Markets at Risk of a "Carbon Bubble"; Fossil Fuel Reserves, Companies Way Overvalued

Evidence suggests both fossil fuel reserves and the shares of companies involved in their extraction are way overvalued. In fact, a "carbon bubble" exists in major stock markets around the world, particularly on the London Stock Exchange - at least if governments are serious about complying with the view of most scientists that we need to limit the average increase in global temperatures to 2⁰ out to 2050, and preferably less, asserts the Carbon Tracker Initiative.

"Currently, financial markets have an unlimited capacity to treat fossil fuel reserves as assets. As governments move to control carbon emissions, this market failure is creating systemic risks for institutional investors, notably the threat of fossil fuel assets becoming stranded as the shift to a low-carbon economy accelerates," according to Carbon Tracker's "Unburnable Carbon - Are the World's financial markets carrying a carbon bubble?"

Busting the World's Carbon Budget

Researchers at the Potsdam Institute have calculated the worldwide global carbon emissions budget to be 886 gigatons of CO2 between 2000 and 2050 if we are to reduce our risk of exceeding 2°C warming by 20%, the report's researchers note. We've "burned through" more than 1/3 of that amount from 2000-2010, leaving just 565 GtCO2 of allowable emissions for the remaining 40 years, according to the report.

The world's investors are not paying much, if any, heed, to any such notions, however. The fossil fuel reserves of privately and publicly owned companies and governments total 2,795 GtCO2 while those of the 100 largest stock exchange listed coal, oil and gas companies is equivalent to 2,795 GtCO2. Yet only 20% of those reserves could be burned if we are to stay within the boundaries established by UN Intergovernmental Panel on Climate Change.

Rewriting the Rules of the Energy Investment Game

Clearly, there's a huge misallocation of capital taking place should dire warnings of the environmental, economic and social costs of average global temperatures rising 2⁰ or more between 2000 and 2050 turn out to be true. That's due in the main to the way "the rules of the game" have been written, i.e. due to the structure and regulation of financial markets and the energy industry, Carbon Tracker says, and hence it's imperative that governments rewrite the rules of energy markets.

"In the past decade investors have suffered considerable value destruction following the mispricing exhibited in the dot.com boom and the more recent credit crunch. The carbon bubble could be equally serious for institutional investors – including pension beneficiaries - and the value lost would be permanent," according to the report.

Just as clearly, climate change legislation supporters have been fighting a losing battle, certainly at the federal government level in the US. That's likely to remain the case unless governments get serious about putting incentives and disincentives in place that put a much higher cost on greenhouse gas emissions. If Carbon Tracker's point about capital misallocation turns out to be true and it continues unabated, investors may well be in for a lot more than just staggering financial losses.

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