The Climate Change challenge to society, industry and investors is not well represented by the concept of long-term global warming (although that will happen) but rather as system wide and unpredictable shifts to a world characterised by increasingly volatile food, water, security and weather.
Climate scientists continually emphasise the difference between the climate and weather – the former being a long-term description of the average state of our planet and the latter being the expression of that climate on highly localised and short-term timescales. Our understanding of climate is relatively robust, based on physical principles that in many cases were established hundreds of years ago. In contrast, our ability to predict how that will impact a specific region at a specific point in the future, i.e. weather, is weaker due to how climate change is manifested through a very complex system.
Long-term climate change is typically represented by the iconic IPCC global warming figure showing the ~1C warming of the past century and the near certain warming up to the year 2100, the forecasts and uncertainty derived from an ensemble of climate models. They collectively depict a relatively monotonic warming if we continue a ‘business-as-usual’ fossil fuel/agriculture trajectory, as well as the associated uncertainty, resulting in cumulative global warming by 2100 of about 4 to 6C. But this trend does not say anything about the year-to-year variability in any particular place. It is not a weather forecast.
It is possible – unlikely but possible – that in the year 2100, in a world 4C warmer than that of today, the Northeast of the United States will be experiencing its coldest year on record. These deviations from the norm could be due to natural variability over-riding the larger global warming trend in that particular time and place. It could be due to global warming having unexpected impacts on ocean and atmosphere circulation. In any case, there are very good reasons for scientists to focus on long-term climate trends, but those trends do not reflect what it will be like to live in a warmer world. They do not reflect how people will be affected, what they will react to or how, or the pressures under which politicians will be making decisions.
The defining features of climate change will be volatility and uncertainty.
Crucially, therefore, these future forecasts fail to inform our understanding of the socio-political landscape relevant to investors.
If climate change is gradual, then the savvy investor should adopt a wait and see attitude. As warming continues, as damage gradually accrues and as political rhetoric (and regulations) grow sharper, investors can adopt different risk strategies, with some inevitably bailing out from high risk ventures too soon and others too late.
But this is not how climate change will be experienced. It will be experienced as extremes, the unexpected, the unusual. In some areas, the 1-in-20 year heat wave will be 10C greater than it is today (i.e. England could experience ~40C heat waves every 20 years rather than ~30C heat waves). A ramped up hydrological cycle on a warmer planet will cause some areas to become wetter and others drier; but in all areas, actual rainfall events are likely to become more intense. In 2050 – or even 2020 – the Midwest of the United States might experience pronounced floods or be in the middle of a devastating 5-year drought.
This volatility is being manifested today. Extremes are part of natural climate variability and we have warmed the world by 1C, the latter sufficient to amplify and complicate the former. In particular, there is strong evidence that warming is already amplifying heat waves, droughts and floods. And most recently, horrifying wildfires. By extension, we could be on the verge of experiencing particularly acute volatility in food prices. Investors in every sector should be deeply concerned about this increased volatility.
However, investors in the energy and fossil fuel sectors should be additionally concerned by how this volatility impacts policy.
If nations actually do enact policies that could limit global warming to 2C (let alone 1.5 C, the ambition of the Paris Agreement), then most of the fossil fuel sector’s assets will become stranded. In fact, even policies that limit warming below 5C will strand significant fossil fuel assets. Many are arguing that until actual policies are put in place, any disinvestment is premature. ExxonMobil has further argued to the SEC (unsuccessfully in 2015-2016) that they do not believe nations will enact such policies and therefore they have no need to plan for them.
Such attitudes are understandable in a world of long-term, incremental change and politicians reluctant to institute policies that overly disrupt the status quo. But incremental change is not the forecast. Volatility is the forecast. Superstorm Sandy had a minor but real impact on the politics of the US Northeast. What would be the consequence of three such storms happening back to back? What would have been the consequences if it had knocked out one of NY City’s central distribution centres, causing tens of millions to face food shortages? Heat waves in the Middle East resulted in thousands of deaths last summer; what are the political consequences of a somewhat more extended heat wave that results in tens or hundreds of thousands of deaths? What are the political consequences of two more years of California drought, especially if it begins to drive farms out of business and food prices upwards? Or if wildfires rip through more populated areas?
I do not pretend to know what tipping points could cause policy makers to switch gears from prevarication and incremental steps to the drastic policy changes that would limit global warming to 2C and be devastating for certain fossil fuel industries and their investors. But we have seen how a combination of factors has devastated the coal industry, with its value perhaps never to be recovered. We have seen how Fukishima had huge impacts not only on the nuclear industry in Japan but also in Germany – with knock-on effects across the EU.
Given this, I can see no logical reason for investors to not demand as much information as they can from their investments, especially those vulnerable to policies that would limit climate change. I can understand if investors want to bet against politicians making difficult choices! But to also bet against technological innovation (fusion, microgrids, batteries)? To bet against economics (decreasing price of renewables)? Ultimately, to bet against people who will be on the front lines of this volatility? Regardless, if fund managers want to make the best possible bets – and they are legally compelled to do so – they need the best possible knowledge. And this begs the question: why would a responsible fund manager not ask all of their major investments – not only but especially the fossil fuel industry – to conduct 1.5 C stress tests.
Different investors – with different risk tolerances – will read the above through different lenses and reach different conclusions. Nonetheless, given the complexity and unpredictability inherent in the climate change challenge, it is astonishingly naïve for any company to argue that politicians will never act on the commitments made in Paris and thereafter. Investors should demand a clear message from those companies that they understand both systemic climate change risks as well as the associated policy and economic risks to their assets. And investors should have confidence that those in whom they have invested have planned for both.
Some final thoughts that did not quite get it into the blog but bear re-emphasis. The key point is that climate change will create volatility and that is not good for anyone. It is especially bad for investors, who rely on stability and predictability. And most of all, investors rely on confidence. The crash of 2008 was not due simply to an accumulation of subprime mortgage funds but rather a loss of market confidence in them arising from increasing awareness of those fund’s quality; the bubble burst. If (when) climate change causes investors to lose confidence in a property market, the re-insurance sector, the construction industry, a government bond market, it is almost certain to create widespread financial shocks. The Bank of England Governor Mark Carney quite correctly views this as systemic risk.
But it is a bit less clear what might cause that loss of confidence. Will it be a particularly severe event in terms of financial or humanitarian terms or will it be a shocking and unprecedented event. Or an accumulation of events. My suspicion is that it will be the cumulative exhaustion associated with volatility and unpredictability. Markets will adapt to long-term gradual change, but adapting to a volatile and uncertain world is far harder.
And unfortunately, volatility is exactly what is happening now and almost certain to be one of the defining features of our future.