Steps to deal with emerging risks of stranded assets

A confluence of risk factors could erode or destroy the value of polluting and environmentally unsustainable assets. These risks range from climate change leading to new environmental regulations to developments in clean-energy technology, resource constraints, as well as evolving social norms and litigation.

These current and emerging risks represent a major discontinuity, able to profoundly alter asset values across a wide range of sectors. As these environment-related risks materialize, they could result in “stranded assets,” when assets suffer from unanticipated or premature write-offs, downward revaluations or even become liabilities. This could have significant implications for investors beyond the business-as-usual creative destruction we see in dynamic market-based economies.

At-risk assets exist throughout our financial and economic systems, from fossil-fuel power stations to certain types of farmland. There could be a significant overexposure to such risks within current investor portfolios. Yet at present, these risks are likely to be fundamentally mispriced and misunderstood by agents throughout the investment chain.

The vast majority of asset owners, money 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 a meaningful way. If there is expertise, it tends to be limited to one or two areas and even then, is unlikely to be appropriately incorporated into decision-making. 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 economic agents involved are beginning to see that such risks could be material over meaningful time horizons — in other words that they could be revealed in the short to medium term and aren’t just very long-term risks that can be put to one side indefinitely. There are already many significant examples of how stranded assets have been caused by environment-related risks and then hit investor returns. They include, for example, renewable energy depressing power prices and negatively impacting incumbent utilities in Europe; the emergence of shale gas stranding coal assets in the U.S. economy; or water constraints stranding coal assets in South Asia.

Investors need to understand these risks in different sectors and systemically. They need to analyze the materiality of such risks over different time horizons and research the potential impacts of stranded assets on investments. In addition, they need to develop strategies to manage the consequences of stranded assets.

One of the emerging conclusions from the work completed so far at the Stranded Assets Program at Smith School of Enterprise and the Environment is that these risks are likely to be correlated. This connection could affect the sequencing of their emergence. For example, the fossil-fuel divestment campaign building momentum in university campuses, particularly affecting U.S. endowment funds, could increase the chance of carbon pollution regulation being introduced, thereby stranding some carbon intensive assets.

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, affecting investors.

While environment-related risks and how they might result in stranded assets is a new, underresearched area, investors can take some steps to manage possible developments. Among the steps:

• Closely monitor exposure to assets that might be at risk. The companies that could be affected come from a surprisingly large variety of sectors.
• Stress-test portfolios against potential environment-related risks under a range of scenarios. Assets unable to withstand these scenarios and potential environmental costs should be more closely monitored.
• Use corporate engagement tool kits. Considerable communication with management can be undertaken to influence behavior so companies better manage these risks.
• Hedge risk exposure and weight portfolios in favor of assets less likely to be at risk.
• 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.

Ben Caldecott is director of the Stranded Assets Program at Smith School of Enterprise and the Environment, University of Oxford, Oxford, England.