Popping the Carbon Bubble

Michael DiamondTeaching Assistant, EES 201

November 13, 2013

Contents

1 Introduction 1

2 Staying below the 2◦C target 22.1 BaU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.2 UN-H . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42.3 UN-M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42.4 UN-L . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3 Other targets 5

4 Carbon capture & storage 6

5 Stranded assets 6

6 Conditions for a carbon bubble 7

7 TL;DR 8

1 Introduction

In the Copenhagen Accord of 2009 and the Cancun Agreements of 2010,the majority of the world’s governments agreed to set a target limiting an-thropogenic warming to 2◦C from preindustrial times. Meeting this targetimplies setting an upper limit on the amount of fossil fuels that can beburnt — this limit can be thought of as a “carbon budget.” In the past fewyears a number of estimates have been made about the size of the world’scarbon budget, making different assumptions about the growth of non-CO2

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greenhouse gas emissions and the climate sensitivity. One of the first or-ganizations to try quantifying the carbon budget was the Carbon TrackerInstitute, a UK-based non-profit dedicated to aligning capital markets witha climate change policy agenda. Its most recent report,1 released in 2013in collaboration with the Grantham Research Institute on Climate Changeand the Environment at the London School of Economics and Politics, isreferenced here. Additionally, the latest version of the IntergovernmentalPanel on Climate Change’s (IPCC) report2 on the state of climate sciencealso includes estimates of the remaining carbon budget, which has broughtmore mainstream attention to carbon budgeting and the idea of the “carbonbubble.”

The idea behind the carbon bubble is that fossil fuel companies and othercarbon-intensive industries may currently be overvalued in capital marketsbecause the impact of climate policy has not been adequately priced. Stayingwithin any of the carbon budget scenarios calculated by institutions like theIPCC require that a large portion of coal, oil, and gas reserves that arealready on the books will need to stay in the ground. Those worried abouta carbon bubble fear that once investors at large realize that much of what iscurrently listed as assets will never be burned, fossil fuel stocks will plummetin an event reminiscent of the 2008 financial crisis.

How likely is it that the carbon bubble exists, and if it does exist, whenwill it pop? No one knows the exact answer to these questions, but we canstart thinking about the problem using the concepts and techniques we havealready learned in this course.

2 Staying below the 2◦C target

In this section, we will explore how long it would take to exhaust the car-bon budget if emissions were to grow as the EIA predicts in its referencecase.3 The parameters P, G, E, F, g, e, and f are the same as those used inthe Decarbonization Project Assignment. We will additionally define three

1Carbon Tracker & The Grantham Research Institute, LSE, Unburnable Carbon 2013:Wasted capital and stranded assets., 2013

2IPCC Fifth Assessment Report, Climate Change 2013: The Physical Science BasisSummary for Policymakers, September 27, 2013.

3U.S. Energy Information Administration, International Energy Outlook 2013. Choose“Kaya Identity Components” under Subject Filter and “World population by region”under Table.

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random4 variables: X, Y, and Z. Let X be the total amount of warming,measured in ◦C, since the preindustrial era; let Y be year; and let Z be thecarbon budget. Z is measured in GtC (gigatons of carbon) in the IPCCreport and GtCO2 (gigatons of carbon dioxide) in the EIA and CarbonTracker reports. The conversion between GtC and GtCO2 is 1 GtC = 12

44GtCO2.

From the IPCC report, we can see that to keep warming below 2◦C witha 33% likelihood of success, the carbon budget would have to be set at 350GtC. For a 50% probability of success, the budget would have to fall to 310GtC, and for a 67% probability, to 270 GtC. We can consider these chancesto be high-risk, medium-risk, and low-risk, respectively.

Now let’s define a few scenarios for different values of Z (this is similarto having different emissions scenarios). Let BaU be the Business-as-Usualscenario, UN-H be a scenario following the IPCC’s high-risk carbon budget,UN-M be a scenario following the IPCC’s medium-risk carbon budget, andUN-L be a scenario following the IPCC’s low-risk carbon budget.

2.1 BaU

For BaU, let’s assume that no action is taken to meet the 2◦C target. Thus,there is no limit on the carbon that can be burned and no chance of acarbon bubble, or at least a policy-fueled bubble. Although carbon-intensiveindustries would be fine in this scenario, climate-sensitive industries couldsuffer.

