What could the Bank of Canada do to assess carbon risks in our national economy?

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Simply producing the research described above would have the benefit of better risk assessment and management by participating companies. By asking high-carbon companies to consider the financial risks associated with carbon re-pricing and commodity market volatility, the Bank would ensure that Canada’s corporate leaders are alive to material risks to their current business models. One result of such an enquiry would be better understanding of the risk of stranded assets facing individual Canadian companies, as well as a macro-policy blueprint for deflating the carbon bubble by the Bank, should one be found to exist.

Given the importance of accurate company valuations for a healthy stock exchange, stable bank loan portfolios, and general economic stability, it is time the Bank of Canada considered risks posed to Canadian capital markets by over-valued fossil fuel reserves.

Do you smell a risk? The shale gas bonanza and bust

The tendency for speculative investment bubbles, and the damage they can cause is well illustrated by the natural gas market. In the North American “shale revolution,” fortunes were made amidst an apparent explosion in company valuations based largely on declared reserves. This has been followed by a similarly rapid shrinking of company valuations as a result of lower oil prices and declining well yield rates.

The shale oil and gas industries respond that the economics of their businesses can only improve, with the costs of production going down and the market price for their products going up, but we have seen that this is not the case.

Whether or not the Bank of Canada already believes that fossil fuel boom and bust cycles are a structural risk to the national economy, they should carry out the due diligence required to better understand the numbers behind a potential carbon bubble, and this means asking tough questions.

Subsidy Endgame?

A further area that the Bank of Canada might look into when considering risks associated with an economically unhealthy industry is the subsidy regime. As I have pointed out before, parts of the Canadian oil and gas sector are already on government-subsidy life support.

If tax subsidies and more or less free water for shale-gas drilling in British Columbia were scaled back, for example, the companies extracting the oil and gas would not be worth investing in. The recent oil price drop demonstrates the precariousness of many oil and gas companies. Last month, the Canada Pension Plan had to extend extra credit to bankrupt oil sands junior Laricina Energy, who would not even be in business at all but for huge subsidies from the Alberta tax payer. How many other pensioners’ assets are being wasted to prop up companies exploring for oil sands that will never be taken out of the ground?

Adversity and market innovation: adapt or the market will destroy you

To see the disruptive innovation that Canada’s fossil fuel and energy companies can look forward to, consider what has already happened in Europe. The top 20 European utilities were valued at US $1.3 trillion in 2008. Today, they are worth half that. It is hard to find a better example of shareholder value destruction and systemic economic risk in action in the energy sector (if you do, please let me know…). The massive loss of value for these companies was a result of the growing success of renewable energy across Europe, combined with their own errors and blindness to risk.

In order to avoid similar value destruction in the Canadian energy system, the Bank of Canada and institutional investors, including pension funds, need to wake up to the risks of stranded assets and uneconomic fossil fuel reserves currently marked as assets on company balance sheets.

As long as the fossil fuel industry remains wilfully blind to the risks associated with high-carbon high-cost energy, we will have to look to our national financial regulator to protect the Canadian economy against the structural risks posed by over-valued assets. Will they respond to the risk?

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