Five Myths About the "Carbon Asset Bubble"

• The idea that efforts to mitigate climate change expose fossil fuel assets to the risk of a bubble-like collapse has attracted some high-profile supporters.
• However, the notion of a "carbon bubble" depends on questionable assumptions concerning our current knowledge of climate change, the rate of adoption of renewable energy technology, and how such assets are valued.

In their recent Wall St. Journal op-ed, Al Gore and one of his business partners characterized the current market for investments in oil, gas and coal as an asset bubble. They also offered investors some advice for quantifying and managing the risks associated with such a bubble. This is a timely topic, because I have been seeing references to this concept with increasing frequency in venues such as the Financial Times, as well as in the growing literature around sustainability investing.

Although bubbles are best seen in retrospect, investors should always be alert to the potential, particularly after our experience just a few years ago. In this case, however, I see good reasons to believe that the case for a “carbon asset bubble” has been overstated and applied too broadly. The following five myths represent particular vulnerabilities for this notion:

1. The Quantity of Carbon That Can Be Burned Is Known Precisely
Mr. Gore is careful to differentiate uncertainties from risks, which he distinguishes for their amenability to quantification. For quantifying the climate risk to carbon-heavy assets, he refers to the widely cited 2°C threshold for irreversible damage from climate change, and to the resulting “carbon budget” determined by the International Energy Agency (IEA). As Mr. Gore interprets it, “at least two-thirds of fossil fuel reserves will not be monetized if we are to stay below 2° of warming.” That would have serious consequences for investors in oil, gas and coal.

The IEA’s calculation of a carbon budget depends on a factor called “climate sensitivity.” This figure estimates the total temperature change resulting from a doubling of atmospheric CO2 concentrations. The discussion of climate sensitivity in the recently released Fifth Assessment Review of the Intergovernmental Panel on Climate Change (IPCC) sheds more light on this parameter, which turns out not to be known with certainty. Their Summary for Policymakers includes an expanded range of climate sensitivity estimates, compared to the IPCC’s 2007 assessment, of 1.5°-4.5°C with a likelihood defined as 66-100% probability. It also states, “No best estimate for equilibrium climate sensitivity can now be given because of a lack of agreement on values across assessed lines of evidence and studies.”

The draft technical report that forms the basis for the Summary for Policy Makers provides more detail on this. It further assesses a probability of 1% or less that the climate sensitivity could be less than 1°C. That shouldn’t be surprising, since temperatures have already apparently risen by 0.8°C above pre-industrial levels. At the same time, the report indicates that recent observations of the climate — as distinct from the output of complex climate models — are consistent with “the lower part of the likely range.”

In other words, while continued increases in atmospheric CO2 resulting from increasing emissions are widely expected to result in warmer temperatures in the future, the extent of the warming from a given increase in CO2 can’t be determined precisely before the fact. For now, at least, the CO2 level necessary to reach a 2°C increase would be consistent with calculated carbon budgets both larger and smaller than the IEA’s estimate. That means that the basis of Mr. Gore’s suggested “material-risk factor” — as distinct from an uncertainty — is itself uncertain.

2. The Transition to Low-Carbon Energy Is Occurring Fast Enough to Threaten Today’s Investments in Fossil Fuels
There is no doubt that renewable energy sources such as wind and solar power are growing at impressive rates. From 2010 though 2012 global solar installations grew by an average of 58% per year, while wind installations increased by 20% per year. Yet it’s also true that they make up a small fraction of today’s energy production, and that the risks for investors of extrapolating high growth rates indefinitely proved to be very significant in the past.

For further clarity on this, consider the IEA’s latest World Energy Outlook, the agency’s analysis of global energy trends, which was just released on November 12. The IEA projects global energy consumption to grow by 33% from 2011 to 2035 in its primary scenario, which reflects expanded environmental policies and incentives over those now in place. In that scenario, the global market share of fossil fuels is expected to fall from 82% to 76%, but with total fossil fuel consumption still growing by 24% over the period. Only in their “450″ scenario, based on similar assumptions to its carbon budget, would fossil fuel consumption fall by 2035, and then only by 11%.

Moreover, in its April 2013 report on “Tracking Clean Energy Progress,” the IEA warned, “The drive to clean up the world’s energy system has stalled.” This concern was based on their observation that from 1990 to 2010 the average carbon dioxide emitted to provide a given unit of energy in the global economy had “barely moved.” That’s hardly a finding to be celebrated, but it serves as an important reminder that while some renewable energy sources are growing rapidly, fossil fuel consumption is also growing, especially in the developing world — and from a much larger base.