Using the EIA’s Kaya identity parameters, we can calculate the pre-dicted growth rates of carbon dioxide emissions that we’ll need for the restof the scenarios:

F(2011) = P(2011) x g(2011) x e(2011) x f(2011)F(2011) = 6,957 x 106 people x 10,515 2005$ per person x 7.33 x 103 BTUper 2005$ x 59.7 x 10−18 GtCO2 per BTUF(2011) = 32.035 GtCO2 = 8.737 GtC

rF = rP + rg + re + rfrF = .008 + .028 - .020 - .002rF = .014

4In probability theory, random means “subject to chance or uncertainty” rather than“arbitrary.”

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2.2 UN-H

In the formal language of probability theory, we could express “the prob-ability that warming stays below the 2◦C target given a carbon budget of350 GtC is 33%” as:

Pr(X ≤ 2|Z = 350) = .33

In order to find out when the carbon budget would run out given theEIA estimates, we need to add each year’s emissions past 2011 (the latestyear for which the EIA has data) until the cumulative sum is equal to Z.This can be done using methods we learned in class by plugging the formulaeinto an Excel spreadsheet. It also possible to find the answer using a simpleintegral: ∫ Y

2011F (2011)erF (Y−2011) dy = Z

Which becomes:

F (2011)

rF(erF (Y−2011) − 1) = Z

Solving this using Z = 350 GtC and the values of F(2011) in GtC andrF , we get:

8.737

.014(e.014(Y−2011) − 1) = 350

Y = 2043

This means that if we were to set a carbon budget of 350 GtC anddid not implement effective climate policies, we would burn through all theallowable fuel by the year 2043.

2.3 UN-M

Repeating the procedure from UN-H, we get:

Pr(X ≤ 2|Z = 310) = .50

8.737

.014(e.014(Y−2011) − 1) = 310

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Y = 2040

To keep warming below 2◦C with a 50% probability, all the fuel thatcould be burned under the necessary carbon budget would only last us until2040 at predicted growth rates.

2.4 UN-L

Repeating the procedure from UN-H and UN-M, we get:

Pr(X ≤ 2|Z = 270) = .67

8.737

.014(e.014(Y−2011) − 1) = 270

Y = 2037

To keep warming below 2◦C with a 67% probability, all the fuel thatcould be burned under the necessary carbon budget would only last us until2037 at predicted growth rates.

These numbers show that unless the rate of emissions growth is sloweddramatically, warming of greater than 2◦C will be inevitable by mid-century.Decreasing the value of rF would extend the timeframe we have to continueburning fossil fuels, but would require greater cuts in fossil fuel use in thenear-term.

3 Other targets

Of course, not everyone agrees that 2◦C is a feasible, or even a desirable,target. In his new book The Climate Casino, William Nordhaus argues thata better target would be 2.3◦C if mitigation were accomplished through aPigouvian tax and up to 4◦C if accomplished through command-and-controlregulations.5 Even if the target warming were higher, however, the basiclogic of a finite carbon budget would not change.

Going in the other direction, there is a strong case that carbon budgetsshould be even lower than the IPCC and Carbon Tracker estimates oncenon-CO2 factors are taken into account. In a recent letter to the journal

5Paul Krugman, “Gambling with Civilization,” The New York Review of Books, Vol.60, No. 17, November 7, 2013.

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Nature,6 a group of climate researchers argue that taking into account theneed to mitigate not only global warming but also impacts such as oceanacidification and biodiversity loss, more stringent carbon budgets would beneeded to meet multiple goals simultaneously.

Finally, the longer we wait to take action on climate change, the feweroptions we will actually have available. Certain warming targets becomeunattainable over time because emissions would need to be reduced by morethan 100% to achieve them. In one study7 published earlier this year onthis topic, the climate scientist Thomas Stocker finds that the 2◦C targetbecomes impossible after the year 2044, which is consistent with our calcula-tions above. When taking into account the economic reality that emissionsreductions above 5% per year are virtually impossible, the 2◦C target is lostby 2027 barring implementation of a serious mitigation policy.

4 Carbon capture & storage

One way to limit warming while still being able to burn more fossil fuels isthe widespread deployment of carbon capture and storage (CCS) technologyto take CO2 out of the atmosphere directly. Unfortunately, even under themost optimistic scenarios, CCS cannot make more than a minor impact.When Carbon Tracker modeled how the carbon budget would expand underthe International Energy Agency’s most optimistic projections, CCS stillonly increased the budget by 12-14%.

5 Stranded assets

Now that we’ve seen over what timeframes the carbon budgets would beexhausted, the next question becomes how these budgets compare with ourreserves of fossil fuels. If the budgets were larger than the reserves wecurrently plan to burn, there would be no problem. Unfortunately, theproven reserves of carbon owned by private companies and governments farexceeds all of the carbon budgets we have analyzed. Using Carbon Tracker’sestimates, listed reserves of coal, oil, and gas total total 762 GtCO2 andlisted resources total 1,541 GtCO2. Reserves are economically recoverablenow, whereas resources are expected to be economically recoverable in the

6Marco Steinacher, Fortunat Joos, and Thomas Stocker, “Allowable carbon emissionslowered by multiple climate targets,” Nature, Vol. 499, pp. 197-201, July 11, 2013.

