With reports on the danger of a carbon bubble in financial markets, the London-based Carbon Tracker Initiative has in a short time made potential consequences of climate change relevant and understandable to the financial community. The carbon bubble concept has quickly gained momentum. Institutions produce reports on the risk that oil, gas and coal reserves are overvalued. Invitations to speak at prestigious forums such as the World Bank and the OECD are pouring in, according to Anthony Hobley, who took charge as the Carbon Tracker Initiative’s first CEO in February.

“The unique thing about Carbon Tracker, compared to other think tanks and NGOs in this space, is that we’re all financial experts. Our mission is to make carbon risk visible in the capital markets today. We understand that world. Whilst we’ve come a long way, there is still a lot of work to do to get that out to mainstream fund managers, investors and financial experts. Part of our mission over the next two years is to socialize this into the mainstream,” Hobley says.

In a recent interview in London, Hobley told me about Carbon Tracker’s new initiatives, among them nothing less than the complete mapping of every single oil, gas and coal project in the world. The goal is to create a tool that decision makers can use to evaluate any fossil fuel project against the carbon budget – the amount of emissions the world must not exceed if we are to avoid catastrophic climate change.

During the conversation, Hobley also commented on the need for more transparency on financial aspects of fossil fuel companies; discussed demands investors should make to the management of oil companies; and explained why he thinks investors underestimate the risk to the global economy of a carbon bubble.

Norwegian Oil Fund and divestment

First, however, we talked about a Norwegian topic with global repercussions – the Government Pension Fund Global, or the Oil Fund, as it is often called in Norway. Carbon Tracker is following the current Norwegian debate on a possible divestment from coal, oil and gas assets with great interest. A divestment from carbon assets would be “an incredibly important development”, Hobley says, and he has clear views on how such a change should be implemented. To divest from coal “would make absolute sense”, he says, but selling all oil and gas assets in one operation is not the way to do it for the Oil Fund:

“Punish the oil and gas companies who are simply trying to keep production up at any cost”

“What you don’t want to do is to divest indiscriminately. Then you have other money that comes in and buys it all cheaply, and that other money is much less scrupulous. In many ways it is far better to be targeted and focused. It would make absolute sense to divest from coal, but maybe choose between the oil and gas companies. That would send an important message – really do the hard work to differentiate between the oil and gas companies: On one side the cleaner ones, the ones that have the potential to handle the transition, the ones that already invest in renewables, cleantech. On the other side, punish the oil and gas companies who are simply trying to keep production up at any cost, both financially and to the environment.”

As the world’s largest sovereign wealth fund, the Oil Fund’s handling of carbon risk would set a precedent, Hobley points out. Norway could reduce its own exposure to fossil fuel by divesting from such companies, but a complete divestment would also lead to loss of influence. By choosing cleaner, more progressive oil and gas companies, the fund will be sending a signal that will have a bigger impact, Hobley believes.

Fossil fuel: Cost curve for all projects

Carbon Tracker’s work, like the first report called “Unburnable Carbon”, has increased awareness of carbon risk and inspired environmental groups that seek to make investors divest from fossil fuels. Increased knowledge by itself may not be enough to make mainstream finance professionals like fund managers act, however. With new analysis projects and tools, Hobley wants to reach decision makers in both finance and politics.

Before next year’s World Economic Forum in Davos the mapping of all the world’s fossil fuel projects will be completed. The work is being done in partnership with analytics company Energy Transition Advisors. (A launch event for the project (pdf) takes place in London on May 8.)

“They are looking at every single oil, gas and coal project in the world. They are going to put that on a cost curve, which will be the cost of those projects versus the price of oil, and carbon intensity. Then we can map that against the carbon budget for 2 degrees, or whatever we decide – 1,5 degrees, 3 degrees. Then you can identify the high-cost high carbon projects that it makes most economic sense to kill, to take off the table.”

A next step is to make the connection between projects and the companies that own them. In turn, that knowledge will inform discussions with investors on concrete divestment options.

“As an investor, it makes sense to know if you are 38 percent exposed to fossil fuels, for example. It makes sense for you to reduce that to 36 percent and hedge into clean energy renewables. But we are now generating the financial information that means you can start to differentiate between fossil fuel companies. You can start to choose fossil fuel light over fossil fuel fat.”

“Fossil fuels are more expensive than we are being led to believe”

Hobley acknowledges that the divestment movement is a dilemma for Carbon Tracker. The movement campaigns for investors to leave fossil fuel completely, and it has succeeded in placing the issue on the agenda.

“It’s really important that some major funds do divest. That allows you to have a sensible conversation with the bulk of the investment community around engaging with the companies they are shareholders in, so those companies actually start to cancel the high cost, high carbon intensity projects and return the money to the shareholders, and those companies start managing this risk effectively.”

One part of Carbon Tracker’s analysis aims to demonstrate that the market is defective already, Hobley adds. It is not properly assessing financial returns on many fossil fuel projects.

