Climate change will change many aspects of our daily lives. Energy, construction, transport, all sectors will be affected.
For a company, it will be essential to anticipate future changes, so as to choose the right long-term investments.
This article will go through the concept of stranded assets within climate change related risks.
Stranded assets in accounting
Depreciation and stranded assets
When a company invests, it includes the price of this investment in its yearly balance sheet. The investment then becomes an asset.
Not all investments last forever: a machine, for example, will stop working after a certain number of years; a trademark is only usable for a certain number of years.
The value of these assets in the accounting books will thus diminish over time. When an asset is no longer usable, it will lose all value. This is known as a depreciating asset, a concept used to determine the value of an investment over time.
Whereas there is “predictable” depreciation (the duration of a trademark), some unexpected events (a machine breaking) can decrease the value of an asset.
Here comes the stranded asset, an asset that loses its value, or becomes unusable, in a sudden or unexpected way. Some assets can become stranded because of climate change.
A stranded asset represents a big loss for a company, as it cannot yield the profits expected by said company.
What can cause an asset to be stranded?
Stranded assets existed before integrating risks of climate change. Some assets can become stranded by the arrival of a new disruptive technology, like computers replacing typewriters.
Climate change has, however, led to new situations that can cause assets to lose value earlier than envisioned. Some climate-related stranded assets are, for example, those that won’t be compatible with limiting global warming to 2℃.
There are multiple factors that can cause an asset to be stranded:
Climate change has caused an unprecedented amount of natural disasters in the past few years. The WMO, World Meteorological Association, has stated that destruction caused by natural disasters (droughts, hurricanes, wildfires, etc.) represented 74% of economic losses from 1970 to 2019.
In August 2021, for example, Hurricane Ida caused $75 billion worth of damage in the USA, causing extensive and long-term damage to the energy infrastructure in a part of Louisiana.
Stranding caused by changes in regulation
Climate change pushes states and world organisations to implement new regulations against global warming. Because of such legislation, some assets are rendered unusable and become stranded.
With changes in regulation, some coal mines, for example, become stranded as coal exploitation is limited, or banned. Also, the European Union voted to stop selling thermal combustion cars by 2035, meaning that many of these cars will be unusable much earlier than first predicted.
Economic stranding can be caused by regulation changes, such as changes in production costs making an asset unusable. A green tax on petrol, for example, could make some assets unusable or less profitable.
In the housing sector, regulation changes concerned with climate change could have potentially detrimental effects, colloquially known as the brown discount.
The growing desire to have “green” buildings (meaning well-insulated and energy efficient) has meant that more environmentally-friendly buildings will have a higher asking price on the market. This means that buildings that are less green will become the more affordable option.
Stranded assets and transition risks
Most climate-related stranded assets will be those that do not fit into a low-carbon world. Climate change thus exposes some assets to risks that are coined transition risks.
In order to anticipate such risks, it is vital to be aware of potential changes in regulation to do with climate change, especially if the industry you work in is likely exposed.
Which sectors are most exposed to stranded assets?
The first to be affected are the companies linked to fossil fuels, whether it is the extraction, refinement, or distribution of said fuels. In order to respect the Paris Climate Agreement, coal mines will have to close down 10 to 30 years earlier than their classic life expectancy.
Companies that consume a large amount of fossil fuels are also at risk of having stranded assets. Such companies are within the construction or transport sectors.
Banks are also at risk of stranded assets, as they have investments in the sectors mentioned above. Banks thus run the same risks as construction, transport, or energy production companies.
What are the potential consequences of stranded assets on banks?
The wealth of a bank depends on the entirety of its investments. These investments are accounted for and regularly reevaluated.
A bank would lose money if its assets became stranded. Banks would thus have to measure and limit their exposure to the sectors most at risk of being stranded, like mines or oil rigs. Insurance companies are already taking the issue of stranded assets seriously, and it is recommended that banks do the same.
Regulation for the transition risk faced by the banking sector
Regulation imposed on banks is becoming ever more restrictive, with the aim that banks move towards greener investments.
The European Banking Authority has pushed banks to adopt the Green Asset Ratio (GAR), which measures the number of green investments in a portfolio. From 2024, banks will need to start publishing their GAR.
This measure is part of a larger push toward non-financial reporting, focused on green investments and carbon emissions.
With the danger of stranded assets, European legislation imposes constraints on companies and helps them with transition risks, by making them aware of both the climate risk and the transition risk.
Reaching carbon-zero in the most polluting sectors will only happen with the help of the banking and finance sectors. Plans to limit stranded assets should be put in place, so as to minimise loss of value for everyone.
Stranded assets are particularly important when considering the risks linked with climate change. When investing, it is essential to take such ecological factors into account in order to determine the return on investment.
The banking sector is particularly exposed to transition risks, so must put measures in place to reduce risk and follow other sectors toward a carbon-neutral world.