High Carbon Investment
Caroline Lucas (Brighton, Pavilion) (Green)
Almost a year ago, an open letter from a high-profile coalition of investors, politicians and scientists to the Governor of the Bank of England warned that the huge reserves of coal, oil and gas held by companies listed in the City of London are what they termed “sub-prime” assets and pose a systemic risk to economic stability. It is that risk and what could be done to protect the economy that I want to speak about this evening. I apologise in advance for the technical nature of the debate, but I hope the Minister will agree with me that the subject is important.
I want to lay out the new maths of climate change, which quantifies the difference between the total amount of fossil fuels in existence that we know of and the amount of coal, oil and gas that can be burnt unmitigated if we are to have a decent chance of achieving the internationally agreed objective of limiting global warming to below 2°. Industry figures suggest that about 2,795 gigatonnes of carbon dioxide are locked up in the known proven coal, oil and gas reserves around the world. That figure can be compared with the much smaller amount, 565 gigatonnes of carbon dioxide, that research by the Potsdam Institute for Climate Impact Research has identified as remaining in our carbon budget for the period 2011 to 2050. That shows that only about one fifth of known fossil fuel reserves can be burnt and their emissions released if we are to stay within the carbon budget. That analysis was confirmed by the International Energy Agency in its recent world energy outlook for 2012.
Research by the Carbon Tracker initiative has shown that at the end of 2010, 745 gigatonnes of carbon dioxide were present as coal, oil and gas reserves on the stock exchanges of the world. That means that just the reserves owned by listed companies, if burned so that the carbon dioxide is released, already exceed the 2° carbon budget. In other words, there is a major disconnect between the direction the world’s stock exchanges are taking and global efforts to prevent dangerous climate change, such as the recent UN negotiations at which the Secretary of State worked hard to argue for a 2° threshold.
Lord Stern made the following observation in a Financial Times article during the Durban climate conference last December:
“As the negotiations at the UN climate change summit in Durban reach the critical stage, we must not overlook a fundamental contradiction between the way global fossil fuel reserves are evaluated and long-term policy goals. By ignoring this contradiction, companies and markets, as well as governments, are undermining management of the huge risks that rising levels of greenhouse gases pose to their survival.”
As Lord Stern indicates, if greenhouse levels continue to rise, that poses significant risks to business as well as to society as a whole. For example, the insurance and property sectors are already seeing increased claims due to extreme weather events. To give just one example, the estimated property damage costs from Hurricane Sandy are $20 billion. Once the costs of lost business are added in, that could reach $50 billion according to some estimates. Ironically, the hurricane even stopped the New York stock exchange from functioning.
The UK has led the way in using carbon budgets to manage its progress on reducing domestic emissions and it is time to apply that approach to the financial markets and align the energy sector with climate targets. Otherwise, we are in danger of allowing a lack of proper financial oversight and regulation to condemn us to temperature rises of as much as 6°—a figure that was even reinforced in a report by PricewaterhouseCoopers just last month.
The financial markets are an indicator of where the energy industry is heading and at present it is clear that the diversion of capital investment away from carbon-intensive energy sources towards clean energy technologies is not occurring fast enough. Unless the financial system starts to respond with some urgency, it is increasingly exposed to the potential for a drastic correction to reduce emissions—in other words, the risk of the carbon bubble bursting.
The UK economy is particularly exposed because of the global role played by our financial sector in raising capital. London’s strong reputation attracts companies from all around the world and has resulted in it becoming one of the global centres for natural resources companies. Indeed, the UK has a much greater exposure to climate change risk through London’s financial market than it does from its own domestic emissions. Carbon Tracker analysis shows that at the end of 2010 the coal, oil and gas listed in London was the equivalent of 105.5 gigatonnes of carbon dioxide. That is 10 times the UK’s domestic carbon budget of around 10 gigatonnes of carbon dioxide between 2011 and 2050.
