Will New Carbon Regulation Leave Investors Stranded?

A recent article on Alpha Now carried the provocative headline: “Idea of the Week: BP – An Opportunity or a Value Trap as Sanctions Bite Russia?” The article explored whether BP may actually be undervalued compared to its peers. What I found most interesting about this and many discussions of the value of oil stocks, for example, is the assumption that the world isn’t dramatically changing for them, at least in a longer term investment horizon. Beyond the near-term geopolitical impact on BP, which was the topic of the Alpha Now article, may not be a bargain its P/E implies – a situation that all carbon extractors share.

What I mean is that at some point, probably sooner rather than later, the risk associated with new regulation and higher carbon pricing will become a core part of equity value analysis. Equities that are particularly dependent on carbon extraction or utilization for their business models will arguably face steadily growing headwinds on the cost for this reliance. Here is an abbreviated list of entities where this risk may become more acute as the climate change story plays out:

Source: Tracing anthropogenic carbon dioxide and methane emissions to fossil fuel and cement producers, 1854–2010

To continue the example without intending to single out one firm [1], BP assumes $40 per tonne of CO2 equivalent as cost as a basis for assessing the economic value of an investment. Now consider a recent statement by the UK secretary of state for energy and climate change, Ed Davey, confirming the regulatory plan to reduce UK carbon emissions by 50% of 1990 levels by 2027: “Retaining the budget at its existing level provides certainty for businesses and investors by demonstrating the government’s commitment to our long-term decarbonisation goals.” Is BP’s cost assumption keeping up with its own regulatory environment? Have investors considered this kind of assumption when assessing the balance sheet of any carbon intensive business?

In short, increasing CO2 concentrations in the atmosphere has costs. These costs will increasingly be allocated through regulation back to their sources. Either these sources (e.g. big oil) will increase their prices to absorb the costs, or they will innovate to find alternative business models (e.g. solar, geo-thermal, wind, etc.), or both. As this trend plays out, certain carbon intensive assets may be “stranded” and left unusable because the costs to the planet in rising sea-levels, property damage, loss of life, etc., will simply be too high.

Who should care? Well, from a strictly financial perspective, if you own a stake in a pension, 401k, endowment or even dabble in mid to long-term stock picking, you may want to consider this risk for your carbon-dependent holdings. In an upcoming blog, I will describe what I found when I tried to do this across our household assets.

Please note that BP may be similar to all its peers in terms of how it values and manages risk associated with carbon emissions, and this article is not meant to single out BP in any particular respect.

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