ExxonMobil Confronts the Carbon Bubble

• Companies and investors are squaring off over the potential impact of government climate policies on asset values, particularly in the fossil fuel industry.

• ExxonMobil gave its shareholders data and assurances of asset resilience under various policies but dismissed the scenario of greatest interest to sustainability investors.

Last fall I devoted a lengthy post to the notion that future policies to address climate change expose investors in companies producing fossil fuels to a potential bubble in asset valuations. So although I am not an ExxonMobil shareholder, I was particularly interested when the company issued a report last month responding to specific shareholder concerns along these lines. Although the term “carbon asset bubble” did not appear in the report, its references to carbon budgets and the risk of stranded assets in a low-carbon scenario were aimed directly at this emerging meme.

Unsurprisingly, ExxonMobil’s management reassured investors that, “none of our hydrocarbon reserves are now or will become ‘stranded’.” Wisely avoiding past tendencies to question interpretations of climate science, their analysis appears to be grounded in mainstream views of climate change. It focuses on the costs and achievability of an extreme low-carbon scenario, and on the resilience of the company’s portfolio under various climate policies.

Exxon's analysis is based on the company’s latest Outlook for Energy, an annual global forecast broadly similar to the main “New Policies” scenario of the International Energy Agency (IEA). It has fewer similarities to the IEA’s “450″ scenario that underpins carbon bubble claims. The company expects energy demand to grow at an average of about 1% annually over the next three decades–faster than population but much slower than the global economy–with increasing efficiency and a gradual shift toward lower-emission energy sources: Gas increases faster than oil and by more BTUs in total, while coal grows for a while longer but then shrinks back to current levels. Renewables grow fastest of all, producing about as much energy in 2040 as nuclear power does today. As a result of these shifts global greenhouse gas (GHG) emissions peak around 2030 and then decline gradually.

That forecast won’t impress those advocating prompt and aggressive changes in the global energy mix to head off serious climate change, but it is not very different from the most recent global forecast of the US government’s Energy Information Administration. If anything, Exxon expects slower growth of energy and emissions than the EIA.

Ultimately, ExxonMobil's argument that it isn’t running outsized carbon asset risks depends heavily on its estimate of the implicit costs of achieving a much deeper and more rapid transition to renewables, compared to its--and others’--forecasts. It gauges this on the intensity of governments’ future climate policies, expressed in terms of their effective cost per ton of CO2 abated, and on the affordability of such measures to energy consumers, especially in the developing world, where emissions are increasing rapidly.

Without directly disputing the technical feasibility of achieving such large and rapid emissions cuts, the company's management essentially questions whether any government would or could impose the extraordinary costs necessary for that to occur. Their proxy estimate of $200/ton of CO2 for such policies is sobering. Even if the sums that would raise were all efficiently recycled by those governments–a heroic assumption–the resulting diversion of investment and increase in energy costs would adversely affect overall economic development.

The sustainable investor groups that raised this issue with ExxonMobil were apparently disappointed with the answer they got. That's not surprising, but having participated in similar exercises at Texaco, Inc., I think ExxonMobil went well beyond the kind of perfunctory reply the investors might have expected. In particular, it has provided enough data to support a more serious dialog with investors on this subject.

For example, Exxon indicated that it “stress tests” its projects and acquisitions at proxy costs of up to $80/ton of CO2, compared to current levels of $8-10/ton in the EU’s Emission Trading System. Implicit in that is the question of whether investors would reasonably expect them to test projects at $200/ton., which would equate to around $100 per average barrel of oil--roughly today's price--based on the nifty “seriatim” chart at the end of the report.

The document also includes information addressing the resiliency of the company’s assets and operations under a lower-carbon future, with their emphasis on natural gas and a global average cost of production under $12 per oil-equivalent-barrel (BOE). Climate policies would have to raise those costs and shrink the associated revenues very significantly to jeopardize current production, nor are low oil prices generally consistent with a low-carbon world. Investments in future production are another matter, though Exxon refers to the IEA’s 450 scenario to demonstrate how much additional oil and gas development would still be required in the next 20 years, even in a world that was determined to constrain global temperature increases to no more than 2°C.

ExxonMobil’s response to investors will not end the debate over the carbon bubble. While providing a lot of information, the company essentially argued that the extreme low-carbon scenario associated with the risks of a carbon bubble is irrelevant, because it can’t be achieved any time soon, irrespective of the risks associated with current emissions levels. That is close to my own view, but it is unlikely to resonate with those who are more focused on the risks of climate change than on the nuts and bolts of what it would take to avert them.

