Who Pays the Price for Stranded Energy Assets?
As pressure builds to decarbonize the global energy system, much of today’s energy infrastructure is becoming obsolete. Over the past decade more than half of the coal-fired power plants in the United States have closed as coal generation has been replaced by natural gas and renewables, while coal plants elsewhere, such as in China, increasingly operate at a financial loss.
The value of certain fossil energy reserves has fallen too. The stock market decline of major energy companies such as ExxonMobil, once the most valuable company in the world, has come as expectations for future oil demand have fallen, making vast underground oil reserves look less valuable today. And the natural gas industry faces an uncertain future as people debate over the role that gas can and should play in tomorrow’s clean system.
Some portion of fossil fuel company investments in reserves and infrastructure will lose value, and become what economists call stranded assets. The prospect of stranded energy assets raises concern among investors and policymakers who must juggle near-term economic interests with essential climate goals.
University of Southern California economist Matthew Kahn discusses the growing concern over stranded energy assets, and looks at some of the people and places that will likely suffer when the value of assets drops. He also explores policy solutions to address the problem of stranded assets while taking vulnerable communities into account.
Andy Stone: Welcome to the Energy Policy Now podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone. As pressure builds to decarbonize the global energy system, much of today’s energy infrastructure is becoming obsolete. Over the past decade, more than half of the coal-fired power plants in the United States have closed, as coal generation has been replaced by natural gas and renewables, while coal plants elsewhere, such as in China, increasingly operate at a financial loss. The value of certain fossil energy reserves has fallen, too. The steep decline in the valuation of major energy companies such as ExxonMobil, once the most valuable company in the world, has come as expectations for future oil demand have fallen, making these companies’ vast underground oil reserves look less valuable today. And the natural gas industry faces an acutely uncertain future as the role that gas can and should play in tomorrow’s clean energy system is debated.
What all this means is that some portion of fossil fuel companies’ investments in reserves and infrastructure will lose its value and become what economists call “stranded assets.” The prospect of stranded energy assets raises concern amongst investors and policy-makers, who must juggle near-term economic interests with essential climate goals.
On today’s podcast, we’ll talk about the growing concern over stranded energy assets and take a look at some of the people and places that may suffer when the value of the assets drops. We’ll also explore some policy ideas to address the problem of stranded assets while taking vulnerable communities into account. My guest is Matthew Kahn, a Professor of Economics at the University of Southern California who focuses on environmental and urban economics. Matt, welcome to the podcast.
Matthew Kahn: It’s great to be here.
Stone: In the intro, I just gave a general outline of what stranded assets are, but I wonder if you could give a sharper definition to the term and also tell us in broad strokes why is there so much concern surrounding stranded energy assets right now?
Kahn: Andy, when I think about any asset, a company like Exxon thought, thinks that there is a bright future for selling gasoline, and it has been prospecting and continues to prospect for natural resources, for fossil fuel resources around the world, with the intent to sell these assets. But the Beatles had that song “Let It Be,” and as an environmentalist, but also as a fan of free markets, a fascinating issue that we’re now approaching is this increased desire in the name of mitigating climate change risk that these assets remain in the ground, and that we “let them be.” And so I realize that’s not a formal economics definition, but notice this change in plans: Exxon and other fossil fuel companies — coal sellers — thought that there was a market connecting them to buyers. But the real world is now quickly changing, and with this shock to the system, a key question is for owners of fossil fuels, now that our expectations of the green economy are changing, what’s their Plan B?
Stone: We talk about oil reserves and coal reserves as being one kind of stranded asset, but it really, as I understand it, can encompass a whole range of assets tied to fossil fuels — everything from pipelines to oil tankers to coal-fired power plants, and even as we’ll talk about a little bit later, even to as far as residential real estate.
