A triple-whammy of new climate change laws and regulations, low fossil fuel prices and clean energy alternatives erases trillions of dollars from coal, oil and gas stocks. This sends markets hurtling into a carbon crash that eclipses the dot.com and sub-prime calamities. 

This is the scenario a Bank of England enquiry is now risk-assessing. Why is it so worried? 

The answer is the risk of a “carbon bubble”. Current valuations of fossil fuel assets may be incompatible with the world’s commitment to limit global warming to 2 degrees Celsius, recently reaffirmed by the G7. To meet that goal, however, at least two-thirds of proven coal, oil and gas reserves cannot be burned, says the International Energy Agency (IEA). 

Yet fossil fuel companies have booked such reserves on their balance sheets and are spending over $1 trillion on new tar sands, deepwater and Arctic projects alone, according to the Carbon Tracker Initiative.

These reserves could become “stranded assets” if governments bring in strict carbon taxes or other policies, and clean technologies become increasingly competitive.

“Stranding risks will become increasingly acute,” HSBC predicts in an April 2015 research note, citing calculations that 35% of oil reserves, 52% of gas reserves and 88% of coal reserves would be stranded under a 2 degrees Celsius scenario.

“Investments in fossil fuels and related technologies...may take a huge hit,” Paul Fisher, Deputy Head of the Bank of England’s Prudential Regulation Authority, warned insurers in March 2015.

Not true, say major fossil fuel companies, arguing that, in BP CEO Bob Dudley’s words, the carbon bubble thesis is “a red herring“. It ignores the reality that governments have failed to act decisively to curb climate change and the IEA forecasts fossil fuels will dominate global energy markets for the foreseeable future.

So how can investors respond? Broadly speaking, they have two options:

• Divestment: sell fossil fuel investments to reduce their exposure
• Engagement: hold fossil fuel investments but encourage change as active shareholders

Time dictates a divestment strategy, says Jenna Nicholas, project manager for the Divest-Invest Philanthropy initiative. Climate change is too urgent a risk to wait for engagement to change the DNA of fossil fuel companies. Decisive action is imperative now.

Divest-Invest is part of the “fossil fuel divestment” movement which urges institutions to sell fossil fuel assets on financial, environmental and ethical grounds. Campaigners recently received boosts from UN General Secretary Ban-Ki-Moon who asked institutional investors to shift from fossil fuels to renewable energies and from Pope Francis who blamed “the intensive use of fossil fuels” for climate-related poverty.

Stanford and Oxford Universities, the Church of England, and the $900 billion Norwegian sovereign wealth fund are among those now withdrawing capital from fossil fuels, mainly coal and tar sands. Divest-Invest advocates philanthropic organizations divest their fossil fuel assets over five years, starting with coal, then oil and then gas. The five-year timeframe helps institutions unwind commitments in comingled funds, tracker or hedge funds without punitive exit fees.

“If we had seen great progress made in terms of investors helping fossil fuel companies to rethink strategies then things might be different. But when you look at the track record of climate conscious investors they have not had a large impact,” she says.

Aside from the time factor, Nicholas identifies four rationales for divestment:

• Avoid stranded assets: $20 trillion of the $27 trillion of carbon underground booked by the top 200 fossil fuel companies is not burnable, according to the Carbon Tracker Initiative.
• Delegitimize fossil fuels: divestment is just as much a social and political statement as a financial statement. It may not starve companies of capital, but it will send a message that business as usual is no longer acceptable.
• Unlock capital for clean solutions: shifting funds into energy efficiency, renewable and other low-carbon technologies will drive the transition to a safer, cleaner world.
• Align investments with philanthropic goals: organizations tackling poverty undermine their own programs and principles by financing climate change, which hits the poorest hardest.

Over 100 organizations managing $5.5 billion of assets have signed the Divest-Invest Philanthropy pledge, including the Rockefeller Brothers Fund. “John D. Rockefeller moved us from whale oil to petroleum and in so doing brought the world great prosperity and progress,” said the Fund’s President Stephen Heinz in a statement. “If JDR were alive today, I’m convinced that...he would be moving out of fossil fuels and investing in clean, renewable energy.

The divestment campaign lacks realism on three counts, argues James Bevan, Chief Investment Officer at CCLA Investment Management, which advises charities and other philanthropic investors:

• Overstated carbon bubble risk: While agreeing that fossil fuel assets are overpriced and thermal coal and tar sands will be “economically non-viable”, Bevan suggests carbon capture and storage (CCS) technology may allow burning of some reserves, thereby reducing stranding risk. CCS would capture CO2 emissions from power plants, liquefy them and store them deep underground.
• Limited scope: Divestment targets listed companies but their fossil fuel reserves are dwarfed by those of state-owned oil and gas companies. The overall impact is severely restricted.
• Artificial discounting: Divestment depresses prices, gifting returns to less scrupulous investors. “People who sold out of tobacco for ethical reasons lost performance while investors made strong returns,” Bevan observes. Otherwise, divestment had no impact.

Rather than wash their hands of fossil fuel companies, investors should help clean them up, says Bevan, pressuring companies to report their carbon impact and support clean technologies like CCS. This is the approach taken by Harvard University and the Wellcome Trust among others.

“If we invest in company A with low carbon intensity, it is already the environmental equivalent of a triple-A bond. If we invest instead in a triple-B bond and through activism and engagement change it to a triple-A bond we will have more secure earnings plus an environmental payoff,” he argues.

CCLA has engaged with BP on their deepwater drilling plans, for example, stressing that the likelihood of carbon taxes coupled with high environmental risks and low margins make these investments questionable.

“Our clear line is that renewable opportunities have a much longer shelf life and higher valuation,” Bevan explains. “My preference would be to persuade BP of the wisdom of committing more fully to that agenda.” A key part of that process is shareholder resolutions committing companies to disclose how they will adapt to carbon pricing, recently adopted by BP and Shell.

“As soon as companies recognize the risk they will plan for it and we will see cultural change,” says Bevan. Like Divest-Invest Philanthropy, he also wants results within five years: “We need companies publishing robust plans on coping with a carbon price consistent with 2 degrees of warming.”

If this doesn’t happen, divestment is the “logical endgame”, but Bevan sees change on the horizon. “We have been able to move oil majors from a position of finding this debate irritating to one where they are cooperating.