The coronavirus crisis may have burst the carbon bubble
Market turmoil reveals the fragility of "brown" assets
Oil stocks in freefall. Billions wiped off bank valuations. Green equities outperforming broad-based indices. All events expected in a climate crisis. All events taking place now because of the coronavirus crisis.
Pandemic panic has shocked the markets without precedent. What’s fascinating is how a confluence of factors have conspired to make the look and feel of this financial meltdown similar to the one predicted by climate risk savants.
Take oil prices. Brent crude tumbled to $33.85 on Friday 13, down 25% on a week ago, following the launch of a Russia-Saudi price war and concerns the coronavirus would gut demand. The shock obliterated the share prices of key drillers, including those of giants Chevron and ExonnMobil, which ended the week down 12% and 20%, respectively.
Smaller, highly leveraged energy firms also had lumps taken out of them. Noble Energy Inc, with a debt-to-EBITDA ratio of 330% at end-2019, saw its stock plunge 46%. Apache Corporation, with a debt-to-EBITDA ratio of 230%, collapsed 61%.
Charles Donovan, executive director at the Centre for Climate Finance and Investment at Imperial College, London, stated that last Monday’s price collapse offered “a rough simulation of a surprise $50/tonne upstream carbon tax on producers” — in other words, a dress rehearsal for an energy transition shock.
Elsewhere Remy Briand, head of ESG at index provider MSCI, said these debt-laden producers are part of the next cohort of “brown” companies heading for bankruptcy, as the collapse in oil revenues brought about last weekend will leave them short of the cash they need to honour their creditors. Their demise was always likely in an economy transitioning away from fossil fuels. Last week’s tumult may simply have brought forward their execution dates.
Even those energy firms on more solid financial footing could topple over a sustained period of low demand. IHS Markit thinks gas guzzling will fall at the fastest rate ever this quarter because of the coronavirus. Now that huge swathes of the US and Europe have been shut down and international travel virtually frozen, it’s highly likely the second quarter will see depressed demand, too.
A Climate Lehman Moment?
This oilpocalypse has sent tremors throughout the financial system. Banks loaded up with “brown” energy loans face crushing losses if their borrowers can’t pay up — a scenario also likely if the carbon bubble popped. As John Paul Getty (an oil man) allegedly said, “If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.”
The Bank of Oklahoma (BOK Financial) is one lender under the microscope for this reason. As of 2019, it had just shy of $4 billion of energy loans outstanding, 28% of its total commercial portfolio. A swathe of analysts downgraded its stock after it fell 22%.
Even the megabanks are vulnerable to an implosion of fossil fuel corporates. Take JP Morgan, which had $41.6 billion of oil and gas exposures in 2019, of which almost half were non-investment grade. The bank states in its 10-K how “a sudden and severe downturn in oil and gas prices” could “incur losses on its loans”. $98 million of these were charged off in 2019. There’ll likely be many more this year.
Top exchange-traded funds are also feeling the heat. The Vanguard Energy ETF, which references 131 energy stocks, is down 34% from March 6. The iShares Broad USD High Yield Corporate Bond ETF, which holds a hefty amount of energy firm debt, is down 6%.
The present tumult presages a ‘Climate Lehman moment’ — the phrase that titles a paper laying out the case for macroprudential climate regulation by Graham Steele, Director of the Corporations and Society research initiative at Stanford Graduate School of Business. In it, he argues that climate risks are highly concentrated in top US financial institutions, through lending, investing and underwriting of fossil fuel companies:
From 2016-2018, six of the eight largest U.S. bank holding companies loaned, underwrote, or otherwise financed over $700 billion to fossil fuel companies, and account for 37 percent of global fossil fuel financing since the Paris Agreement was adopted. If the six largest bank holding companies’ aggregate fossil fuel assets were themselves a standalone institution, they would be the seventh largest bank holding company in the nation, and would exceed the banking agencies’ consensus asset threshold for a systemically important bank holding company.
Steele argues that fossil fuel price-related losses could pile up on top of one another at these megabanks, and at top insurers and asset managers, putting their solvency ratios under pressure. They could also spread panic throughout the financial system by trying to offload their failing assets at fire-sale prices. We may already be seeing some version of this because of the coronavirus.
To guard against climate-related losses triggering a systemic crisis, Steele says that the existing US regulatory toolkit should be deployed to impose enhanced supervisory and prudential measures on those firms that are most exposed.
The Financial Stability Oversight Council (FSOC), a US agency set up under the 2010 Dodd-Frank Act, has the existing authority to designate firms as systemically important financial institutions (Sifis) if their “material financial distress” or the “nature, scope, size, scale, concentration, interconnectedness, or mix of the activities … could pose a threat to the financial stability of the United States”. The Federal Reserve then has the freedom to tailor enhanced prudential standards for firms so designated.
Should the FSOC use its powers to brand a clutch of institutions as climate Sifis, a series of venerable names could be placed under Fed oversight, such as asset manager BlackRock, which Steele says has “both the largest absolute holdings of thermal coal producers, the highest density of coal holdings, and nearly $61 billion in equity in four of the largest global oil companies”.
However, though there’s no need for an overhaul of post-crisis rules and agencies to tackle the systemic risks of climate change, what is lacking is the political and administrative will to get the FSOC to designate fossil fuel-heavy financial firms in the first place.
Today, the FSOC is a shadow of its former self, its reputation in tatters having lost a legal fight on insurer Metlife’s Sifi status and failed in efforts to designate top asset managers as systemically important. Under the Trump administration, it’s also seen staffing cuts and an ebbing away of influence and importance.
The council’s voting members are also almost exclusively drawn from the top regulatory agencies, and include the Secretary of the Treasury and chairman of the Securities and Exchange Commission. These are political appointees, meaning their approach to the FSOC’s mandate is shaped by the aims and objectives of the Trump administration — one that denies the very idea of climate-related risk.
Put simply, the FSOC is not set up today to designate climate Sifis. But it could turn on a dime. Yesterday, the chair of the Federal Reserve said the FSOC “wouldn’t hesitate” to impose additional regulations on nonbank firms deemed a systemic risk in the current crisis.
A revitalised FSOC under a new administration could similarly move quickly to tackle climate risks and prevent the actual popping of the carbon bubble from unleashing the kind of financial devastation witnessed last week.
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