1. There have been recent claims that the market value of fossil fuel companies is grossly overstated and about to collapse (here, here).  One report went as far as concluding that this would cause a major economic crisis (here). Is there a carbon bubble about to blow? Bubbles are being blown, for sure, but rather by the researchers making up fantastical claims (here). See also this curious we-know-he's-wrong-but-we-don't-want-to-offend-Lord-Brentford piece in the Economist.

    Let us consider the causal chain step by step.
    (1)    Climate policy is about to end the use of fossil fuels, making fossil fuel reserves worthless.
    (2)    Fossil fuel reserves are a major determinant of the value of fossil fuel companies.
    (3)    The stock market value of fossil fuel companies is a major determinant of the business cycle.

    The first hypothesis is readily dismantled. Europe, the self-proclaimed leader in climate policy, has seen a collapse of the price of carbon dioxide emission permits. Attempts to reform the EU Emissions Trading System have been blocked by politicians who think that cheap energy is more important right now. Japan is likely to abandon its emissions target after this summer’s elections. The Obama administration has ceased to try and find bipartisan support for climate legislation. China is the only ray of hope to those who wish for a stringent climate policy. There are persistent signs that China will regulate emissions before the decade is over, but no sign that regulations will be particularly stringent.

    None of this particularly relevant, however. The claim is that there is a carbon bubble. That is, the “market” puts an unjustifiably high value on fossil fuel reserves. Put differently, traders believe that climate policy will continue to lack ambition for the foreseeable future, but politicians are secretly plotting to implement a stringent climate policy soon.

    As soon as the “market” expects that new regulation will seriously devalue an asset, its price drops. Bubbles only arise if the “market” is misinformed. The “market” is by no means infallible when it comes to pricing risk, but an expectation of “not much climate policy any time soon” strikes me entirely realistic.

    Refuting the second hypothesis requires more specific knowledge. The market value of fossil companies is based on a number of factors, chief among them the expected dividends over the next few years. The value of a company’s assets in the long term is heavily discounted, and particularly so in a business as uncertain as energy exploration and exploitation. Fossil fuel reserves and resources are often owned by states or state-owned companies rather than by public companies. The supermajors in oil and gas add value through their expertise in engineering, project management, and finance, which could be redeployed to other activities in energy and other areas.

    In the unlikely case of unexpectedly stringent climate policy, sovereigns would be hit. This is one reason why climate policy will not accelerate much. It is not wise to cause unrest in Iraq, Iran, Russia, Saudi Arabia or Venezuela.

    The third hypothesis ignores basic facts. Fossil fuel companies are among the largest companies in the world, but their total market capitalization is small relative to the total stock market. Even if they were wiped out completely, the world economy would shrug its shoulders and move on. We have witnessed rapid falls in the stock market value of fossil fuel companies – of all companies as the oil price fell, or of particular companies as disaster struck – and we know from those episodes that the economic impact is limited.

    In sum, there is no carbon bubble. If there were a carbon bubble, it would not be about to burst. If it would burst, the economic impact would be minimal.

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