Very few of these reserves are actually located in the UK. For example, one third of the coal is in Australia, with major reserves also in Indonesia, South Africa and Botswana. Only a tiny proportion of the coal listed in London is actually in the UK—about 0.36%. This means that investors, such as pension funds, which put their money into so-called UK funds are in fact exposing themselves to risks around the world. For example, there are increasing constraints on the markets for coal across the world, including carbon taxes in Australia and South Africa, the EU emissions trading scheme, carbon intensity targets in China, mercury regulations in the United States, and water availability in India. Moreover, renewable technologies are becoming more advanced and more competitive on price all the time. That has led to increasing uncertainty about the viability of new coal power generation in a number of markets.
All sectors go through changes, which can result in obsolete technologies and stranded assets. The communications industry, for example, has seen a rapid switch to mobile communications. Similarly, traditional photographic equipment has been superseded by digital photography and multipurpose devices that can take pictures and share them with others. We need a similar revolution in the energy sector, which brings through new technologies and delivers the green investment and development opportunities that investors and Governments are seeking—and the markets need to reflect carbon constraints and the reality of fossil fuels as stranded assets. If they fail to do so, as Al Gore argues, fossil fuel reserves will be the next sub-prime crisis.
We therefore urgently need action better to prepare the financial markets for this systemic risk and to prevent a repeat of the recent financial crisis. In the first instance this is about ensuring that the financial system at least starts to consider the risks associated with those so-called stranded assets. HSBC estimates that carbon constraints post-2020 could impact valuations of coal assets, for example, by as much as 44%, with the actual stock impact determined by company exposure to coal. This could translate into a downside risk of between 7% and 15%, according to HSBC, adding a new dimension to risk assessment for both corporate strategy and anyone looking to avoid further economic crisis.
Around one third of the value of the FTSE 100 is currently made up of oil, gas and mining companies, with investors tied into the composition of the markets. That can be directly, through the use of tracker funds, which mirror the largest companies listed on the exchange, for example the FTSE 100 index, or it can be indirectly, by using such indices as a benchmark for fund performance, which results in funds closely matching the sector composition of the benchmark. As a result many investors end up following the market, owing to the herd mentality of the investment system.
The Kay review commissioned by the Government found that equity markets are subject to structural flaws which prevent the management of investments from reflecting the long-term investment horizon of many pension funds. John Kay recommended that metrics should be directly relevant to the creation of long-term value in companies. Until the markets are able to demonstrate that they have fully integrated such risks, it is clear that they will be subject to the dangers of financial instability. Given that climate change is an enormously important long-term systemic risk, as well as a massive market failure, it should surely be seen as a key test of whether markets have adequate information and are functioning efficiently.
The Government have already taken an important first step towards giving markets some of the information they need to deal effectively with climate-associated risk, by introducing greenhouse gas reporting as part of the disclosure requirements for large listed companies. This puts emissions information alongside the material financial data provided for the investor audience. That is a useful first step, but it is important that these emissions data also pass the materiality test, and are of use to investors. However, the current proposal is for a one-size-fits-all approach, which will not give investors information about just how exposed a company is as the result of increasing constraints on carbon intensive activities. Whether a mining company has energy efficient offices or an oil company reduces its business travel provides no material information for shareholders. Good housekeeping by companies whose core business is increasing the production of billions of tonnes of coal and oil simply will not deliver the scale and pace of change required. What investors need is a forward-looking indicator of how the stock levels of fossil fuels compare with the future market for the companies’ products—coal, oil and gas.
Therefore, I propose that the Government should demonstrate true leadership by requiring extractive companies to report the greenhouse gas emissions potential of their reserves. I recognise that it is the Department for Environment, Food and Rural Affairs that leads on greenhouse gas reporting, but I hope that the Minister can assure me that the Department for Energy and Climate Change is actively involved in discussions about the shape of the proposals and that he is using every opportunity to press for an approach that will demonstrate the UK’s commitment to global leadership and protect our economy from the threats posed by the carbon bubble.
The Climate Change Act 2008 draws its powers from the Companies Act 2006, and section 416(4) of that Act allows the Secretary of State to
“make provision by regulations as to other matters that must be disclosed in a directors’ report.”
