Risky business
The only thing certain about how climate change will unfold in politics and the economy is that it will happen in surprising and unexpected ways. This reality has been on my mind as I’ve worked with investment and risk expert, Phil Preston, on a major new paper we are releasing today that looks at carbon investment risk through the lens of climate science.
We examined whether the tipping point for the now inevitable economic transformation could occur in financial markets rather than in the world of politics or public opinion. This is the opposite of what most people expect – they assume that regulation and the pricing of carbon will be the trigger for a market shift. But what if markets move first by pricing in risk? And what if they do so more quickly and more dramatically than anyone expects?
In considering this possibility, Phil and I focused on the most important issue facing investors with carbon risk – the vexed issue of timing. While collapse in value is a huge issue for companies, it doesn’t really matter for an investment manager if they can pragmatically assess the risk and get out before a price collapse. Timing is really the only key unknown with climate risk because any dispassionate investor knows that carbon exposed assets, particularly coal companies, will drop in value at some point. This is inevitable because for CO2 emissions to fall at the scale science demands, it requires governments to phase out our use of coal, oil and gas well before discovered reserves are used up. But the question is, when?
There are two aspects to this timing. Firstly, will this value collapse occur suddenly over months or gently over 20 years, and secondly, will it start soon or is still decades away?
We started by looking at what the scientists were saying, as this underpins everything else. Politics and markets work to human emotions and beliefs, which means change is influenced by negotiations, delays and preferences. Science doesn’t work like that. The rules of physics, chemistry and biology are set in stone and don’t negotiate with us.
What the science says is that allowing 2 degrees of global warming above pre-industrial levels is a step too far. It takes us into territory where system-wide feedbacks could spiral out of control and threaten the stability of the global economy, perhaps even civilisation. Some argue that even 2 degrees is way too high, noting this would still involve catastrophic impacts such as the likely loss of all coral reefs, quite considerable sea level rise, increased extreme weather and unstable food supplies. The fact that governments consider all that to be manageable just emphasises how risky going past 2 degrees is.
Responding to the science, all the big emitters including the US, China, EU and India have agreed that 2 degrees is the line in the sand we must not cross. This is not a radical view, having been endorsed by the likes of GE, HSBC and Rio Tinto and hundreds of other corporations at the Copenhagen climate conference. So 2 degrees seems like the rational basis for assessing economic and financial market impacts of climate change, particularly timing.
The next question then becomes, what will achieving this goal require society to do? The highly respected Potsdam Institute for Climate Research provides the most useful basis from which to answer this question. They developed a “carbon budget” – how much CO2 in total can we put in the atmosphere if we want to limit warming to 2 degrees? Their answer was framed in probabilities, recognising that, as a society, we will ultimately have to make a decision on how much risk we want to take. This is an interesting question – if 2 degrees of warming represents an unacceptable risk of a runaway climate and global collapse, how much risk do we want to take? Phil and I thought “not very much at all” would be a good answer! Maybe 5 per cent? But we ended up using their analysis that accepted a 20 per cent chance of going past 2 degrees, recognising this was probably a real-world assessment of where the politics will end up. Potsdam also gave the option of 50 per cent, but this seemed highly unlikely given the consequences of exceeding 2 degrees are catastrophic and quite possibly irreversible.
So if we assume a one-in-five chance of a manageable future, our carbon budget is 890 billion tonnes. This is the amount that can be emitted between 2000 and 2050. Given we’re well into this period, and assuming growth as forecast, the next question becomes – when is the budget all used up? The answer is quite startling. It’s all gone by 2024, just 14 years away. The other startling conclusion was that a full 75 per cent of proven reserves of oil, coal and gas would then be still in the ground, never to be used, meaning they are today probably worth nothing.
When we considered this as an investment question, the logic flowed clearly. First we concluded that, despite the lack of action to date, it seems inevitable we will act and act strongly. This is what history says we do, whether it’s WWII, the financial crisis or any number of smaller-scale issues – we wait until the crisis is full blown then we act dramatically. Slow, but not stupid.
With 2 degrees an immovable limit, approaching the point of no return on our way there becomes the crisis. However we can’t stop emitting suddenly in 14 years time – that would trigger the economic collapse we’re trying to avoid. So, logically, we will have to take strong action before then. This is where it gets interesting for investors.
Financial markets do not act in a smooth and orderly manner. They are like waves approaching the shore – in this case, more like a tsunami. While at sea, a building tsunami is hardly perceptible and if you were floating on one you wouldn’t notice it as your boat quietly rose and fell while it passed beneath you – like the tipping point in momentum for action on climate that we’re floating on right now. However as the tsunami approaches the shore, it builds height because the ocean floor below leaves it nowhere else to go. Likewise, our fossil fuel budget has a precise end date – immovable by politics or markets because its defined by physics and chemistry. As such waves or investment trends hit the shore, their enormous power races across the ground sweeping away all before them.
Hard to imagine? It certainly is. But it’s certainly no harder to imagine than the alternative – doing nothing as we head towards economic collapse. Remember, as an investment risk problem, the question is not “will this be the outcome?” but “is there a reasonable risk of this being the outcome?”. Then that level of risk will be priced in.
