Climate Change Planning: Banks Weigh Risks of Devalued Stranded Assets 

Climate change will challenge businesses’ asset valuations in two main ways. Physical climate change itself will reshape the world, leaving previously fertile areas barren and making it difficult to reach assets effectively un-exploitable. Transitional policies, put in place to mitigate the effects, will also remove the value from accessible assets.

Stranded assets need to be separated from the more common definition of transitional risk. Transitioning to a green economy will require legal and regulatory changes that may prove to be extremely expensive for firms to comply with. The risk that this cost will destabilize the firm’s business model, and substantially increase their credit risk profile, is the most common definition of transition risk. When an asset that is accessible, and currently has ‘potential’ value, is made worthless by new regulation, it becomes a stranded asset. A stranded asset forces a business to rethink its revenue strategy and reduces its residual value in the case of a default. This double hit, to ‘the probability of default’ and the ‘loss given default’, means that asset stranding needs to be considered as a discreet problem within the risk department.

Examples of the potential magnitude of the stranded asset impact can be gleaned from the Carbon Disclosure Project (CDP). This ‘not for profit’ charity published a report in 2019 that estimated that, up to $1 trillion could be lost from its sample base of 215 companies, with one-quarter of that loss arising from stranded assets.

A common rebuttal to the stranded asset question is that governments will pay compensation for stranded assets and so the net loss to the firm will be zero. This rests on an unproven assertion, as policies being developed by progressive governments include transitional subsidies but rarely include direct compensation for asset stranding. Even when policy suggestions are discussed to pay for ‘oil to be left in the ground’, the debate moves to, for exactly how long, and whether or not such payment would be required if oil-based products themselves are banned from production. In conclusion, it is likely that short-term ‘operational’ compensation is paid to facilitate the transition, but where policy means an asset simply becomes worthless, it is far less likely.

Oil is used as an obvious example of a stranded asset, as it fits the definition from both, a physical extraction and transitional policy perspective. That said, assets will be stranded across almost every economic sector. Agriculture could be severely hit by this phenomenon, seeing large areas of arable land reclaimed by a rising sea, salination of wetlands, and reforestation policy. All of these will compound the complexity of the equation that asks us to feed and house more people on less land.

Banks need to include asset stranding in all of their credit assessments when looking at climate change risk. They will specifically have to:

• Create asset stranding as a specific feature

• Change asset valuations throughout stress test to reflect this

• Alter credit profiles to take the asset valuation change into account

• Re-calculate their RWA, as the standard measure of credit risk levels in the balance sheet

• Build tools for loan officers to use to ensure that problem is not being magnified by new business

With these processes in place, assets will still be stranded, but banks will not suffer ‘collateral’ damage of the effect through an unexpected credit shock to the system.