Over the past decades, markets have invested in damaging industries such as fossil fuels and financial speculation. This has contributed unsustainable development, and may well be creating an enormous ‘carbon bubble’. However, there are steps we can take to stop this bubble turning into another subprime-to style crisis.

Large sums of money, private as well as public, have for a long time been invested in sectors that counteract sustainable development. In the report Towards a green economy: Pathways to Sustainable Development and Poverty Eradication, the UNEP describes how a number of crises – for example relating to the climate, biological diversity, fuel, food, water, the financial system and the economy at large – have one basic element in common: the large-scale misallocation of money: “during the last two decades, much capital was poured into property, fossil fuels and structured financial assets with embedded derivatives, but relatively little in comparison was invested in renewable energy, energy efficiency, public transportation, sustainable agriculture, ecosystem and biodiversity protection, and land and water conservation”.

Private investors as well as public subsidies and loans have contributed to unsustainable development. For example, the World Bank and the European Investment Bank (EIB), as well as private pension and mutual funds, have, through their investments, counteracted political targets.

The threat of great, irreversible and devastating climate change is imminent and illustrates the problem with the misallocation of capital. Steps taken by the international community, as well as by private actors, to tackle the climate issue are counteracted by steps taken in the opposite direction.

Uncontrolled climate change or collapse of the stock exchanges – the carbon bubble in the finance sector

Two major climate-related risks are connected in a way that is problematic no matter how we tackle the issue: if known coal, oil and gas reserves are burnt, the politically-agreed 2°C target will not be met. If, on the other hand, these energy reserves are left untouched, it affects the valuation of the companies that own the resources. If the evaluation of the fossil energy companies is a bubble, the effects if the bubble bursts could prove devastating for pension funds and the stock market. If politicians and the international community are serious about their ambitions not to surpass the 2°C target, it is just a matter of time before the bubble bursts. Politicians and other decision makers must shoulder their responsibility and act to minimize the harm.

The threat of great, irreversible and devastating climate change is imminent and illustrates the problem with the misallocation of capital.

Carbon tied up in known reserves of fossil fuels in listed companies

In order for there to be a reasonable chance of achieving the 2°C degree target, there is room to emit 565 billion tonnes of CO2 (GtCO2) into the atmosphere by 2050. This assessment is uncertain, however, and the probability of going beyond a temperature increase of 2°C is 20%, which is essentially playing Russian roulette with the survival of civilisation (Carbon Tracker, 2011).

The 100 major listed carbon companies and the 100 major listed oil and gas companies have between them fossil fuel reserves corresponding to 745GtCO2. That is 180GtCO2 more than the 565GtCO2 there is room for. If we use the known resources of these listed companies, we will emit so much CO2 that the global temperature increase will surpass 2°C. The consequences are impossible to ignore.

Carbon tied up in known reserves of fossil fuels

Apart from reserves in listed companies, there are reserves of carbon, oil and gas in other companies and in public ownership. The largest known reserves can be found, for example, in Saudi public oilfields or gas fields controlled by Russian oligarchs. Even if some observers claim that the reserves in the Gulf region have been exaggerated for political reasons, we have already found more fossil fuels than we can ever use whilst staying within environmental limits.

CO2 in the fossil fuel reserves known today – taking into account listed as well as unlisted companies – amounts to 2,795Gt, of which 65% comes from carbon, 22% from oil and 13% from gas. This means that, in practice, governments and the global market have available a fossil fuel resource which is five-fold greater than the global carbon budget for the next forty years.

Unconventional reserves – oil sand and shale gas

Apart from the known supplies of oil etc., there are large so-called “unconventional” energy reserves. The estimates for these, for example oil sand, are – due to the accounting principles in certain countries – conservative. In Canada, for example, the reserves are not accounted for when they are discovered, but only when the oil is taken up from the ground. In other words, the Canadian stock markets could offer a few surprises in terms of hidden CO2.

Other unconventional resources not stated in the figures above include shale gas, which emits more CO2 than conventional gas. Shale gas fracking also creates a number of other problems; for example, the great quantities of chemicals used can adversely affect human health. The underestimation of unconventional reserves, and the fact that they are more carbon intensive, affects how much emissions can be reduced by.

