The Negative Alpha of Flies
A lot of problems get solved when you understand natural tendencies. Everyone has had the experience of a single buzzing fly in the house on a summer night We used to run around with a newspaper while the fly laughed, until we remembered that flies gravitate towards light. So when a rogue fly appeared in the evening, we would turn off all the lights and open the door to a small lighted room. The fly would fly into the room, we would close the door, and summary execution soon followed. It’s easier to get flies or people to move in the directions they’re predisposed to move.
With no disrespect intended toward the flies, just as flies move towards light, so investors move towards the prospect of profits. And they generally don’t expect to get whacked either.
Climate Science Implications for Investors
This leads us to a conversation with Gernot Wagner, an environmental economist (yes, they do have such things) who authored the book But Will the Planet Notice? How SMART Economics Can Save the World. Gernot spends the bulk of his time within the interface between capital flows and climate science issues. His underlying premise is that
“We can’t ban carbon, nor should we want to. We need to guide money to go toward low-carbon investments, which is where the science indicates it should go.”
As an economist, he assesses societal and economic implications of climate change probabilities. As an environmentalist, he assesses the global effects of climate change. Above all, he understands that the profit motive will attract capital to climate investing, and endorses systemic developments towards that goal.
An example of Gernot’s point of view is enlightening. After his recent talk in Corpus Christi, a member of board of the port of Corpus Christi mentioned that he thought climate science was a hoax. This gentleman is helping to oversee a $1 billion improvement in the port of Corpus Christi. Gernot asked, “what if you just give it a 5% chance that all the world’s scientists are right on this one, and that the sea level will rise by a meter or more in the next hundred years. Would you still make the same investment?” No answer.
By sheer coincidence, a recent news article shows exactly how appropriate Gernot’s question really was. The Houston Chronicle reported Rice Professor John Anderson’s charge that the Texas Commission on Environmental Quality (TCEQ) systematically omitted all references to climate change and sea-level rise from an article he wrote for a TCEQ report about changes in Galveston Bay. Gernot, who is, like Arnold Schwarzenegger, an Austrian born dual citizen, although a bit smaller, commented:
"Interesting — and disheartening — article. But sadly not too surprising. It is amazing how politics doesn’t just overpower the economics here but even the natural science.”
This sort of thing doesn’t happen in sports. Sports fans tend not to argue about the accuracy of statistics and results, since they are accepted as fact. If a group of New England Patriots fans decided that the Pats beat the Giants in the Super Bowl because fourth quarter points didn’t really count, it would be laughable. Of course, sports fans generally don’t believe their favorite team is in some way morally superior to another team. Viewed in this light, the TCEQ excision of scientific facts which didn’t suit their orthodoxy is equally laughable, but potentially harmful. The TCEQ, whose members had all been appointed by Gov. Rick Perry, did, after media scrutiny, relent and publish the report intact. As the Houston Chronicle commented in the update, “Science should not play handmaiden to politics.”
Free Markets Versus Regulation for Carbon Emissions: A False Dilemma
Gernot had a comment on political resistance to climate science. In his experience, he noted, people who deny climate science worry that government intervention will supplant capitalism. Gernot’s view is quite the opposite, that markets are not free enough. He decries the socialization of pollution costs, mainly through the fact that polluting industries cause taxpayers to pick up costs which the industries themselves should bear. If you, dear reader, have to bear the cost of picking up garbage dumped on your freshly manicured lawn because your rich neighbor doesn’t want to spend the money to take his garbage to the dump, you’ll probably decide that your neighbor has a lot of f***ing nerve. So it’s hard to understand why the person who would object to the socialized cost of a pittance for an unemployed worker would give a free pass to someone else who generates substantially greater real-time public health and societal costs. Gernot suggested that a consistent libertarian view will bring this issue into clearer focus.
The same argument that regulation impedes free markets unfairly can be used to show that government-imposed traffic lights also impede the free-market rights of the individual to get where he wants at his desired speed. We leave it to the reader to determine whether this shows the absurdity of the regulation – free market debate.
The Cure for Locust Economics — Cap and Trade; or, Treat Fish as a Free Resource and Watch Them Disappear
Gernot Wagner’s book cited examples where in a variant of cap and trade has accomplished two community economic goals: preservation of a dwindling, soon-to-be extinct resource, and a free-market system whereby market forces allowed the participants in a particular industry to bid for the rights to a scarce resource. Gernot showed how solutions evolved for Maine lobsters and for Alaskan halibut using two simple devices: first, a CAP on the total amount of yearly catch for the entire industry; second, a facility to TRADE the rights to catch allocated volumes of fish, so that those who could handle larger volume had the ability to get smaller market players’ rights. The industry adapted successfully, and still exists because of this. In Maine, it was the local lobster gangs that enforced that system. Easily done, because Maine lobster doesn’t move much out in the ocean. For the Alaskan halibut, government had to step in and establish the system – creating a market where there was none before and solving overfishing as a result.
Without any of this, free market forces would have ensured the disappearance of an entire industry, since no single market participant would have had a reason to voluntarily withdraw or limit their catch so that the industry could survive. In this sense, free market economics without oversight risks becoming rather more like locust economics, where a swarm devastates a field and then moves on. The trick is to develop an oversight system that disrupts as little as possible, so that competition can flourish. Which seems to be something fans have no problem with in sports.
Cap and trade allows public oversight to determine the one thing a free market cannot: how much of a resource or emission should be created each year to serve common interests. From there, the free market takes over.
The point is made a bit more graphically in the closing stanza of The Walrus and the Carpenter, by Lewis Carroll:
“O Oysters,” said the Carpenter,
“You’ve had a pleasant run!
