Is your board vulnerable to stranded asset risk?
While the problem of stranded assets can be seen as negative, the emphasis on a movement away from climate exposed investments also opens up new opportunities.
Stranded asset risk is an important consideration for boards. Just as assets may become technologically redundant when they are replaced with a newer model, assets may also become politically or economically redundant. Even if you're the best blacksmith, you don't want to be the last blacksmith when horses make way for cars. Stranded assets are assets that suffer from unanticipated or premature write-downs, devaluations or conversion to liabilities. For example, there is potential for coal-based assets to become 'stranded' if government policies and consumer preferences force a move away from fossil fuels.
Boards routinely assess the overall risks to their organisation in the context of the contemporary environment and predicted future trends. These risks are best weighed against the opportunities available in such an environment. As a board, it’s important to understand your company’s exposure to stranded asset risk and to give adequate consideration to these risks when making investment decisions.
Climate change as a potential stranded asset risk.
A 2017 published study from Oxford University indicated that 'understanding climate change, and its associated investment implications, remains far from universal among investment professionals.' Alarmingly, the same study showed that only 30% of investment professionals in Australia and the UK were aware of stranded asset risk.
While climate change is not the only stranded asset risk, it's an important and relevant example in the current environment. The implications of the Paris Agreement for future investment decision making cannot be understated. Even though United States President Donald Trump has chosen to overturn US obligations regarding climate change, the market forces in favour of renewable energy alternatives and low carbon options may outweigh any government regulation in this regard.
As an example, the MSCI ACWI ex-Coal Index includes large and mid-cap stocks across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. The index represents the performance of the broad market while excluding companies that own coal reserves. Since November 20, 2010, the MSCI ACWI Ex Coal index has demonstrated annualised returns of 10.44% compared with 10.24% for the parent MSCI ACWI Index.
Positive opportunities by reducing climate exposure.
While the problem of stranded assets can be seen as negative, the emphasis on a movement away from climate exposed investments also opens up new opportunities.
The average dollar capital expenditure per megawatt for solar PV and wind dropped by 10% in 2016. ‘Ever-cheaper clean tech provides a real opportunity for investors to get more for less,’ said Erik Solheim, Executive Director of UN Environment. ‘This is exactly the kind of situation, where the needs of profit and people meet, that will drive the shift to a better world for all.’
New investment opportunities have emerged in the renewable energy sector, which is gaining strength. According to Prof. Dr. Udo Steffens, President of Frankfurt School of Finance & Management, ‘The investor hunger for existing wind and solar farms is a strong signal for the world to move to renewables.’
Another opportunity is in the emerging markets for 'green' financial products, which has seen the creation of new financial instruments, such as Green Bonds.
The Queensland Government last year announced that it will issue Green Bonds via Queensland Treasury Corporation. The Green Bonds must meet strict criteria and are independently verified by the Climate Bonds Initiative, based in London. The stated objective of the Climate Bonds Initiative (CBI) is to mobilise the funds in the $100 trillion bond market, to climate change solutions. In 2016 CBI issued $81.0 B and in 2017 this figure was almost doubled to $156.7 B. In 2018 CBI estimates it will issue more than $250 Billion in Green Bonds.
The negative impacts of holding climate exposed assets. The negative impacts of climate change initiatives on climate exposed assets are fairly clear. There are likely to be reduced returns on existing investment in assets of this type and long-term capital losses.
Furthermore, the likelihood that an asset will become stranded may lead to reduced investment in the maintenance and upkeep of that asset. This could lead to unplanned shutdowns, service interruptions and safety hazards such as explosions, crushing and falls. All of these factors are likely to further undermine the reputation of companies that own or invest in these assets and will further reduce investor confidence.
Summary
The potential for assets to become stranded is an important consideration for boards. Climate change and the associated changes in demand for coal-based products poses a risk to companies that have coal-dependent assets. Boards will want to ensure that they are fully informed on climate change issues and their potential impacts on the company’s investments, not just in the long-term, but also in the short to medium term. External and in-house training and review of decision-making policies need to take account of the latest research. Which of your assets are vulnerable?
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