The transition to lower-carbon energy sources is inevitable. However, it will take longer than many suppose, and it cannot be accomplished effectively with the technologies available today. That’s a view shared by observers with better environmental credentials than mine.

3. All Fossil Fuels Are Equally Vulnerable to a Bubble
As Mr. Gore correctly notes, “Not all carbon-intensive assets are created equal.” Unfortunately, that’s a distinction that some other supporters of the carbon asset bubble meme don’t seem to make, particularly with regard to oil and natural gas. The vulnerability of an investment in fossil fuel reserves or hardware to competition from renewable energy and decarbonization doesn’t just depend on the carbon intensity of the fuel type — its emissions per equivalent barrel or BTU — but also on its functions and unique attributes.

The best example of this might be a recent transaction involving the sale of a leading coal company’s mines. What’s behind this wasn’t just new EPA regulations making it much harder to build new coal-fired power plants in the US, but some fundamental, structural challenges facing coal. Power generation now accounts for 93% of US coal consumption, as non-power commercial and industrial demand has declined. This leaves coal producers increasingly reliant on a utility market that has many other--and cleaner--options for generating electricity. That’s particularly true as the production of natural gas, with lower lifecycle greenhouse gas emissions per Megawatt-hour of generation, ramps up, both domestically and globally. Coal accounts for about half of the global fossil fuel reserves that Mr. Gore and others presume to be caught up in an asset bubble.

Compare that to oil, which at 29% of global fossil fuel reserves, adjusted for energy content, still has no full-scale, mass-market alternative in its primary market of transportation energy. Despite a decade-long expansion, biofuels account for just over 3% of US liquid fuels consumption, on an energy-equivalent basis. They’re also encountering significant logistical challenges and concerns about the degree to which their production competes with food. This has contributed to efforts in the EU to limit the share of crop-based biofuels to around 6% of transportation energy. Biofuels have additional potential to displace petroleum use, particularly as technologies for converting cellulosic biomass become commercial, but barring a prompt technology breakthrough they appear incapable of substituting for more than a fraction of global oil demand in the next two decades.

Electric vehicles offer more oil-substitution potential in the long run, though they are growing from an even smaller base than wind and solar energy. Their growth will also impose new burdens on the power grid and expand the challenge of displacing the highest-emitting electricity generation with low-carbon sources.

Meanwhile, natural gas, at 20% of global fossil fuel reserves, offers the largest-scale, economic-without-subsidies substitute for either coal or oil. In any case, it has the lowest priority for substitution by renewables on an emissions basis, and so should be least susceptible to a notional carbon bubble.

4. A Large Change in Future Fossil Fuel Demand Would Have a Large Impact on Share Prices
Although Mr. Gore’s article includes a good deal of investor-savvy terminology, it is entirely lacking in two of the most important factors in the valuation of any company engaged in discovering and producing hydrocarbons: discounted cash flow (DCF) and production decline rates. Unlike tech companies such as Facebook or even Tesla, the primary investor value proposition for which depends on rapid growth and far-future profitability, most oil and gas companies are typically valued based on risked DCF models in which near-term production and profits count much more than distant ones.

At a conservative discount rate of 5%, the unrisked cash flow from ten years hence counts only 61% as much as next year’s, while cash flow 20 years hence counts only 38% as much. Announced changes in near-term cash flow due to unexpected fluctuations in production or margins would normally be expected to have a much bigger impact on share prices than an uncertain change in demand a decade or more in the future.

This is compounded by the decline curves typical of many large hydrocarbon projects. If the first 3-5 years of a project account for more than half its undiscounted cash flows, it won’t be very sensitive to long-term uncertainties, nor would a company made up of the aggregation of many projects with this characteristic. This is even truer of shale gas and tight oil projects, which yield faster returns and decline more rapidly.

I can’t speak for Wall Street's oil and gas analysts, but I’d be surprised based on past experience in the industry if the risk of a 10% or greater drop in global demand for oil or gas in the 2030s would have much of an effect on their price targets for companies — certainly not enough to qualify as a bubble.

5. Fossil Fuel Share Prices Don’t Already Account for Climate Risks
The assertion of a carbon bubble in fossil fuel assets ultimately depends on investor ignorance of climate-response risks, presumably because companies haven’t quantified those risks for them. To the extent the latter condition is true, it represents an opportunity for companies seeking to capitalize on the boom in sustainability-based investing.

However, you needn’t be an adherent of the Efficient Markets Hypothesis for which Eugene Fama was named as a recipient of this year’s Nobel Prize in Economics to realize that thanks to the Internet, average investors have access to most of the same information on this subject as Mr. Gore and his partners. Institutional investors, who make up the bulk of the shareholding for at least the larger energy firms, and the analysts who follow these companies have the resources to access even more information.