Given the significance of the carbon dioxide potential of reserves, surely extractive companies must be required to report that vital information at the earliest opportunity. That information can then be collated by the regulator and the level of carbon dioxide in reserves listed on our stock exchange can be monitored. These data should in turn be considered and reported by the Bank of England’s Financial Policy Committee. The committee is charged with identifying, monitoring and taking action to remove or reduce systemic risks, with a view to protecting and enhancing the resilience of the UK financial system.
A number of actors from the financial markets, including Aviva, HSBC and PricewaterhouseCoopers, have already made representations to the Bank’s executive director for financial stability on that matter. Without a thermometer taking the temperature of the market, investors have no idea if the systemic risk is being managed or if the situation is getting worse. Given that most investors are tied to the composition of the market, it must fall to the regulator to take action on that kind of systemic risk and mandate disclosure. London has a reputation for strong corporate governance and transparency, which that measure would maintain.
According to the International Accounting Standards Board, the performance of an organisation is affected by the economic resources it controls, its financial structure, liquidity and solvency and its capacity to adapt to changes in the environment in which it operates. Financial performance is, fairly obviously, an organisation’s ability to earn a profit from the resources that have been invested in it. It also takes into account the actual and potential impacts on performance, viability and earnings of the activities of stakeholders and of systemic risks.
Requiring disclosure of the greenhouse gas emissions potential of reserves is therefore a matter of helping directors to fulfil the duty to report on what might affect the future performance of their company. Boards should be required to explain how their business model is compatible with future scenarios. Directors should be required to explain what level of climate change they are assuming in their strategy and which technologies they assume will be in place by what date. For example, we need to know whether the management of mining and oil companies currently assume that the world will continue on the pathway to 6° of warming.
Many business leaders have made statements supporting the 2° framework and emissions targets. They need to explain how such a position is compatible with their current business model that includes fossil fuel assets. It is clear that business as usual will not prevent dangerous climate change; on the contrary, it is much more likely to lead to catastrophic climate change. Therefore, the Government need to create a framework that facilitates change and protects the economy.
This is probably a good point at which to explain briefly why carbon capture and storage is not the answer to the challenges I have outlined. CCS would obviously primarily be applied only to major coal and gas generation point sources of emission—power stations. It will have no impact on the oil-related emissions generated by transport. Furthermore, given the huge difference between the tight carbon budget and the huge fossil fuel reserves, even widespread CCS would not close the gap sufficiently.
If companies are using a business model based on CCS, they should be required to explain clearly their assumptions about time scales and cost. The International Energy Agency has indicated that commercially available CCS is not likely to come in until after 2030. That leaves around two decades of unmitigated emissions if business continues along the current trajectory, with the carbon budget well and truly spent before CCS can come in. Even at that point, it could be prohibitively expensive to retrofit to existing plants and CCS would primarily be added to new facilities. Unless investors are taking a particularly long-term view, they will not be factoring that into their assessments of a company’s value—there is too much uncertainty. Is it realistic to expect pension funds, for example, to put their money behind a technology that is not yet proven commercially and which even the industry accepts is decades away? If the future viability of coal companies is dependent on CCS in the near future, investors should know about it.
DECC has developed the capital markets climate initiative. That recognises the important role of public sector action in mobilising private capital and encouraging new markets in low carbon investments. However, at present the initiative is completely missing the other side of the equation; there is a need to change the frameworks around the high carbon end of the spectrum to drive capital towards the low carbon end. By starting to address the full picture of capital markets and climate change, the Government can redress the imbalance.
By providing better information, the Government can facilitate active shareholders challenging where capital is being allocated and help secure the significant shift in investment needed to create a green, resilient and sustainable economy. Furthermore, they can avoid picking up the otherwise inevitable tab for damage to infrastructure, property and agriculture, and consumers subject to increased volatility of commodity prices. Those are costs that neither the Government nor individuals can afford.
DECC’s own policies, of course, should also be helping to make markets more resilient in the face of climate change, not less so. Yet tomorrow sees the Second Reading of the Government’s much anticipated Energy Bill, which creates a legal framework to lock the UK into expensive, high carbon gas generation for decades to come. The Bill not only runs counter to scientific advice on the urgency of action needed to avoid irreversible climate change and prevent devastating global warming, but omits a target to reflect the independent expert advice of the Committee on Climate Change—that emissions from the power sector should be virtually zero by 2030.