“These companies are able to get away with throwing billions of capex on projects that don’t make financial sense. If you add carbon bubble risk to that… It will all be fascinating once we have got our cost curve and you can start overlaying other issues: water stress; political risk; the 60 dollar a ton carbon price that Exxon puts on its internal decision making; remove fossil fuel subsidies and see what that does to a lot of these projects. I think one of the things beginning to emerge from proper analytical research is that fossil fuels are more expensive than we are being led to believe.”

Another of Carbon Tracker’s current projects is a review of how the fossil energy business is regulated. Today’s financial regulatory system is not fit for purpose, Hobley says:

“It is not requiring disclosure from companies of the carbon intensity of their reserves, or the amount of carbon that would be released into the atmosphere should they develop and sell and burn those fossil fuels. I don’t think enough work has been done to convince those who are the guardians of our financial systems – in the UK the Bank of England, in the US the Treasury and the Federal Reserve – of the potential risk here, the systemic risk.”

London is disproportionally exposed if the carbon bubble should burst, Hobley adds. The London stock exchange is becoming the global centre for coal.

Alternatives for investors: Dividend, hedging

The risk of a carbon bubble might lead to investors in oil, gas and coal adopting a more critical stance towards company management. Given that all reserves cannot be burnt, if they conclude that expensive extraction projects to replace reserves are no longer financially meaningful, what could investors do?

“You could say sorry, no, we’re not happy doing that project, give us that money back, we have much better places where we can invest it and make a higher return. Wouldn’t it be amazing if you could do that analysis across major oil and gas companies as we did during the financial crisis, break them up into bad fossil fuel companies and good fossil fuel companies?”

What about other options? Should oil companies rethink and start investing in renewable energy?

“The shock that bursts the bubble and causes the financial crisis… may not be very far away at all”

“That is not necessarily our place to say. But certainly shareholders could be asking: How are you managing your risk, what’s your longer term strategy to make money, possibly diversify, hedge? Is it better for oil and gas companies to do that, or is it better for the shareholders to simply take the money out of those companies and put it into other companies who are good at that? These companies are made up of geologists and engineers who know how to find, extract and deliver fossil fuels. I’m not sure they necessarily have the right structures, business plans, expertise to develop renewables. It’s a completely different business model in many cases.”

Hobley is fascinated by major economic changes, such as the demise of the railway and the rise of the automobile in the US during the first half of the 20th century. The locomotive manufacturers dominating the New York stock exchange were not able to imagine a future of transport that wasn’t dominated by the steam locomotive; with few exceptions they went bankrupt. Kodak is one recent example of a company with a similar fate.

Fear of last minute panic

In the long term the carbon risk now increasing will not necessarily become a financial bubble, Hobley says. But he fears that it might develop into one, and the analogy is the subprime credit bubble: It wasn’t inevitable in the late 1990s and early 2000s that it had to turn into a systemic financial risk – but it did.

Hobley outlines three outcomes of how the world manages climate change. In the best case, a global deal on climate is reached in Paris in 2015. A policy signal is delivered in time to allow an orderly transition. “It would allow for a managed deflation of the carbon bubble and the number of stranded assets would be quite minimal. Because you would have enough time to do it in a managed way.”

The other extreme is the nightmare outcome where the world never manages to regulate emissions and slides into a temperature increase of 3-6 degrees – with all the catastrophic consequences that would flow from that. 80 percent of the world’s cities would be stranded assets within the end of the century, Hobley says: “Good luck carrying out any business or investment in that world.”

The third outcome is based on the way humans have reacted to crises historically, with the last financial crisis as a good example:

“All the evidence is here that we are approaching a massive change”

“We leave it to the last possible minute, events happen, politicians panic, and we regulate overnight, we throw everything at the problem. That’s when you get the shock that bursts the bubble and causes the financial crisis. That may not be very far away at all. You see the recent political reactions in some countries to severe weather events in the last 12 months, you can see the type of thing that could unfold.”

The political reaction to the flooding in the UK and the heatwave in Argentina are examples of this, he adds. He hopes for the first outcome, but fears we will end up with the last minute panic scenario.

Political and physical processes

A common counterargument against the carbon bubble concept is that it is premised on a global political will to regulate emissions. That will not happen, critics claim. But they forget that this is not only about politics, but about natural physical processes, Hobley points out.

“Unlike any other problem we have got a massive physical process here that keeps on grinding, winding itself up. The longer we delay action, those people who think there is no political will now, they ignore the physical reaction, this chain will grind on and create events, and events will drive the response. It is events that will drive what we will do about climate change.”

Another counterargument is that carbon risk is already factored in by the markets. Hobley notes that even in normal times, disruptive change driven by new technology happens. In a last minute scenario we will see disruptive change at an enormous scale, and the change will come very quickly.

“The problem is, it’s very difficult to break the model we have of the world and see a new world. There were probably scribes and business people beavering away behind the walls of Rome right until the Goths came and swept Rome away. Human history is full of these massive tipping points. All the evidence is here that we are approaching a massive change. We can either take control ourselves, and avoid the physical consequences, or there will be the physical consequences.”