Kahn: That’s correct. And I’d even add in the workers themselves, the men and women who work, whether it’s in fracking or coal mining or as you said, in the infrastructure. These fossil fuels are heavy to ship, of these logistics of getting fossil fuels from origin to processing them, such as refiners, and then how we get these final resources to the consumers in cities around the world who have been consuming them. And so there’s a whole supply chain that’s going to be affected by the rise of the green economy with the sunset of the traditional fossil fuel energy extraction and distribution economy.
Stone: Yes, you talked about the rise of the green economy, and it seems that climate policy obviously is a major driver of that and could be a major driver of asset stranding. Is this in fact the case? And what else might cause this stranding of assets?
Kahn: Nobody buys gasoline or coal because they derive direct satisfaction from that. Every family needs transportation services to get through their day. In a tough winter, we all need to heat our homes so that we can continue to thrive. Fossil fuels, for hundreds of years and in many nations, including India and China today, have provided these services. But going forward, if the green economy — even if there weren’t sharp subsidies for the green economy — progress in wind and solar is taking place. And so, Andy, there’s sort of this amazing race in terms of technological progress between green and dirty energy. And if green energy made sufficient progress as a low-priced energy source, it could have knocked out the fossil fuels even without government subsidies.
Stone: There’s an interesting little bit of data that the Financial Times reported. The data comes from Bernstein Research. It states that 80% of hydrocarbon assets in the ground — that’s oil, gas, coal — would become worthless in a scenario where global warming is held to 1.5 degrees Celsius. That’s policy solutions that would keep us at that point. Can you tell us a little bit more about how we quantify this amount of carbon that has to be kept in the ground, these assets? It sounds like it’s huge.
Kahn: This goes beyond my economics training, but in my discussions with climate scientists, they do the following arithmetic: They study the climate sensitivity by taking an upper bound of the highest we would allow average temperatures to rise, and let that be 2 degrees Celsius. You can use a mathematical equation of what’s the most greenhouse gas emissions we can continue to release such that we don’t exceed that 2 Celsius target? And the numbers you quoted, Andy, sound right to me. And so this is putting an upper bound on how much of the coal we can extract out of the ground without unleashing Mother Nature’s fury.
Stone: One of the current hot spots, it seems to me, in the debate around stranded assets has to do with the transport of natural gas. And I’m talking here about pipelines, natural gas pipelines, primarily. Looking ahead, it’s not clear how much gas we’re going to need, how much gas is going to be a welcome part of the clean energy mix or not. And recently we’ve seen some major pipeline projects canceled. I’m thinking, for example, about the Atlantic Coast Pipeline, and part of that cancellation is around, I think, the question of the future utility of those projects. Does fear of stranded assets mean that we’re not going to be seeing any more big natural gas infrastructure bills, at least in this country?
Kahn: That’s an excellent question, and I’ve learned that I’m not great at prediction. Andy, an issue we’re facing — so Europe is right now wrestling, at least the UK — with very high natural gas prices. And the Wall Street Journal reports today of rising natural gas prices for winter that families are going to face. A fascinating issue with stranded assets is the following: If fossil fuel companies start to disinvest from this sector, and if we’re slow with the green transition, we could end up with too little energy and thus very high energy prices, just as we need it, like during a cold winter. And so I’m not directly answering your question, but I would want your listeners thinking about fossil fuel energy as sort of an insurance policy, that we have constant needs for mobility and for heating and keeping our households going. And if we solely rely right now on green power, are we setting up some risks for families? If that logic is true, then we will continue to need some fossil fuels as sort of a backstop technology.
Stone: You mentioned Europe. I want to ask you generally, is the conversation around stranded assets in the United States different from the conversation in Europe or other parts of the world? Again, I think that would be based on what the status of climate policy in each place would be, right?
Kahn: You nailed it. So a little bit like the Riddler in Batman, a question I wanted to pose to you is: Are stranded assets stranded? If a future Republican leader, if a future conservative leader is elected somewhere in Europe, will he or she reverse the Greta Thunberg-like policies. Economists call that “political business cycles.” If there’s this stop and go with respect to carbon pricing and green policy, it can be profitable for fossil fuel sellers to stay in the game as they wait for a politician who’s more simpatico to take office. And in that case, you get back to “Drill, baby, drill.”