Interestingly, the company’s report on carbon risks was issued on the same day as the latest iteration of the predicted consequences of further warming from the Intergovernmental Panel on Climate Change (IPCC). In a sense each report provides context for the other, so that investors who accept the IPCC’s analysis can weigh the potential costs of global warming against the cost and scale of the changes that would be required to put the world on a crash program to avert the worst climate-change-related outcomes. They can then buy or sell accordingly.

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

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.

Justifying $15 Trillion for Renewables

Yesterday I received a joint press release from a group of renewable energy trade associations. It touted a new report from the UN Intergovernmental Panel on Climate Change (IPCC) on the potential growth of renewable energy by 2050. The report has already garnered an impressive array of headlines, such as "Renewable Energy Can Power the World" and "Renewable Energy Key to Solving Climate Change". The headline from the Financial Times was characteristically more concrete, "World faces $15,000 bn renewable energy bill." Unfortunately, although the final report, rumored to run 1,000 pages, might support all of those conclusions when it is issued at the end of the month, the 25-page "Summary for Policymakers" falls far short of inspiring such confidence. Heaven help those policymakers if the summary is all they actually read.

I'm not even sure if "read" is even the correct verb to apply to this document. Once I got beyond the introductory paragraphs it seemed to degenerate into jargon and bureaucratese that was very hard to parse into plain meaning. The report's genesis as the product of pure consensus is readily apparent. Or as Andy Revkin of the New York Times' Dot Earth blog kindly put it, "it doesn't take readers much beyond what is already well established." That's a shame, because we don't need yet another report telling us that we are swimming in enough renewable energy to power our civilization umpteen times over, if we can merely muster the willpower to reach out and tap it. What we urgently need is a roadmap that describes a path--or preferably several possible paths--through the brambles that separate the energy status quo of 2011 from its ideal low-carbon state of 2050.

For example, we need to understand just how renewables will supplant the petroleum that currently provides around 94% of all transportation energy, at least in the US. That demand might be met by biofuels, although the report points out that the first-generation biofuels that supply nearly 3% of global road transport fuel today, but are still the only kind available on a commercial scale, have serious shortcomings. Closing the gap between 3% and 94% would require a true revolution in next-generation biofuels from sources such as cellulose and algae, yet after reading the Summary for Policymakers we are no wiser about when and how this will occur. I might note that such developments are rarely amenable to precise timetables, as the EPA is learning to its chagrin.

Alternatively, or in combination with biofuels, renewables might replace petroleum in transportation via the potentially more robust pathway of vehicle electrification, matching improved batteries with rapidly expanding supplies of intermittent renewables (wind, solar, tidal, etc.) delivered via increasingly intelligent power grids. But if that's the scenario, its crucial details are barely hinted at here.

The basic message of the summary appears to be that with enough investment, supported by the right policies, the currently identified renewable energy sources could expand by enough that in the very best case (out of 164 scenarios they considered) they could supply roughly as much energy by mid-century as we currently get from fossil fuels. That corresponds to 77% of total expected energy consumption in 2050 and may be the source of the headlines I saw. Of course the median level of those 164 scenarios is quite a bit lower, and the determination of the share of renewables in total energy relies on a projection implying that total global energy consumption will grow by an average of just 0.25% per year over the next 40 years. That suggests either a massive energy efficiency effort or minimal further economic uplift in the developing world. On a more reasonable track of 1% annual energy growth, the top scenario in the scatter chart on page 19 would meet 58% of total 2050 demand, while the median result would cover just a third of global energy needs. That's still impressive, compared to where we are today, but not quite as headline-grabbing.

I will be keenly interested to see what sort of scenarios the IPCC looked at in putting together the report on which this summary is based. Something tells me that they are likelier to fall into the category of what I would call projections or "cases" than true scenarios, which dig deeply into underlying trends and uncertainties and are not merely the output of a mechanistic model. That's not just a technical quibble, because I'm not aware of a single model-type forecast from 1970 that accurately projected the economic and sociopolitical conditions in which we find ourselves today. The intervening improvements in computing power and econometric sophistication still seem insufficient to conquer the fundamental unpredictability of looking that far into the future. But then the IPCC has a built-in bias to accept the results of such work, since long-term climate models underpin its entire effort. I hope I'm not alone in thinking that the expenditure of up to $15 trillion requires a much more rigorous justification than anything provided in this document. Whether or not Saint-Exupery really said it, a goal without a plan is just a wish.

