Home » Economics » Climate Change-Induced Financial Disaster

Climate Change-Induced Financial Disaster

Sign up to the Barefoot Economist’s Newsletter

© Barefoot Economic Services

All content on this website (unless otherwise specified) is copyright of Barefoot Economic Services. Please acknowledge any content used in your work appropriately. Thank you for your consideration.

One of the extraordinary things to witness at the G20 meeting in Brisbane during the weekend of 15-16 November, was Australia’s rearguard action to keep climate change of the agenda. The G20 host’s justification was that climate change would distract from the economic policy focus. Besides, according to Australia’s Treasurer (i.e. Finance Minister), climate change is no impediment to economic growth. This is despite the wealth of economic research that has been produced that has modelled the economic impacts of climate change. A potential economic impact that has been gaining some traction is the ‘carbon bubble‘. The carbon bubble is where assets that derive most of their value from carbon reserves (i.e. coal, oil and gas) become ‘stranded assets’ as their value falls in response to international climate change action. For a country like Australia that is heavily dependent on fossil fuels for its prosperity, you would think a carbon bubble would have a serious economic impact. I went along to listen to a talk about what a carbon bubble meant for Australia. The panel was made up of Prof. Ross Garnaut, Jemma Green, Dr John Hewson and Tony Wood. Each of them an expert in economics, finance and energy in their own right. This is what I took from the discussion.

There was some consensus amongst the panellists that we may already be experiencing the bursting of the carbon bubble. Prof. Garnaut argued that the peak in China’s demand for coal has driven the recent decline in coal prices. Ms Green quoted research by MSCI that showed that returns were higher and less volatile with stock market indexes that exclude coal, oil and gas stocks. Dr Hewson argued that the finance sector needed to be better at managing the risk of stranded assets by understanding how exposed their portfolios are to a carbon bubble. Dr Hewson chairs the Asset Owners Disclosure Project that fills the information gap by providing a ‘climate rating’ for each pension fund. Mr Wood argued that fossil fuel companies were well-prepared for a carbon bubble bursting because their investment planning processes incorporate a ‘shadow’ carbon price that tests the sensitivity of an investment project to the introduction of stronger climate change policy. So there appears to be signs of a carbon bubble but it doesn’t appear to have sunk in to fossil fuel companies, investors, the finance sector and the general public.

The panel were asked if a carbon bubble could cause a financial crisis on the scale of the 2008 Great Recession. Prof. Garnaut noted that a financial crisis has its causes in flaws in the financial sector. Referencing his book, Dog Days, he argued that the seeds of the carbon bubble had been sown during the recent resources boom. Despite historical experience, investors and resource companies over-invested in projects thinking that this time it would be different. However, the ramp up in supply from new projects (here and overseas) and the slowing of Chinese demand has resulted in lower prices of fossil fuels. This has lead to a fall in the value of fossil fuel companies in Australia and globally as reflected in their stock prices.

Ms Green added that the decline in China’s demand for fossil fuels was partly the result of China changing its energy mix to include more renewable sources. The recent US-China climate change agreement that has China agreeing to increase its proportion of renewable energy to 20%, which would mean building 800-1000 gigawatt (GW) of renewable energy projects. To put that into perspective, that is equivalent to all of existing China’s coal-fired plants or all of the US electricity-generating plants. So, China’s demand for fossil fuels is unlikely to pick up.

Dr Hewson pointed out that globally, fund managers have invested $55 trillion in fossil fuels but have only allocated $2 trillion to renewable energy. This is despite the outperformance of clean energy technology stocks such as Tesla. Dr Hewson suggested that these fund managers may have failed in their fiduciary duties to invest their client’s money prudently. As a result, pension and superannuation portfolios are exposed to carbon bubble risk.

Mr Wood argued that fossil fuel companies would adapt quickly when new climate change policies were introduced. The inference being that a carbon bubble wouldn’t have a significant impact on fossil fuel companies. He used the example of shale gas of fossil fuel companies adapting quickly to price signals.

To me, it wasn’t clear from the preceding discussion if we should be concerned about a carbon bubble-induced financial crisis. To expand on Prof. Garnaut’s point that a financial crisis has its origins in the flaws of the finance sector, I looked at how exposed our major banks are to a carbon bubble. According to the website Market Focus, the ‘big four’ banks (Commonwealth, Westpac, ANZ and NAB) have a fossil fuel portfolio of approximately $19.8 billion. Comparing this to their combined market capitalisation of $588 billion, fossil fuel investments comprise 3% of the big four’s market capitalisation. So, even if fossil fuel investments were completely wiped out in value, a carbon bubble is unlikely to cause a financial crisis.

What about our superannuation (i.e. pensions)? Here, the ordinary working person is more exposed than the banks to a carbon bubble. According to a joint report by the Carbon Tracker Initiative and the Climate Institute, the average superannuation fund invests 29% of its portfolio in fossil fuels. According to the Association of Superannuation Funds of Australia, superannuation funds manage $1.85 trillion of assets as of the end of the June Quarter 2014. This means around $536.5 billion of superannuation is exposed to carbon bubble risk. This is over 27 times the big four banks’ exposure to fossil fuels. Furthermore, superannuation exposure is almost equivalent to the big four’s market capitalisation. Clearly, the superannuation of ordinary Australians is more highly exposed to stranded assets caused by a carbon bubble than the banking sector. Therefore, if a carbon bubble was to cause a financial crisis, it would probably originate in superannuation funds. Do you feel comfortable with such a high exposure to a carbon bubble?

The good news for superannuants is that you can manage your risk. Using resources such as the Asset Owners Disclosure Project, you can assess how exposed your retirement fund is to a carbon bubble. By understanding your exposure you can then take steps to manage it. You can manage it by reducing your holdings of fossil fuel companies. Alternatively, you can hedge against a carbon bubble risk by investing in renewable energy, energy efficiency, electric vehicles and other low-carbon investments. By taking charge of your retirement fund, you can send a small, but powerful signal to your fund managers that you are taking in account the risk of a carbon bubble and so should they if they want to keep your business.