Apr 15, 2013

Investor alert: TSX over-valued due to a “carbon bubble”


Canada’s economic development model is on a collision course with the urgent need for global climate action. Worldwide, extreme weather events from drought to floods to powerful storms and record-breaking temperatures are making a powerful statement that climate change can no longer be denied.

Hurricane Sandy, which rudely interrupted a US election in which candidates ignored climate change, pushed climate action back onto the US policy agenda. Costs are piling up, with one recent estimate of $1.2 trillion per year in global damages already from climate change and related environmental costs from a carbon-intensive economy.

In short, at some point soon we are going to see a strong global climate treaty. And when that happens, a day of reckoning is coming for Canada’s fossil fuel companies, whose value is tied to carbon assets they will be forced to leave in the ground.

From a scientific perspective, what matters most is the world’s carbon budget –the total amount of CO2 that can “safely” be emitted in coming decades. For an 80% chance of keeping global warming below 2°C, the target for international negotiations, the world’s carbon budget is now approximately 500 billion tonnes (gigatonnes, or Gt) of carbon dioxide.

Canada’s share of that carbon budget would depend on negotiation, but almost certainly falls between 2 and 20 Gt. Canada’s reserves of bitumen, oil, gas and coal, when converted into potential emissions, are substantially larger: proven reserves are equivalent to 91 Gt; and adding probable reserves yields 174 Gt.

So even with a generous carbon budget of 20 Gt, some 78% of Canada’s proven reserves, and 89% of proven-plus-probable reserves, need to remain underground.

This is bad news for carbon-intensive assets, and for Canada’s financial markets. The Toronto Stock Exchange (TSX) is highly weighted towards the fossil fuel sector, with total market capitalization of fossil fuel companies around $400-500 billion. Fossil fuel companies account for about 24% of the total value of the S&P/TSX60 index.

The recent experience of high-tech and housing bubbles should serve as a warning to policy makers. In 2008, the collapse of a housing bubble threatened the global financial system as a whole, and affected a broad segment of society because housing is the most important asset for middle-class households.

Next to home ownership, the right to future income through employer pension plans is the second-most important asset for a wide swath of middle-class households. Registered pension plans cover more than 6 million members in Canada, and the total market value of trusteed pension funds in 2012 was over $1.1 trillion, of which almost one-third was held in stocks.

It is difficult to ascertain the exposure of Canadian pension funds to a carbon bubble. More than half of Canada’s pension system is in the form of employer pension funds (55%), followed by RRSP assets holdings (35%). In the US experience, pension funds own almost one-third of oil company stocks.

Addressing risk is inherent to financial market investment, which routinely must account for risks due to inflation, currency movements, regulatory changes, political turmoil and general economic conditions. However, there has been a general failure to account for climate risk, and a tendency to view any screening for environmental purposes to be detrimental to financial performance.

In fact, the problem is just the opposite: by not accounting for climate risk – and the inevitability of climate action – large amounts of invested capital are vulnerable to the carbon bubble. Carbon stress tests across the financial industry, and in particular for pension funds, are needed to get a better handle on climate risk in Canada.

While pension funds have to generate maximum current return value for existing (and soon-to-be) pensioners, at the same time they are legally obligated to ensure the long-term sustainability of the fund. That is, funds must equally represent the interests of young workers for their eventual retirements.

Fossil fuel divestment has become a hot topic in the US and Canada, with students leading the way by targeting university endowments. Churches, local governments and pension funds are also beginning to wake up to the mismatch between climate change and fossil fuel investments.

Canada badly needs climate leadership to deflate the carbon bubble, including saying no to new fossil fuel infrastructure like pipelines. A coordinated program must accept a carbon budget, shift incentives through carbon pricing, and supply financial markets with alternative investment vehicles like green bonds tied to building the green infrastructure we need.

Together, these moves would comprise a “managed retreat” from fossil fuel investments that ensures Canada’s financial markets are part of the solution.

This piece is based on the study Canada’s Carbon Liabilities (co-authored with Brock Ellis).

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