New York State attorney general Eric Schneiderman gave an eye-opening exclusive interview to the New York Times last week. In it he suggested that his office's securities fraud investigation of Exxon Mobil (NYSE:XOM) is not based on a purported cover-up of the company's own climate change research in the 1970s and 80s, as has been previously reported. Rather, Mr. Schneiderman believes that the company may have committed fraud by failing to properly account for the diminished value of assets that could be "stranded" in the future by climate change legislation:
"Early on, [Schneiderman's] office demanded extensive emails, financial records and other documents from the oil company, leaving many observers with the impression that a deeper look into the company's past was the focus of the investigation.
But in an extensive interview, Mr. Schneiderman said that his investigation was focused less on the distant past than on relatively recent statements by Exxon Mobil related to climate change and what it means for the company's future.
In other words, the question for Mr. Schneiderman is less what Exxon knew, and more what it predicts.
For example, he said, the investigation is scrutinizing a 2014 report by Exxon Mobil stating that global efforts to address climate change would not mean that it had to leave enormous amounts of oil reserves in the ground as so-called 'stranded assets'."
In June I wrote about the dangers that the fraud allegations had for producers of both fossil and renewable energy. Specifically, I expressed concerns that expanding the definition of securities fraud to include a lack of reliance on environmental forecasting models could lead to a wave of politically-charged investigations given the magnitude and timing uncertainty that surround catastrophic climate change's impacts. A number of legal experts at various universities and law firms criticized the investigation on similar grounds. Mr. Schneiderman's comments are good news for energy investors, then, since his office's investigation no longer threatens to set a precedent of politically-motivated climate change investigations in New York and other states.
Or doesn't it? As the Times interview continues:
"But many scientists have suggested that if the world were to burn even just a portion of the oil in the ground that the industry declares on its books, the planet would heat up to such dangerous levels that 'there's no one left to burn the rest,' Mr. Schneiderman said.
By that logic, Exxon Mobil will have to leave much of its oil in the ground, which means the company's valuation of its reserves is off by a significant amount.
'If, collectively, the fossil fuel companies are overstating their assets by trillions of dollars, that's a big deal,' Mr. Schneiderman said. And if the company's own internal research shows that Exxon Mobil knows better, he added, 'there may be massive securities fraud here.'"
In other words, if the investigation determines that Exxon Mobil is expecting regulations to reduce the value of its vast fossil fuel reserves by forcing them to remain in the ground rather than be extracted and combusted, then, according to New York's attorney general, it has knowingly overstated its book value to investors.
Stranded assets and energy
The "stranded assets" theory states the following. First, that the combustion of all proved fossil fuel reserves will irreversibly push the planet into catastrophic climate change. Second, that humanity will not let catastrophic climate change occur and will therefore prevent the fossil fuel reserves from being combusted. Finally, that fossil fuel reserves are valued on the assumption that they will be combusted (they have no value if they are not combusted, after all), so fossil fuel reserves are very overvalued at current market prices.
Stranded assets theory is closely linked to the divestment campaigns that are active on many college campuses. These campaigns intend to bring the market value of stranded assets more in line with what they perceive to be their "true" lower value by encouraging large investors, especially university endowments, to sell all holdings in fossil fuel companies. In market terms, divestment campaigners are the fossil fuel sector's permabears.
Predicting the unpredictable
Both the theory and the movement are controversial. Stranded assets theory suffers from two critical flaws of logic, for example. First, it assumes that the world will take the necessary steps to prevent catastrophic climate change from occurring. There is by no means a consensus on this, with the broad policy community being split into a "mitigation" camp, which believes that climate change itself can and should be mitigated, and an "adaptation" camp, which believes that climate change is inevitable and humanity should instead focus its limited resources on reducing its impacts - building sea walls around coastal urban centers, for example.
History provides numerous examples that support the adaptation camp's position. For instance, every semester I have students ask me why the United States doesn't have a cap-and-trade program when many developed countries, including the European Union and Australia, have created their own programs (although, in another example, Australia eliminated its program only a few years after implementing it). The answer is what I consider to be an instructive story about the 2010 special Senate election in Massachusetts.
