Stranded Asset Risk and Political Uncertainty: The Impact of the Coal Phase-Out on the German Coal Industry.

• Author: Breitenstein, Miriam

1. INTRODUCTION

   Under the 2015 Paris Agreement, the global community committed itself to keeping global warming well below 2.0[degrees]C (UNFCCC. 2015). In its 2018 report, the Intergovernmental Panel on Climate Change (IPCC) stresses the potential impacts of global warming greater than 1.5[degrees]C above the pre-industrial levels. It endorses the obligations set within the Paris Agreement to keep global warming below 2.0[degrees]C and, at best, to limit it to 1.5[degrees]C (IPCC, 2019). One step toward this end is to phase-out coal-fired power generation (Zhao and Alexandroff, 2019). This is especially important for Germany because, on the one hand, the country is struggling to meet its own voluntarily set obligations, most notably its greenhouse gas emissions target for 2020 (Heinrichs et al., 2017), and, on the other hand, coal is the largest source of CO2 emissions in the German energy sector (Umwelt Bundesamt, 2021). (1)

   To achieve the national climate targets, the German Government has appointed the German Commission on Growth, Structural Change and Employment, commonly referred to as the Coal Commission, to develop a national emission reduction initiative. It presented its final report in early 2019 (Federal Ministry for Economic Affairs and Energy (BMWi), 2019). In this final report, the Coal Commission, which included representatives of all the major stakeholders (industry, consumer and non-profit groups, and environmentalists as well as federal and state governments), suggested phasing out coal-fired generation by 2038. (2) It has been argued that a phase-out by 2038 might be too late to meet the 2.0[degrees]C target by 2030 stipulated in the 2015 Paris Climate Agreement (Climate Analytics, 2018). While the Commission compromised on a national phase-out in 2038, a survey has shown that many German voters would prefer an even earlier phase-out even if it is associated with higher costs (Rinscheid and Wustenhagen, 2019).

   The Commission's suggestion raises the question of how the coal phase-out would affect the German coal industry's valuation. Thereby, the arising costs that adversely affect the commitment to phasing out coal can be specified as stranded assets (Jewell et al., 2019), which refer, in this context, to the decrease in valuation of the coal power generation industry in Germany. The decrease in valuation can be a basis for possible compensation payments, which the Coal Commission has proposed to alleviate the financial impact of the coal phase-out on the coal industry (Federal Ministry for Economic Affairs and Energy (BMWi), 2019). (3) On the one hand, some studies have argued that compensation is inevitable due to the size of the industry, which can be seen as "too big to fail" (Sen and Schickfus, 2018). On the other hand, recent studies have concluded that the coal phase-out is in line with the constitution and that compensation payments are legally controversial (Deutscher Bundestag. 2018: Institute for Climate Protection Energy and Mobility, 2018). While the industry is expecting considerable payments and is therefore against the coal phase-out, (4) environmental groups especially assume that no compensation will be due (ClientEarth, 2019; Leipprand and Flachsland, 2018). If no compensation payments are made to reimburse energy suppliers, the potential decrease in valuation will be transferred to financial assets. Accordingly, this study also highlights the impacts of stranded asset risk on the financial sector as well as estimating the compensation payments resulting from the stranded asset value. (5)

   In this study, we contribute to the stranded asset literature by quantifying the economic, financial, and industrial impacts of the coal phase-out in Germany under different scenarios:

1. An unanticipated early phase-out by 2030 (the Enforcing the Paris Agreement Scenario, EPAS)

2. A scenario following the scheduled phase-out of German coal-fired power plants by 2038 (the Maintaining Climate Action Scenario, MCAS)

3. A reference scenario in which the current hard coal and lignite power plants operate until the end of their technical lifetime (the Delaying Climate Action Scenario, DCAS)

   For each scenario, the valuation of the German coal industry is estimated using the overall net present value of the industry.