7Thomas Stocker, “The Closing Door of Climate Targets,” Science, Vol. 339, pp.280-282, January 18, 2013.

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future. In comparison to these numbers, Carbon Tracker calculates that thecarbon budget needed to have a 50% chance of avoiding 2◦C is 269 GtCO2

and 3◦C is 356 GtCO2. Thus, there is already three times as much carbonin listed reserves as it would take to blow through the 2◦C target, andthere is six times as much carbon in listed resources. Even when using themore lenient 3◦C target, there is twice as much carbon in reserves and morethan four times as much carbon in resources than can be burned. Makingmatters worse, the figures above only include reserves held by publicly listedcompanies. Governments (think Venezuela and Saudi Arabia) own about75% of all reserves, bringing the real total to 2,860 GtCO2, or more thanten times the carbon budget for 2◦C.

Not only do current reserves exceed the allowable amount that can beburned, but fossil fuel companies are spending on the order of $6-7 trillioneach year in capital expenditures exploring for new reserves. Traditionally,fossil fuel companies have been evaluated based on their reserves replacementratio (RRR), which is basically a measure of whether reserves are growingor shrinking. Companies have financial incentives to maintain RRRs over100%, meaning their reserves will grow. However, if a carbon budget isenforced, most of those new reserves will become stranded assets — aneconomic term meaning that assets that the companies were developing onthe assumption they would have future value turn out to be worthless. Thus,if emissions reductions are achieved, most of the capital investment that haswent into exploring for new reserves will have been wasted.

6 Conditions for a carbon bubble

The mere existence of stranded assets, however, does not mean that therewill necessarily be a carbon bubble. The Bank of England has identifiedthree necessary conditions for there to be a true “carbon bubble”:

1. Financial institutions must have a large exposure to the affected stocksof carbon-intensive industries relative to their total assets.

2. The risk of climate policy stranding carbon-intensive assets must notbe properly priced by the market already, either through lower expectedreturns or higher risk premiums.

3. The transition away from fossil fuels must happen so quickly thatcompanies do not have enough time to adapt and alter their business plansand institutions do not have enough time to adjust their portfolios.

Arguments could be made for or against the plausibility of any of thosethree conditions. Additionally, it is far from certain that a binding treaty

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will emerge from the Paris Climate Conference in 2015 to replace the KyotoProtocol or that any other concerted international action will be successfulin limiting global greenhouse gas emissions, potentially making the wholeissue of a carbon bubble a moot point.

Nevertheless, the impacts of a carbon bubble, if one were to burst, shouldnot be taken lightly. According to one report by the bank HSBC, between40 and 60% of the market capitalization of certain fossil fuel companiescould be at risk if a stringent carbon budget is adapted.8 Additionally, theHSBC report casts doubt on the idea that this risk has been sufficientlypriced already, perhaps because it is a long-term risk in a market that tendstoward myopia.

Moreover, the lessons of the financial crash of 2008 do not bode well for acarbon bubble. The risk posed by subprime mortgage assets seems obviousin retrospect, and was obvious to a few Cassandras beforehand, but mostmarket participants were taken by complete surprise. It seems possible,at the very least, that history could repeat itself with the carbon bubble.Although it is still too early to say with any confidence when, and whether,the carbon bubble will pop, in any event the logic of carbon budgeting posesa real challenge to business-as-usual in resource exploration and extractionin the fossil fuel industry.

7 TL;DR

If we are to limit global warming to within 2◦C, only a certain amountof fossil fuel reserves can be burnt. This limit is referred to as a carbonbudget. Based on figures from the latest IPCC report and expected growthin emissions from the EIA, this budget would be exhausted sometime around2040 barring ambitious climate policy at the international level. The amountof carbon fossil fuel companies and resource-rich governments have in reservevastly exceeds the carbon budget for 2◦C, meaning these companies couldtake a large hit in their stock prices if a carbon budget is enforced. Thiscould result in the popping of a carbon bubble, hurting investors acrossthe economy. Although the probability of the carbon bubble popping isunknown, it is a real risk that should be taken into account by investors andpolicymakers.

8Paul Spedding, Kirtan Mehta, and Nick Robins, “Oil & carbon revisited: Value atrisk from ‘unburnable’ reserves,” HSBC Global Research, January 25, 2013.

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