Forget the housing and tech bubbles -- this is the real reason to worry in 2014. Thanks, energy companies!

Beware of the carbon bubble: The biggest threat to the environment you haven’t heard of yet

Sean McElwee and Lew Daly

While the year’s end saw an uptick in concern about a new tech bubble, the truth is that there’s a much different, scarier bubble we need to worry about: the carbon bubble. What is the carbon bubble? Basically, it’s just another way to describe the worrisome fact that many energy companies are hoarding oil and gas, despite the rest of the world’s effort to move to a more environmentally sustainable economic system. In much the same way that governments fail to accurately measure social progress and sustainability, these companies are stuck in a dying paradigm. As The Economist puts it, “either governments are not serious about climate change or fossil fuel firms are overvalued.”

It’s simple math. In the 2010 Cancun Agreements, the international community pledged to prevent global temperatures from rising by more than 2 degrees Celsius above pre-industrial levels. But even this number is likely far too high. After all, the .8 degrees Celsius temperatures have risen thus far has already severely damaged ecosystems and economies. But given that the current trajectory would, according to IEA economist Fatih Birol, increase global temperatures by 6 degrees, 2 degrees is a politically and scientifically feasible red line. And it won’t be easy: The most recent Carbon Tracker report estimates that to have an 80% chance of holding temperatures below that threshold, no more than 900 gigatonnes of carbon dioxide (GtCO2) can be released into the atmosphere between 2013 and 2049. This range is called the international “carbon budget.”

The problem is, the total known fossil fuel reserves being held would release 2,860 GtCO2 into the atmosphere if burned. Of those reserves, listed companies account for 762 GtCO2; the rest is owned by governments. If all of the potential reserves currently being explored or developed by these companies are included, their reserves jump from 762 GtCO2 to 1,541 GtCO2. What’s more, over the last two years, the number of CO2 reserves listed on the New York Stock Exchange increased by 37%. Assuming that state-owned companies and corporations divide the carbon budget proportionally, listed companies must keep their CO2 emissions below 225 GtCO2, which means that 65 to 80 percent of their reserves cannot be burned. The inevitable conclusion? A whopping two-thirds of reserves listed on markets are potentially worthless.

Steve Waygood, head of Sustainability Research at Aviva Investors, a global asset management company, sums up the conundrum: “Valuations of the oil and gas sector still assume that they will be able to take all proven and probable reserves out of the ground and burn them. Based on credible data we cannot be allowed to do that…” So in much the same way that pre-Great Recession housing prices were based on the assumption that their values would continue to rise and homeowners would pay off their mortgages, the valuation of oil and gas companies is based on the assumption that they will be able to extract resources that must remain in the ground.

Amazingly, even given these realities, companies have allocated up to $674 billion to explore for new, unusable reserves. The Carbon Tracker report finds that, if exploration trends continue at the same rate over the next decade, “it would see up to $6.74 trillion in wasted capital developing reserves that is likely to become unburnable.” Not only will much of their reserves be unusable, but big oil and gas companies face the threat of waning demand as the international community moves toward a more sustainable economy. An HSBC report puts the problem thusly, “The main risk for the oil sector, however, is whether a low-carbon future would lead to lower fossil fuel prices.” The decline in demand will be driven partially by government initiatives and partially by the increase in alternatives (most significantly natural gas). A growing, international divestment movement will no doubt play its part, too.

The carbon bubble has big implications. It could wipe out market capitalization for behemoth firms and render oil states destitute. Companies are still inflating the bubble, and many policymakers, especially those who are subservient to big oil, are turning a blind eye. If the international community is serious about limiting warming to 2 degrees Celsius, carbon assets may face a $20 trillion write-down (the U.S. GDP was $15.7 trillion in 2012). Investors and governments should take note of the growing carbon bubble and work to pull asset prices down with regulation, disinvestment and accurate pollution pricing. Companies should adopt internal pricing mechanisms, as many have done. Companies, governments and individuals should invest in green energy, which will drive sustainable growth. The only other alternative is to continue on the current path, eating up our carbon budget and pushing global temperatures past the already dangerously high levels we are facing.