Robert Mudra, CFA investigates how investors will need to adapt to the impacts of a changing climate.
Is climate change for real? The short answer is—yes. According to Doug Sisterson, author of ‘How to Change Minds About Our Changing Climate’, about 98% of climate scientists believe that the Earth’s climate systems are changing due to “anthropogenic” (caused or produced by humans) greenhouse gas (GHG) emissions.
Based on peer-reviewed scientific reports, the International Panel on Climate Change (IPCC) concludes that the effects of greenhouse gas emissions, and their anthropogenic drivers, are extremely likely (95% – 100%) to have been the dominate cause of global warming since the mid-20th century in its‘ Climate Change 2014 Synthesis Report Summary for Policymakers’. The IPCC describes the causes of climate change as follows:
SPM 1.2 Causes of Climate Change
“Anthropogenic greenhouse gas emissions have increased since the pre-industrial era, driven largely by economic and population growth, and are now higher than ever. This has led to atmospheric concentrations of carbon dioxide, methane and nitrous oxide that are unprecedented in at least the last 800,000 years. Their effects, together with those of other anthropogenic drivers, have been detected throughout the climate system and are extremely likely to have been the dominant cause of the observed warming since the mid-20th century.
The IPCC presents an interesting graphical view of GHG emissions (in gigatonnes of CO2-equivalent per year, Gt CO2-eq/yr) for the period of 1970 to 2010 (as shown in Fig. 1). Interestingly, annual CO2 emissions from fossil fuel combustion and industrial processes accounted for 65% of the 49 Gt total. Other major sources include methane (CH4) at 16%, CO2 from Forestry and Other Land Use (FOLU) at 11% and Nitrous Oxide (NO2) at 6.2%.
The risks associated with global warming are expected to create widespread impacts across the planet—and include more severe weather-related events. In Asia, the IPCC identifies increased drought-related water and food shortages, more heat-related human mortality and increased flood damage to infrastructure, livelihoods and settlements. Europe faces increased damage from river and costal floods, increased water restrictions and increased damage from extreme heat events and wildfires. North America faces similar problems with increased damage from wildfires, increased heat-related human mortality and increased damage from river and coastal urban flooding. The oceans face reduced fisheries catch potential, mass coral bleaching/mortality and increased damage from coastal inundation and loss of habitat . While this is not an exhaustive list, the point is that the effects are widespread and can impact human health, agriculture, housing, infrastructure and many other industries too—think of the massive insurance claims after extreme weather events.
How will the world respond?
In order to limit the harmful effects of global warming, the United Nations Framework Convention on Climate Change (2010) established a global accord in Copenhagen that attempts to limit the future increase in global temperature to 2 degrees Celsius from pre-industrial temperatures. Since scientists estimate an almost linear relationship between cumulative CO2 emissions and projected global temperature change to the year 2100; this effectively means that a “carbon budget” on CO2 emissions has been established between 430 to 530 Gt CO2. Fig. 2 illustrates the relationship between the carbon budget (CO2 emissions permitted below a 2 degree temperature increase) and climate change.
Not so fast. Under this carbon budget, the International Energy Agency (IEA) reports that no more than one-third of proven fossil fuel reserves can be consumed prior to 2050, unless carbon capture and storage (CCS) is widely deployed in its ‘2012 World Energy Outlook’.
This dilemma has led some to conclude that fossil fuel reserves may become “stranded assets” that won’t or can’t be used in the future—which could lead to asset write downs (impairment) on balance sheets and imply that current stock prices are overvalued. The Carbon Tracker Initiative notes that assets can be stranded for regulatory, economic or physical reasons.
“Stranded assets are fossil fuel energy and generation resources which, at some time prior to the end of their economic life (as assumed at the investment decision point), are no longer able to earn an economic return (i.e. meet the company’s internal rate of return), as a result of changes in the market and regulatory environment associated with the transition to a low-carbon economy.” (Carbon Tracker Initiative: Resources: Stranded Assets, Web. June 2015.)
However, according to Julie Fox Gorte, Ph.D., Senior Vice President for Sustainable Investing at Pax World Investments, “Factually, unburnable carbon doesn’t exist.” In short, Dr. Fox Gorte correctly points out that in order for fossil fuel reserves to become stranded (unburnable) assets there would need to be new regulations that don’t exist today in Pax World’s ‘ESG Matters’ September 2013 edition.
“I know of no nation that has or is considering legislation to make it either illegal or uneconomic to extract remaining coal, oil or natural gas reserves and burn them in the engine of commerce, mostly to produce energy” .
What can investors do?
First, recognize that the problem is real. Second, understand that the timing, magnitude and consequences of climate change are evolving issues. Consequently, one could develop an investment strategy that evolves as new scientific information, technology, environmental markets (for greenhouse gases, carbon, water, weather risks, etc.) and legislative or regulatory policies emerge.
Many colleges, universities, foundations, cities and other civic, charitable and religious institutions have opted to divest from fossil fuels ( See Fossil Free ).Others have opted to influence change through corporate engagement. And still others use low carbon indexes to increase exposure, while reducing tracking error, to more carbon-efficient companies (see ‘MSCI Beyond Divestment: Using Low Carbon Indexes’).
Finally, let’s not forget that climate change will create exciting new investment opportunities—and new environmental markets. Surprisingly, the best trade can be counterintuitive. Richard L. Sandor, Ph.D., Chairman and Chief Executive Officer, Environmental Financial Products, LLC, recently talked about his new book ‘Sustainable Investing and Environmental Markets: Opportunities in a New Asset Class’ by authors Sandor, Clark, Kanakasabai and Marques in Chicago. Sandor explained that markets often over-estimate the cost of compliance with new environmental regulations, so the best trade could be to short the market—even though your gut is telling you that the price will go up. BM