Principles and Practice of Green Finance
What is stranded asset risk?
Following the release of his new benchmark green finance book, Simon Thompson, author and Chief Executive of the Chartered Banker Institute, discusses the growing impact of stranded asset risk.
One of the key concepts we discuss in Principles and Practice of Green Finance is what’s called stranded asset risk.
For example, an oil and gas company like Shell or BP might have hundreds of billions of dollars of oil and gas in the ground around the world sitting on their balance sheet. That’s where a large part of the company’s value comes from.
If, to achieve the Paris Agreement targets, that oil and gas has to stay in the ground, or a large portion of it has to stay in the ground, its value is a lot less than it is currently being booked at. Its asset is impaired and, in extremis, if it’s never extracted it could be stranded, with the oil in the ground worth absolutely nothing.
There are other risk factors around this. For example, if we introduce more robust carbon pricing then the cost of using fossil fuels as input into all sorts of manufacturing processes will increase, so people will look for alternatives and substitutions.
That will also then lead to fossil fuel assets being impaired or stranded.
Because the world at the moment still depends on carbon and fossil fuels for the vast majority of production and energy, if this transition happened very quickly – if those assets were stranded quickly or overnight – then it creates huge risks to financial stability. Because we all have our pensions invested in in these companies. And it’s not just the BPs and Shells. It’s every car manufacturer and all the pharmaceuticals – an overvaluation of fossil fuel assets that should exert downward pressure on valuations. Some argue (I’m not one of them, at least at the moment) that valuations in some cases should be marked down to zero.
Businesses will try to make sure this doesn’t happen by transitioning out of carbon-heavy sectors. We are already seeing portfolio decarbonisation happening, not just on moral grounds but on economic grounds, because of the risk of stranded assets. At the moment it’s smooth and steady, but a much more rapid transition – which is required if we are to meet the Paris Agreement targets – could threaten financial stability. And that worries financial regulators, and should worry those who invest in or lend to high carbon industries or firms.
This is a key concept in green finance, but is not a niche within a niche. It will soon become part of the mainstream of financial services and will impact on everyone’s professional practice sooner than we think.
All Chartered Banker Institute members receive a 20% discount on books and ebooks from publisher Kogan Page via our bookstore.