Australian based analysts at Citigroup says fossil fuel reserves in Australia face significant value destruction in a carbon constrained world, with the value of thermal coal reserves likely to be slashed dramatically if governments get serious about climate action. It says fossil fuel asset owners could be best advised to dig the resource up as quickly as they can.
In a further sign that the idea of carbon budgets is gripping mainstream investment and business discussion, Citi recognises the potential impact of “unburnable carbon” – where decisive climate policies will force the bulk of the world’s fossil fuels to be left in the ground. It says the declining cost of renewables could have the same impact.
The Citi report – lead authored by Elaine Prior – downplays any immediate threat to these fossil fuel investments, and is warning its clients not to bail out of fossil fuel investments too early. But it concedes that half of the value ascribed to the thermal coal assets of BHP Billiton and Rio Tinto and specialist coal miners could be lost if the world took decisive action on climate change by 2020.
Citi judges that it is unlikely the world would act in such a decisive nature that would force the world’s biggest fossil fuel companies to leave their cherished assets in the ground, but is “monitoring” developments. Ironically, it suggests investments may be equally threatened by the fact that these fossil fuels could be exploited and more warming is created.
“Unburnable carbon is clearly a risk. However, at the other extreme of the spectrum, there is the risk that the world does not successfully embark on coordinated carbon constraints,” the Citi analysts write. “In this case, key risks would be those resulting from physical climate change (eg droughts, floods, cyclones, sea level rise, melting icecaps, etc), rather than from devaluation of fossil fuel reserves. “
The conclusions of the Citi report may reflect some of the thinking going on in the boardrooms of the biggest fossil fuel companies in the world, and their strategies at influencing national and global policy development.
Citi suggests that the concept of unburnable carbon is no longer an “if”, but a “when” – so fossil fuel companies may be best advised to develop, produce and sell a significant portion of their reserves before markets are significantly impacted.
This is revealing, and underlines why the biggest policy battle going on in energy and resource markets across the world is about “delay” – the fossil fuel companies working hard to push back the development of renewables, and the environmental organisations ramping up their opposition to fossil fuel projects, knowing that they may soon be priced out of the market, even if policies do not deliver – a possibility recognised by Citi analysts (and in a previous report by Citi’s global energy team, which underlined why even cheap shale gas would not push back wind and solar).
Other organisations have written extensively about this “carbon bubble”, and there is a huge amount at stake – some $1 trillion a year in revenues by 2050 if the world diverts from what the International Energy Agency describes as business as usual to a carbon constrained world that aims to limit global warming to 2C.
Indeed, in one section of this latest report, titled “Should fossil fuel companies build windmills?”, the Citi analysts questioned the idea that fossil fuel companies should diversify into sectors such as renewable energy.
“… From the perspective of (asset owners), it is not clear to us that this is a logical strategy,” the analysts write. “Instead, it may be more sensible for fossil fuel companies to exhaust their reserves as fast as possible, and pay out the proceeds as dividends, ultimately to (asset owners).”
The analysts say the asset owners could then reinvest that cash themselves. It notes that the fall in costs in renewable technologies, particularly solar, are likely to have an impact on fossil fuel developments as well, as are unilateral national policy decisions from big importers such as China.
“In our view, technical progress might lead to renewables such as solar becoming cheaper and more economically viable than fossil fuels. If alternatives to fossil fuels are financially viable without regulatory support, this would seem to offer the best prospect of moving away from fossil fuels,” it writes. “Otherwise, regulatory measures such as global carbon constraints would seem harder for major governments around the world to establish and maintain when faced with plentiful cheap energy resources in the form of fossil fuels.”
The Citi report is significant because it is not produced just by the “carbon” specialists within the group, but draws on the input of those specialising in mining and energy industries, illustrating that the concept of unburnable carbon is seeping through to the people making recommendations about investments. Even if you agree with the Citi conclusions or not, the significance lies in the fact that fossil fuel risk is now a mainstream issue.
Citi seeks to downplay the broader impact of a severe carbon budget on the Australian Stock Market. It says that around 14.1 per cent of the ASX200 market capitalisation relates to fossil fuels, but only about 1.5 per cent relates to thermal coal production. A further 2.0 per cent is ascribed to coking coal, 7.7 per cent to oil and gas, and the remaining 2.8 per cent to other related businesses.
Specifically on Australian companies, Citi underlines the value of policy “delay” to asset owners, saying that if coal demand holds up until 2025, about 70-80 per cent of the value attributed today to BHP’s and Rio’s coal assets would have been realised.
But if the change happens as soon as 2020, only about half of the value would have been realised. If it occurs after 2030, there would be minimal loss of value.
However, for companies the size of BHP and Rio, thermal coal contributes only around 5-10 per cent of global value, so even if half the value of each company’s thermal coal was at risk under an “unburnable carbon” scenario, this would be roughly 3-4 per cent of its valuation of each company.
The impact would be more significant for “pure play” coal miners such as Whitehaven Coal. It says one third of the value of that company could be at risk.
It says those companies most at risk will be those heavily leveraged to new, long life thermal coal projects, which has interesting implications for those companies seeking to develop green-fields projects such as the massive Galilee Basin in Queensland with its multi-billion dollar infrastructure requirements (railroads, electricity and ports).
So what should asset owners and asset managers do? Apart from digging up fossil fuels as quickly as they can (see above), Citi says investors who strongly believe in “unburnable carbon” would find it more productive to actively tilt their portfolios, while accepting that this strategy also poses risks if fossil fuels are stronger for longer than they expect.
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