As last week ended, I looked over notes cobbled together on coverage of the COP26 global climate summit in Glasgow. To my surprise, a practical structure for transition to a low carbon economy emerged. It was further supported by news and events during the first part of this week as well. Perhaps it was “out there” all along, but I hadn’t seen a clear and specific solution expressed in easy-to-understand terms before. So I’m going to throw it out there, keeping out of the weeds as much as I can.

There are three critical cornerstones of the model:

  1. Cost-effective energy must continue to be available.
  2. There is no acceptable alternative energy solution ready to deploy at scale in the near term to replace fossil fuel.
  3. Allowing energy producers to operate profitably is necessary to achieve #1 and #2.

This means that in the short term, fossil fuels are necessary, but bound by even more complicated (and time-bound) supply & demand dynamics than normal.

A Possible Model

What could come out of COP26 builds on Larry Fink’s “good bank, bad bank”: a pragmatic business model where carbon intensive companies separate their fossil fuel assets (the “bad bank”) from lower carbon/alternative energy based assets (the “good bank”). Note that “good” and “bad” are his wording and way of describing this in simple terms – we aren’t casting a values judgment.

Fink described operating the “bad bank” like a declining trust where it would fund the “good bank.” Carbon taxes being discussed (and proposed as part of a Biden Administration program that may actually see the light of day) would act not only as a potential disincentive to simply shuffling ownership of carbon intensive assets, but also help fund “good banks” to further bolster the business model. If “good banks” are funded by their own operations and a meaningful portion of “bad bank” revenue, they can be less reliant on governmental support, allowing government support to be spread around more widely to more lower carbon companies/technologies. At some defined point in time, carbon intensive assets would cease operation as they are replaced by lower carbon operations.

Certainly there are complexities, but the basic principle is tested. As one example I experienced in the 1990s, I worked at Georgia-Pacific Corporation when the company spun off all its timber properties into a standalone stock, fully separating manufacturing operations/assets from the timber holdings. It is common for companies to spin-off lower performing operations as a means to focus the business and improve returns. As reported a few weeks ago, an activist has targeted an oil major to suggest a similar breakup.

There are complications, especially with running a company out – one being funding asset retirement obligations (AROs) of “bad banks” to help prevent them from creating long-term environmental problems. My friend Greg Rogers has been preaching this gospel for years. AROs are an unfunded balance sheet liability. Long term risks such as third-party claims, plant decommissioning and environmental risks are part of AROs that must be addressed. To fund them, “bad banks” would need a significant amount of revenue from operations, reducing what is available for “good banks.”

Insurers can help by bringing new coverage solutions for AROs, or expanding capacity for existing applicable coverage types. With the industry under fire recently for supporting fossil fuel companies, carriers would want to communicate clearly on the key role they would play in helping “bad banks” through the transition. 

This brings me to offsets. If a practical transition structure gets legs, offsets may be less valuable than anticipated – and sooner. For buyers, this might be good news as they may be able to rely on clearly defined physical emissions reductions rather than more controversial approaches like nature-based sequestration. It is possible the hundreds of millions in capital being put toward offset mechanisms right now could be more at risk than is apparent. Moody’s issued a new report indicating that indeed some sectors have moved forward more quickly than expected, and others are poised to do so.

What This Means for You

For those in the offsets market (both buyers and sellers): Consider the impact of more rapid and meaningful physical emissions reductions on your offset purchasing/pricing strategy. Investors in offset mechanisms should think about the impact of accelerated value/demand reduction surprises due to speedier business transition.

For carbon intensive companies:

  • Consider undertaking a vulnerability and opportunity assessment of businesses with a near- and mid-term perspective.
  • Model emerging business structures to support carbon transition based on the findings of the assessments.
  • Evaluate availability, pricing and terms for risk transfer options to manage asset retirement obligations to support a transition.
  • Be aware that activists are increasingly using ESG issues as part of their campaigns. Consider this in your vulnerability assessments – do not be caught flat-footed.

For insurers: Consider developing or expanding coverage for AROs to support a transition. Most of the exposures are types that are already insurable and familiar. Yet it could mean creating new policies, underwriting models or expanding capacity for what may be a huge market in a few years.

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