What are stranded assets?

Reaching a goal of limiting climate change to less than two degrees of warming would require us to keep a large proportion of existing fossil fuel reserves in the ground.  According to a recent study in Nature, an estimated third of oil reserves, half of gas reserves and more than 80% of known coal reserves are ‘-and referred to as ‘stranded assets’. The value of ‘stranded assets’ might not be fully reflected in the value of fossil fuel companies, which could result in a sudden drop if this risk were priced in.

How could assets become stranded?

A variety of factors could lead to assets becoming stranded. These include: new government regulations that limit the use of fossil fuels (like carbon pricing); a shift towards renewable energy (for example because of increased demand from consumers, or lower energy costs); or even legal action.

Who’s exposed to the risk of stranded assets? And how much could they lose?

Primarily, those who have invested in the company (e.g. shareholders ) This covers a wide variety of people and institutions such as individual investors, hedge funds,  and banks, as well as entities like universities and pension funds.

The size of potential losses is difficult to estimate because it depends on different scenarios about the future (for example, advances in renewable technology, the price of carbon, emissions pathways) and how they would affect the value of the underlying assets. To get a rough idea of the scale, Weyzig (2014) estimated that the exposure of the European financial sector (banks, insurance companies, and pension funds) to high-carbon assets was over €1 trillion.

Although the ‘stranded assets’ discussion often focuses on fossil fuels, it’s not just oil, gas, and coal companies that could be affected by transition risk. Other companies that use fossil fuels as inputs for production, or are otherwise energy- or carbon-intensive, could also be affected by new climate legislation, technological advances, or a shift in demand.

That’s why international bodies like the Financial Stability Board are encouraging firms to increase their disclosure about climate-change related risks, and why it’s important that to make sure this disclosure is done effectively.

Will they affect my savings and pension?

Savings and pension funds may hold fossil fuels and other carbon-intensive assets, which is one reason why the divestment movement encourages people to talk to their pension funds about reducing climate risk exposure.

What does the Paris commitment mean for stranded assets?

The Paris Agreement signalled an increase in ambition for targets, which could leave more assets stranded, though firms and investors may still be unsure of when and how these emissions reductions will happen.

Could stranded assets create a financial crisis?

While we don’t have enough information to say for sure, many supervisory authorities are considering this question and concluding that there is a potential risk of an abrupt transition having destabilizing effects on the financial system.  This is less about the shift away from fossil fuels than about how smoothly it’s done – for example, credible climate policy can help firms put into place long-term strategies  for a slower and smoother adjustment that would avoid sudden shocks.

What can we do about stranded assets?

Individuals concerned about stranded asset risk could talk to their pension funds or asset managers about reducing portfolio exposure to carbon-intensive assets, or increasing investment in low-carbon assets such as renewable energy.

For regulators and supervisory authorities who are monitoring the financial system as a whole, the main focus at the moment is on encouraging greater disclosure, so that investors are better aware of the risks and can make more informed decisions. Regulators can also try to better understand the potential risks, for example by developing dedicated ‘carbon stress tests’ to test the resilience of financial institutions under different scenarios.