We will discuss that issue in the context of the Second Reading of the Energy Bill tomorrow, so now is not the time to go into further detail. Suffice it to say that we clearly need an overall impact assessment to evaluate the health, soundness and vulnerabilities of the financial system as we proceed with low carbon transition. The Treasury will need to take a lead on much of that, but DECC has an important and key role as well. I look forward to hearing from the Minister about how he intends to play it.
The Minister of State, Department of Energy and Climate Change (Mr John Hayes)
I am delighted to respond to this debate and I congratulate the hon. Member for Brighton, Pavilion (Caroline Lucas) on securing it.
It seems to me that the hon. Lady’s argument is based on three fundamental misassumptions, and because of that much of her case is invalidated. The misassumptions are these. First, there is the notion that carbon-intensive industries and other parts of the economy that rely on them are at a peculiar and specific risk. The hon. Lady made that case—I shall put it as generously as I can—with confidence. However, it would be a hard case to prove and she brought very little evidence apart from the letter, sent to Mervyn King, the chairman of the Financial Policy Committee at the Bank of England, that she quoted at the beginning of her speech.
Let me deal specifically with that letter. The hon. Lady is right to say that it was signed by a number of people. The Bank’s current position is that the interim Financial Policy Committee is aware of the issue and should the FPC conclude at any point that carbon assets do pose a systemic risk to the financial system, it will report and explain that risk in its six-monthly financial stability report. It has not done so at this stage, because it has not come to the hon. Lady’s conclusion—that there is that particular risk—on which the rest of her argument is predicated.
The hon. Lady’s second fundamental misassumption—
Caroline Lucas
I am grateful to the Minister for giving way. Will he explain whether he thinks it is a misassumption to state that only one fifth of known fossil fuel reserves can be burned and their emissions released if we are to stay within the carbon budgets? That is not predicated on any letters, but on the figures coming from some of the foremost climate institutes and others.
Mr Hayes
But this is about the connection between that fact and the effect that it has on the financial climate in which these organisations operate, on their stability, and on their attractiveness to investors. That is the myth. The hon. Lady’s argument is based not on the bald fact but on the connection between it and other things.
The second misassumption that underpins the hon. Lady’s analysis—I am afraid that I must put it this way; I always try to be generous, as you know, Madam Deputy Speaker—is that she assumes a superior grasp, or understanding, of the patterns of investment, the basis on which investors operate, and the climate and modelling that they take into account in making these large-scale investment decisions, than I would have the temerity to claim. I do not want to lecture her—I say this as a paternal bit of advice, really—but a degree of humility is required in these matters. I am by no means wedded to the idea of the market, but I do take the view that the market has an important role to play in signalling to us and to the business community what investors believe to be attractive and unattractive. I therefore do not claim the kind of insight, prophetic powers and extraordinary understanding that the hon. Lady clearly does.
The third misassumption on which the hon. Lady’s performance was based was her extraordinary ability, so it seems, to predict likely changes in the availability of technologies such as carbon capture and storage, changes in the patterns of demand for energy, and changes in cost and price. It is true—perhaps this is where we can reach a synthesis—that in acknowledging that almost all we know about the future is what we do not know, we cannot simply therefore take no strategic view or no long-term decisions. Indeed, the Energy Bill, which she mentioned, is very much about trying to take long-term decisions. However, it is best to do so on the basis that those decisions are not framed around a definitive view of what is bound to occur but an understanding that the creation of a highly responsive system will allow us to deal with those things that are, by their nature, unpredictable, or certainly so in their detail and extent.
