The rising (albeit still low) likelihood of a Democratic sweep of the White House, Senate and House of Representatives in next month's elections has raised the prospect of major changes to U.S. energy and climate policy in the near future. Environmentalists view such an event as an opportunity to abandon the Democratic Party's previous "all of the above" approach to energy policy with a much more restrictive "keep it in the ground" stance on fossil fuels. The Democrats showed their hand back in July with the release of a Party Platform document that called for heavy restrictions on fracking and the replacement of new natural gas power plants by renewable energy capacity. Subsequent investigations into how Exxon Mobil (NYSE:XOM) forecasts energy prices in the context of climate change by state and federal officials have further raised the stakes for fossil fuel companies. This article introduces investors to the "keep it in the ground" movement and discusses why they should be aware of it.
Environmentalists have long opposed fossil fuels on the grounds that they are substantial causes of pollution, both local and global. This opposition has taken on a new sense of urgency in recent years as rising greenhouse gas [GHG] emissions have caused the atmospheric CO2 concentration to increase at an accelerating rate. Now, with the atmospheric concentration substantially above 400 ppm for the first time in at least 400,000 years, many climate scientists calculate that catastrophic climate change (the onset of which is associated with the passing of the 450 ppm concentration and 2 degrees C global temperature increase thresholds) cannot be averted simply by gradually transitioning to renewables. Rather, humanity can only combust a fraction of its proved fossil fuel reserves in the near future without exceeding the 450 ppm threshold. All reserves beyond that fraction must remain unextracted and uncombusted, hence the "keep it in the ground" slogan.
The exact percentage of fossil fuels that must remain uncombusted depends on the world's fuel mix in the near future. For example, combusting a BTU's worth of coal emits roughly twice the amount of GHGs as combusting a BTU's worth of natural gas, so banning coal outright would allow for a much larger fraction of the world's natural gas reserves to be combusted without exceeding the 450 ppm threshold. In general, however, climate scientists calculate that a majority of the world's reserves must remain in the ground.
A 2013 report by the London School of Economics calculates that only 225 gigatons CO2 can be emitted to have a 80% chance of not crossing the 2 degrees C global temperature increase threshold, or 30% of the 762 gigatons of CO2 emissions contained in the fossil reserves owned by the world's publicly listed companies. A later analysis published by researchers at the University College London in the journal Nature calculates that 33% of global petroleum reserves, 50% of global natural gas reserves and 80% of global coal reserves (all proved and on an existing basis) will need to be stranded through at least 2050 if humanity is to have a 50% chance of keeping the global temperature increase below 2 degrees C. One analysis, albeit from an environmental think tank rather than a refereed publication, finds that only 88% of the world's developed (as opposed to proved) fossil reserves can be combusted without exceeding the threshold.
Recent research certainly indicates, then, that the world's existing fossil reserves cannot be extracted and combusted without causing catastrophic climate change. Proponents of the "keep it in the ground" movement argue that the fossil reserves that currently are accounted for as assets on fossil fuel companies' balance sheets are therefore overvalued. A fossil fuel reserve only has value if one assumes that it is combusted, the argument runs, so a large fraction of proved and even developed reserves is actually worthless. Logically, the argument runs like this:
- Proved fossil reserves cannot be extracted without causing catastrophic climate change.
- The world's politicians will not allow catastrophic climate change to occur.
- Therefore, the world's politicians will not allow proved fossil reserves to be extracted, resulting in policy-induced stranded assets.
There is little debate regarding the validity of the first statement in the scientific community. Negative emissions technologies such as carbon capture and sequestration could mitigate or even reverse the atmospheric CO2 concentration, of course, but their development has been painfully slow to date.
The second statement is on shakier ground, however. Yes, representatives from the vast majority of the world's countries agreed last December in Paris to keep the global temperature increase below 2 degrees C, thereby preventing catastrophic climate change in theory. Proponents of the "keep it in the ground" movement point to this event and the subsequent ratification of the Paris Climate Agreement (also known as the COP21) as confirmation of the second statement's validity. The problem with this is that the emission reduction targets established by the COP21 agreement on its own have only a minimal impact on global GHG emissions. Bjorn Lomborg calculates in research published in the journal Global Policy that the COP21 agreement will only reduce the global temperature increase by 0.17 degrees C through the end of the century. In other words, the agreement is only the first step if catastrophic climate change is to be avoided. To use an American football analogy, the agreement represents a first down for a team that started with the ball on its own 1-yard line. It still has the vast majority of the field to go before it scores a touchdown.
Indeed, it could be argued that the second statement has already been proven to be false. An analysis published by Oxford researchers earlier this year in the journal Applied Energy calculates that all electricity generation capacity built after 2017 must be zero-carbon, if the world is to have a 50% probability of remaining below the 2 degrees C threshold. That means no new natural gas-fired capacity in addition to no new coal-fired capacity. Despite this, China, India and Indonesia alone are expected to build 300 GW of new coal-fired capacity over the next five years, the COP21 agreement notwithstanding. The building of new natural gas-fired capacity is a centerpiece of America's Clean Power Plan, which is its contribution to the COP21 targets. Japan's government endorsed plans earlier this year to build 1.3 GW of new coal-fired capacity in Tokyo alone, and the country as a whole is steadily phasing out zero-carbon nuclear power with new coal-fired capacity. Not only has the world not stopped building new fossil-fired power plants, but its developed economies are building new capacity and, in the case of Japan and Germany, actually replacing existing zero-emissions nuclear capacity with increased coal consumption.
Investors in major publicly-traded oil and gas reserve holders such as Exxon Mobil, BP (NYSE:BP), Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) and TOTAL SA (NYSE:TOT) have noticed that the values of their positions have not been sensitive to the headlines that have followed both last December's COP21 agreement and last month's successful ratification of the same. Indeed, with the exception of ConocoPhillips, the share prices of all of the above have outperformed the S&P 500 index in 2016 to date, in some cases by a sizeable margin (see figure). The market clearly does not expect a large fraction of these firms' fossil assets to become worthless in the near future despite what proponents of the "keep it in the ground" movement contend. It is possible that the market is incorrect, of course, especially in the event that the Democrats sweep next month's national elections and commit to enforcing the Democratic Party Platform's energy planks. Barring such a development, however, there is little evidence that world leaders will take the necessary steps to avoid a 2 degrees C global temperature increase despite recent pledges to the contrary.
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 long XLE.