What Are The Financial Risks Of Climate Change?

In a blink, trillions of dollars in investments become worthless. Stock markets reel as banks play "hot potato" with once-lucrative assets they now can't unload quickly enough. The price of crude has collapsed, and now every financial product buoyed by oil – every share of ExxonMobil, every corporate bond taken out to fund drilling, every derivative on the price of crude 12 months hence – is barely worth the paper it's printed on. One too-big-to-fail firm, unable to stanch the bleeding, declares bankruptcy. Again, the financial system teeters on the edge of collapse.

This is the nightmare financial scenario presaged by the end of the oil market. By now, the science is clear: Averting catastrophic climate change will mean dramatically slashing fossil fuel use. But when you compare the amount of known oil in the ground with how much carbon human activity can reasonably emit before warming becomes irreversible, you're left with $20 trillion in fossil fuel investments that would need to stay effectively buried. How could the financial system weather that shock?

Recently, The Bank of England formally took up the question in its latest research agenda. It is the first time a central bank of its size has examined the systemic risks of stranded assets – the oil, gas and coal that must go untapped if the world acts on its climate goals.

Now that the Bank of England is investigating the financial threats that climate change poses, will the U.S. Federal Reserve follow suit?

To date, the Fed hasn’t publicly grappled with the risks associated with stranded assets or moved to study them. Charged with conducting monetary policy and guarding against systemic risk, members of the Fed regularly weigh in on matters of market wellbeing. But the so-called “carbon bubble” has yet to grace its agenda.

When reached for comment about stranded asset risk, a Fed representative told International Business Times, “We do not have any guidance on this matter.”

Nonetheless, potential losses to the financial system from stranded assets are huge. “We know that we’ve got more oil and gas supplies underground than we can possibly burn if we’re going to maintain a livable climate,” says Shanna Cleveland, senior manager of the Carbon Asset Risk Initiative at Ceres, a business sustainability nonprofit.

According to a pioneering recent study, 82 percent of coal deposits would need to stay buried, along with half of known gas reserves and a third of the world’s oil, if warming is to be capped at 2 degrees Celsius – a benchmark the scientific community sees as an upper bound for maintaining human livelihood. Amid deep emission cuts or collapsing oil prices, trillions of dollars in fossil fuel investments could be wiped out and a sprawling extraction and refining industry could tank.

As Cleveland explains, the issue is not just the face value of unburnable fuels, but the web of debt and investment that surrounds them: corporate bonds, oil-backed securities, a universe of swaps and options. “Assets like this are being packaged together and sold to investors with the expectation that demand will continue to rise unabated.”

What happens if a regulatory regime or sudden natural event causes oil prices to plummet? “You have the risk for a bubble similar to the one in the housing market in 2008,” Cleveland says, echoing concerns sounded by Al Gore and others that the souring of fossil fuel investments could precipitate a full-on financial crisis.

If crude prices fall for a protracted period of time, Cleveland says, “You would start to see banks that were selling a large number of these assets suffer.” Institutional investors like pension funds and insurance companies would take a hit as securities backed by fossil fuels became toxic. The financial system could suffer “a cascading effect,” says Cleveland.

Still, a massive volume of capital continues to flow to high-risk extraction projects. The Carbon Tracker Initiative, an organization that surveys the fossil fuel economy, estimates that annual capital expenditures amounting to nearly $700 billion flow to projects that could end up abandoned. According to the group’s calculations, fossil fuel companies traded on the New York Stock Exchange are worth a combined $1.5 trillion.

For their part, oil giants have shrugged off the possibility that their profits could be marooned. “We are confident that none of our hydrocarbon reserves are now or will become ‘stranded,’” ExxonMobil has declared. In the last decade capital expenditures into oil exploration and development have doubled.

But various scenarios could imperil broad swaths of the energy market. Governments could tax fossil fuels or simply cap their use to slow climate change. Or market pressure from burgeoning green-energy technologies could make the most speculative investments in fossil fuel untenable.

Meanwhile, a growing divestment campaign composed of university endowments, investment funds and religious institutions has ditched billions in fossil fuel assets. Though its aims are more political than practical, the campaign’s message has spread into the financial sector. Last year a Scandinavian financial services company swore off fossil fuel investments, citing a “financial and climate-related decision” that stemmed in part from the potential dangers of stranded assets.

It’s enough for industry players to start seriously fretting over fossil fuels. Ratings agency Standard & Poor’s issued a report discussing credit downgrades in a “carbon-constrained future” in 2013. Last December, amid a plunge in crude prices, Goldman Sachs warned that nearly $1 trillion in investments for proposed oil projects had become unsafe.

Even former Treasury Secretary Henry Paulson now co-chairs the Risky Business Project, which “focuses on quantifying and publicizing the economic risks from the impacts of a changing climate.”

Despite the growing awareness surrounding the systemic risks of stranded assets, it remains unclear when – or if – the Federal Reserve plans to take on the issue. But the pressure is mounting. A representative from the Carbon Tracker Initiative, which prodded the Bank of England to investigate stranded assets, said the organization may petition the Fed next.

“In a case like this where it is such a significant part of our financial system,” says Ceres’ Cleveland, “it would be a very positive step for the Federal Reserve to get involved.”