Exxon Mobil announced on Oct. 28 that it may have to take the largest asset write-down in its history. The company said that 4.6 billion barrels of oil and gas assets – 20 percent of its current inventory of future prospects – may be too expensive to tap.
Some took Exxon’s statement as evidence that the fossil fuel industry is not doing enough to inform investors about climate change risk. As governments step up efforts to regulate carbon emissions, the thinking goes, fossil fuel companies’ assets are worth less.
It follows the opening of a Securities and Exchange Commission (SEC) investigation into how Exxon discloses the impact of that risk on the value of its reserves. That probe and others build on the claim that the present system of voluntary and mandatory disclosure has failed investors by not providing enough information on the risks of climate change. Disclosure advocates are pressing the SEC to take more decisive action.
But what’s the proper policy that balances the need for disclosure with its costs and impact on confidentiality?
This debate matters not only to investors but to the public as well. Bank of England Governor Mark Carney and others worry that the underreporting of climate change information is creating a big risk for financial markets – a carbon “bubble” – that could lead to a major market failure. Some, like Carney, are worried about a financial crisis similar to 2008-2009.
All this is premised, however, on the notion that investors don’t already have enough information to accurately price in the impact of climate change. A growing body of academic research, including our own, however, suggests markets have access to substantial climate risk information, and that the SEC and others would be wise to tread carefully.
The problem of stranded assets
Regulators in both the United States and Europe have been urging oil and gas companies to say more about the potential for their booked assets to become “stranded” over time.
Stranded assets are mainly oil and gas reserves that might have to stay in the ground as a result of policy actions that seek to limit greenhouse gas emissions. Those limits hinge on keeping global warming to no more than 2 degrees Celsius over preindustrial levels, although some have warned that even warming of 2 degrees is unsafe.
The collapse in coal equities last year highlighted that concern. Intensifying price competition from cleaner energy sources such as natural gas and solar energy and the increasing cost of developing “clean coal” to satisfy government criteria overwhelmed the industry’s already declining revenue.
In the U.S., the SEC and the New York attorney general are pressing Exxon hard to disclose more of this information in its financial statements. Both inquiries raise the fundamental issue of whether the current system has, in fact, failed investors and the public at large.
Currently, the SEC requires full disclosure of all information deemed “material” for investors in companies’ regulatory filings, while everything else is voluntary.
It is far from obvious how much the current system is failing to price risks accurately. As Exxon’s disclosure shows, the market already has a lot of information. And new details are quickly absorbed.
Exxon’s share price fell 2.5 percent after the write-down, but that was more likely a reaction to the sharp drop in third-quarter profit from a year earlier. It was hardly an extreme reaction that suggested investors were taken aback by the asset disclosure.
While that gave investors more clarity about how Exxon is valuing its oil sands assets, information on the risks of that investment had already been widely available from a variety of sources. And regardless of what Exxon says, its share price will partially reflect the disclosures of rival companies. Chevron and Chesapeake, for example, have already cut the value of their oil and gas reserves by billions of dollars, while Total, Statoil and ConocoPhillips have volunteered information on how they incorporate climate change risk into their strategies.
A growing body of academic research also supports this view, concluding that, in general, investors are already pricing stocks based on the vast amount of publicly available information on the costs and risks of climate change.
As the Exxon revelation highlights, however, the market clearly does not have all information. There are good reasons for this. For competitive reasons and business survival, certain company information is kept confidential and private. Companies argue it could be harmful to shareholders if disclosed prematurely.
But the fact that Exxon’s stock did not collapse when it volunteered its write-down news is also evidence that it knew what the markets already knew: namely, that its oil sands operations were risky and expensive.
Costs of carbon
The stock market reaction to Exxon’s possible write-down is also an indication that the climate-related market crisis that some fear is not around the corner.
Our research confirms that financial markets already price much of this climate risk into oil and gas company stocks based on company reports and a vast array of data from public and proprietary sources. These data allow investors to estimate reasonably accurately the effects of climate change on companies, including the expectation of write-downs.
For example, our work suggests that investors first began pricing in this kind of data as early as 2009, when the scientific climate change evidence about stranded assets first became known. Our latest research shows that the share price of the median company in the Standard & Poor’s 500 reflects a penalty of about US$79 per ton of carbon emissions (based on data through 2012). This penalty considers all S&P 500 companies, not just oil and gas firms.
This penalty comprises the expected cost of carbon mitigation and the possible loss of revenue from cheaper energy sources.
Exxon, for its part, says it prices the cost of long-term carbon internally at $80 a ton, matching our market model.
The right mix
All this begs the question of what level of additional mandatory disclosure is needed to improve the “total mix of information available” for investors on which to base decisions.
With climate change a pressing concern, investors certainly have a right to demand more disclosure, and we agree with that. But at what cost?
Indeed, the cost of disclosure can be significant, and it’s not just the direct out-of-pocket costs that policymakers should consider when drawing up new regulations. Indirect costs, such as forcing oil and gas companies to disclose vital confidential information to rivals, could be particularly burdensome to particular companies. And society could pay a heavy price if new rules lead companies to make unwise operating or investment decisions or postpone investment unnecessarily. Energy costs could increase or supplies decrease because of miscalculations.
Additionally, the private sector is trying to fill the gap on its own. Moody’s Investor Service, for example, announced in June that it will now independently assess carbon transition risk as part of its credit rating for companies in 13 sectors, including oil and gas.
Given these and other factors, rather than mandate any new disclosures now, we urge the SEC to first implement a voluntary program along the lines of its successful 1976 program for the disclosure of sensitive foreign payments (like bribes). The SEC’s report on this program showed no harm to the stock prices of participants after they disclosed payments.
In fact, it is often the lack of participation that invites a negative stock price response, as markets often view nondisclosing businesses as those with something to hide.
We would hope that a voluntary disclosure program for climate change would achieve a similar goal. That is, formal disclosure requirements that consider the interests of all parties.
Such a program could initially target a defined group, such as the 50 largest SEC-registered oil and gas firms. That would give the SEC and private organizations like Moody’s the hard data and experience needed to examine the costs, benefits and financial market impacts of climate change risk disclosures.
Doing this would pave the way for more permanent rule-making to better serve the needs of investors, companies and, ultimately, the public.