Termination Risk and Sustainability

This paper examines optimal behavior of companies and investors in businesses that have uncertain termination dates at which they will stop doing business. It is shown that intuitively and in simple models that such businesses will underinvest to avoid stranding assets when termination occurs. As supply is reduced, output prices and stock prices will rise. It is argued that this characterizes fossil energy firms, investors and even countries. A consequence of this behavior is that many “sustainable” funds are underperforming as they are underweighting the energy sector. Nevertheless, today’s high fossil energy prices provide a strong incentive to decarbonize. However better policies could lead to even better outcomes.