Shall we be trotting home again?’
But answer came there none–
And this was scarcely odd, because
They’d eaten every one.
Black Swans a-Swimming and Tipping Points
Gernot’s question to the port director was totally on point. Climate risks may even now be beyond the black swan category. As we noted in a previous article, the US Department of Defense quadrennial report considered climate issues to be a serious threat to national security:
“The U.S. Global Change Research Program, composed of 13 federal agencies, reported in 2009 that climate-related changes are already being observed in every region of the world, including the United States and its coastal waters. Among these physical changes are increases in heavy downpours, rising temperature and sea level, rapidly retreating glaciers, thawing permafrost, lengthening growing seasons, lengthening ice-free seasons in the oceans and on lakes and rivers, earlier snow melt, and alterations in river flows. Climate change could have significant geopolitical impacts around the world...and will contribute to food and water scarcity, will increase the spread of disease, and may spur or exacerbate mass migration. While climate change alone does not cause conflict, it may act as an accelerant of instability or conflict, placing a burden to respond on civilian institutions and militaries around the world…”
If the DoD sees fit to devote a section on climate issues in a major security report, do you, as a professional investor, then conclude that Gernot’s hypothetical 5% chance rise in ocean levels this century overstates or understates? In fact, climate science tells us that the meter of sea level rise has a much higher chance than just 5%. That’s the median value we can expect to happen by 2100. Presumably the DoD isn’t thinking about events that might be a couple hundred years away. Many effects of global warming are obvious even now.
If you’re an international investor, how does this affect your investment decision to invest in the real estate of the island nation Maldives, top elevation five feet above sea level? Or low lying areas in the United States, knowing that the moment enough people take the threat of climate change seriously, those properties will likely lose significant value?
The history of financial markets could easily be described as anticipatory movement as what is unknown but suspected becomes known and verified. Of course, when it comes to individual stocks and indices, often the first knowledge of an important new development is not the last.
Today, there are several climate change tipping points. The big one is the planetary tipping point, the point at which the momentum of carbon emissions sends the planetary system into a period of dramatic change until systemic equilibrium is established. There’s significant debate about where we stand with respect to that tipping point.
For the investor, there’s a different tipping point, reached the moment enough of the investor class decides that climate change is a variable which influences investment decisions. You can imagine how that will impact valuations by assessing relatively minor phenomena like the mortgage implosion in 2008 which almost brought down the financial system. Then, as now, there were some investors like John Paulson who did the research to sort it all out in advance.
The weather service has reported that March 2012 in the United States was the warmest since temperatures began to be recorded. An IPCC report noted some developments consistent with climate change, and also mentioned that parts of Mumbai could become uninhabitable due to storms and flooding. Miami was mentioned as one of about ten world cities as being at lesser risk. You can model the investment implications, positive and negative, for yourself.
When Gernot was asked about the recent uptick in unusual weather events, he was quick not to pronounce this as evidence of climate change. Taking the standard approach by the vast majority of climate scientists, he noted that recent weather phenomena are what one might expect from global warming to date, but that one couldn’t reach conclusions. One might contrast this approach with Fox News reports in January 2011 wherein their newscasters conclusively “disproved” global warming, based on some heavy snowstorms in Washington, DC, over a two week period. To put this in perspective, Fox “scientists” based their “disproof” on a three-week sampling without any controls of 1/1000 of 1% of Earth’s total area. We’re not sure which is funnier — the statement itself, or the fact that many of their viewers believed them. Money talks, but it doesn’t always tell the truth.
Gernot emphasized that it should become increasingly tough to look the other way.
“This is 19th century stuff,” he said about the science. “We’ve known about the greenhouse effect for over a hundred years.” While we can’t take a single heat wave as proof or a single snow storm as proof to the contrary, the evidence is clearly building up. Gernot concluded the point: “The third hottest decade? The 1980s. The second-hottest decade? The 1990s. The hottest one? The 2000s. Do you see a pattern?”
The bottom line is really this, according to Gernot: Average projections are already bad enough. What really should get us going is the possibility of Black Swans. When the risks are large enough to become quantifiable, when there is reason to think that black swans are turning grey, capital will inevitably seek to capitalize on the problem even as it seeks to solve it, and reassess valuations in the light of new information.
Climate Change Technical Analysis
Yes, trader friends. Why not? A graph of temperature, carbon dioxide, and sunspots may well say as much to you as this article. The sunspots may not matter so much, except to show you that scientific types make a good faith effort to sort out the truth. Temperature and CO2 both staged technical breakouts. You know what that means.
Granted that this is happening on rather a longer time scale than the typical high frequency trader horizon. Nonetheless, there are venues to begin including this in your portfolio, such as trading on the European Climate Exchange. It has suffered growing pains in its early stages, which accounts partly for low current carbon valuations on that exchange. Nonetheless, additional exchanges have been approved for Australia and California, and a dozen other countries have formally said that they want to add carbon exchanges. There is hope that China, which would be a major market, will open for carbon trading this decade.
We expect to revisit Gernot Wagner soon to get updated on other liquid and private market opportunities for professional investors in this space, even if he is only an economist.
This article was written by Doug Friedenberg and originally published on AllAboutAlpha under the title: The Climate Change Trade: Your Portfolio May Never Look the Same
More readings on the impact of climate change:
- The Impact of Climate Change on Business, by Graham Dawson
- Climate Change and Insurance, by Stephen Haddrill
- Pension funds search for climate change risks and opportunities, by Ian Fraser
- Global warming, the challenge for the insurance sector, by Anthony Harrington
Tags: alternative investment , climate change , global warming , green investments , investment model , investment risk , investments , portfolio , risk , socially responsible investment , trade , water risk