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BP And The Stranded Assets Problem – The Carbon Freaks Are Wrong

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The former British Petroleum, now BP, has just written down the value of its reserves. Given that the oil price has fallen and looks most unlikely to rise back to its former heights any time soon this seems reasonable enough.

The problem here though is the manner in which the carbon freaks are claiming it proves their theory about stranded assets. That those to be exploited in the future reserves have no future value and therefore the shares of the companies that own them should be much lower now. Thus all should sell out of fossil fuel companies now ahead of the rush.

The problem with this idea is that this current BP write down entirely disproves their idea.

BP will take a hit this quarter of up to a $17.5 billion as it abandons oil discoveries and writes down the value of its assets after slashing its oil price forecasts.

The oil giant has reduced its assumption of the Brent crude price from $75 a barrel to $55 because the coronavirus pandemic and the global shift to greener energy would mean lower demand.

OK, the assets owned by the company are now worth less than they were when the oil price was higher. Seems an entirely fair observation really. And now for one of the carbon freaks:

Since 2008 one of the continuing themes of the Green New Deal Group has been that we have a fossil fuel crisis, one of the manifestations of which has been that far too much money has been going into the fossil fuel sector that should have been invested in clean energy.

What we have talked about are ‘stranded assets’ – which are the investments in fossil fuel extraction that can never pay a return because the fuels in question can never be burned if we are to survive here on earth.

Well, it seems logical but is it true?

In other words, it’s recognising the scale of its stranded assets.

At last.

I won’t resist the temptation to say ‘told you so’.

And just remember, if you have a private pension fund that’s invested in shares that is your pension that they wasted and are now writing off. You should feel this personally. Their waste matters, and there’s a lot more of this to come as yet.

Have pensions been hit by this?

Well, the problem with the claim is that it’s entirely missing the very problem we’ve got with climate change in the first place – discount rates:

As we all know the net present value of an asset depends upon its future value and the interest rate we use to discount that to the current value. Using exactly the same sums we can work out that future values become less important with respect to current the further out they are in time.

A 1% discount rate means that something which happens in a century has pretty much no value now buit still a significant one in 20 years. One of 10% means that something that happens in a decade (note they’re usually worked out on a declining balance basis so it’s not just a straight line calculation) has pretty much no value now. What the discount rate is matters.

Indeed so. And we’ve a long discussion of this concerning climate change and the value of oil assets too. It’s part of that 1,200 page Stern Review:

Think back to the Stern Review. The original economic justification for doing anything about climate change anyway. What was the central problem identified? It was about discount rates, wasn’t it? That if we use a high discount rate then things that happen in the future aren’t given a sufficient valuation today. So, the damages that climate change will cause, we’re not doing enough about them today.

Specifically, the complaint was that market interest rates are much too high to inform our decision making two and three and more decades out. We must use a much lower discount rate in order to incorporate the importance of that future climate change.

OK, we can have arguments about that. But note what is being said again. Market interest rates make valuations two and three decades out much too low.

And what are market interest rates? Well, we could look at the (before QE) risk free rate, which was 3 to 4% or so on government bonds. Or a more general nominal rate on private sector bonds of perhaps 6%. Or even use the numbers that the Stern Review did for the general market interest rate – thus looking at equities – of 7 and 8%.

So, we’ve two competing narratives here. Fossil fuel reserves will be worth little some decades into the future therefore fossil fuel stocks should fall now. The carbon freak argument. Or, the market argument – derived as we can see from the Stern Review – that those future values of fossil fuel reserves don’t make much difference to the value of fossil fuel stocks right now because we already discount that far future by using market discount rates.

If only we had a manner of deciding between these two hypotheses. And, gloriously, we do. If the carbon freaks are right then the BP writeoffs should lead to a significant fall in the BP share price, right now. If the market freaks are right – as, again, the Stern Review suggests they are – then the BP share price will do not very much here as we’re already discounting the value of those to be used in the future reserves down to pretty much nothing.

Aaaaand, the envelope please:

The stock’s fallen tenpence. Well within the normal daily variation. A 3% change in price.

The carbon freaks are wrong, aren’t they? For their argument is look, folks, you really need to know this, pay attention. And the markets are going, yeah, we know already, right?

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expunct

in British English
expunct (ɪkˈspʌŋkt)
VERB (transitive)
1. to delete or erase; blot out; obliterate
2. to wipe out or destroy

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