December 15, 2016 1:45 am JST
Jean-Marc Champagne

Asian investors should prepare for fall of big oil

Fossil-fuel assets face devaluation as climate warms and electric cars spread

Climate change is an unprecedented global challenge for humanity, one that will cause catastrophic damage to life on earth if it is not stopped or tempered significantly. However, from within any great challenge to humanity there is potential for transformational solutions and technological innovation to emerge.

There are also financial opportunities for those with foresight and the potential for losses for those without. The failure to anticipate the impact of transformational technologies has cost corporations and their investors billions of dollars in the past. When short-term results are sought at the expense of long-term capital growth and preservation, history can easily repeat itself.  

Humanity has known for some years that the main driver of climate change is the burning of fossil fuels. At current levels of fossil fuel extraction, the Earth's temperature is projected to increase 4-6 degrees Celsius. This would be catastrophic, so the rise must be capped at well below 2 degrees.

Achieving this will require a global transition from fossil fuels to renewable sources of energy as well as wiser use of energy. To meet the 2-degree target, 80% of known fossil-fuel reserves must stay in the ground.

Many companies heavily dependent on fossil fuels are listed in Hong Kong and on other Asian stock exchanges. Oil, coal and gas companies have been valued by how much burnable carbon they can produce. These underground assets are set to go under water. Given the increasing resolve of governments worldwide to limit the use of fossil fuels, alongside advances in low-carbon technology, there will inevitably be major revaluations ahead for these companies.

While some investors are waking up to the new reality, there remains a general lack of understanding of this threat among Asia's investors.

An area primed for change is in transportation. Electric vehicles can offer transport with little or no carbon dioxide emissions. Their rapid adoption in China is being driven by technological advancements and government policy. As usage scales up, electric cars will vastly reduce the demand and need for oil.

Electric vehicles will proliferate as costs fall with improvements in battery technology. Prices will decline to the level of traditional internal combustion engine vehicles by the mid-2020s. As a direct consequence, 1 million barrels per day of crude oil could be displaced by the late 2020s. This could rise to 2-4 million bpd by 2035 and 4-6 million bpd by 2045. 

This may not seem like a catastrophic outcome for oil producers. After all, 1 million bpd is a small amount compared with the current global demand of 95 million bpd. But it is important to remember that marginal changes in supply and demand, and the speed of change, determine commodity prices. Additionally, oil producers, once they recognized the risk of holding a permanently impaired asset, would have no choice but to offload their reserves quickly. This in turn would drive oil prices down further, with a spiraling effect on the valuation of reserves.

Oil loses shine

Only a moderate pace of technological advancement over time is needed for green vehicles to take hold of the market. The late 2020s and 2030s could be a period of widespread adoption, playing out over 10-20 years given the typical vehicle replacement cycle.

If this proves true, the impact on the oil industry will be catastrophic globally. But Asian investors can draw upon the experience of China in particular to see the potential for an orderly re-allocation of economic capital from internal combustion engine vehicles and oil to electric vehicles and renewable energy.

Asian institutional investors should establish a prudent carbon-risk exposure policy consistent with global commitments to tackle climate change. Compared with their European counterparts, very few Asian asset owners have developed such policies. The construction of an investable decarbonized stock index hinges upon the availability of data on individual companies' carbon footprints. A more holistic approach would be to calculate a composite score for each invested entity based on its direct and indirect exposure to carbon and climate-policy risks.

Asian investors should also screen their portfolios for carbon-intensive companies and engage with those they invest in to encourage changes compatible with a low-carbon economy. The proliferation of electric cars could lead to permanently cheap oil. This would present an overwhelming case for a substantial reduction in exposure to oil and oil-related assets. Thus prudent climate and investment policies are not necessarily in conflict.

In circumstances where screening out carbon-heavy holdings may not be feasible in the immediate term, Asian investors should construct a dynamic hedging strategy by taking opportunities to reduce climate risk while minimizing deviations from market benchmarks. Under the premise that the market is inefficient in pricing carbon and climate policy risk and will only price in these factors gradually, this strategy should yield returns largely in line with market benchmarks initially and outperform as carbon risks get priced in.  

While technology, consumer behavior and oil prices can be unpredictable, one certainty is that Beijing will continue to encourage uptake in electric vehicles. It should be apparent that many energy companies and investors are grossly underestimating the impact of widespread adoption of electric cars. Investment managers can play a vital role in global efforts to mitigate climate change by reallocating financial resources from polluting, low-return assets to more sustainable alternatives.

Jean-Marc Champagne is climate finance adviser to WWF-Hong Kong, an environmental campaign group, and co-author of "No Middle Road: The Growth of Electric Vehicles and their Impact on Oil."

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