Why our continued use of fossil fuels is creating a financial time bomb

The numbers are startling.

We know roughly how much more carbon dioxide we can put into the atmosphere before we exceed our climate goals—limiting warming to 1.5° to 2° C above preindustrial temperatures. From that, we can figure out how much more fossil fuel we can burn before we emit that much carbon dioxide. But when you compare those numbers with our known fossil fuel reserves, things get jaw-dropping.

To reach our climate goals, we'll need to leave a third of the oil, half of the natural gas, and nearly all the coal we're aware of sitting in the ground, unused.

Yet we have—and are still building—infrastructure that is predicated on burning far more than that: mines, oil and gas wells, refineries, and the distribution networks that get all those products to market; power plants, cars, trains, boats, and airplanes that use the fuels. If we're to reach our climate goals, some of those things will have to be intentionally shut down and left to sit idle before they can deliver a return on the money they cost to produce.

But it's not just physical capital that will cause problems if we decide to get serious about addressing climate change. We have workers who are trained to use all of the idled hardware, companies that treat the fuel reserves and hardware as an asset on their balance sheets, and various contracts that dictate that the reserves can be exploited.

Collectively, you can think of all of these things as assets—assets that, if we were to get serious about climate change, would see their value drop to zero. At that point, they'd be termed "stranded assets," and their stranding has the potential to unleash economic chaos on the world.

Fantastic assets and how to strand them

To explain stranded assets, Armon Rezai of the Vienna University of Economics and Business turned to actual strandings. If you have a boat and it runs aground, you can no longer derive any financial benefits from the boat—it remains an asset, but it's no longer useful. The same thing goes for any goods it was carrying, as well as the crew that was familiar with all its peculiarities.

While that sort of one-off disaster can definitely occur with fossil fuel production and use, it doesn't represent the sort of wholesale threat to all fossil fuel production that's at issue in the near future.

But there are many ways that assets can become stranded beyond freak events, and many of them are relevant to fossil fuels. Joyeeta Gupta of IHE Delft noted that assets could be stranded by something as simple as a brand falling out of fashion, leaving its owners with excess production capacity. Technological changes can also make a product obsolete, stranding all the infrastructure used to make, sell, and service it.

Stranding of infrastructure like this is metaphorical, not physics.

All of the people we talked to noted that these sorts of strandings are a normal part of capitalism. And they definitely apply to fossil fuels, as people have started to seek out cleaner alternatives and renewable technologies undercut them in price.

But there's an added risk here: policy interventions by governments. Already, various governments have put a price on carbon emissions, launched carbon trading systems, and taken other actions to either discourage the use of fossil fuels or encourage the use of cleaner alternatives. (Of course, many of them have done that at the same time that they pursued other policies that promoted fossil fuel use.)

It's tempting to consider these stranding mechanisms in terms of trying to identify which of them will be decisive. But all of them can—and in fact are—acting in parallel. And if we want to reach our climate goals, they'll have to act much more quickly than they have been.

Assets vs. the climate

Several things could potentially drive an acceleration. The growing frequency of climate-related disasters could gradually focus the public and governments on limiting climate change. Technology's march could also change the energy markets; Oxford's Rick van der Ploeg mentioned the possibility of a breakthrough in battery technology, which would enable a move away from oil in transportation and the use of solar and wind for more of our electricity needs.

The big question is whether these pressures build slowly or suddenly. If assets lose their value slowly, without major strandings, everyone can adjust. Investors can shift to other markets, companies can change their focus, infrastructure can be allowed to deprecate until much of its value is gone. There will undoubtedly be some economic pain, especially if you're in the fossil fuel business, but there won't be wholesale economic disruption.

Unfortunately, our climate goals and our continuing emissions are making the probability of this sort of soft landing increasingly remote. "We dragged our feet, and we kind of have to double down," Rezai told Ars. "If we have to have quicker adjustments, that creates the possibility of more disruptive adjustments, less smooth adjustments." My conversation with him and Van der Ploeg was filled with talk of the potential for a Minsky moment, in which the value of some assets drops dramatically. For the climate, this could come in response to technology changes or government policy changes.

This sort of sudden collapse will have sweeping effects. People who have livelihoods based on fossil fuel extraction will see their jobs vanish. Governments that rely on taxes and fees from fossil fuel extraction and use may struggle to replace the lost revenue. Companies throughout the economy will take a huge hit. Obviously, this will include lost revenue for fossil fuel companies. But it can also mean that things they treat as assets—from equipment to extraction licenses—will have to be written off as stranded.

What happens when all this hardware loses its value?

Equipment manufacturers will suffer similar problems, as will companies that transport fuels and run pipelines. Every industry that makes the equipment used to extract, transport, or burn fossil fuels will see its market evaporate. Companies that make transportation hardware, like automobiles and trains, will struggle to adjust. All the utilities that have invested in building and maintaining fossil-fuel-powered generating facilities will see them retired long before their useful life is over. The concrete, steel, and chemical industries that rely on fossil fuels will face consequences.

"It's huge, because we're not just talking about oil and gas and coal," Gupta said. "We're talking about the aircraft industry, we're talking about the car industry, we're talking about scooters, ships—all those industries. We're talking about every house that has a gas connection, we're talking about pipelines that connect with gas. It's massive."

