The stark warning from Bank of England governor Mark Carney of the serious risks posed by climate change to global financial stability marks the first time that such a high-profile figure in the financial community has lent credence to the concept of a carbon bubble.
It may signal that the mainstream investment community is finally recognising that the threat of stranded assets amid tighter climate policy is real and must become a standard consideration in asset valuation and risk assessment.
In an eloquently crafted speech of over 4,000 words, Breaking the tragedy of the horizon – climate change and financial stability, Carney drew a parallel between climate change’s inevitable impacts on investment returns and the 2007 global banking crisis’s repercussions.
Financial assets are not only at risk of climate change’s physical manifestations, such as a flood or storm. Policy actions to spur the transition towards a low-carbon economy will inevitably spark a fundamental reassessment of the value of a wide range of assets, the BoE’s head pointed out.
Fossil fuel firms are the most vulnerable to a depreciation of their assets as the global economy moves towards decarbonisation. Only between one-fifth and one-third of the world’s proven reserves of oil, gas and coal can be used, if we are to keep within the carbon budget that the IPCC estimates will limit global temperature rises to 2°C above pre-industrial levels. This will render the vast majority of oil, gas and coal reserves stranded.
Global investors’ exposure to these shifts is huge. Around one-third of equity and fixed income assets are linked to firms in the natural resource and extraction, power generation, chemicals, construction and industrial goods sectors.
The global stock of manageable assets faces expected losses of around $4.2 trillion out to 2100 — roughly equivalent to the total value of the world’s listed oil and gas companies, the Economist Intelligence Unit estimated in an Aviva-commissioned report, The cost of inaction: Recognising the value at risk from climate change, released in July.
The speed at which the inevitable re-pricing of global assets occurs is uncertain. But the maximum 10-year timeframe within which business, political and monetary policy decisions are taken is far too short to account for the longer-term impacts of climate change.
This means that, in the words of Carney, once climate change becomes a defining issue for financial stability, it may already be too late.
And yet, despite the clear financial risks it poses, carbon is still largely an un-priced externality in investment portfolios. Hence, Carney calls for a proper reporting of the carbon intensity of different assets to become standard so that their true value can be disclosed.
As a first step, Carney proposes that a climate disclosure task force should be established to develop a voluntary carbon disclosure standard — a move that would mirror the push for greater transparency following the financial crisis. Such a task force would develop a uniform set of carbon intensity standards to replace the existing surfeit of disclosure schemes. The G20 is uniquely positioned to meet this challenge, given that its member states account for around 85pc of global emissions, Carney suggests.
Alongside a uniform set of carbon disclosure standards, Carney advocates stress-testing assets and that government provide guidance on possible carbon price paths, indicating minimum and maximum prices so that climate change’s impact on the returns of various businesses can be better profiled.
Even if the initial price is set far below the “true” cost of carbon, the price signal itself holds great power as it would link climate exposures to a monetary value, he says. It would also provide a perspective on the potential impacts of future policy changes on asset values and business models.
Carney’s proposal is only a small step in the right direction. But, given his standing as a respected figure in mainstream banking, it marks an important milestone and could herald a shift in the right direction.