Climate and Investing
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. – Mark Twain.
That word is used a lot (more) with climate change now.
I'm not here to convince you that climate change is real, or what the consequences of it will be. Instead, let me show you what the investment implications of some of the climate predictions are.
Climate change will pose several different categories of risks for investments:
- Physical risks - Hurricanes, fires, and droughts
- Transition risks - Carbon taxes, shifts in demand
- Second order risks - Water, biodiversity, supply chain interruptions and breakdowns, carbon border taxes, falling property values, rising insurance costs, and more
Each risk category will be affected differently: Physical risks depend on the effect of GHG levels on storms, while transition risks depend on the measures taken to limit the effects of climate change. Thus, measures which reduce physical risk for some assets may increase transition risk for others.
The NGFS Case Studies book performed several such analyses:
- In Chapter 6, an analysis of the impact of natural disasters on residential mortgages in China's coastal cities showed an increase in defaults by anywhere from 0.04% to 0.38% (from baseline of 0.4%) and losses by 0.01% to 0.11% (from baseline of 0.11%) under the RCP 6.0 scenario. This wide variability results from differences in climate scenarios and variability in the effect under each of those scenarios (Mean, Severe, and Extreme) around those scenarios. These numbers sound smaller than they actually are. At the baseline 0.4% default rate and 0.3% loss severity, the cumulative losses for a 30-year mortgage pool assuming 8% constant prepayment rate is 1%. If the default rate increases to 0.58%, the cumulative loss is 1.43%. At 0.78% default rate, the cumulative loss is 1.9%. Compared to Fannie Mae's historical loss rates, we see that the cumulative lifetime loss rate rose from 1% for 2004 originations to 2.4% for 2005. So we're not quite at full blown credit crisis levels but getting there.
- Chapter 20 of the NGFS Case Studies book analyzed P&C losses from climate change under 2 and 4 degree scenarios using Climada and Future Flood Explorer on mortgages, showing 61% and 130% increases in losses due to flood risk in the UK. This seems to agree with the results from Chapter 6. It further stated that such analysis may understate risk, and insurance may become generally unavailable if the annual probability of flooding is greater than 1.3%. (Don't worry -- if the State of Florida is any guide, we can just socialize insurance to keep things going and pay the bill later.)
- Closer to home, Chapter 24 of the NGFS Case Studies book analyzed the property value at risk in San Francisco at the high end of the projected sea level rise by 2100, which is an amazing 66". (At least Nob Hill will be OK?) The total value of the property at risk was $55 billion. The total value of real estate in the San Francisco metropolitan area is about $1.3 trillion.
- Chapter 7 of the NGFS Case Studies book analyzed the effect of transitioning to the Paris Agreement's 2-degrees scenario on coal-fired power generation companies in China. The analysis projected the effects of higher carbon taxes (RMB 508/tCO2e, or about $78/tCO2e), lower demand (-30%), and lower price for power generated (RMB 0.20/KW instead of 0.33/KW) due to falling price of renewables on the income statement and balance sheets of the electric utilities. It did not look good. The combined effects of all these shifts would push the probability of default for these companies to over 20% by just 2030. This would push the credit ratings to the single B category.
- Chapter 16 of the NGFS Case Studies book estimated the Value at Risk (VaR) of the Chinese equity market from higher carbon prices. It found that "if the carbon price rises from 20 yuan to 200 yuan (approximately USD28), the market value of CSI 300 index has a 40% chance of dropping 8.4%, a 30% chance of losing 10.4%, and a 20% chance of falling 12.7%" and "According to the World Bank, a price at USD 80-120 (approximately 560-850 Yuan) a tonne in 2030 is needed to meet the Paris Agreement targets."
