Risky Business – Is the Carbon Shock Imminent?

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The only sure thing in how climate change will unfold in politics and the economy is that it will happen in surprising and unexpected ways. This reliable fact 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 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 the 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 is the underpinning of 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 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 bad going past 2 degrees is.

So 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 we concluded 2 degrees was the rational basis for assessing economic and financial market impacts of climate change, particularly in terms of 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 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%?

But we ended up using their analysis that accepted a 20% 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% but this seemed highly unlikely given the consequences of exceeding 2 degrees are catastrophic and quite possibly irreversible.

So assuming a 20% chance of a manageable future, our carbon budget is 890 billion tonnes 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 was quite startling. It’s all gone by 2024, just 14 years away. The other startling conclusion was that a full 75% 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, we will inevitably 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. With 2 degrees an immoveable 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 underneath you, like the tipping point in support for action on climate that we’re floating on right now. However as the tsunami approaches the shore, it builds height because the constraint of the ocean floor below leaves it no where else to go, like our fossil full 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? Yes it certainly is. But it’s certainly no harder to imagine than the only alternative – doing nothing as we head towards economic collapse. Remember as an investment risk question, 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 is 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. We believe markets won’t wait for government to act. Markets will pre-empt this by pricing in the risk that governments will take the action science demands and that they’ve already agreed is correct.

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 5 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.

19 thoughts on “Risky Business – Is the Carbon Shock Imminent?

  1. salamander

    Australia is only finally seriously considering action because the Greens got such a good result, and almost by chance, certainly by a massive chunk of good luck, we don’t have a Liberal as PM. That means political will for action is still lacking. Bob Brown is the fall guy – if the decisions are too unpopular or they stuff up on the presentation, as Rudd did with the mining tax, Gillard will lay the blame with a trowel and the Liberals will be laughing. And if Abbott does manage his one stated aim so far, to bring down the government, he will presumably reverse any decisions, adding to the uncertainty.

  2. Well done on your efforts to put a time frame on things Paul. I have been trying to understand the same on peak oil without much success because of the huge variables. My bet is that by 2020 the world will be an entirely dfferent place to live, with our values and lifestyles changed substantially. It is unlikely that these changes will occur tomorrow and it is unlikely that they will be close to your 2024 date. The great disruption that you have talked about is probably a few years away but when? Investment decisons based on business as usual in five years time seem to be to be fraught with risk, but again who really knows? All we really know is, as you say, the clock is ticking.

  3. Practical Wisdom

    When the constituents the Liberal party supposedly represents (big business including coal) are requesting a price on carbon be decided and legislation enacted, one has to question what’s going on. Obviously Abbott thinks the most electable position is one of opposing a carbon tax but those with a wider view (CEOs running global enterprises) have concerns and information he doesn’t wish to acknowledge.

    We can hold the hope that – like salamander lays out in their post above – something genuinely helpful for the common good will come from the chaotic soup of a Parliament we currently have in Australia.

  4. One of the real obstacles to achieving the changes that are needed is the kind of people who are making the decisions currently. The people who are in power and in decision making positions are risk takers who have been successful and who think that risky behaviours pay off. I have written about this in the past….
    http://kapundagarden.blogspot.com/2009/11/game-theory.html
    and
    http://kapundagarden.blogspot.com/2010/03/sunny-morning-in-garden-with-marx-in-my.html
    These risk takers have so far been “on the winning side” but as the “playing field” (which is not level anyway) changes, perhaps different people will be allowed a voice.

  5. Sarah Severn

    Paul
    Thanks as always for your contributions to this issue. It’s very valuable material that we can use with CERES, BICEP and other groups that are still working towards a sane US and global response. At this point my money is with the investors, not the politicians.

  6. Paul, your overall thesis is interesting and relevant. If the market withdrawals from fossil fuels, big changes will happen.

    Beyond that, I think the piece has room for improvement.

    First, given that Arctic seabeds are now releasing methane from gas hydrates at present levels of global warming, the 2° limit and carbon budget that Paul refers to is simply irrelevant. Even though the amount is small at present, as I read it we are in fact at the beginning of uncontrollable self-escalating global warming. This is the plain fact that we all have to come to terms with, and begin asserting directly. Or so I think. Paul, what is your view?

    The release of gas hydrates may still be stoppable through a suite of techniques including withdrawing atmospheric CO2 by rapidly building soil fertility on a global scale, reforestation to increase reflective cloud cover, and rapidly reducing CO2 emissions – in other words, a massive emergency campaign to cool the planet: Climate Code Red!

    So we need to be very innovative in getting masses of people to engage with this.

    Second, your logic assumes that people who may be investing in fossil fuel production are on top of the 2° figure and the carbon budget. From the outside, it seems possible to me that they may be quite unaware of it, despite the fact that governments took a position, or if they are aware they may not care. How callous! So I do not believe that the 2° limit will necessarily act as an automatic brake.

    Nevertheless, you have identified a really important point of change. If some of us had time and resources, it would be great to work on getting “the market” to understand the ecological realities.

    Yours for a world that works,

    Andrew Gaines
    Transform Australia

  7. Paul Gilding

    Andrew, on your question. There is no question in my opinion, recognising this is an opinion not yet clear science, that 2 degrees is way too high. I use that in this paper to show even the accepted, inadequate target of 2 degrees has incredible implications for society. My view is that 1 degree is the right target and this would required a response as I outlined in an earlier paper The One Degree War Plan:
    http://paulgilding.com/cockatoo-chronicles/cc20091106-odw-launch.html

    On your other point, no, most people in the market don’t understand 2 degrees or what it means. But they will, is my basic premise, as the idea moves through society.

  8. Doug McLean

    Great points Paul!
    Is the major paper you mentioned available to the general public? If yes, where?
    Do you believe that the problems of coal ash will play any significant role in putting burning coal to a longer overdue rest?
    Coal Ash: China’s Forgotten Pollutant | Greenpeace China
    Opponents, supporters sound off on coal ash issue – BusinessWeek
    Coal Ash Is More Radioactive than Nuclear Waste: Scientific American

    All the very best
    Doug

  9. Keith Reeves

    Hi Paul. If we are to reduce our carbon consumption then we only have one sustainable option at the moment and for the foreseeable future. That option has been embraced by most European democracies which need to preserve their environment and financial long term viability. That option, of course, is Nuclear Generation. Clean, safe and much cheaper than all of the alternatives.

  10. Keith Reeves

    Hi Practical Wisdom. Do you really believe that Tony Abbot “thinks the most electable position is one of opposing a carbon tax”. I think even he is smart enough to know that he lost a lot of potential votes for his stance on the carbon issue. He wasn’t being very practical, like BHP, which has seen the issue as a business opportunity. They know how to take advantage of a business situation. They know that regardless of the science, they can make money dealing in carbon credits and are not worried about the environment.

  11. Thanks a bunch for sharing this with all folks you actually know what you are speaking about! Bookmarked. Please additionally talk over with my web site =). We can have a hyperlink exchange contract between us

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