It’s time for investors to stop fixating on normal distributions while watching for the occasional black swan over the horizon. That model is broken. In the same way that the financial crisis happened slowly and then suddenly exposing vulnerable institutions, and causing the systemic failure of the global financial system, climate change risk is likely to result in gradual, then sudden value erosion for certain sectors of the market over the medium to long term.
It is relatively easy to recognize that climate change poses a direct and major risk to fossil fuel investments. A significant percentage of coal, oil, and gas reserves may never be burnt, becoming stranded by a global governmental response to CO2 emissions. Fossil fuel companies have yet to account for this material risk in their balance sheets, possibly because doing so would result in large write-downs.
While portfolios with the largest allocations to fossil fuels are most at risk, climate change is also likely to have a long term, far reaching impact on almost all sectors. The size and extent of this is not widely recognised or appreciated. One analogy to consider is that of a frog in water. A frog placed in boiling water jumps out immediately, but a frog placed in cool water that is heated gradually sits in its pleasantly warming bath until it is too late to jump. Investors need to be vigilant about the gradual changes wrought by climate change that might cause their portfolios to suffer a fate similar to that of the frog.
Climate change is indisputable and already causing financial damage
The science of climate change, including the conclusion that the burning of fossil fuels has been the dominant cause of our planet’s warming since the mid-20th century, is now unequivocal. The average temperature of the earth has already increased by approximately 0.85o C, according to a 2013 report by the Intergovernmental Panel on Climate Change. This may not sound much but a global rise approaching 2o C is likely to make our planet uninhabitable. As our planet warms, we are already witnessing greater and unprecedented extremes of temperatures, more frequent heat waves, floods and storms, resulting in increased damage to assets, higher insurance premiums, and major challenges to global food production chains. Many governments have thus begun to act to reduce their CO2 emissions significantly in recognition of this growing problem.
How can the investor reduce risk and uncover investment opportunities?
Impax has long advocated diversifying energy holdings to include low carbon energy. By replacing fossil fuel stocks with energy efficiency and renewable energy investments, we have demonstrated that it is possible to improve risk-adjusted returns, we reported in “Impax: Beyond Fossil Fuels: the Investment Case for Divestment.” Additionally, investing in a broader portfolio of resource optimization stocks including water, waste and resource recovery, and food, agriculture and forestry sectors, offers more opportunities - and the potential for higher returns in an increasingly carbon constrained world.
Consider, for example, that climate change is changing weather patterns, putting less water in some regions of the US and more in others. There are significant investment opportunities emerging from the need to provide more clean water out West and to manage the impact of super storms like Sandy in the East. Acute water shortages are leading to large investments in efficient irrigation systems, aquifer recharge stations, and desalination plants.
Concurrently, massive infrastructure investments are ensuring we can pump water out of where it is not wanted and that we have power to run the pumps in an emergency.
Meddling in global energy markets is inevitable
After sitting on the fence for many years, Governments around the world are finally making policy decisions to reduce CO2 emissions. Investors should expect ever tighter carbon regulation and a higher price for carbon ‐ with profound economic effects ‐ in many regions of the world in the not too distant future. These regulations are likely to be incremental, but they are only moving in one direction – towards a lower carbon world.