Transition risks are risks that arise as a consequence of global action to combat the climate crisis. The transformation of the global energy system, driven by technological disruption, government action, changing consumer preferences, and other factors, will inevitably harm asset values in the carbon-intensive industries that must necessarily be abandoned in order to achieve the less than 2 degree outcome agreed upon in the Paris accord. In the fossil fuel industry, perhaps the most well known transition risk is the risk that currently proven hydrocarbon reserves will be stranded due to the fact that there is more carbon bound up in existing proven reserves than the atmosphere can absorb without pushing the world past the 2 degree threshold.

There is a much less understood risk attendant to stranded assets, but one that has significant implications for the economic viability of many extractive developments, and also for the governments that host and permit those developments–that is, the risk that the substantial decommission and remediation liabilities linked to extractive development, known in the US as Asset Retirement Obligations (AROs), will be stranded concurrently with the assets themselves. This creates the significant business challenge in which liabilities increase dramatically just as assets are written down, which is a recipe for equity destruction.

 

Numerous studies and white papers have described various elements of transition risk, including the clear risk that vast swaths of proven fossil fuel reserves will be stranded. However, very little has been written about the trillions of dollars in decommissioning liabilities associated with those reserves, a huge portino of which may become stranded as well, fundamentally changing the equation on the value of capital investments in oil and gas extraction. Critically, AROs are bound to oilfield assets, and though there are a variety of ways to manage those obligations, there is no way to split them off. As such, when assets become stranded, liabilities are stranded in tandem, creating a dual pressure on corporate balance sheets.

All else remaining equal, if a company's assets decline and their liabilities increase, the dual effect is charged to equity. In other words, the value of a corporation to its owners will be written down as assets become unrecoverable due to economic and policy factors that will increasingly pressure the oil and gas industry as the energy transition accelerates.