Thirteenth International Conference on Climate Change: Impacts & Responses

Abstract

Similar to the housing bubble, a carbon bubble is being fueled by misaligned corporate governance structures and market incentives that distort capital allocation. Science indicates that a rapid energy transition is needed; however, oil and gas reserves already vastly exceed what can be consumed and continue to increase. A significant portion of fossil fuel assets will eventually become “stranded”- prematurely obsolete over their expected lives. This study examines the various market actors and motivations that are distorting corporate and financial climate risk management. Incentives and structural impediments among key market participants such as short-termism/myopia, long-term arbitrage costs, agency costs / career self-interest, and analytical and cognitive limitations (e.g., bounded rationality), exacerbate the problem. Recognition of these motivations is an alert for shareholders, investors and others to better manage risk. For example: investors, creditors, and corporate management can incorporate a carbon price when underwriting investments and projects, ensuring appropriate risk-adjusted returns; energy shareholders should focus on executive compensation structures to focus on shareholder profitability and not continued reserve growth; analysts can avoid generating estimates derived from backward looking models and inputs; banks, insurance companies and regulators can reduce future financial contagion by examining incentives that increase stranded asset exposure. All of these actions indicate improved long-term capital allocation that benefits society and long-term business actors. However, the most important corrective would be a carbon price high enough to promote a faster and more comprehensive transition, and thereby reduce further capital misallocation.