Risky Business - Is the Carbon Shock Imminent?

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.