21 December 2011

Have Markets Misvalued Energy Companies?

A few weeks ago Nicholas Stern had an op-ed in the FT in which he claimed that markets are failing to reflect the risks of aggressive climate policy or climate impacts into the share prices of energy companies. Richard Tol and I submitted a short op-ed in response which was not published, so we publish it here.
Have Markets Misvalued Energy Companies?

Roger Pielke Jr. and Richard Tol

Writing in the Financial Times (Dec. 9) Lord Stern of Brentford suggests that the financial markets have grossly misjudged the valuation of companies that produce fossil fuels, writing, “the market has either not thought hard enough about the issue or thinks that governments will not do very much.” Stern argues that the misjudgment poses a “risk to the balance sheets of large companies – or to the planet, or both.”

Have markets misvalued energy companies? While markets are of course not perfect, for two reasons we believe that in this instance there is no evidence to suggest that the valuation of fossil fuel producers has been grossly misjudged.

First, let us assume that governments around the world decide to take swift and effective action to reduce emissions. Would this mean that fossil fuel companies would go out of business in the near term? No.

Consider the case of Apple. Apple’s revenues depend upon selling products that will be obsolete within years and historical relics in a generation. That does not stop the company from being among the most highly valued in the world. If the world transitions to carbon free energy supply, the big energy producers of today are likely to play a big role.

Under all scenarios for future energy consumption the world is going to need vastly more energy and – whether governments act to decarbonize or not – vastly different types of energy too. Energy majors are so highly valued not simply because of the fossil fuel reserves they own, but because they have the expertise to supply energy at a massive scale along with a track record of successful and rapid innovation, with the ongoing shale gas and ultradeep oil revolutions as the latest examples.

Second, what if governments fail to deeply cut emissions? Might the impacts of unmitigated climate change lead to a dramatic reduction in the valuation of fossil fuel companies?

According to the work of Nick Stern himself this seems highly unlikely. In his famous review of climate change Stern argued that unmitigated climate change might reduce global GDP by as much as 20% by 2100. Using Stern’s own numbers for the most extreme impacts would mean that instead of growing by 2.5% per year to 2100, GDP would grow by 2.24%, with the largest effects occurring at the end of the century. This hardly seems cause for a dramatic revaluation of fossil fuel companies today.

The impacts estimated by Stern on behalf of the British government are very pessimistic compared to the estimates found in the academic literature. Furthermore, changes in the growth rate of the economy have a muted impact on the growth in energy demand.

Indeed, future demand for energy is largely insensitive to whether governments decide to act on climate change. The more than 1.5 billion people without reliable access to electricity will demand access regardless. A world with unmitigated climate change could in fact be more energy intensive, for instance if more people demand air conditioning. In either case the future for energy companies would be bright.

Humans affect the climate system and it is important for policy makers to respond. But it is unlikely that efforts to second guess the market valuation of energy companies will contribute to such responses. Of course, if Nick Stern really believes that energy companies have been grossly over-valued he could put his money where his convictions lie. Who knows, he may one day be the subject of the sequel to the Big Short.

Roger Pielke Jr. is a professor at the University of Colorado. Richard Tol is a professor at the Economic and Social Research Institute in Dublin and at the Vrije Universiteit in Amsterdam.


  1. The best way to reduce the book value of fossil fuel companies is to reduce the price of their product which devalues their reserves. Ironically, environmental restrictions makes fuels more expensive and the value those reserves higher.
    Government regulators seem to play a poor game of checkers, only thinking about the next move. The big energy companies seem play a very good game of chess, thinking 4 or 5 moves ahead. it's no wonder the government's broke and the energy companies are valued by the markets more highly than ever.

  2. Markets tell us the choices people make with their own money--perhaps why Lord Stern has so little faith in them.

  3. I've looked to find when Stern wrote that the Euro-zone would collapse. Oddly, I can't find the reference.

    World-wide amphibian deaths didn't work, and his own preposterous cooking of the books didn't work, so now he's taking another tack. At least the communists took some time off when the Berlin Wall came down. These people just keep talking about their historical inevitability.

    As Pat Moffitt says above, it is each individual - person or institution - that sets their own value on a company. At 57 years old, I have not the slightest interest in what Exxon will be valued at the day after I sell my stock. Even so-called long-term investors can always sell and reallocate if needs be.

  4. According to Bloomberg this morning:

    BP Plc is exiting the solar business after 40 years, countering a trend led by Google Inc. (GOOG), Warren Buffett and Total SA (FP) of investing in the industry just as competition drives down the cost of sun-based power.

    By day’s end BP’s stock was down 1%. (That’s probably a dynamic link where the data is constantly updated.)

    BP’s management has been characterized as “uneven,” but it’s margins are suffering thanks to competition and it can’t justify to itself a reasonable ROI for the business. It’s played a role of battered investor / developer with loads of overpriced assets on its hands, while Google, Total, and Buffet are purchasing operational sites developed by folks who’ve taken a beating on their solar investments.

    If you think of BP as a venture capitalist that lost on this bet, keep in mind that Buffet is not a VC. He and his organization excel at finding companies undervalued in the market that have the potential for continued growth. He’s not in at the ground floor like BP was with solar, but will swoop in when a concern is going yet not fully appreciated by most others.

  5. The Stern review was not only criticized for being too concerned with the more extreme scenarios, but for applying a near zero discount rate. Whatever the economist’s policy-related arguments over discount rates (and Prof. Tol uses 3% plus), the market valuations of share prices are based upon much, much higher discount rates. This is for good reason. Suppose at the end of 1911 someone could have known that there would be an oil embargo in 1973, resulting from a cartel of oil-producing nations usurping the considerable power of the oil companies. What should have been the discount factor on the 1911 price of oil stocks considering in the interim there were two world wars, between which there was a massive global depression? Even if this was the case the local market factors (such as the emergence of the car industry, global growth, the development of the internal combustion engine and the relative fall in the oil price against coal) were far more important than the historical events. I would contend that in 1911, even if were highly likely that an oil company would be rendered bankrupt 60 years later, the discount factor on the share price would be approximately zero.
    Furthermore, since the Stern review the scientific evidence has consistently failed to support the more alarmist scenarios resulting from any further warming (e.g. rapid melting of the Himalayan Glaciers or increased severity of hurricanes), nor for extreme temperature rises resulting from positive feedbacks to the CO2 induced warming. To the outsider looking at the emerging evidence, the cost impact of do-nothing scenarios (weighted by risk) is many times lower than when the Stern Review or AR4 were being published.
    I fully realise that your comments were moderated to increase the chance of publication. However, if a more balanced version of Stern were done on today’s evidence, I firmly believe that (like Prof. Tol has concluded) current proposed mitigation policies do not have any form of benefit-cost justification.