbacks amplifying it out of our control, I think we would still wake up a couple of decades from now. Eventually the public will demand that fossil fuel burning be stopped. That scenario would also mean stranded assets (though we will have bigger problems to deal with than a financial shock).

From a climate point of view, when the bubble bursts is all-important: much better sooner than later. From a financial point of view, the main implication is that the bubble will burst at some point (and the later it is, the larger the impact will be).

There is increasing discussion of the idea of a carbon bubble. All the analyses I’ve cited (except the science) were published in the last 18 months. It is a powerful idea because if we can convince enough people there is a carbon bubble, it will be a self-fulfilling prophecy. The bubble will inevitably burst at some point, and it’s better for both the economy and environment if it bursts sooner. By spreading the idea of a carbon bubble, we can all help to bring about its bursting.

Environmentally unsustainable investments are ultimately also economically unsustainable. So getting your money out of fossil fuels is not only the right thing to do, it is also in your financial interests. Now is the time to change. Those least reliant on fossil fuels will be best prepared for the shock.

Where will your money be when the carbon bubble bursts?

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