Waking Up to the Fossil Fuel Risk Premium

Climate Finance Week in Paris Continues

(Part 2 of the ongoing Carbon Tracker Initiative Series continues with a view from Paris)


As the world’s top financiers gather in Paris ahead of International Climate Finance Day on Friday a core theme will be how to redirect private capital away from “brown” investments in fossil fuels – what we see as the proverbial elephant in the room.

To prepare the ground for the bold transition to a low-carbon economy and level the playing field, financial markets need to correctly price climate risk and the “true” costs of investing in fossil fuels.

Yet companies continue to pump money into high-cost, high-carbon projects because these risks are not fully considered in the strategic decision-making process that by and large remain opaque.

At Carbon Tracker we have coined the term the “fossil fuel risk premium” to explain this structural flaw, thereby waving a red flag to both markets and investors.  And that risk is growing as companies invest in ever-costlier projects despite trends in commodity price volatility, rising climate regulation, demand fluctuations and a rapid decline in clean energy costs.

Through our financial analysis, mainly via our “Carbon Supply Cost Curves” studies, we have shown companies and investors the dangers of pressing ahead with projects that rely on high prices to make a decent return, or that may become ‘stranded’ in a climate-constrained world.

Many high-cost projects we have highlighted -- in the oil sands, the Arctic, deep water, and for coal -- are also high-carbon and represent significant financial risk right now.

Looking at oil projects, even with a low-to-zero carbon price, many need a high oil price to be worthwhile for investors.

Our analysis has shown this could put more than $1 trillion of capital at risk in the next decade, under current policy settings, as rising investment is hit by a perfect storm of emissions curbs, efficiency gains, technological advances and growth in China hits demand.


This in turn could expose societies and businesses to a needless rise in energy costs. We call this the “dirty trillion” -- projects needing $95 a barrel or more to make a satisfactory return.

In our May 2014 “Carbon Supply Cost Curves” report, we found that potential spend on high-cost projects could rise dramatically to more than $20 trillion by 2050 if the development of these high-cost projects and the seeking out of yet more carbon to replace reserves continues unchecked.

With the recent volatility in oil markets and oil companies making big cuts to capital expenditure or 'capex' budgets, our warnings are timely enough. 

The risk premium we set out is just as pertinent in coal. Coal export markets continue to be very weak, with Australian prices having recently hit six-year lows. The collapse has been such that investors need to consider a fundamental question: do you think the seaborne thermal coal is in structural decline?  Or, is it just experiencing the bottom of a super cycle?

Much of this rides on China, where again demand may surprise to the downside. If a company is investing capital in anticipation of an upturn in the coal export market, this leaves them exposed to the gap between demand trajectories.


We recently published a paper on this topic focusing on US thermal coal market concluding that a combination of factors including competition from other energy sources and increasing regulations to combat pollution meant that it was unlikely that the sector would ever recover.

Regardless of whether current low prices in oil and coal persist or rebound, investors and corporates must learn lessons and translate them into lasting changes in the way they look at fossil fuel investment practice.

If markets were made aware of the risks (through for example, our deep-dive analyses), rather than being used to fund high-cost fossil fuel projects, capital could be diverted now to develop clean, secure and affordable energy sources, accelerating the development of lower-cost, clean energy.

And there is demand:  investor groups are calling for the “clean trillion” -- an extra $1 trillion per annum to be diverted to clean energy, as recommended by the IEA.

(Editor's Note:  The IEA and World Bank have jut also issued a new report on the gaps in needed renewable energy investment)

We know we can’t burn it all. Let’s start by empowering investors like you and I to challenge the most climate damaging and economically costly ventures before its too late.

If the market and companies begin to correctly price the fossil fuel risk premium it will level the playing field between business-as-usual fossil fuel investment and green climate finance, giving us the chance to break the cycle.