All of these stranded assets may ultimately be written off as losses, leading to sudden changes in profitability throughout the economy. This will obviously affect their financials. But it will also affect things like retirement funds, college endowments, and other entities that, either directly or indirectly, have invested in these companies. "The residential housing crisis of 2008 was not the whole market; it was rather a very isolated and smaller portion of the financial market," Rezai said. "Because of the interconnectedness of the banking system, [that] led to a meltdown on a bigger scale." While he and van der Ploeg are skeptical that fossil fuels will create problems on a similar scale, the risks aren't zero.

Sending signals

So how can we address the climate while keeping stranded assets from crashing the economy? The financial risks associated with fossil fuels are so widely distributed in our economy that minimizing those risks could require a number of different approaches.

One is simply for governments to agree to pay companies for assets that get stranded. Referring to coal plants, Rezai noted that, "in Germany, the owners of those companies were actually bribed into giving up their rights to pollute or their squatter rights to pollute—it's not an acquired right; it's just they have been doing it in the past." Van der Ploeg bluntly suggested that this sort of thing was going to be widespread, saying, "The Pigovian carbon price may be interesting, but you really have to pay those bastards off." He also suggested that, for coal at least, doing so made financial sense: "The benefits from these [lower] damages from global warming is more than enough to pay for litigation—to pay them off, to bribe them off."

Rezai also indicated that governments were probably best positioned to run the sorts of programs needed to help the human capital—experienced workers in industries that would be going away—to retrain for new careers.

But the fossil fuel industry is far too large to eliminate through compensation, and there are many governments without the financial means that would allow them to do so. So this sort of government action isn't going to be sufficient to handle all of our problems. But there are other things that governments can do that largely involve signaling to the market that climate policies are going to become increasingly strict. Those sorts of signals can range from simply announcing more aggressive climate policies to pushing the funding for the development and deployment of alternatives.

There's an element of that happening at present, but it has not been consistent or aggressive in most countries. A comprehensive government commitment will be needed to send the right signals. "If the government did that, then I think investors in the financial industry will soon realize it's the end of the game; it will be soon the end of the music," van der Ploeg said.

An extended hangover?

Complicating all of this is the risk that fossil fuel companies can sue governments for damages if there are limits imposed on the use of said fuels. "In many parts of the world, the state retains the ownership of the oil and the gas underground, and the company gets the rights to take it out," Gupta told Ars. "The fact that a company may not be allowed to extract fossil fuel in the future may lead it to demand compensation from the state."

This situation creates a significant asymmetry. "Business law is enforced in international and national courts; nobody would undertake business risks if they were not sure that their business was protected by the law," Gupta said. "But public international law or agreements between states such as the Kyoto Protocol or the Paris Agreement are different. There's no way to enforce the US to ratify Kyoto or to implement Paris—you know, you can't force a sovereign country."

Most of us own some equipment that will have to go away if the world moves off fossil fuels.

How big of a problem is this? A recent paper in Science estimates that over 10,000 fossil fuel extraction projects in 97 countries are covered by international business treaties. The total value of these projects could rise above $200 billion. Some of the countries that have high exposure to these risks, like the UK, could easily afford the cost of these suits, which could range up to $14 billion in its case. But it would be harder for some of the other countries at high risk, like Guyana and Mozambique.

How can countries protect themselves? The paper suggests countries ban all further fossil fuel exploration to avoid seeing the problem grow. And then consider dropping out of a specific commercial treaty that creates the most risk. Both of these actions, however, could cause short-term economic turbulence.

Complicating matters is the fact that many of the countries that are most at risk from these sorts of lawsuits also have fossil fuel deposits that are cheap to extract. "It's not like we found the cheapest [oil deposits] already and we're only finding more and more expensive ones," Rezai said. "We keep finding also big ones that are very cheap to pick up. And that's mostly in the global South at this point."

Mixed signals

On the financial side, there is some indication that the markets are starting to recognize the risks. "I think a key moment was in 2015, 2016—if you look at the data, people started pricing in those risks," van der Ploeg said. "Investors like institutional investors; they want higher returns on dirty assets. So say there's a Shell or a BP or a steel factory—or cement or coal—they just had to pay quite a bit higher rate of return. And that's to compensate them for the transition risk."

Over time, as transitions away from fossil fuels become more common, these risks will increase, and demands for returns should scale accordingly as the process proceeds. "At some point, the music will stop, and then people will be running to the exit," he said.

Efforts to divest from fossil fuels have the potential to depress the price of fossil fuel assets and lay the groundwork for pricing in the risk of stranded assets. But so far, these efforts are having less of an impact. "Divestment may solve the problem if everybody divests simultaneously and the price falls and nobody wants to buy the shares," Gupta told Ars. "But the way I'm seeing divestment happen now, it's all behind closed doors, and people are buying the shares because they do not see a large-scale divestment process. So the vested interests remain, only they are new vested interests."

Van der Ploeg also praised the central banks of many countries, which were already aware of the risks of stranded assets and are taking steps to manage the situation. This is happening despite the fact that the government that created the bank is often doing nothing. "Governments seem to be oblivious. They don't seem to care," he said, later remarking on the potential for counterproductive government responses: "You don't know—just because it's stupid policy doesn't mean to say it's not going to happen."

All of that is focused on the large-scale risks of stranded assets. However, Gupta emphasized that every individual will also end up with some assets that are likely to be stranded. "I think the discussion about how each house, each business, and each university becomes independent of fossil fuel has yet to start," she said. "Every house, every person, every individual has to get involved."