Are Coal, Oil and Gas the Subprime Assets of the Future?

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This is a guest post by Danย Zegart

That question was actually asked by British Secretary of State for Energy and Climate Change Ed Davey last year, and its ramifications are extensively explored in a provocative report released today by the Center for International Environmental Law, a Washington, D.C. thinkย tank.

According to CIEL, the answer to Daveyโ€™s question is a resoundingย โ€œyes.โ€

The report makes a compelling case that the three big financial rating agencies โ€“ Moodyโ€™s, Fitch and Standard & Poor – that gave clean bills of health to the toxic financial products that caused the 2008 worldwide financial meltdown are giving similarly bad advice to investors by rating fossil fuel investments without acknowledging climate change-relatedย risk.

Along the way, the report, called โ€œ(Mis) Calculated Risk and Climate Change: Are Ratings Agencies Repeating Credit Crisis Mistakes?,โ€ stresses the potentially enormous legal liability for the agencies if their ratings understate the pitfalls of what are likely to be severe climate impacts on oil, gas, and particularly coalย companies.ย 

Coal is not only the leading contributor to atmospheric CO2 levels, it is the most financially dangerous investment. Coal prices have plummeted. Between 2010 and 2014, three coal plants were delayed or scrapped for every one built. After being dropped from Standard and Poorโ€™s 500 Index in September, Peabody Energy, the worldโ€™s largest private sector coal firm, was dropped from Standard & Poorโ€™s MidCap Index today because its market cap has plunged from $3.9 billion to just $700ย million.

Other recent developments have made the idea of stranded fossil fuel assets far more tangible. These have included the G-20 conference asking for an investigation into $6 trillion in planned fossil fuel extraction investments, the wholesale divestment from coal by the Norwegian Pension Fund, and the International Monetary Fundโ€™s repeated calls for an end to fossil fuelย subsidies.ย 

So far, the Big Three rating agencies have ignored all this โ€“ just as they, along with the rest of Wall Street, ignored both common sense and strong evidence that housing prices would not rise forever.ย  The U.S. Financial Crisis Inquiry Commission, which probed the causes of the 2008 crash and worldwide depression, called the three rating firms โ€œkey enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards that were hinged on them. This crisis could not have happened without the rating agencies.โ€ย 

Now the agencies are again playing the role of the blind leading the blind, relying on the assumption that no steps will be taken to reduce fossil fuel reliance, and that a warming world wonโ€™t interfere with business as usual.ย  CIELย writes:

โ€œMany in the finance industry continue to rely on the current โ‰ฅ4ยฐC climate scenario (a โ€œcarbon bubbleโ€), just as many relied on scenarios where housing prices did not decrease or stabilize. Indeed, the financial risks of a 2ยฐC climate scenario loom large, just as the risks of sub-prime mortgages loomed over the financial industry prior to the credit crisis. Some analysts project that the fossil fuel industry could lose $28 trillion USD of revenue over the next two decades.ย  Recently, the Bank of Englandโ€™s Finance Policy Committee announced that it will investigate whether the carbon bubble could lead to a financial collapse.โ€ [The 4-degree scenario is one in which no measures are taken to restrict warming to 2ย degrees.]

To nail down how wrong-headed the ratings system can be, CIEL looks at Moodyโ€™s decision in the fall of 2014 to give a Baa3 rating, which is investment grade, to the $150 million in bonds issued to finance the Adani Abbott Point Terminal, a port facility that will be part of the massive Australia-Galilee Basin system of mines and rail lines designed to get Australian coal to Asian markets.ย  Dubbed a โ€œcarbon bombโ€ by environmentalists, Galilee coal will create substantially more CO2 each year than Australiaโ€™s entire current annual greenhouse gasย emissions.ย 

The Adani situation is a neat microcosm of the entire problem with the Big Threeโ€™s approach to carbon โ€“ or rather, its lack of an approach.ย  Moodyโ€™s used a generic project finance methodology to assess the investment risk, the same method it uses for non-carbon intensive projects โ€“ for example, parking garages.ย  That methodology assigns only 15 percent weight to exposure to event risk, 25 percent to long-term commercial viability, and a whopping 60 percent to cash flowย stability.ย 

And Moodyโ€™s vastly overvalued the price Adani coal will fetch on the market – $84/ton when prices at the time of rating were just above $70.ย  And India, where Adani plans to sell most of its coal, six coal plants have been postponed or dumped for every one built, while the government has announced plans to vastly upscale its use of renewableย energy.

This is all in addition to the likelihood of major disruptions to mining operations from a spike in extreme weather events along the Australian coast, such as more ferocious cyclones, high temperatures, and heavy rainfalls that can flood the mines, shutting them down forย months.

All of which could lead the rating industry back to one of the ugliest moment in its legal history.ย  Following the 2008 crash, large institutional investors โ€“ most notably, CalPERS, the California Public Employees Retirement Systems โ€“ sued the rating agencies.ย  In the CalPERS case, filed against Moodyโ€™s, the court brushed away the agencies traditionally successful defenses, and approved the suit going forward on the basis of a negligent misrepresentation claim.ย  The CalPERS appellate court opinion quoted an expert who said the ratings agencies โ€œhad no empirical or logical basis of assumptionโ€ for the ratings it gave to the financial products CalPERS purchased. Moodyโ€™s settled โ€“ a development that would have been almost impossible to conceive a few yearsย earlier.

Based on Moodyโ€™s handling of the Adani bonds, one could easily imagine a similar expert opinion in a climate lawsuit, and a similarย outcome.

That could turn out to be a legal roadmap to doom that convinces the Big Three to take a more realistic view of what the future holds for fossil fuels.ย 

Image credit: Abandoned coal mine via Shutterstock.

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