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Do investments in oil and gas constitute systemic risk?

19th October 2016

A new IHS Energy report disputes concerns by some central banks and regulators that climate change may pose systemic risk to the financial system.

Oil and gas company valuations are primarily based on reserves
Oil and gas company valuations are primarily based on reserves

This view was notably articulated by Mark Carney, Governor of the Bank of England, who declared in a September 2015 speech that climate change I in particular transition risk – could threaten financial stability via a sudden and significant collapse in asset values.

In response, the Financial Stability Board, which reports to the G20 governments and is chaired by Governor Carney, launched a task force to develop a climate risk disclosure framework for market participants. The task force will release its voluntary, unified guidelines for climate risk disclosure in December 2016.

A key consideration in this debate is the valuation of oil and gas reserves. In the September 2015 speech, Governor Carney cited the carbon bubble thesis, stating that a key risk to financial stability could come from potential sharp drops in the valuation of oil, gas and coal companies, owing to stranded reserves that may never be produced.

However, IHS Energy research on oil and gas company valuations in the financial marketplace has shown that the risk of overvaluation of these companies is limited, owing to how fossil fuel reserves are valued and contribute to the market capitalization of oil and gas companies.

Oil and gas company valuations are primarily based on reserves that will be produced and monetized over a 10–15-year period – a relatively short time frame in which an energy transition is unlikely to unfold.

The IHS Energy analysis also found that about 80 per cent of the value of most publicly traded oil and gas companies is based on their proved reserves, which accounts for roughly 20 per cent of the resource base of global international oil companies by volume. Their valuation is based on the present worth of expected cash flow from projects and reserves that will be produced in the short to medium term and are consequently at minimal risk of being stranded.
The oil price decline over the past two years has provided a real-life, high-intensity, externally driven stress test for the oil and gas sector and its potential to have any broader systemic impact, the report says.

According to IHS Herold, 82 global oil and gas companies lost 42 per cent of their market value from June 2014 to December 2015 – equal to $1.4 trillion in market capitalisation. Yet, this fall has had minimal systemic impact on the global financial system thus far. Since oil prices fell below $100/bbl in September 2014, the Dow Jones Index has risen 6 per cent.

The history of past transitions suggests that the unfolding of a lower-carbon energy economy, possibly supported by carbon capture, will also be a gradual process that can be priced in by the market over time, the report says. The energy economist Vaclav Smil, an expert on energy transitions, has noted that “even a greatly accelerated shift towards renewables would not be able to relegate fossil fuels to minority contributors to the global energy supply anytime soon, certainly not by 2050,” the report notes.

Overall, the report says, any transition that unfolds over decades – as would take place with any energy transition given the extensive amount of capital invested, the long life spans of energy assets, among other factors – does not constitute abrupt systemic risk to the financial system. 

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