The transition to a low carbon economy carries both opportunities and risks. One of the risks is the stranding of assets, affecting companies and insurers, both in terms of investment and claims.
The concept of stranded assets is not new. Stranded assets are those that have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities due to changes in their risk profile. However, this issue has become more high profile recently due to the risks presented by climate change. Such risks can be physical, such as changes in the environment, or societal, such as regulation, legislation, litigation, changing social norms and consumer behaviour.
How will companies be affected?
The issue is already on the radar of major fossil fuel companies. Shell’s 2022 Annual Report stated the transition to a low carbon economy could result in underutilised or stranded oil and gas assets. In 2020,Exxon was reported to have written down between US$17bn to US$20bn in natural gas holdings as stranded assets, and TotalEnergie identified a Canadian oil sands project at risk.
However, the transition is not straightforward from a business planning, regulatory or political perspective. Indeed, it poses a set of highly complex challenges. While the shift from carbon-intensive assets is arguably not moving at the appropriate and necessary pace, we have seen as a result of recent geo-political developments that fossil fuel companies are generating record profits and global trade and economies remain fundamentally dependent on fossil fuel derived energy. What is clear is that the risk for companies in relation to stranded assets is going to depend on how the transition to a low carbon future plays out, and that itself is subject to volatilities and uncertainties.
A methodical transition would be of most benefit. As the Organisation for Economic Co-operation and Development (OECD) highlighted in 2015, a progressive and collaborative approach would mean “less value will be destroyed and more can be re-invested in low-carbon infrastructure”.
Regrettably, the risk of a sudden, disorderly transition becomes greater each year. This could be prompted by a single trigger event providing the necessary urgency to wider action. From a societal perspective, this could be the introduction of a carbon tax, a significant piece of litigation or a sharp reduction in the cost of renewable energy technology. The trigger could also be physical, such as a series of natural disasters or extreme weather.
In 2022, the Financial Stability Board and Network for Greening the Financial Sector completed scenario exercises which demonstrated that there were more significant GDP and financial losses in the event of a disorderly transition.
The consequences of transition risks are unlikely to be limited to fossil fuel companies. Wider energy infrastructure, such as pipelines, refineries, engineering facilities and transport could also be subject to stranding in the transition to a low-carbon future.
As far back as 2015, the OECD highlighted that other carbon-intensive activities such as cement, steel, petro-chemicals and aviation may also be exposed to the risk of stranding and warrant a closer look by financiers.
Where is the risk to insurers?
Insurers are, and will have to continue, to consider the cascading impact and tangential effects of the transition and possible asset stranding.
Plainly, there are significant physical risks associated with climate change, but from a D&O perspective, for example, we have already seen the recently issued shareholder derivative action by ClientEarth against Shell. The action, alleging the board of directors is failing to manage material and foreseeable risks posed to the company by climate change, is an example of the creative methods climate activists are using.
The physical outcomes of climate change are already apparent. Directors of companies will be expected to take measures to protect company assets. If companies are forced to abandon assets in certain locations due to volatile weather trends rendering them no longer financially viable, claims are likely to follow. The passage of carbon reduction legislation leading to stranded assets, will lead to questions being asked of boards about their preparation, particularly fossil fuel companies.
It is not unreasonable to foresee social unrest occurring in various locations in the event of a disorderly transition. Property damage and business interruption claims may follow.
The tangential impacts of events should not be underestimated. There may also be losses in pension funds which chose not to divest their carbon holdings. Mass unemployment could be caused by a financial crisis following the loss of value of fossil fuel companies.
What can insurers do?
In short, it remains the fact that alongside the general debate surrounding ESG, the cost associated with stranded assets, and the risk to corporates, investors and the broader economic system is the one constant that needs to be addressed.
The insurance industry, and its regulators and supervisory bodies, are well aware of the threats associated with climate risk and transition. For example, on 24 May 2022, the Bank of England published the results of its 2021 Climate Biannual Exploratory Scenario (CBES) which endorsed the potential drag effect of climate risks on longer term profitability of UK banks and insurers together with the need for a well-managed approach to managing climate risk. The report itself identified the difficulties associated with projecting climate losses and a subsequent report, published in 2023 by the UK Centre for Greening Finance and Investment and the Climate Financial Risk Forum, found CBES was a good first step in improving the awareness and capability of financial institutions. However, to improve future scenario planning, it was suggested that closer alignment with expected and potential UK policy should be sought.
In the meantime, insurers are already utilising their significant knowledge and expertise in the development of policy and regulation to help them manage the transition. The assessment of climate risk already forms part of many insurance underwriting and investment activities. However, there can be no complacency in respect of the challenges these issues present.
The complexity of the challenges confronting insurers is more recently evidenced by the withdrawal of three participants in the Net-Zero Insurance Alliance. Those who have withdrawn have stated ancillary reasons for doing so, indicating they remain committed to the principles underpinning the NZIA. But the ancillary reasons and withdrawal highlight the practical challenges transition entails.
Insurers are clearly aware that an orderly transition to a low carbon future will create less risk of asset stranding and associated financial risk and losses. The insurance industry remains uniquely placed to invest in a well-managed transition to low-carbon energy sources, and the associated changes in infrastructure.
This article was first published in Insurance Day.