- Chapter 19 of the NGFS Case Studies book shows a study by 2 degree investing which estimated the impact of a "too late, too sudden" transition on bond values. It showed that for bonds with 10 years to maturity, the repricing would be -17% for coal power, -16% for oil, -13% for coal, -9% for gas, -6.5% for steel, cement, and airline sectors. These repricings imply downgrades of all these sectors to non-investment grades. For equities, the change in value would be -80% for coal electricity, -57% for coal mining, -53% for upstream oil, -52% for crude steel, -30% for upstream gas, -27% for cement, -21% for aviation, -20% for gas electricity, and -9.5% for automotive. On the bright side, wind electricity, solar PV, and nuclear power would gain 13%, 19%, and 20%, respectively.
- Chapter 22 of the NGFS Case Studies book compares the transition versus physical risks across industries and countries. They show that real estate, materials, and food/staples retailing industries and China and Canada had the highest transition risks, while real estate, materials, and consumer durables industries and China had the highest physical risks. Meanwhile capital goods and technology hardware and equipment industries had potential to gain from transition risks, presumably from required equipment upgrades.
- Chapter 9 of the NGFS Case Studies book analyzed the effect of water shortages on different companies in the mining, power generation, and beverage industries by applying a "shadow water price" to the amount of water used. The shadow water price is based on what the price of water should be given its economic value. It was calculated for different regions of the world based on availability and use of water, and then allocated to different companies based on the locations of their operations. Surprisingly, it found a much greater impact on mining and power generation companies than beverage companies. Because of the higher operating costs from higher water prices, the Net Debt/EBITDA increased by 2x to 3x for BHP Billiton, Glencore, and Rio Tinto (mining), Eskom and Sempra (power generation), and Femsa (beverages), putting their debt into non-investment grades.
- Chapter 14 of the NGFS Case Studies book analyzed the transition risk to the South African economy. They found that transition to limit climate change to 2 degrees C would cost a staggering one third of South Africa's GDP, concentrated in its coal mining, power, refining, ports, freight rail, and pipeline sectors. Furthermore, most (75%) of the transition risk is due to policies outside of the country's control.
- A study of the effect of the climate change on credit spreads of corporate and sovereign bonds that combined climate policy models with credit default models showed an increase in the sovereign spreads of 245 bp for the sovereign bonds of Australia, 205 bp for Norway, 175 bp for Poland, implying all three countries are non-investment grade given the carbon intensive nature of their economies and their lack of climate aligned policies. In comparison, US and UK bonds would see 52 bp and 6 bp increases in credit spreads.
- Moody's publishes a Environmental Heat Map which as of December 2020 showed $3.4 trillion in debt faced heightened environmental credit risk, $4.5 trillion have high transition risk, and $7.2 trillion have high physical risks. While they provide this as a warning, they have not acted to downgrade, because "There is also typically greater scope for issuers to adjust to or manage environmental risks; for example, by adapting business models, changing policies (in the case of governments), or by passing on expected cost increases to customers or taxpayers.” In other words, maybe we'll all come out OK.
- Or are we sitting on a carbon bubble of trillions in fossil fuel assets that can never be safely extracted, yet have been financed by the global banking system? What will happen if the financial markets come around to this point of view?
“It's tough to make predictions, especially about the future.” - Yogi Berra
Did you know Nostradamus and Niels Bohr also said the same thing? The fact is, everybody knows predictions are hard to make. Yet scenarios help us see and prepare for the range of potential outcomes. Even more importantly, they're read by policymakers and regulators and thus have a habit of actually influencing the future.
Take a step back, and you'll see that a few things are already clear:
- Climate change is happening.
- The longer we try to ignore it, the higher the costs which will be disproportionately concentrated in some geographic areas and specific sectors of the economy.
- If we manage a gradual transition, the costs of mitigation and adaptation could be spread out for an orderly transition.
- In any scenario, there will be winners and losers.
What makes it complicated is that mitigation and adaptation could take place over decades. While it's good to have time to prepare, it also creates a lot of different options. Once you add different industries, countries, and the politicians who support them, it becomes even more complicated. Hence the difficulties of knowing how it will play out.
But as investors, our job is to judge, not to know. As I will show you in the next chapter, we can compare the market's expectations with our analysis and make investment decisions, even if we don't know exactly how climate change and its related transition will play out.