(Bloomberg) - Financial markets aren’t pricing in the heightened risk of mass writedowns across energy portfolios that’s implied by the Inflation Reduction Act, according to the chief executive officer of Impax Asset Management.
Investors are still “really struggling” to calculate the so-called stranded-asset risk that oil, gas and coal producers face, Ian Simm, CEO of the $50 billion London-based sustainable investment manager, said in an interview.
There’s already a “significant risk” that energy investors will be left holding stranded fossil-fuel assets, the 56-year-old said. “And that’s been exacerbated by the Inflation Reduction Act,” he said, as unprecedented subsidies for green energy start to wipe out the competitiveness of a number of high-emitting assets.
Stranded-asset risk, whereby carbon-intensive companies face the obsolescence of the building blocks of their business, is “almost certainly not being correctly valued,” Simm said. The upshot is that “there are large, large balance sheets, which in a net-zero world will be entirely useless.”
The IRA, which was signed into law by President Joe Biden last August, earmarks about $370 billion in subsidies and tax credits for clean tech. But BloombergNEF has noted that the figure is in principle uncapped, and analysts at Goldman Sachs Group Inc. recently estimated that as much as $1.2 trillion in IRA support will end up being tapped. Whatever the figure ends up being, it’s money that will go to “the competitors of fossil-fuel suppliers,” Simm said.
Though the need to cut emissions is widely acknowledged, very few corporations, investors or governments are doing so fast enough. That’s in part as energy markets ride out continued geopolitical shocks such as the war in Ukraine, that have led to supply cuts and inflated prices. In response, many investors have piled into oil, gas and even coal with short-term price gains in their sights.
But the cost of sticking with fossil fuels is growing. A 2022 analysis published by the London School of Economics’ Grantham Research Institute on Climate Change and the Environment warned of the “cascading impacts” that investors in carbon-intensive companies face. Globally, $1.4 trillion in oil and gas assets are now at risk of becoming stranded, according to another 2022 study.
A separate analysis in 2021 found that for there to be a 50% probability of limiting global warming to 1.5C, close to 60% of oil and gas needs to stay in the ground. For coal, the figure is 90%. That means that many operational and planned fossil fuel projects are already “unviable,” according to the study.
Some investors are already acting on concerns that demand for fossil fuels will peak as soon as 2030, adding to the likelihood that assets such as oil wells, pipelines and other infrastructure end up stranded. Blackstone Inc., once a major investor in shale patches, told clients last year that its private equity arm will no longer invest in oil and gas exploration and production.
While the fossil-fuel industry is particularly vulnerable to the decline in asset values associated with the move toward net-zero emissions, other industries are also firmly in the crosshairs. These include aviation, as well as plastics, cement and steel.
At the same time, most high-carbon activities are bound by commitments to eliminate their emissions. Maia Godemer, an analyst at BloombergNEF, estimates that 68% of global greenhouse gas emissions are currently covered by a net-zero target with a further 23% under discussion, which is adding to pressure on asset managers to ensure their portfolios aren’t left holding potential stranded assets.
Part of the reason fossil-fuel assets continue to be mispriced lies in the time horizon investors typically apply, according to Simm.
“There are so many factors around which there’s uncertainty,” making time lines hard to pin down, he said. And that “then gives the accountants and the boards or management teams the scope to sort of sit on their hands and wait before taking the plunge and writing down assets. So we might be sitting on a buildup of systematically overvalued fossil-fuel assets.”
The issue is that “many investors are simply looking at next year’s earnings or next year’s dividend and applying multiples to those numbers,” Simm said. Instead, they should be applying discounted cash flow models and scenario analyses that span time horizons of 10 to 15 years, he said.
Failure to take true valuations into account could lead to legal liability, according to Kelvin Law, an associate professor of accounting at Nanyang Technological University.
For firms sitting on their hands, there’s an “increased litigation risk because of the potential omission of material financial information,” Law said. However, “because this type of disclosure is forward-looking in nature, the potential lack of sufficient data makes this task very difficult.”
This year, the International Accounting Standards Board started exploring ways to have financial statements better reflect climate-related risks. The work runs in tandem with efforts by the International Sustainability Standards Board, which is writing new guidelines for corporate reporting on climate and sustainability issues.
In the meantime, “there’s a real need for boards of companies and accounting firms to be questioning the valuation of these assets at the end of the year and to be taking a prudent approach to write-offs,” Simm said.
(Adds reference to divestments in ninth paragraph.)
By Sheryl Tian Tong Lee and Alastair Marsh
With assistance from Frances Schwartzkopff
