The model re-prices environmental debt by calculating the discounted present value of future annual debt payments (in the form of asset retirement costs) over the number of years that existing production assets are expected to be decommissioned.  The following scenarios help frame the possible timing and amount of these future cash flows.

Baked in the Cake

Environmental debts are present obligations arising from past events. In that sense, they are already “baked in the cake”. Re-pricing environmental debt requires assumptions about the timing and amount of future cash flows to extinguish these obligations.  The interactive model allows you to experiment with a wide range of scenarios using different combinations of payment periods and payment growth rates.  Keep in mind that the model re-prices only existing asset retirement obligations.  It does not price new AROs that will be incurred in future years as companies construct new production assets.

Steady As It Goes

The model assumes a “steady as it goes” scenario, both retroactively (2003-15) and prospectively, in which oil companies settle their environmental debts over decades in an orderly manner and on a roughly first-in-first-out basis as production assets become noneconomic and are permanently retired.  For example, assuming a 30-year average economic life, in 2046 the company would retire assets placed in service in 2016.  In this scenario, concerns about mispricing of environmental debt and the industry’s ability to pay off these obligations as they come due are partially mitigated by the hope of gradual asset retirements and continuing production revenues to pay for asset retirement costs.

Too Late Too Sudden

In the “too late too sudden” scenario aptly named by the European Systemic Risk Board (ESRB), an abrupt implementation of quantity constraints on the use of carbon-intensive energy sources results in the premature and sudden abandonment of carbon assets around the world. Vast amounts of in-ground coal and petroleum reserves become “stranded” and the value of related marketable securities plummets.

In this scenario, asset retirement costs would be accelerated as existing production assets become suddenly stranded.  For example, in 2031 the company might have to retire assets constructed in 2015-16.  The timing of cash outflows for asset retirement costs would be accelerated, but the amount would not be reduced.  In effect, the same number of debt payments for the same amounts would be compressed into a shorter time period.  Because the payments would come due sooner under this scenario, the present value of the obligations would increase. and liquidity would decrease, perhaps dramatically.  The model does not attempt to re-price environmental debt under this scenario, but the degree of mispricing would only be exacerbated.