Perhaps the most interesting conclusion we came to was that such a carbon-induced financial disruption was likely to approach quite suddenly and relatively soon; that markets won’t wait for government to act but will preempt them. Government and the corporate sector have already agreed to the 2 degree target and the scientific evidence to support that target firms up every day. All it will now take for governments to act is for markets to price in the risk. Then the tsunami will have hit the shore.
In financial markets, very few like to be first out the door, but absolutely no one wants to be last. So the immovable logic of the rapidly diminishing carbon budget means the rush for the exits may come tomorrow, next year, or in five years time. With the end date of 2024 set in stone, the clock is ticking.
You can download the report here. I look forward to your reactions.
Comments on this article
I am writing a term paper on
I am writing a term paper on this topic and came across your post which was very helpful. Do you know where I can find more information about this? order checks
I am delighted to find many
I am delighted to find many useful things here, that's superb. Thanks for sharing engraving supplies
Gulf Stream
And what might cause a "Gulf Stream Hiccup"? - A decrease in the temperature differential between the pole and the tropics http://data.giss.nasa.gov/gistemp/maps/. This is due to the greater warming at the pole than in the tropics as predicted by the climate models. By the way sex is what you might call 'digital' if you'll excuse the expression - it is M or it is F. Temperature on the other hand is 'analogue' - it can be A, Z, or anywhere in between. To quote your Kiwi friend, Walsh, please "...get it right."
Exponential Growth... cont..
3. I think that looking for a pricing to 'fix' this won't work. The corporations that exploit the resources, if looked at as people [which legally and in many other ways they are], are sociopaths [as the film 'the corporation' notes]. If you have a sociopath in your street, exploiting you, killing some of you, and generally acting like hes the only one on the street that matters, do you deal with him by playing his own game? when he has all the money and seems to have most of the power? I suggest not; I suggest that you would get a few big mates together and go down there with axe handles and sort the situation out... or you would call the cops... or you would move streets.
I think that the end to this is going to be dramatic... as Martenson says, 'The next 20 years are going to be totally unlike the last 20'.
And What of Exponential Growth?
It seems that the authors didn't take into account a couple of important aspects of this dynamic situation.
1. the nature of our economic system is that it has to grow; any closed system that grows at a constant rate is a doubling time. http://www.youtube.com/watch?v=F-QA2rkpBSY explains this.
Martenson, in the Crash Course, goes further to put this human failing to internalise the exponential function in the context of the economy and the environment. I wonder if the authors understand this? it appears they don't. If they did, I think they would be talking of the need to change the system that drives this growth and subsequent resource extraction.
2. Humanities default setting for denial. WWII was in our faces; It is hard to deny tanks... it's not a wise thing to do. Climate change appears different. Intelligently reasoning that we have X tons of carbon to use and that in Y years we will have done so & that therefore we have to change and change dramatically isn't the same to me as a tank... therefore, i don't think we, as a society, will act the same, or as dramatically, esp. with a threat that is so 'easy' to deny until it's too late.
Price waste as a penalty.
Yesterday's "discovered reserves" are long since used up. Today the miners are busy discovering tomorrow's "discovered reserves", which are replacing today's "discovered reserves" even as they are extracted. However resources are not so much "used up" as converted to waste.
.
If the "value" of using a resource is balanced against the cost of emitting its waste, the pattern of investment is self-limiting. Profitability then guides investors to find sources of energy that have low waste costs.
.
Market economics has failed to maintain a penalty price against waste as a wrong. Buying a right to waste contradicts that principle, so any ETS guarantees continuing failure - and courts disaster.
.
In the absence of a market solution, or a criminal penalty, the best way to eliminate carbon from an industrial economy is to tax its waste - punitively.
Wrong in fact
Bernard Walsh commented that global temperatures have not altered by more than 0.5C in 10,000 years.
10,000 years ago the Earth's was at apogee from the sun (at least in its gross orbital mechanics), and the planet was much less than 0.5C than it is today today. About 8,000 years ago we had an ice age that reduced sea level enough to allow the Aboriginess to walk downhill to Queensland. About a thousand years ago Europe suffered the Little Climactic Optimum, which had distinctly warmer northern hemisphere temperatures.
Talking about "average global temperatures" is as accurate and useful as talking about "average sex", since on average human beings are half male and half female. This is as meaningless as the distortions feed to us by greenie goofs.
If the Gulf Stream hiccups before 2024, as is now very likely, global warming will not be a problem, since most of Europe and Eastern USA will be facing a "Day After Tomorrow" scenario.
To quote my Kiwi friend, Walsh, please "...get it right."
@Liam Munro
@Liam Munro
Obviously I failed to make my point clearly. The article argues that the market should recognise risk and pre-empt legislation in valueing assets. I tried to argue that the assets will not be correctly re-valued because of the combination of moral hazard of Government compenstaion and the profit opportunity of blackmailing society to deliver stability. I don't really want us to nationalise these assets, I want an environment without such distortions so that the market can work efficiently. ie. it drives change & rewards people with vision, rather than resisting change and rewarding those who live in the past.
