Investors should be wary of domino effect on ‘stranded assets’

The US fossil fuel divestment campaign could increase the chance of carbon pollution regulation, thereby stranding some carbon-intensive assets

A variety of converging risks could erode or destroy the value of polluting and environmentally unsustainable assets around the world. These range from climate change, through to new environmental regulations, developments in clean energy technologies, resource limits, evolving public opinion, and litigation.

These environment-related risks could result in ‘stranded assets’, where assets suffer from unanticipated or premature write-downs, devaluations, or become liabilities.

At-risk assets exist throughout our financial and economic systems, from coal-fired power stations to certain types of farmland, and there could be a significant over-exposure to such risks within current investor portfolios. Yet at present, these risks are likely to be fundamentally mispriced and misunderstood by investors. 

The vast majority of asset owners, asset managers, banks, investment consultants, actuaries, accountants, equity analysts, credit ratings agencies, lawyers, and regulators – not to mention the companies involved – don’t yet have the tools or expertise to appreciate environment-related risks and manage them in any meaningful way. Quite simply, these are not the kind of things that investment committees or pension fund trustees currently tend to care about or question.

This will change, and could change quickly. Some of the agents involved are beginning to see that such risks aren’t just long term issues that can be put to one side indefinitely. There are already many significant examples of how assets have been stranded by environment-related risks and then hit investor returns. For example: renewable energy depressing power prices and negatively impacting utilities in Europe; the emergence of shale gas stranding coal assets in Australia and the US; water constraints and air pollution concerns stranding coal assets in China.

At Oxford University’s Smith School of Enterprise and the Environment we have begun a research programme to understand these risks. One of the emerging conclusions from the work completed so far is that these risks are likely to be interrelated and this could result in a domino effect. For example, the fossil fuel divestment campaign building momentum in university campuses, particularly in the US, could increase the chance of carbon pollution regulation being introduced, thereby stranding some carbon-intensive assets.

Our work also looks at how the way we value assets might change, thereby stranding assets. It might be reasonable to think that new valuation frameworks, norms, and approaches to valuation might emerge in response to the financial crisis or the challenge of environmental sustainability. These new approaches could influence future capital allocation, as well as corporate strategy, which could then affect investors.

Investors can take some steps to manage these possible developments and promote reform. Here are five to start with:

First, monitor exposure to assets that might be at risk. The companies that could be affected comprise a surprisingly large variety of sectors and markets.

Second, stress test portfolios against potential risks using a range of scenarios. Assets unable to withstand these scenarios and the internalisation of environmental costs should be much more closely monitored.

Third, engage with companies that you have invested in. Considerable communication with management can be undertaken to influence behaviour so that companies better manage these risks.

Fourth, hedge your exposure to risk by spreading portfolios in favour of less risky assets.

Fifth, work on and support others working on the development of frameworks and tools that help investors to understand and quantify such risks. There is much to do and all parts of the investment chain need to be involved.