Therefore, for the hon. Lady to claim that “carbon capture and storage is not the answer”, to use her precise words, is a pretty bold—some might say a pretty extraordinary—claim. Of course it is true that carbon capture and storage is still at the beginning of its journey and that it will take some time for it to reach the scale that will allow it to become commercially viable. She knows, however, that the Government have invested in a £1 billion competition, that we are backing four projects in that competition, and that they offer significant potential. She will also know, because she studies these matters assiduously, that the taskforce we set up to look at cost reduction for carbon capture and storage concluded just a fortnight or so ago in its interim report—a considered report that I recommend to her if she has not seen it—that carbon capture and storage could become available and commercially viable much more quickly than she has said; it speaks of the early 2020s. I recommend to her the graphic illustration of that argument in the document, which shows that carbon capture and storage is not only becoming technologically proven but is more widely admired than perhaps she wants, because once one accepts that fossil fuels and their effects can be mitigated, the rest of her argument becomes less plausible. Those fundamental misassumptions rather colour her approach to these matters.
There are further problems. I challenge the idea that investment in fossil fuels and the move to a low carbon economy are fundamentally incompatible, and I believe that the market is better able to assess for itself how to manage its assets and investment decisions and that the Government’s Energy Bill provides investment, clarity and certainty. The hon. Lady will understand that the point about long-term contracted prices is that they lower the cost of capital and create an environment for investors that is, by its nature, more certain. Not only do I think all of those things, but I think, less apologetically —not that I have been particularly apologetic so far—that the mix of technologies that we believe is necessary to deliver energy security is not only a guarantee that, in the unpredictable world that I have charted, doors will be left open that the hon. Lady would want to shut, but is more likely to deliver the kind of secure, efficient and effective future that will allow us to be confident that supply can meet demand in an affordable way.
I think there is some agreement, in general terms, on this subject across the House, although there will be differences of opinion with regard to detail. I do not want to anticipate too much of tomorrow’s debate, but the Opposition have made some plausible arguments about demand reduction, market entry, liquidity and regulation, and they will no doubt want to articulate their case tomorrow. The hon. Member for Rutherglen and Hamilton West (Tom Greatrex), the shadow Minister, is in his place. Far be it for me to write his speech for him, but I have no doubt that those things will be in it.
In those terms, I think that the hon. Lady is not only outside the mainstream, but, arguably, on the very fringe of the debate. I do not want that to be the case, because, as I have said, I am generous and am approaching the issue as paternally as I can. Dickens wrote about
“a heart that never hardens, and a temper that never tires, and a touch that never hurts.”
I do not want to hurt the hon. Lady.
Caroline Lucas
How disappointed I am with the Minister’s response. I base my statements on expert advice from financial analysts, university academics and climate experts, so his patronising response is particularly misplaced. We may disagree about the precise time that CCS will come in, but the very fact that there is uncertainty surely means that financial markets should be addressing it.
On the Minister’s point that the Greens are somehow on the fringe, we have been told that for 30 years. We were told that when we started talking about the ozone layer and about climate change, and eventually the other parties caught up. I hope that he catches up soon, too, because if he does not the future looks pretty grim.
Mr Hayes
The hon. Lady knows that the Committee on Climate Change has recognised in its recent progress report—I know that she takes that seriously and that she will have read it—that we are on track to meet our first three carbon budgets, which amount to a 35% reduction in emissions by 2020. She knows that, as a result of the levy control framework negotiations that led to the bargain between the Department of Energy and Climate Change and the Treasury, we have made £7.6 billion available for investment in renewable technology, carbon capture and storage and, at the back end of that period, nuclear power, which she acknowledged recently as salient, because it is a low carbon technology.
Mr Hayes
The hon. Lady shakes her head, but it is, of course, a low carbon technology. All I am saying is that a degree of humility in these matters is important. That is not patronising—far from it. It is about acknowledging that we want a system that is robust but flexible; that takes a strategic view but that does so in a measured way; that is balanced, not extreme. We want a system that allows investors to choose from technologies that can stand up to the kinds of tests that the market would expect. That means that the technologies need to deliver and that they need to be resilient—technologically sound and commercially viable. I believe that that can be true of carbon capture and storage and of renewables, as scale grows and costs fall.
As I have said, in my view, ours is a balanced, measured, moderate and humble approach. Before the hon. Lady speaks tomorrow, I hope she will think again about the Government’s position.