Financial bubbles can wreak havoc on industries (think dot com) or commodities (like gold). Investor excitement builds, asset prices skyrocket, and eventually enthusiasm gives way to a crash, wiping out huge amounts of value practically overnight. In short, the bubble bursts.
It’s time we extended this framework to a new value-inflating culprit: carbon.
Financial Markets Blowing Hot Air
The concept of a carbon bubble was first given voice by the Carbon Tracker Initiative in a landmark 2011 report. Their key finding: if we are to limit the earth’s average temperature rise to the internationally accepted 2 degrees Celsius and avoid catastrophic climate change, we cannot exceed a global “carbon budget” of 565 gigatonnes of new emissions between now and 2050.
This restriction would cap the world economy’s carbon dioxide output at just 20% of existing fossil fuel reserves, and is less even than the 745 gigatonnes held by the top 100 listed coal companies plus the top 100 oil and gas companies - not to mention national governments, smaller companies, and others. Adding to the pressure, current patterns of energy consumption would bring us to the end of our carbon budget in less than 16 years.
Facing such a dire situation, governments around the world are likely to take concertedaction to limit greenhouse gas emissions in the near future. If and when they do, fossil fuel producers will be left with heaps of worthless assets stranded on their balance sheets. Huge reserves of oil and coal will be rendered unburnable, and market valuations will plummet.
As the impending carbon bubble becomes more widely known, you’d expect investors to take notice and begin incorporating climate-related risks into their asset valuations. A look at financial markets, however, tells a different story.
HSBC recently examined how a low carbon world would affect European oil and gas companies, finding that the value at risk could be as much as 40-60% of their market capitalization. Closer to home, ratings giant Standard & Poor’s wrote in March 2013 that medium-sized oil and gas companies in North America could be subject to ratings pressure within just one or two years, while the risk assessments of oil majors could be affected within as few as five years. Yet recent research has shown that fossil fuel companies continue to spend hundreds of billions of dollars each year replacing reserves that already vastly exceed our shrinking carbon budget.
Sounds like a bubble waiting to pop, doesn’t it?
An Uncertain Atmosphere
There’s a reason why investors are having so much trouble incorporating carbon risk into their ballooning valuation models. Asset pricing relies on the ability to measure and account for risk in forecasting future earnings. The problem is, no one knows when governments will step up their restrictions on carbon emissions or how heavy-handed their policies will be. Without consensus estimates to go on, let alone hard data, it’s difficult for investors to build new valuation techniques to account for the massive risks creeping onto their spreadsheets.
Despite the uncertainties, thought leaders in the financial sector have begun making headway on this issue.
The most thorough treatment of climate risk thus far is investment consultant Mercer’s 2011 report entitled “Climate Change Scenarios - Implications for Strategic Asset Allocation
.” Mercer’s analysis, sponsored by a slew of financial and environmental organizations, suggests that uncertain climate policy could contribute as much as 10% of total portfolio risk for institutional investors over the next 20 years. Put differently, the market should expect to absorb about $8 trillion in economic cost due to climate-related regulation between now and 2030.That should raise eyebrows all the way from pension fund executives to individuals saving for retirement. But the key question is - what can all these investors do to protect themselves from carbon-related risks?
It’s not as easy as simply divesting from fossil fuel assets (though ten prominent U.S. cities and European heavyweights Rabobank and Storebrand have already committed to doing so). Since climate regulations affect much broader swaths of the economy than the oil and coal industries alone, a more sophisticated approach is needed. Mercer advocates a fundamental shift in thinking to focus more on sources of risk rather than fund allocation among asset classes.
In particular, the company proposes a novel remedy to address climate risks: realigning investor portfolios to include “climate-sensitive” assets, or assets that can adapt easily to a low carbon economy. Examples of such investments abound, and include clean infrastructure projects, renewable energy companies, sustainably-harvested timber, and green agriculture, among many others. Mercer recommends an investor targeting a 7% annual return allocate up to 40% of its funds to investments like these.
Climate-sensitive assets, which are expected to retain their value better than more traditional investments in the face of carbon constraints, function as a “climate hedge” - that is, their value moves in opposition to oil- and gas-intensive assets and thus reduces overall climate risk in a diversified portfolio. Not only will they be protected from large losses in the event of a bursting carbon bubble, many of them are positioned to appreciate substantially as demand for low emissions products grows.
Out from Under the Clouds
In the wake of Mercer’s report, a January 2012 follow-up study found about a third of their partners had already decided to allocate more of their investment dollars to climate-sensitive assets. An additional half indicated they were considering doing so in the future.
Mosaic sees global financial markets on the verge of a profound “reallocation moment” - a paradigmatic shift away from the carbon-based economy of the twentieth century to the sustainable, clean-powered economy of the future. Our company was founded on the idea that solar energy has the potential to create a new energy economy of abundance for all, and we take very seriously our responsibility to lead change in the energy sector as well as our commitment to providing low risk investments that enable everyone to prosper from the sun.
Part of our challenge, too, is educating our diverse stakeholders on how to evaluate climate-related investment risk and how to build sustainable investing principles into their portfolios. Understanding and addressing the energy challenges we face requires new ways of thinking about wealth, value, and prosperity, and an ability to look much further into the future than we’re used to - no small task for a financial system firmly set in its quarterly ways.
If we succeed in bringing clean energy investing into the mainstream, we can make a successful transition to a low carbon economy without allowing climate change to deflate our wealth or our prospects for growth. We hope you’ll join us outside the bubble.
Alex Colman is an MBA candidate at the Kellogg School of Management and a member of Mosaic’s institutional investment team. Prior to Kellogg, Alex spent four years as an analyst providing economic and financial research to companies involved in corporate litigation. He also has two years of experience leading a student-run microfinance institution serving the Connecticut small business community.