Global carbon budget is a harsh reality check for Canadian investors

The recent report of the Intergovernmental Panel on Climate Change (IPCC) should be a wake-up call for Canada. With a development model based on ever more fossil fuel extraction, Canada’s economy and financial markets are on a collision course with the urgent need for global climate action.

The IPCC, for the first time, stated an upper limit on total greenhouse gas emissions – a global “carbon budget” to keep temperature increase below 2°C. This is considered to be the threshold for “dangerous” climate change, and also the target for international climate negotiations.

A global carbon budget along IPCC lines works out to about 921 billion tonnes of carbon dioxide (gigatonnes, or Gt, of CO2), and that is for a 66% chance of staying below 2°C. The more we emit, the worse the odds get: emit up to 1068 Gt and we are down to a coin toss (50% chance of staying below target).

Canada’s share of a global carbon budget would depend on negotiation, but almost certainly falls between 4 and 24 Gt, based on our share of world population and GDP, respectively. However, Canada’s reserves of bitumen, oil, gas and coal, when converted into potential emissions, are substantially larger: proven reserves are equivalent to 91 Gt; and adding probable reserves yields 174 Gt.

So let’s say Canada’s negotiators are shrewd and they garner a 30 Gt carbon budget because Canada is a fossil fuel exporter. That budget still means two-thirds of Canada’s proven reserves, and 83% of proven-plus-probable reserves, need to remain underground.

This math should alarm institutional investors, and pension funds in particular. Because stock market valuations are premised on those companies extracting those resources, analysts have called this a “carbon bubble” in our financial markets.

This is bad news for the Toronto Stock Exchange (TSX), which is highly weighted towards the fossil fuel sector, with total market capitalization of fossil fuel companies around $400-500 billion. Fossil fuel companies account for about 24% of the total value of the S&P/TSX60 index.

Rights to future income through employer pension plans is the second-most important asset (next to home ownership) for a wide swath of middle-class households. Registered pension plans cover more than 6 million members in Canada, and the total market value of trusteed pension funds in 2012 was over $1.1 trillion, of which almost one-third was held in stocks.

Pension funds are now waking up and starting to make the connections between their investments in fossil fuels, and whether that makes sense in a world of constrained carbon. A group of 70 large institutional investors with $3 trillion in assets recently called on fossil fuel companies to respond to the brutal logic of carbon budgets and climate science with detailed assessments of their climate risk.

Earlier this month, the City of Vancouver took an important first step by seeking a review of its own pension fund investments in fossil fuel (and other harmful) industries. This was driven by a staff report noting that the City’s mission and values, including its ethical purchasing policy and eco-friendly aspirations, are not aligned with its pension fund investments.

What’s interesting about pension funds is that they must account for intergenerational equity. They have to generate maximum current return value for existing (and soon-to-be) pensioners, but at the same time they are legally obligated to ensure the long-term sustainability of the fund. That is, funds must equally represent the interests of young workers for their eventual retirements.

While pension funds are now seeking to talk to companies about whether their capital plans make sense, their position has been strengthened by a growing movement calling for fossil fuel divestment. Students concerned about climate change have been leading the way by targeting university endowments.

The divestment movement is based on moral arguments about climate change. But we should not ignore the economic arguments: if you do the math, any plausible carbon budget for Canada means the vast majority of fossil fuel reserves will need to stay in the ground.

In short, extreme weather, oil spills and other damages from fossil fuel development suggest it is only a matter of time before the world gets serious about climate change. When that happens, a day of reckoning is coming for Canada’s fossil fuel companies, the bulk of whose fossil fuel reserves will become stranded assets. A “managed retreat” from those investments is in order, and much preferable to a meltdown.

[Published in the Globe and Mail’s Economy Lab]