   Under the assumption of moderate carbon and fuel prices, we find evidence that an accelerated coal phase-out by 2030 would lead to the lowest valuation of coal and lignite power plants, with an absolute stranded asset value (defined as the loss difference between the DCAS and the EPAS) reaching [euro]14.2 billion. Moreover, the stranded asset value for the scheduled phase-out by 2038 only amounts to [euro]2.6 billion, which is significantly below the values approximated by the Coal Commission and the industry. In addition, if no compensation is paid, stranded asset risks will affect the share prices of listed companies in the utilities sector and thus spill over to the financial sector (Dietz et al., 2016). Finally, higher carbon and fuel prices as well as the feed-in from renewable energy sources have been found to be important factors that decrease the valuation for both hard coal and lignite.

   Using a Monte Carlo analysis in combination with a discounted cash flow model to assess the three different pathways, we account for various uncertainties but also dependencies within the scenarios. Our findings are robust to changes in critical input variables, such as the base load and the cost of capital.

   The remainder of this study is organized as follows. Section 2 briefly reviews the literature related to the financial assessment of stranded assets. Section 3 presents the underlying scenarios as well as the methodology of the Monte Carlo simulation employed to conduct the scenario analysis. Section 4 reports the empirical findings and discusses their implications. Section 5 concludes this work and gives an outlook for policy implications. The Supplementary Material to our study provides further technical details, data, and assumptions and additional robustness checks.

2. LITERATURE REVIEW ON STRANDED ASSETS ASSESSMENT

   Stranded assets generally describe economic losses resulting from assets becoming devalued or no longer earning an economic return. Since political decisions on the phase-out will terminate and impair the running of businesses with coal to differing extents, these devalued or stranded assets bear an uncertain risk for energy suppliers. Stranded assets eventually translate into a decrease in firms' valuation (Carbon Tracker Initiative, 2011). The subject of stranded assets due to environmental risks was discussed by Meinshausen et al. (2009). The authors investigated the remaining carbon emissions between 2000 and 2050 that will exceed the 2.0[degrees]C global warming carbon budget. They argued that the carbon reserves may not be fully exhausted. (6)

   Stranded asset risk has, over the last decade, gained increased attention with the growing topicality of the climate change emergency, climate policy uncertainty, and financial implications through environmental hazards (Bloomberg, 2013; Breitenstein et al., 2021; Caldecott, 2017). Companies whose physical assets become worthless will suffer huge financial losses, and these will affect financial markets as a whole. (7) For instance, Atanasova and Schwartz (2019) examined the North American oil industry and concluded that adverse effects exist between firm value and proved oil reserves. Thus, the higher a firm's oil reserves, the greater its exposure to climate policy risk. The study by van der Ploeg and Rezai (2019) found that immediate climate action, for example a carbon tax, reduces the societal cost in terms of CO2 emissions but increases the value of stranded assets for exposed firms.

   Current research on stranded assets is mainly driven by academic and non-academic research initiatives, including, among others, the University of Oxford's Smith School of Enterprise and the Environment, the World Resources Institute and the United Nations Environment Programme Finance Initiative, the International Renewable Energy Agency, and the Economist Intelligence Unit. The branches of institutional investment and investment consulting (e.g. HSBC, Bloomberg, and Mercer Consulting) are also concerned about assets becoming stranded and have addressed the financial assessment of stranded assets. However, the overall quantitative results show that financial assessment research, especially academic research, except for the contributions published by the Oxford's Smith School, remains quite rare. Our literature review is not exhaustive, but we were able to find only limited scientific research on the magnitude of stranded assets due to climate change.

   Table 1 provides the main features of the relevant literature that has recently assessed and estimated the financial impact of stranded assets. Ansar et al. (2013), Silver (2017), and World Resources Institute and Unep Finance Initiative (2016) have provided theories on the magnitude of stranded assets' financial impacts. Most of the other research has consisted of case studies, and most of these studies have focused on fossil fuels. The analyses have been conducted on different levels: the financial portfolio level or the industry/company/asset level. First, the financial portfolio level includes integrated assessment models (IAM), such as the macroeconomic dynamic integrated climate-economy (DICE) model or the E3ME-FTT-GENIE models. The effects of stranded assets on industries, companies, and individual financial assets have been studied using the discounted cash flow (DCF) and net present value (NPV) as tools. One-fourth of the studies that we found focused on firms in the fossil fuel industries.

   All the case studies are scenario analyses undertaken to estimate the potential value of prospective stranded assets, over the short to medium terms, with respect to the impending...