Nor is the idea of a carbon bubble exactly new. Mr. Gore didn't create it, and I’ve been following it for a couple of years, as it took over from waning interest in Peak Oil. It’s not an obscure risk, either, in the sense that sub-prime mortgages and credit default swaps were in the lead-up to the failure of Lehman Brothers in 2008. It’s becoming more mainstream every day, although the burden of proof that this risk is mispriced rests with those advocating this view.

Before concluding, a word of disclosure is in order. As you may gather from my bio, I spent many years working with and around fossil fuels, though my ongoing involvement in energy is much broader than that. As a result of that experience, my portfolio includes investments in companies with significant fossil fuel holdings. I strive for objectivity, but I can’t claim to be disinterested. However, neither can Mr. Gore. As a major investor in renewable energy and other technologies through the firm cited in the article and other roles, he has as much at stake in promoting the idea of a carbon bubble — and on a very different scale — as I might have in dispelling it.

The carbon bubble is an interesting hypothesis, even if I don’t yet find the arguments made in support of it convincing. Despite that, I see nothing wrong with investors wanting to track their carbon exposure, consider shadow carbon prices, or ensure they are properly diversified. However, the biggest risk I see that might eventually warrant considering divestment of fossil-fuel-related assets isn’t based on the merits of this analysis, but on the possibility of creating a self-fulfilling prophesy by means of drumming up social pressure on institutional investors. You might very well think that applies to this Wall St. Journal op-ed. I couldn’t possibly comment.

A different version of this posting was previously published on Energy Trends Insider.

The Hinge of Fate

We seem to be accumulating crises at an alarming rate, lately, between the financial crisis, energy crisis, and climate crisis, along with incipient crises about which experts have been warning us, such as the government debt crisis and the looming Social Security and Medicare crises. Combine all of these and factor in the natural tendency for exaggerated predictions of disaster in an election year, and it is a wonder that we don't have more people dropping out of society to join survivalist communities in the hills. Are things really as bad as they appear, or have the aggregated uncertainties merely grown so large that our confidence in a recognizable future has been shaken?

Consider the economic crisis. Not long ago, there was still disagreement about whether the US was in a recession. Now, from media and politicians alike, we hear daily warnings about another Depression, and the tension is between those who view 2008 as 1929 or as 1932. Yet as Robert Samuelson's op-ed in today's Washington Post points out, the current situation has some ways to go before it rivals even the most serious post-war recessions, let alone the Great Depression, nor does it share the same mix of factors that made the Depression so intractable. A year ago, it seemed to many that we were headed for a repeat of 1970s-style stagflation. Given the complexity of interacting trends and events, however, I find it at least as probable that we are moving into a future for which these precedents won't prepare us very well. That could be true for energy, as well.

We've had energy crises before, too, but never one for which our responses faced a constraint such as climate change. If greenhouse gas emissions weren't an issue, we could deploy coal liquefaction on a crash basis and buy ourselves a decade or two of greatly reduced dependence on foreign energy suppliers. But the collision between coal and climate change now looms so large that a former Vice President of the United States has shockingly called for civil disobedience to stop the construction of coal plants that don't capture and sequester CO2--which today includes essentially all of them. Nuclear power, a proven large-scale alternative, faces other hurdles, including permitting problems and disagreements over waste management.

The preferred solution involves a dramatic shift to renewable energy, even though renewables have not yet reached the scale at which they are ready to take up the burden of supplying the economy with enough energy to grow. They are ramping up rapidly, and the tax credits that were extended last week will help. However, the net contribution of even the most advanced of these is still modest. Wind power is expected to grow by 7,500 MW this year, adding the equivalent of only 0.5% of net power generation. The 2.5 billion gallons per year of new ethanol capacity under construction would displace only 0.6% of US oil consumption--before factoring in the oil consumed to produce it. So while the combined energy/climate problem looks enormous, our currently-deployed options offer only incremental, not revolutionary change.

Perhaps our challenges look as big as they do because our faith in the tools available for tackling them is so limited. Every one of these problems is serious, and ignoring them would be a recipe for disaster. But unless we are truly within a few years of a climate change tipping point, they all look manageable over a longer timeframe. The economy will contract and eventually recover, as it has after every recession. Ten years from now, we won't all be driving electric cars recharged by wind and solar power--if anything, a recession will slow that transition--yet the ongoing shifts in our patterns of energy consumption and production will accumulate. Our energy diet will begin to look quite different from today's, and it will emit less CO2, per unit of economic output and in aggregate. The ultimate outcome might be less dramatic than we sense at this pre-election moment that feels like the Hinge of Fate, but we will get there, and I have a hunch that new fortunes will be made along the way.