Stone: So we’re talking about a lot of uncertainty here, it sounds like, right? Kind of a ping-pong of policy.
Kahn: You’re correct. So Andy, if I can jump in there, you’re absolutely right. On the front page of The New York Times today is an article that private equity is investing in fossil fuels. The people in private equity are very good at what they do, that they must smell an arbitrage opportunity that some of these folks are betting that this is the right time to invest in these distressed assets. And so that speaks to your point that when there is uncertainty — and there are a couple of dimensions of uncertainty — political risk: Will the Al Gores of the world continue to be elected as our leaders? In that case, I would anticipate that the stranded asset issue becomes even more important because of a credible commitment to a rising carbon tax, and also technological advance. The boosters for green power correctly have argued that we’ve made great progress on wind and solar and hydro in recent years. Will that progress continue such that green power will out-perform conventional power in the marketplace?
Stone: You bring up an important issue here of investor reaction to all this. Many of the biggest banks continue to finance fossil fuel projects, despite the apparent potential risk. To what extent are major lenders weighing stranded asset risk at this point?
Kahn: So you’re going to give me a B-. [LAUGHTER] I love that question, and I’d actually like to work on that. Andy, if I can say something cynical, economists studying the major banks have argued that there’s a “too-big-to-fail” phenomenon. So let’s play this out. Suppose a major bank makes some ex post risky loans to the fossil fuel industry, and the bank teeters on bankruptcy. If the federal government bails out that bank, that creates moral hazard effect, such that the bank doesn’t bear the consequences of its ex ante risky behavior. To put on my slight Libertarian hat, banks will better manage the emerging risk of stranded assets if they bear the full consequences of making bad loans.
Stone: I think one of the big questions here, and what I really want to get into with you today in depth is — Who ends up suffering if and when fossil energy assets lose their value? And as we’ve just been talking, the obvious losers would be clearly the fossil fuel companies and investors. But there are some broader economic impacts which I think you’ve been looking into, in particular, as it relates to the fate of parts of the country that are economically dependent on the fossil fuel industry, what have you found?
Kahn: So Andy, last year Jonathan Eyer and I published a paper called “Prolonging the Sunset.” And it was a paper about coal in America, in areas like West Virginia. We documented this interesting pattern that West Virginian power plants continued to purchase coal from West Virginian coal mines. And yes, these two are physically close together, so one theory would be that there are low transportation costs. But using a funky statistical design, we argued that governors in coal extraction states were taking steps to encourage the prolonging of coal by encouraging entities within their jurisdictions like power plants to continue to purchase local coal.
And so the point of this story is there is a recognition that America has many areas built up, fossil fuel communities where one’s identity and where one’s paycheck is tied to this. Optimists say these men and women could easily become solar panel installers, but labor economists are pessimistic that you can teach old dogs new tricks. I’m 55, and if I couldn’t be an economics professor, I’m not really sure what I would transition to. And for coal mining communities, where they’ve set up their lives and their social networks, the green economy is asking them to reinvent themselves. And on some level, that’s unrealistic. So that’s an example of how middle-aged people will bear the brunt of a sharp transition if fossil fuels are now stranded assets.
Stone: Well, this is tied into the whole larger conversation that’s on-going about what happens to these communities when the industries that have long supported them decline and potentially go away. I want to bring up a city that is so tied to the oil industry, and that’s Houston. You’ve been, I think, looking at some real estate-related issues. When you’ve got a very large, very well developed city like Houston that is so tied, clearly, to the fossil fuel industry, the oil industry in particular. There are so many assets in that general area. What are the long-term implications if those assets become stranded? And explain for everybody’s information here, we’re talking about oil and gas and not using pipelines and these types of things, but how does this spill even further into the real estate in a city like Houston?