The only thing certain about how so-called "global warming,"
.... blatantly morphed into so-called "climate change," will unfold in politics and the economy is that, given the degree of mass-hysteria this fascist fraud - this state-sanctioned godless religion - has whipped up, it will....
.... be a while before climate change is once more called by its proper names: spring, summer, fall and winter -- and "global warming" by its proper name. The Goebbelsesque Marxification of the world's greatest ever (Multi-Trillion Dollar!) fraud!
Brian Richard Allen
Lost Angels - Califobambicated 90028
And The Very Far Abroad
Risky Business - Climate Change
I would like to refer you to the discussion on Tuesday, 28/09/2010 on ABC RN's Bush Telegraph program, between presenter Michael Cathcart and climate scientist, Peter Waterman, Associate Professor in Environmental Science at the University of the Sunshine Coast and member of the management committee of the National Climate Change Adaptation Facility.
The program's website states that Peter Waterman welcomes many aspects of the government's policy (to form the Multi-Party Climate Change Committee to look at how a carbon price might be introduced), but also warns that the rhetoric is preoccupied with the politics of setting a carbon price. He warns that this will not stop the process of climate change and argues that Australia needs a program of adaptation to the coming reality of climate change and the resulting extremes in weather.
A link to this story (including full audio) is available at http://www.abc.net.au/rural/telegraph/content/2010/s3023918.htm
A Royal Commission
The science is not settled. There should be a Royal Commission. This video is worth watching http://bit.ly/aGRw7v
2 degrees is a step into the unknown...
I would disagree with Alan Fields when he states that there is no scientific basis for the 2 degree C figure - there is, based on an enormous amount of climate modelling, and examination of the paleoclimate records (ice cores & the like).
And contrary to his assertion that 2deg is nothing unusual for humans, refer to this graph from wikipedia:
http://en.wikipedia.org/wiki/File:Holocene_Temperature_Variations.png
Please note the citations at the bottom of that page - it's based on peer-reviewed papers, not random blog posts.
It seems pretty clear from that graph that temperatures have generally varied by less than +/- 0.5degC over the past 10,000 years or so (since the end of the last ice age). The earliest records of human civilisation go back about 4,500-5,000 years, with the earliest evidence perhaps as far back as 10,000 years. During that time, many civilisations have been wiped out by climatic shifts.
Alan is also getting confused between weather and climate. Weather is the short-term (e.g. daily) temperature variations, which are quite large. Climate is the average of those temperatures over a time-scale of years to decades.
Example to be seen
very interesting article. I would argue that large business has priced in carbon for many years, and taken the profit for a while, but that the recent pro-carbon price utterances by some business leaders is an attempt to progress broad scale action as they can otherwise see themselves "blinking" and taking unilateral action on climate change (carbon?) risk to avoid the tsunnai - or risk mass upheaval later.
@Dave Turner
@Dave Turner: They should pass laws nationalising assets with no compensation??? Umm, so who exactly do you think will build all the green technologies required to combat CO2? I'm sure investors who just got burnt to the tune of millions of dollars by a draconian govt is going to be heaps keen to jump back in with more cash to build a solar plant/wind farm etc. There's a saying you might have heard: "fool me once, shame on me ...". That's the problem with all these stupid statements like this. These tricks only work once, and they tarnish the country for decades as a place for future investment. You'll start to see this in Aus VERY soon anyway, given how the fed/state govt's have treated investors with their dodgy PPP's/forced procurment of assets (Telstra), retrospective RSPT etc etc etc.
Risky business
This is all predicated on the 2 Deg C fatal figure, after which we will al be exposed to some catastrophe. There is no scientific basis for this belief. The figure is an estimate of the past maximum average temperature since man came on the scene. It is the difference between a warm summer and a cool one. it is less than the change in most latitudes between day and night. If this temperature applied previously in mans exustence, why do we believe it will suddenly spark some kind of feedback catastrophe? It never did before. - Neither did higher levels of CO2 in the atmosphere. Most companies see the regulation of CO2 as a way to increase their prices to the consumer without a backlash. Companies are driven by the bottom line and will vote for anything that improves it.
Moral Hazard will stop the market moving first
The market will not move before Government due to the moral hazard from an expectation that the Government will bail investors out when the change is imposed / occurs. The lower value of investments will only be 'official' when specific legislation is passed that changes the rules at which point investors will hold the Government accountable and expect compensation.
A second factor sustaining investment value is the bet that through the transition period the owners of the assets will be able blackmail the community for their support of a smooth transition and extract high profits in the process.
Look at Hazelwood for a good example. The power stations should be worth nothing but the expectation of a soft deal gives them a distorted financial value today.
The Tsunami will hit the shore when the Government makes it clear that there will be limited or no compensation! They should pass laws allowing the nationalization of assets if there is a threat of disruption. If they were strong and set an example with Hazelwood then we will see the market really working the way it should. We would get efficient allocation of capital and the funding of a solution.