Climate Change Regulation, Stranded Assets, and American Investors

Scott Looney

“‘Stranded assets’ are assets that have suffered from unanticipated premature write-downs, devaluations or conversions to liabilities.”[1]

With a non-binding proposal for a Green New Deal (“GND”) that would “achieve net-zero greenhouse gas emissions” introduced in Congress,[2] climate change policy is at the forefront of a national conversation with familiar arguments. Those in favor of a GND describe the proposal as an appropriate response to an existential threat posed by climate change[3] while those opposed characterize it as a very expensive way to destroy jobs.[4]

Regardless of position, GND-style or other climate-related regulations, such as a carbon tax favored by major petroleum producers,[5] will have a dramatic effect on the economy. However, policy makers are not addressing the potential impact of sudden regulatory changes on Americans’ investments. Americans and financial institutions have hundreds of billions of dollars invested in carbon-intensive industries.[6] These exposures are compounded by investments in (other) financial institutions that have similar, if not nearly identical, holdings.[7] Additionally, $1.4 trillion worth of commercial and residential property is located within one-eighth of a mile of the U.S. coast.[8]

This leads to the idea of stranded assets. Any attempt to mitigate the impact of climate change will result in the devaluation of certain businesses and assets. By one estimation, “a third of [global] oil reserves, half of [global] gas reserves and over 80 per cent of current coal reserves should remain unused from 2010 to 2050” to hit the United Nations’ target of keeping the average global temperature below that of the pre-industrial era average by 2°C.[9] Under this somewhat extreme scenario, the assets used to extract these resources, as well as the fossil-fuel-related equity and debt securities, become virtually worthless as cash flows dwindle.[10]

Financial losses caused by stranded assets will not be limited to firms with fossil-fuel related capital expenditures and their investors and creditors. For many Americans, the most significant investment is their home.[11] Natural disasters obviously pose a threat to the $882 billion in residential property at risk of projected sea level rise by 2100.[12] However, there is evidence that markets for housing at risk of flooding are not efficient. Less sophisticated owner-occupiers, rather than more sophisticated investors, are not discounting property values in real estate transactions to account for rising sea levels, leaving them vulnerable to financial shock.[13] A subtler effect concerns insurance. Of the eleven million structures in FEMA flood zones, less than half carry catastrophe insurance.[14]Similarly, one-fifth of National Flood Insurance Program policies are officially subsidized and charge less than the full risk level.[15] Any regulation that alters the current flood insurance scheme, especially one that requires owners to purchase insurance or that alters subsidies, could force holders to more significantly internalize their own risk, affecting real estate values.[16]

Uncertainty about the future effects of climate change, the prospects of future climate-related regulation, and the form of such regulation(s), if any, prevents market forces from efficiently pricing assets at risk of becoming stranded due to environmental concerns. To prevent financial shock, any regulation addressing climate change or its risks should be enacted quickly, deliberately, and in such a way that allows maximum possible predictability for markets to adjust.[17]

[1]Ben Caldecott et al., Stranded Assets and Scenarios(2014) (discussion paper), https://www.smithschool.ox.ac.uk/research/sustainable-finance/publications/Stranded-Assets-and-Scenarios-Discussion-Paper.pdf.

[2]H.R. Res. 109, 116th Cong. (2019); S. Res. 59, 116th Cong. (2019).

[3]See Thomas L. Friedman, The Green New Deal Rises Again, N.Y. Times(Jan. 8, 2019), https://www.nytimes.com/2019/01/08/opinion/green-new-deal.html.

[4]The Editorial Board, Vote on the Green New Deal, Wall St. J.(Feb. 11, 2019), https://www.wsj.com/articles/vote-on-the-green-new-deal-11549931107.

[5]Oliver Milman, Exxon, BP and Shell back carbon tax proposal to curb emissions, TheGuardian(Jun. 20, 2017), https://www.theguardian.com/environment/2017/jun/20/exxon-bp-shell-oil-climate-change.

[6]Stefano Battiston et al., A climate stress test of the financial system, 7 Nature Climate Change283, 285 (2017).

[7]Id.

[8]Duff Wilson et al., In metro Houston, an uphill fight to build a Texas-size defense against the next big storm, Reuters(Nov. 24, 2014), https://www.reuters.com/investigates/special-report/waters-edge-the-crisis-of-rising-sea-levels/(Part 3: Grand Designs).

[9]Christophe McGlade & Paul Ekins, The geographical distribution of fossil fuels unused when limiting global warming to 2 ºC, 517 Nature187, 187 (2015). But see, ExxonMobil, 2018 Outlook for Energy: A View to 2040 12-13(2018), https://corporate.exxonmobil.com/en/Energy-and-environment/Energy-resources/Outlook-for-Energy/Energy-demand(projecting that natural gas will grow “the most of any energy type, reaching a quarter of all demand”).

[10]See FT Alphachat: Climate change is not a business cycle, Fin. Times(Feb. 8, 2019) (downloaded using iTunes).

[11]The median American net worth drops from $68,828 to $16,942 when home equity is excluded. This figure over-simplifies, presuming that the same median American has both a $68,828 net worth and$51,886 in home equity. U.S. Census Bureau, Wealth, Asset Ownership, & Debt of Households Detailed Tables: 2014, Survey of Income and Program Participation(2014), https://www.census.gov/topics/income-poverty/wealth/data/tables.html.

[12]Krishna Rao, Climate Change and Housing: Will a Rising Tide Sink All Homes?, Zillow(Jun. 2, 2017), https://www.zillow.com/research/climate-change-underwater-homes-12890/.

[13]Asaf Bernstein et al., Disaster on the Horizon: The Price Effect of Sea Level Rise, J. Fin. Econ.5 (forthcoming).

[14]David M. Harrison et al., Environmental Determinants of Housing Prices: The Impact of Flood Zone Status, 21 J. of Real Est. Res.1, 4 (2001).

[15]Laura A. Bakkenson & Lint Barrage, Flood Risk Belief Heterogeneity and Coastal Home Price Dynamics: Going Under Water?31 (Nat’l Bureau of Econ. Research, Working Paper No. 23854, 2018).

[16]Id. at 4 (finding that “benchmark results imply that coastal housing prices currently exceed fundamentals by 10%”).

[17]See Frederick van der Ploeg, Professor of Economics and Research Director, Oxford Centre for The Analysis of Resource Rich Economies, Climate Policy and Stranded Carbon Assets: A Financial Perspective, Keynote Address at the EAERE conference on Climate Policy & Stranded Assets: A Public Finance and Financial Economics Perspective (Jun. 27–28, 2017) (arguing that, because climate change regulations are unavoidable, financial markets can be characterized as a carbon bubble).