Kahn: I love this question. Economists note — and I realize that this is obvious — that different cities specialize in different activity: New York with Wall Street; San Francisco with Silicon Valley and tech; Los Angeles with Hollywood, tourism, and startup companies now in Silicon Beach. The cliché and the reality is that much of the Houston economy is based around fossil fuels, and extraction and executives living there and working in the energy sector. If there is this sharp transition towards the green economy, will Houston reinvent itself? If the local economy fails to do so, and if there’s a sunset for these stranded assets, then this whole city that you sketched out — home prices will shrink in that city, as demand falls to live there because this industrial agglomeration would decline.
And for the men and women who own these homes in this area, whose wealth is tied to the real estate they own, and the real estate has value because of the proximity to major fossil fuel companies — all of this would be in decline. So Andy, a key thing that I want your listeners thinking about is that there are distributional effects of the decline of the traditional fossil fuel economy. In the United States, we have different pockets of economic activity, and the congressmen and congresswomen who represent these districts are going to fight hard to keep the status quo, because they’re well aware of these wealth effects that would transpire with a sudden switch to the green economy. And this is my political economy explanation for the ugly carbon politics in the US and why we’ve been so slow to enact a carbon tax.
Stone: So people’s wealth is largely, or in big part, tied to the homes in which they live. That wealth, that value becomes stranded, too in this scenario, it sounds like.
Kahn: Yes, and I’d also say the human capital of individuals. A big point that economists make is that much of our earnings is tied to our skills, and if you’re a middle-aged executive trained in this industry and these firms, and if they start to decline, how easily can you transition? Can an old dog learn new tricks? Unfortunately, labor economists are pessimistic about that.
So Andy, I’d say there are several stranded assets here. With the stranding of the traditional fossil fuels’ economy, homes close to these areas would decline. There’s a question of what’s their next-best value? Could Houston become a leisure and senior citizen retirement area? And for the men and women who’ve devoted their careers to this sector, if this sector declines, what do they now transition to doing all day long?
Stone: I know you are an economist, but the question I want to ask here is are there any potential policy solutions or other types of solutions that might be considered that would come into play, should this bad outcome become reality in certain cities, such as Houston?
Kahn: An idea that interests me very much is to let a thousand flowers bloom. For example, if we now have pipelines that used to carry natural gas, there’s an interesting question: What is their scrap value? What can we now do with these things? Will these be used by Elon Musk to ship something? That was a joke. I don’t have sufficient imagination to think through the next-best alternative. One point I would make is would we need new zoning and land-use regulation laws to think about what could be done with an oil refinery, what could be done with pipelines if they’re no longer shipping fossil fuels? What could be shipped in these entities? And I don’t have enough science fiction knowledge or engineering knowledge to know that, but I’d love it if the US had a set of flexible rules.
An example: In New York City, when manufacturing declined, manufacturing areas were turned into apartment lofts, like in Greenwich Village. We need sort of a funky zoning code to allow these transitions. When there’s durable capital, what is its next-best use when the old use becomes out-of-date?
Stone: I assume that the companies in the fossil fuel industry are going to be looking for ways to maintain their valuation so that their assets do not become stranded. Is it a worthwhile policy endeavor to, for example, repurpose pipelines for carbon dioxide transport or retrofit coal plants with carbon capture to continue to provide base low power, to continue to provide jobs, to support the industry generally?
Kahn: I respect the point you’ve just made. As a free-market environmentalist, I would want proof that these technologies achieve the double bottom line you just sketched. The win/win would be to decarbonize the fossil fuel sector. And I think to some environmentalists, the technology you’ve just listed sounds like magic. I think in fairness to the environmentalists, and I’m one of them, we need proof from the industry that these magical technologies — and please keep in mind I’m an economist; I’m not an engineer. I would want to see proof that these technologies you’ve just listed actually achieve what the industry claims they yield, and if that’s the case, I think that’s very exciting because it would offer the win/win of the best of both worlds, of keeping our existing infrastructure and lives — whether that’s in Houston, whether that’s in West Virginia — keeping the middle class dream going without the Greta Thunberg nightmare of more greenhouse gas emissions.