Changing Our Energy Diet

Over the weekend I participated in a panel discussion on space-based solar power (SSP) at a space-development conference, for the second time in as many months. My presentation focused on what it would take for a new source such as SSP to find a place in our energy diet, which will be changing at the same time that the technology for producing power in space and sending it to markets here on earth develops. The audience of entrepreneurs and space professionals was quite engaged by the idea that SSP couldn't just be a space project; it had to be a viable energy project, too. These same challenges apply to any new energy technology with a long development period, including some that are much more established than SSP. But with politicians, pundits, and experts of all stripes telling us we must rapidly shed our addiction to fossil fuels, the inertia of our present energy diet remains the under-appreciated elephant in the room.

I began my brief remarks with a simple pie-chart showing US energy consumption for 2007, based on data from the Energy Information Agency of the US Department of Energy. As replicated below, it showed the breakdown of our primary energy supply--the raw energy going into power plants, factories, and oil refineries for further processing into fuels, electricity and materials, along with the contribution from nuclear power plants and those energy sources that produce electricity directly, such as hydroelectric dams, solar panels and wind turbines. Despite the recent, breathtakingly-fast growth of wind and solar, and the tremendous success of the nuclear industry at squeezing more output from its 104 existing reactors, the low-emission portion of our energy diet only accounts for 15% of our primary energy needs, and less than a third of our electricity demand, with 93% of that coming from mature hydropower and nuclear sources.

US Primary Energy Supply

As in a diet, not all calories are equal or interchangeable. The 39% of this diet supplied by oil cannot be replaced by renewable sources of electricity without a lengthy and dramatic change in our vehicle fleets, because oil accounts for less than 2% of our electricity generation, and there's very little of it left to displace from the power sector. Nuclear power and natural gas already accomplished that task over the last several decades. The much bigger challenge now is to shift the roughly 97% of transportation energy currently derived from oil to other sources--either electricity in the view of Al Gore, Dr. Andrew Grove and others, or natural gas, as suggested by T. Boone Pickens. But as we make that shift, we can't leave the portions of our economy that will still depend on oil high and dry. We must continue to provide enormous quantities of petroleum, even as we work aggressively to shrink its share of our diet and expand the portion supplied by sources that don't emit greenhouse gases or contribute to our trade deficit. It is fundamental to the nature of oil production that if you don't keep drilling, its supply quickly dwindles.

Tom Friedman's column in Sunday's New York Times drew a parallel between Mr. Gore's ten-year goal for ending our use of fossil fuels and President Kennedy's commitment to reach the moon in a decade. Unfortunately, this analogy breaks down once it gets past the R&D stage. I regard our accomplishment of landing two men on the moon 39 years ago yesterday as the pinnacle of the 20th century. It was a remarkable feat, requiring billions of dollars and hundreds of thousands of scientists, engineers, and support staff of every description, yet it ultimately only put 12 Americans on the lunar surface. We're talking about displacing 85% of the current energy diet of a nation of 300 million people that accounts for between a fifth and a quarter of global GDP. Doing that within a decade wouldn't just be moonshot-impressive; it would require a flat-out miracle.

The Other Half of the Nobel

I'd be derelict in my duty if I let the announcement of this year's Nobel Peace Prize pass by without comment. However, I'd like to focus on the half of the award that did not go to former Vice President Gore. If you read the Nobel citation, you'll see that the Intergovernmental Panel on Climate Change (IPCC) actually received top billing, even though the media have largely ignored that or treated it as incidental. While it's understandable that we should focus more on the individual who personifies the cause of climate change in this country, and perhaps the world, I think the award to the IPCC might actually be more significant. By awarding the Nobel Peace Prize to the IPCC, the Norwegian Nobel Committee is putting its moral authority behind what is generally referred to as the "scientific consensus on climate change."

Not to diminish Mr. Gore's efforts, but without the work of the IPCC, his presentation on climate change, captured on film in "An Inconvenient Truth," would have rested on mere conjecture. It took thousands of scientists and decades of research, peer review and public debate to arrive at the present picture of the interaction of all the factors affecting the global climate system, including the man-made greenhouse gas emissions that are nudging the Earth's climate towards a warmer state, with consequences both foreseeable and unknowable. Nor is this a static picture. Evidence is still being gathered, computer models improved, and data periodically reviewed and corrected. That's how science works.