If it seems that I'm being overly critical of a 1,000 page report that I haven't even seen on the basis of the horse-by-committee summary that I have seen, I plead guilty. But isn't that the same sin that the journalists and industry spokespeople are committing when they use this summary as the basis of glowing claims about the potential of renewables? And then there are the politicians and bureaucrats who will attempt to commit vast sums without ever reading any more than summaries such as this--at best--and without questioning the host of assumptions that went into them. If anything, this Summary for Policymakers reinforces my concern that the UN climate process has become so unwieldy and unresponsive that we must look elsewhere for leadership on this complex challenge. Meanwhile, we deserve a clearer articulation of how renewables can overcome the considerable obstacles that stand between their recent impressive performance and the achievement of the milestones this report suggests lie ahead.

The Verdict

Last Friday the Intergovernmental Panel on Climate Change (IPCC) concluded its meeting in Paris with the release of the Summary of its Fourth Assessment Report (4AR.) There's not much I can add here to what is being reported about the significance of its findings on the connection between greenhouse gases and climate change, and of the likely course of the latter over the rest of the century. I think I contribute more in two areas that haven't gotten a lot of attention in the media blitz over the 4AR: the value of the engineering approach for problems at this stage, and how best to regard the remaining climate skeptics.

Even though I haven't done much actual engineering in the last 25 years, my engineering training provided a framework for problem-solving that informs everything I do. Engineering is all about turning the results of science into practical things in the real world, and that is increasingly relevant to the problem of climate change. With the release of the full 4AR over the next several months--last week's output was just the executive summary of the first of the three main Working Groups--we're reaching the point at which the main focus must shift to action, rather than more analysis. That doesn't mean the scientific investigation of climate change should stop, or that we know everything we need to know about climate change; rather, in the manner of the solution to Zeno's Paradox, we know enough to get started. It's time to turn the engineers loose on this problem and move the scientific debate off to the side.

Making our energy systems more climate-friendly will be the centerpiece of that work. There are many competing blueprints for how to do that, and another one was also released last week by the American Solar Energy Society, with some impressive institutions and individuals behind it. Although I wonder how rapidly their proposed solutions could actually be ramped up, the report provides a good picture of the magnitude of response necessary to avert the consequences that the 4AR describes. (The IPCC will apparently contribute its own thoughts along these lines in the upcoming reports of the second and third Working Groups.) And we shouldn't limit ourselves to devising new ways of generating electricity or making cars more efficient. It may turn out that the only means of arresting the uncontrolled science experiment we've been running for the last century is with some truly large-scale engineering, and we ought to have options for that in our back pocket, in case we encounter a "runaway greenhouse" effect. I recognize that some will find that idea nearly as worrying as the climate problem itself.

Now to the skeptics. Although the strengthened scientific consensus of the 4AR will change the landscape for them, no one should expect the skeptics to disappear, nor would that be desirable--and here I draw an important distinction between genuine skepticism and self-interested obstructionism. That doesn't mean the skeptics should be driving the agenda, but having to answer their hard questions will clarify our thinking. Fundamentally, if they are going to challenge the IPCC view, they must do so in the only way that has worked throughout the history of science: by creating a better hypothesis that can be demonstrated to fit more of the available data and observations. Until that should happen, we must assume that man-made greenhouse gases are warming our planet, and act accordingly.

Life is going to get progressively harder for the skeptics. Their sources of funding will start drying up, and they may find themselves persona non grata, even among those whose support they could count on in the past. With the future of the planet increasingly seen to be on the line--and the fate of our descendants with it--the non-scientists' view of climate science is taking on attributes of religious dogma, and skeptics are being cast as heretics. That isn't healthy, but it's understandable. We need to preserve a level of continued funding and access to the mainstream of science for skeptical scientists, on the off chance that the consensus might prove to be wrong in some important way. If it turned out that the main driver of climate change were something other than man-made greenhouse gases--be it the cosmic ray/cloud hypothesis or something else--it would be nice to know that before we've spent trillions of dollars on a crash effort to decarbonize our energy systems and transform the global economy.

As the 4AR has made quite clear, waiting for the last lingering doubts about climate change to be resolved is a losing game that risks highly detrimental, potentially irreversible changes in our environment. Now we must see what the scientists can convince the policy makers to engage the engineers and financiers to do. I don't think we're going to have to wait long to find out.