Stone: We’ve talked a little bit about policies as driving asset stranding, and I think one other obviously clear driver of this would be investors getting spooked, getting out of certain companies and industries that don’t look like they necessarily have a real durable future. And I want to pull out a few numbers here, okay? There is a report from Global Energy Monitor which found that are $1 trillion in new natural gas pipelines globally, I think that are either being built or planned that are at risk of seeing their value disappear under aggressive climate policies. And the Financial Times again has reported that about 900 billion in oil and gas company valuation would disappear if governments adopted policies to keep global warming to 1.5 degrees Celsius.
So look, those are really big, dramatic numbers, right? Those are big, global numbers, but I think an important question is how well investors understand the potential value of the stranded assets and the impact on their investments. And that brings up the key question here: How much reliable and transparent information is there to show a given company’s stranded asset risk?
Kahn: So at least when I’ve tried to look at major companies, it is difficult to see their full inventory of assets. Maybe I’m not very good at reading 10-K accounting forms, but I’ve had some trouble reading these. And so there’s this new generation of rating firms, these ESG raters, where ESG is environmental and social governance rankings of companies. So Santa Claus knows who’s naughty and nice. How do you know how to rank whether Exxon is doing a better job on environmental performance? We need these rankings to help investors who have a double bottom line mentality, but I’m worried that the environmental accounting industry is not mature enough. They need to attract more talent and invest more resources to do the research to be like Santa Claus, because it would be horrible if the rating agencies mis-ranked companies, and then green investors invested in the wrong companies. In that case, capitalism won’t help the green companies because of this greenwashing.
Stone: The Securities and Exchange Commission, I would imagine, comes in here, right? There’s got to be some rules to ensure that there’s clear, consistent, transparent data available on risk here. What’s going on with the regulators?
Kahn: With the Biden administration only having been in power for one year, I bet that the talented people in the Biden administration are working on exactly that issue. But Andy, key issues arise. When I teach my students at USC, I give them extra credit for those who make progress in the class. So if Exxon is a dirty company, but it’s making progress grading itself, do you give it an A? Do we grade on rates of change or on levels, if I can say something nerdy? And so the Biden administration is going to have to make a whole bunch of decisions. What are a kosher set of rules of the game that companies cannot manipulate such that they have valid report cards for whether they’re making low-carbon progress?
Stone: So let’s say investors do get everything they need to evaluate the risk. Does that mean that the fossil fuel industry falls off a cliff when people presumably — I guess “presumably” — see the risk?
Kahn: You are at the University of Pennsylvania. The Wharton School Finance Group has some terrific faculty. And one idea that I learned from that faculty when I was younger was the following: Suppose there are investors who only care about rate of return risk-adjusted, and they don’t care about this green stuff. While there are other investors like a Greta Thunberg with a double bottom line point of view, for those ruthless investors who only care about rate of return, the fear of stranded assets could actually be a boon for these guys, as they can purchase assets cheaply. You mentioned that Exxon’s stock is falling sharply. Does that create a potential billion-dollar arbitrage for Wharton MBAs who say to themselves the following: “Let me purchase Exxon shares?” Or if you’re a big investor: “Let me buy 20% of this oil well, and with all this demand for cars in Nigeria, I — the investor — bet that the future is we’re not going into the United States where people are now driving electric vehicles, but our oil will now be shipped to the developing world.”
So Andy, notice what I just did in that long speech. There were two types of investors: The green investors, who will substitute away from the dirty companies because of the stranded assets effect. But then these arbitrageurs who say, “This is my time to buy low and wait for the demand for energy in the developing world to make me rich.”
Stone: So as long as the cash flow is positive, there’s money to be made in these companies, right? Is that the fundamental story?