But if the Nobel for the IPCC is a vote for this cumulative body of science and the scientists who produced it, I think it's important to understand that it is a very different kind of endorsement than the Nobel Prizes for the various sciences, which are awarded by the Nobel Committee of the Royal Swedish Academy of Sciences. The Peace Prize, on the other hand, is awarded by a committee selected by Norway's parliament, the Storting. This year's committee includes a university president, a theologian, and a consultant. All served in Norwegian politics or government at some point. In that light, the award to the IPCC should be viewed as a recognition of the geopolitical and world-historical importance of global warming, rather than any kind of peer review of the science behind it. My purpose in drawing this distinction is not to validate skepticism, but to suggest that this Nobel signals an evolution and perhaps even a turning point on the issue.

Now, I realize that some of my readers remain skeptical about the extent and risks of climate change, and of the very notion of a "scientific consensus." But I think we're now at a point with regard to our understanding of climate change and its risks that the main theater of activity will be political and diplomatic, rather than scientific. The scientists have communicated their conclusions, including a detailed series of reports released this year on the scientific basis, potential impacts, and mitigation strategies. It is now up to governments at all levels to decide what to do about it, based not only on the science, but on all of the other issues for which they are responsible: the prosperity, security, and well-being of their citizens, and of the world as a whole. The choices aren't as simple as they apparently seem to some, but neither can they be ignored. And that's what the committee says plainly in the concluding paragraph of the citation:

"By awarding the Nobel Peace Prize for 2007 to the IPCC and Al Gore, the Norwegian Nobel Committee is seeking to contribute to a sharper focus on the processes and decisions that appear to be necessary to protect the world’s future climate, and thereby to reduce the threat to the security of mankind. Action is necessary now, before climate change moves beyond man’s control."

Who's Right?

Digital video recorders are wonderful. I was able to record former Vice President Gore's appearances before the House Energy and Commerce Committee and Science Committee and the Senate Committee on Environment and Public Works this Wednesday, watching most of his hours of testimony over the last couple of days. Aside from the expected debate over the details of global warming, which one Congressman characterized as being over in science but not in politics, another interesting dichotomy was also on display. In response to several questions on the merits of nuclear power in addressing the need for cleaner energy, Mr. Gore sketched out his vision of a much more networked and dispersed economy, in which central power generation plays a smaller role and so-called distributed power sources, including solar and wind energy, lead the way. It's tempting to come down on one side or the other of this debate, but like the one about alternative energy technology, the better answer probably lies with a blended solution.

Along with reprising most of the arguments from his Academy Award winning film, "An Inconvenient Truth", the former VP peppered his responses with interesting energy ideas, including the establishment of a federally-chartered Carbon-Neutral Mortgage Association, "Connie-Mae", to underwrite energy efficient home construction features that the market won't yet value in the selling price of a new house. He also pushed the idea of a smart, networked power grid to accommodate small, distributed generation from cleaner, more efficient sources. It's an appealing picture, and one that I first encountered a decade ago, in my energy scenario work. There are lots of benefits of this sort of approach, particularly in countries that are growing rapidly and have to build new energy infrastructure, anyway. Our own power grids are evolving in this direction, with trends such as "net metering", and they will need to, in order to adapt to the changing demands of their customers for higher quality, more reliable power.

However, even in this bright new world of decentralization, someone must still smelt aluminum, mill steel, build cars, and do all the other grimy, old-economy things upon which we still depend, some of us for our livelihoods, and the rest for our lifestyles. These activities require vast amounts of reliable, baseload power, of the kind that nuclear and coal-fired power plants excel at. Coal looks highly problematic in a carbon-constrained world, depending, as the new MIT study suggests, on the development and deployment of a largely untested carbon sequestration technology that will be very difficult to retrofit to existing plants. For this reason and others, nuclear energy is attracting more interest, globally.

Mr. Gore worked hard to avoid sounding rigidly anti-nuclear, focusing instead on concerns about waste storage--he opposes the Yucca Mountain waste facility--and the very large capital costs involved in building new nuclear plants. Yet despite these issues, we are likely to see the first new nuclear plant in this country in two decades get its permits within a few years. The cloud of uncertainly that the recent TXU deal has cast over new coal-fired power plants will inevitably improve the prospects for new nukes.

To refine a statistic tossed out by one Senator, in 2005 nuclear power contributed 68% of all the low-carbon electricity generated in the US. As we contemplate a cap on carbon emissions and a carbon tax or an emissions trading system--or both, as Mr. Gore advocated Wednesday--the market value of all those green electrons from wind, solar, hydropower and nuclear will go up significantly. I doubt we can rely exclusively on wind and solar energy to provide all the green electricity we'll need, and efficiency won't eliminate the role of central power plants. I'd be very surprised if the greener world we need to create didn't also feature a bigger contribution from nuclear power.