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What do coal, oil and gas companies have to lose from efforts to prevent climate change? Apparently a whole lot.

In 2010 at the UN Climate Change Convention (UNFCCC) in Cancun, governments from around the world met to "establish clear objectives for reducing human-generated greenhouse gas emissions over time to keep the global average temperature increase below two degrees Celsius." To keep global temperature increases below 2°, models by Carbon Tracker, the EIA and the London School of Economics estimate that global CO2 emissions must be limited to under 565-1075 GtCO2 (billions of tons of CO2) until 2050.

However, this limit is only a fraction of the carbon embedded in the world's fossil fuel reserves, which amounts to 2,860 GtCO2. This means that only around a third of fossil fuel reserves would be able to be burned before 2050. Furthermore, these emissions targets provide for an allowance of only 75 GtCO2 for the second half of the 21st century leaving more than two thirds of fossil fuel reserves stranded until 2100. Adjustments made to comply with these goals would render trillions of dollars worth of reserves owned by fossil fuel companies and billions of dollars worth of capital expenditure developing coal mines and producing oil fields stranded and practically worthless.

But how have oil companies responded to international targets for CO2 reduction and the growing presence of renewables? It appears they have done little to nothing.

In 2000 The Intergovernmental Panel on Climate Change (NASDAQ:IPCC) released a report detailing 40 different outcomes in 6 different scenarios to determine the possible future CO2 emissions and temperature increases. At one extreme is scenario A1FI that assumes "very rapid economic growth, global population that peaks in mid-century and declines thereafter, and the rapid introduction of new and more efficient technologies but a continued reliance on fossil fuels". The upper end of this model coincides with Exxon's (NYSE:XOM) 2013 annual energy outlook which anticipates large population growth in the developing world in the first half of the century and that in 2040 that fossil fuels will still provide over 80% of global energy generation. Unsurprisingly enough, Exxon's projections of energy use have global CO2 emissions hitting approximately 1100 GtCO2 in 2050 almost guaranteeing a 2° rise in global temperatures. However two other IPCC scenarios, with similar GDP growth rates in the developing world and large population increases, project much lower carbon emissions. Scenario A1B assumes a more even blend between renewable and fossil fuel use whereas scenario A1T assumes a shift towards renewable dominance- both of which substantially reduce CO2 emissions.

The gap between government goals and Exxon's projections means that something has to give; either global governments stick to their plan of maintaining a global temperature increase under 2° mainly through the shift to renewables from fossil fuels; or global governments fold to the oil and coal companies and allow global climate change to continue mostly unabated.

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How might government's enacting a carbon budget effect equity valuations of fossil fuel companies? By stranding assets leaving them worthless and creating massive declines in market cap.

Currently oil companies' valuations are still dependent on the belief that governments will do little to stop climate change, and that renewables will only capture a small portion of the energy market. For example, Exxon believes only 15% of global energy in 2040 will be from renewable sources. However if this belief is wrong and renewables prove to be the disruptive technology that even the utilities think they could be, there is now an immense amount of risk in being invested in fossil fuel companies.

HSBC estimates to uphold climate targets that the energy supply mix would also need to shift from an 81% reliance on fossil fuels today to just 43% by 2050 creating a 40-60% downside in the market capitalization of most oil and gas companies. Of course all this is dependent on governments sticking to their climate plans and not caving to the interests of fossil fuel companies which is yet to be determined and in the opinion of some unlikely. However Norwegian pension and insurance giant Storebrand has already started to divest from fossil fuels because of this risk. Investors should follow suit and divest some of their holdings in fossil fuels and reallocate to renewables that are poised to take a bigger share of the energy market.

Why invest in renewables? They are poised to be competitive with other sources of energy which will expand industry growth.

Although the drop in fossil fuel equities is not likely to be quick and dramatic it is time to reallocate to solar while the industry is in a tremendous phase of expansion and revolution. Reallocating to renewables will also be an effective hedge against declines in fossil fuel equity valuations. If governments take action to move prevent climate change this would necessitate an even faster expansion of renewable energy project development.

As solar's levelized cost has decreased to 10-20c per kWh in many locations consequently solar power has hit grid parity in eleven markets worldwide: Los Angeles, Hawaii, Chile, Japan, South Korea, Australia, South Africa, Israel, Italy, Spain, and Greece. Furthermore Deutsche Bank believes three-fourths of the global solar market could be competitive without subsidies as soon as 2014. Given the stiff competition between solar panel manufacturers reallocating to companies also involved in the marketing and sales of distributed solar such as SolarCity (NASDAQ:SCTY) or to solar debt products like solar notes makes sense as an investment alternative to coal, oil and gas investments.

Why SolarCity? Because it is a rapidly growing, well managed company in an industry ready to take off.

When evaluating a high growth company in an emerging industry it isn't reasonable to expect short term profitability or to make judgments based on typical valuation metrics. Instead it is better to look at long term trends, the size of the potential market, and whether or not the companies model is able to exploit them better than competitors.

The first relevant statistic are retail electricity prices to residential users. According to EIA data in the last 10 years they have risen approximately 30% and are expected to continue rising. Currently the national residential average electricity cost for 2013 is only expected to be 12.7 c/kWh. Although this is lower than the average rate at which SolarCity sells power to the consumer at 15 c/kWh, the California retail average for SolarCity customers is 18 c/ kWh and at peak demand when solar panels are producing the most, electricity prices in California often top 30 c/kWh. Panels currently make economic sense to many consumers, enough so that CEO Lyndon Rive has set the goal of 1,000,000 solar rooftop customers in 5 years. This goal should be made easier as electricity prices continue to rise nationwide and solar prices continue to fall the advantages of solar will only become more apparent.

Apart from positive developments in the solar industry, as an individual entity SolarCity has trends demonstrating its capacity to grow to meet expectations. In FY 2012, SolarCity deployed 156 MW, against a plan of 146 MW deployed. This represents 117% growth over 72 MW deployed in 2011. Furthermore SolarCity expects FY 2013 deployments to be 250 MW. Two additional positive trends are decreasing customer acquisition costs between 2011-2012 as well as increasing residential market share throughout 2012-2013. For Q2 2013 the company also had more than 64,000 cumulative customers, up over 97% from the prior twelve months.

Whether or not to invest in solar stocks at steep valuations rests fundamentally in the belief that current trends in electricity prices and solar system costs will persist and that the electricity generation infrastructure of our world is undergoing a massive transformation that will result in the rise of a large profitable renewables industry with solar as a main component. For those less inclined to take equity risks there are solar debt products that offer predictable returns comparable to bonds.

Source: Fossil Fuels Contain Buried Risks; Look To SolarCity For Growth

Additional disclosure: I currently own Mosaic's solar notes.