Kahn: To recap that again, if we see a private equity investor, be it a couple of hundred million dollars for some perceived stranded assets, they’re making a bet that demand for fossil fuels in the developing world is going to rise. I’m actually working on that right now. In Africa, there’s a growing middle class. These men and women have the same American dream as we do. Unless electric vehicles get very cheap, they’re likely to drive used vehicles. There are all these used vehicles in Africa from Japan. I’ve documented in past work all these cars in Mexico are used cars from the US that are age 15 years old, and they get shipped there. So Andy, America’s assets will not be stranded assets if they fuel the middle class lifestyle in the developing world.
Stone: That brings up such an interesting question. Let me see if I can articulate this one, okay? So we have in the United States abundant natural gas. We’re a major exporter, one of the leading exporters, of liquefied natural gas. Let’s say that policy clamps down on natural gas consumption in the United States, yet the exports still continue. Where does that leave all of our LNG export terminals? I don’t know if I’m really asking a question here, but there’s a lot of uncertainty around the future of those assets, as well.
Kahn: You nailed it. I published a book about China a couple of years ago, where I argued that because China is polluted and because the nation is getting richer and more sophisticated about the costs of pollution, that the nation would substitute from coal to natural gas. China does not have a lot of natural gas, and I was writing that it should import our natural gas through liquid natural gas infrastructure. Those trades are starting to take place, but the international relations between China and the US have slowed that down. What’s fascinating about your point is that many of our liquid natural gas terminals are in areas like Seattle that want the green economy, and they don’t want to be a key intermediary of shipping fossil fuels to other places. So it’s as if these terminals are boycotting the fossil fuel economy as they try to strand these assets.
Stone: It’s interesting. I’ve read, and there’s an interesting report from about four years ago from the International Renewable Energy Agency arena that points out that the longer policy-makers dither on this whole question of enacting aggressive climate policy — the longer it takes to come to terms and enact these types of policies, the greater the value of stranded assets will be. And by extension, I would imagine, the more economic damage that could result. Does that sound right?
Kahn: It does. I want to twist that a little bit. A very talented European economist named Bard Harstad wrote a paper eight years ago called “Buy Coal.” So buy — not “by” buy, but B-U-Y, the opposite of sell. And Harstad’s point was the following: Rather than regulate fossil fuels out of existence, when could progressives and those who want to stop climate risk now just simply purchase all of the coal and fossil fuel assets of all the owners like Exxon, and just let it be? So Andy, do you see that that would be a way, using free markets, to commit — it would be costly — but that would be a way right now. The owners of these assets access these assets intending to sell them. If these assets were purchased, they would just be left in the ground, and that would preclude some of the issues you just raised.
Stone: So let me ask you kind of a final question here. Is there a risk that stranded assets themselves become an additional barrier to the energy transition, as companies do everything that they possibly can to stop these assets from losing their value?
Kahn: Yes, but I want to twist your fascinating question just a little bit. During war time, people discuss human shields, of civilians being used to scare your enemy to not attack because there might be collateral damage. A smart fossil fuel seller who does not want their assets stranded should point out the men and women who work for the company, whose lives would be devastated as an unintended consequence of carbon pricing. And to show us their faces and their families and their lifestyles that would be disrupted.
So Andy, in this sort of Instagram, Facebook age, if I owned a fossil fuel company and wanted to protect the status quo, I would show the disruption to my middle-class workforce, and I believe this would motivate the US — this would get the US Congress thinking and would slow down change.
Stone: Matt, thanks very much for talking.
Kahn: This was great. Thank you.
Stone: [MUSIC] Today’s guest has been Matthew Kahn, Provost Professor of Economics and Spatial Sciences at the University of Southern California. Visit the Kleinman Center’s website for more podcasts, as well as energy policy research and digests from experts in the field. To keep up with the latest from the center, subscribe to our monthly newsletter on our website. Thanks for listening to Energy Policy Now and have a great day.