Impairment and Stranded Asset Risk
A risk management discussion
By Gabriel Thoumi, CFA, Senior Sustainability Analyst, Calvert Investment Management, Inc.
In the report Unburnable carbon 2013: Wasted capital and stranded assets, we learned that existing global fossil fuel reserves are estimated to exceed the PwC Low Carbon Economy Index 2013: Busting the carbon budget global carbon budget by a magnitude of 3x to 4x. If we want to avoid catastrophic global warming greater than 2°C, we cannot exceed the PwC budget.
Furthermore, it is estimated that in 2012 the largest 200 oil and gas, and extractives companies globally spent $674 billion to obtain further oil and gas reserves.
Actual returns on these capital expenditures are not always public. Yet, suggested returns on this $674 billion capital expenditures are suspected to be below some of these firms’ required return on investment – or hurdle rate. Given that much of the financing of these capital expenditures comes from financial institutions, both oil and gas and the extractive sectors, and the financial services sector may be exposed to possible impairment and eventually stranded asset risk.
Stranded assets are simply illiquid assets – either on – or off-balance sheet – whose market value is less than book value and where it is difficult to find buyers.
This has a couple of implications to the risk manager.
- We, as risk managers, may want to fully value projects – from a forward-looking risk perspective – such that event risk – defined as both a) the probability and b) the impact of the event – related to climate change is priced into current valuations supported by appropriate non-linear, non-parametric scenario, stress, and factor analyses. This is event risk, and why climate risk is financial risk.
- We may also want to incorporate non–linear elasticity assumptions into pricing of associated fossil fuel assets including price shocks fully into the credit assumptions of the underlying asset.
At the same time, due to its diverse causes and effects, climate change can be built into financial models applying various analyses tools – scenario, stress, and factor – such that risk managers and associated advisors, attorneys, and underwriters can fully incorporate these risks from a forward-looking basis into their process–driven capital underwriting approaches.
As institutions across various sectors begin to incorporate their climate change risks into their underwriting, this will more fully inform their stranded asset risk, as measured by various metrics, including through their financed emissions, which are the emissions induced by an institution’s lending or financing of investments in companies and projects that emit greenhouse gases. The Greenhouse Gas Protocol, a partnership between the World Resources Institute and the World Business Council for Sustainable Development, has developed tools to measure financed emissions.
For example, in HSBC’s 2013 research report, Oil & carbon revisited: Value at risk from unburnable sources, market capitalizations of oil and gas producers could decrease by 40–60% in a 2°C constrained economy. This would be due to the loss of cash flows accompanied by a deterioration of the credit quality of these fossil fuel companies and a corresponding increase in credit risk for underwriters.
Climate change has begun to impact the traditional framework for risk and return for lending and financing institutions. Risk managers may want to now consider incorporating non–linear, non-parametric assumptions into their “event risk” models so as to inform underwriters and to safeguard shareholder value against impairment and eventually stranded asset risk.