To recap: In the summer of 2009 both the U.S. House and Senate passed cap-and-trade bills. The bills differed slightly and needed to be reconciled before going to President Obama for his signature. The Democrats had a majority in the House and a supermajority in the Senate at the time, making the program's implementation seem inevitable. Rather than rush things, the Democratic leadership decided to wait until after the summer break to bring the two bills together. Senator Ted Kennedy lost his battle with cancer during the break, however, depriving his party of its supermajority in the Senate. Unable to overcome a GOP filibuster, the Democratic leadership opted to put the cap-and-trade legislation on the back-burner until Mr. Kennedy's replacement could be elected. It was in Massachusetts, after all, and the Democratic nominee for the Senate seat, Martha Coakley, led her Republican opponent, Scott Brown, by 30 points in early polling.
The reason that the U.S. doesn't have a national cap-and-trade program today is that Democratic primary voters had picked one of the single worst political campaigners of the 21st century in Ms. Coakley. Her campaign did everything wrong, even misspelling the name of the state in one infamous election ad. Her biggest mistake came, however, when she stated in a radio interview that Boston Red Sox hero Curt Schilling, he of World Series bloody sock fame, was a New York Yankees fan. As Mr. Schilling commented later, "I've been called a lot of things ... but never, I mean never, could anyone make the mistake of calling me a Yankee fan." One polling outfit found that an 8 point lead for Ms. Coakley in the week before her radio interview had turned into a tie immediately after it. Mr. Brown ultimately won and took over Mr. Kennedy's former seat. Cap-and-trade at the national level in the U.S. has been dormant ever since.
Where does technology fit in?
The second problem with the stranded assets theory's logic is that it assumes that humanity is only capable of sending greenhouse gases in one direction: into the atmosphere. In reality, however, a number of technologies have been developed for permanently sequestering atmospheric carbon dioxide. Some of these are very high-tech efforts being developed at America's leading universities. Others have been deployed for hundreds, and possibly thousands, of years. That they aren't commercially deployed today has to do with economic rather than technical constraints: there is little to no value proposition for carbon sequestration, even in regions with cap-and-trade programs such as the European Union. Widespread atmospheric carbon removal and sequestration would offset at least some greenhouse gas emissions, however, making it possible to utilize more fossil fuel reserves without contributing to catastrophic climate change.
Mr. Schneiderman's new securities fraud rationale continues to concern me as both an investor and a proponent of efforts to mitigate climate change due to its reliance on the flawed stranded assets theory. First, as the 2010 Massachusetts special election first demonstrated and the Brexit vote showed more recently, accurate policy predictions can be impossible to make even days before an election, let alone years and decades before the fact. Imagine if Exxon Mobil had publicly reduced the stated value of its assets in the summer of 2009 on the consensus expectation that the U.S. was about to implement a cap-and-trade program. According to Mr. Schneiderman's logic, it would have committed securities fraud by failing to predict the actual policy event's outcome.
Likewise, consider the position of renewable energy producers today. Their assets, whether hydroelectric dams or wind farms, have much higher true values than the market currently gives them if it is assumed that fossil fuels such as petroleum and natural gas will become stranded assets at some point in the relatively near future. What if the market gives them such higher values on the expectation that stranded asset theory is correct, only for politicians to fail to implement the laws necessary for such value to be recognized in reality? Under Mr. Schneiderman's logic, those renewable energy producers might be committing securities fraud if they fail to accurately predict such an outcome. Similarly, they might also be liable if they fail to predict a breakthrough in carbon capture and sequestration technology that results in steeply lower costs.
Climate change is occurring. Its effects will be overwhelmingly, if not uniformly, negative. The likeliest explanation is anthropogenic greenhouse gas emissions. I do not disagree with any of these facts. If Mr. Schneiderman's previous climate change "fraud" rationale was dangerous to fossil and renewable energy investors alike, however, then the most recent rationale is even more so. Catastrophic climate change will only be prevented if renewable energy becomes a major part of the world's overall energy portfolio. Such a result is less likely to occur if one of America's largest states by energy consumption injects uncertainty into the market by twisting securities law in unprecedented ways.
If climate change is to be mitigated, the necessary technologies will most likely be developed (if they haven't been already) and commercialized in the U.S. Their widespread commercialization and adoption will rely heavily on the equity markets to raise the requisite capital. The investigation's intended outcome of changing legal precedent in one of America's largest economies and the heart of American finance will not advance the fight against climate change, no matter how well-meaning the intentions behind it.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a member of the New York State Bar Association and nothing in the above article should be interpreted as legal advice.