Does Mark Carney Understand How Financial Markets Work?

By Paul Homewood

 

 

Yesterday I mentioned Mark Carney’s latest call for the financial sector to divest from fossil fuels:

 

Mark Carney has claimed the pension fund investments held by millions of people could become “worthless” unless the financial sector reacts quicker to the climate change crisis.

Financial firms are starting to curb investment in fossil fuels but are “not moving fast enough,” the Bank of England governor will say in an interview for an edition of the BBC Today programme edited by Greta Thunberg, the teenage environmental campaigner.

The Bank of England claims up to £16 trillion of assets could be wiped out if the climate emergency is not addressed effectively including by banks and pension funds over-exposed to “sunset” fossil fuel industries…

Pressed on whether pension funds should divest from fossil fuels even if the returns are attractive, Mr Carney said: "Well that hasn’t been the case but they could make that argument.

"They need to make the argument, to be clear about why is that going to be the case if a substantial proportion of those assets are going to be worthless."

He added: “The judgement of some leading pension funds is that if you add up the policies of all of the companies out there, they are consistent with warming of 3.7-3.8 degrees. That is far above the 1.5 degrees that the people say they want and governments are demanding.”

The Governor who steps down in the New Year to be the UN’s special envoy for climate action and finance, warned that unless firms woke up to the “climate crisis,” their assets would be worthless.

“If we were to burn all those oil and gases there’s no way we would meet carbon budget,” he said. “Up to 80 per cent of coal assets will be stranded, (and) up to half of developed oil reserves.”

https://www.telegraph.co.uk/politics/2019/12/29/pension-fund-investments-held-millions-could-rendered-worthless/

 

Not only does this show a naivety about the politics of climate. Perhaps even more alarming, given the fact he has been in charge of the Bank of England for umpteen years, is that it shows a complete lack of understanding of how financial markets work.

So, to re-cap:

Carney argues that investments in fossil fuels, such as oil and mining companies, could eventually be worthless, as their assets will be “stranded”.

However, the market normally values shares not on the perceived asset value in decades time, but on discounted future returns, ie dividends. Because they are discounted, potential dividends in the near future are worth considerably more than those, say, in twenty years time. Put another way, BP could go bust in 2050, but it would make next to no difference to its market value now.

(There are exceptions to this, notably where investors buy into loss making companies, in the hope they will become successful and profitable in future. However, this is a huge gamble).

To see how the numbers work out, let’s look at BP’s accounts:

Currently BP’s market capitalisation is £95bn  – 20.2m shares at £4.70 per share.

According to their 2018 Annual Accounts, post tax profit came to $9.4bn, or £7.2bn.

https://www.bp.com/en/global/corporate/investors/results-and-reporting/annual-report/annual-reporting-archive.html 

 

So in simple terms, if you bought a share in BP today, you would get all of the money back in 13 and a bit years, assuming profits are maintained at this same level. Of course, you would need to discount these numbers, as you could have invested it somewhere else and earned interest as well as getting your money back.

Nevertheless though, you can see that BP is a worthwhile investment, assuming returns can be maintained over a period of maybe about 20 years. And let us be absolutely clear here, regardless of Carney’s scaremongering, fossil fuels will still be in global demand for many years to come.

In fact though, an investment in BP is even more attractive than my figures indicate, because free cashflow is much greater than profits. Last year, operating cashflow was $22.9bn, more than double profits. This is because that figure does not include capital expenditure, roughly $16bn in 2018, which makes up such a sizeable proportion of the oil industry’s costs.

If Carney is really right, and the world stops using oil and gas in the next decade or so, what will BP and other oil majors do? Very simply, they will do exactly what they do every time there is a market slump.

That is, they will cut back on new capital expenditure, possibly to nothing. The money they would have spent on drilling new oil fields will instead go to enhance dividends or fund share buy backs.

In the event that Carney is right then, investors can expect to recover their capital in four years. As I say, this is a common practice when demand for oil is low, and oil prices tank. To make things even more attractive for investors, BP holds $26bn in cash and cash equivalents in its balance sheet, covering more than a quarter of current market value.

 

As I say, I find it frightening that the Governor of the Bank of England does not appear to understand this very basic market mechanism. Or maybe he does, but would rather scaremonger for political reasons.