New findings

Large amounts are invested yearly in the search for new fossil fuel reserves or to squeeze out more from the existing ones. In 2010 the investments of listed oil and gas companies only were an estimated 798 billion dollars, of which a dwindling part was invested in renewable energy. To this should be added investments in unlisted companies that together control two-thirds of the world’s fossil fuel assets (Initiative Carbon Tracker, 2011). If only a fifth of known reserves were to be used, which is the only reasonable approach if the precautionary principle is applied, this will have significant consequences for financial markets and therefore our pension funds.

Effects for the fossil companies – the carbon bubble

Using a fifth of the total reserve of fossil fuels means that only 149 out of 745 GtCO2 from listed companies can be emitted. If decision makers are serious about the 2°C target, investors risk getting stuck with “unburnable carbon”. This constitutes nothing other than a carbon-based asset bubble as lifting away 80% of the declared reserves from the market would have significant consequences for the companies’ rating.  A strict implementation on the stock market would result in a re-evaluation of the fossil fuel companies’ assets, making earlier price adjustments, such as when real estate or IT bubbles have burst, look marginal. This situation has arisen and been allowed to continue as no financial control unit has the responsibility to systematically monitor climate related risks.

If only a fifth of known reserves were to be used, which is the only reasonable approach if the precautionary principle is applied, this will have significant consequences for financial markets and therefore our pension funds.

The risks involved in, on the one hand, the burning of carbon and the resultant effects of climate change, and, on the other, the regulation of fossil fuel use and the consequent devaluation of companies’ fossil fuel assets, are of such magnitude that social stability is threatened. Authorising and regulating authorities in both the financial and environmental domains should, together with investors and creditors, take these risks seriously. The EU is currently discussing the idea of introducing its own credit rating institutes, due to dissatisfaction with the market’s inability to foresee and deal with the Euro crisis. In addition, we need to establish an institute for evaluating the financial risks which result from environmental problems. Investments in fossil fuel companies or in the search for new fossil resources would automatically be given junk status. Both the environment and the economy stand to gain from AAA investments which take environmental problems into account, that is, investments with the highest grades, or the lowest risk, according to the rating agencies.

Time to take on the capital market carbon bubble

The European Union should consider making it mandatory for banks and other credit institutions to account for their exposure to climate risks. This is at least something the authors of the report Funding the Green New Deal  suggest. They believe that the climate risk is so significant that is should be understood as systemic. It should be mandatory for banks, other financial institutions and investors to evaluate their CO2 exposure in lending portfolios as well as investments. This would facilitate a shift of hundreds of billions worth of investments from the “dirty” to the green sector. One example is mandatory stress tests to investigate how an investment would be affected by increased fuel and emission prices. Such a test would increase the investors’ awareness of the CO2 risks they are exposed to. Swedish state-owned company Vattenfall can serve as a warning example: their expansion into Poland and Germany could prove expensive. Had the company accounted for the costs of CO2 emissions increasing over time, investments in lignite would perhaps have been lower. Stress tests would also illustrate the investment opportunities in the green sector. Green investments would constitute a well-needed diversification and risk reduction, not least for the well-filled coffers in the public funds of oil countries.

The European Union should consider making it mandatory for banks and other credit institutions to account for their exposure to climate risks.

Conclusions and recommendations

The fossil fuel sector seems to be over-capitalised. The capital market has made decisions about financing the future production of fossil fuels based on an incorrect assumption: that was has been financed could actually be used. This constitutes a great and presently unheeded risk for the capital market. Using all fossil fuels presents a risk for the whole of humanity. Stuck as we are between a rock and a hard place, uncontrolled climate change must be regarded as ten times worse than a financial carbon bubble.

Taking responsibility – regulating authorities and stock markets

The British Department for Environment, Food and Rural Affairs (DEFRA) and the Climate Disclosure Standard Board (CDSB) draw the conclusion that regulating authorities need to act: “… the scale of environmental investing [will] grow only if the entire market would first swing to environmental investing. (…) Without structural intervention of some sort, an impasse is likely to remain.”(Financial Institutions: Taking Greenhouse Gases into Account). This implies that voluntary action has peaked and those most ready to act have already done so.


Taming the Giant – Towards a Sustainable Financial System
Taming the Giant – Towards a Sustainable Financial System

How to create a financial system that helps, not destroys, the real economy? Seven years on from the financial crisis that heralded the great recession, this question remains unresolved.

Cookies on our website allow us to deliver better content by enhancing our understanding of what pages are visited. Data from cookies is stored anonymously and only shared with analytics partners in an anonymised form.

Find out more about our use of cookies in our privacy policy.