Let’s say you believe oil major Shell is massively overvalued. The “carbon bubble” of overinflated fossil-fuel assets will burst once the world takes decisive climate action, you reason, leaving the firm’s unburnable assets stranded. So naturally, as a savvy investor, you will be shorting shares in the firm.
But if so, Shell thinks you are an “alarmist”, and it has written a 30-page letter to investors explaining why.
Who’s right? For the moment it’s probably Shell. The world’s energy system is like the proverbial oil tanker: it’s slow to change direction. Demand for oil and gas is high and rising, driven by a growing population and rising living standards.
Shell says the world is not on course to avert dangerous climate change.
It says it agrees with the latest Intergovernmental Panel on Climate Change (IPCC) report that warming will exceed two degrees by the end of the century if we continue on our current trajectory. And Shell doesn’t expect that trajectory to change much any time soon.
Shell thinks fossil fuels will continue to dominate our energy system for decades, even though massive investments in renewable energy are expected. That means the world will need oil and gas for “many decades to come”, it argues.
“Shell does not believe that any of its proven reserves will become ‘stranded’ as a result of current or reasonably foreseeable future legislation concerning carbon.”
The company’s expectations for the future of the world’s energy mix are broadly in line with those issued by other oil firms. Exxon, for instance, recently responded in similar fashion to shareholder concerns over stranded assets and the carbon bubble.
Shell is also in broad agreement with the International Energy Agency (IEA). The IEA world energy outlook 2013 said:
“Today’s share of fossil fuels in the global mix, at 82%, is the same as it was 25 years ago; the strong rise of renewables [is only expected to reduce] this to around 75% in 2035.”
The IEA expects demand for oil in 2035 to have increased by around 15 million barrels per day, up from today’s 85 million barrels. That would leave plenty of room for Shell and the other majors to invest in extracting more oil. It would also see the world warm by six degrees, IEA analysis suggests – not two.
Will Paris pop the carbon bubble?
What if world leaders agree a strong climate deal at Paris next year? Surely that would limit future fossil fuel use and cut the profitability of Shell’s carbon-heavy assets.
But at current rates, Shell’s reserves of oil and gas will be used up in just 11.5 years, and will pay back the money invested well before then. Getting strong climate policies that will limit its operations will take longer than that, the firm reasons.
Shell also argues that the near-term cost of its investments is more important to profitability than the possibility of a rising future price on emissions. That means shareholders need not worry because its existing and currently planned assets will still make money, it says.
Shell checks all investment decisions against a carbon price of $40 per tonne to see if projects would still make money. Current prices are below $10 on EU carbon markets, so Shell is probably safe for a while.
However, this assumes that climate policy proceeds at a fairly sedate pace. What if the world gets ambitious and goes all out for limiting warming to two degrees?
The IEA has sketched a two degree scenario, but Shell doesn’t think it’s going to happen: “We … do not see governments taking the steps now that are consistent with the two degree scenario”. Sticking to two degrees fails to take account of “today’s realities”, the company says.
Shell’s focus on oil and gas may also protect it. Even if there is a strong climate deal at Paris consistent with two degrees of warming, according to the IEA analysis the only fossil fuel facing large reductions in demand in the 2030s will be coal. Shell does not do coal. The firm’s reserves are split roughly evenly between oil and gas.
With strong climate action, the IEA still expects oil demand would continue to rise until 2020 and gas demand until 2030.
Why? The problem is that for transport fuels like oil there are few credible alternatives on the horizon. Biofuels are not about to take off and electric vehicles are starting from such a low base they will take years to grab a significant share of the market.
So oil will continue to do the heavy lifting. Air travel is a case in point, which is why the Longitude Prize is considering giving Â£10m towards the development of low-carbon flight.
Energy expert Robert Rapier has written:
“If you really want [oil firms] to leave their oil in the ground, convince everyone to stop using it, and do so yourself. Then the asset will be stranded. But you aren’t going to have much luck stranding the asset when demand continues to grow. Every time you justify your oil consumption, [oil firms justify] producing more oil.”
All this means that Shell is probably right to be optimistic about its medium-term future. Serious strengthening of global climate ambition could squeeze its longer-term plans – that’s probably why it’s hedging its bets and investing in carbon capture and storage and biomass. After all, the IPCC says both will be essential to low-cost climate action.