Representatives from the finance world have come to the Paris conference in unusually large numbers. While representing diverse groups, most of them have been working on some aspects of climate financial investments for many years. So, they still represent a small number compared to the size of the overall investment market. They are really dwarfed by the status quo: the market is still tied up in the incumbency, the fossil fuel industry. What are these new players at the COP telling us? How does this desire to participate and contribute tell us about the future of investments in America?
Many Americans believe that Climate Change is something that happens to the rest of the world even though the drought and fires in California are exacerbated by global warming. What we hear from the financiers is that, in the long run, these physical climate impacts might not be the main impacts that Californians will experience. And it is likely through the financial consequences of Climate Change that most American will be most affected in the future. At least this is the argument that was presented at the COP by investment specialists at the end of the first week. Unless fund managers take climate and environmental changes into account in the way they invest retirement funds, pensioners will be at risk in a 20 to 30 years time frame.
To appreciate how this might happen one must grasp the notion of stranded assets with regards to environmental and climate risks. As defined by the International Energy Agency, stranded assets are “those investments which are made but 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, as a result of changes in the market and regulatory environment.” This notion gained prominence about a decade ago and has since been used extensively by the Carbon Tracker Group in its analysis of what constitutes a good investment in a warming world. The financial community initially received the idea that fossil fuel investments could be stranded assets in the relatively near future with much skepticism and this is still the case to some extent, at least in the US. However, the notion was seriously discussed and used at COP 21 and even the governor of the Bank of England recognizes that stranded assets are a real possibility that has many implications.
So why is this notion of stranded assets taken seriously nowadays? Essentially, we are at a point in the understanding of the evolution of our climate and of the risks associated with doing business as usual that we know that must limit the warming to 2ºC by the end of the 21st century. In fact this maximum temperature change threshold is more likely 1.5 ºC if we want to protect the most vulnerable countries. This temperature constraint gives us what is called a carbon budget that is the maximum total emissions allowed over that period of time. The exact value of this carbon budget cannot be exactly computed because we are talking about computed probabilities of remaining below that threshold estimated with climate models. Anyway, the exact number is not terribly important and its value will be refined over time. It is the concept of carbon budget that matters.
Given a certain carbon budget, several questions can be raised. The main one is: how will we spend or, better, allocate this budget? This is like if we were given a certain money allocation for our Christmas shopping and could spend it in the way we wanted. What would we choose to spend it on? In the framework of climate change we are talking about how do we spend the world’s carbon budget till the end of the century. What fuels would we use it on? What mix of coal, oil or gas should that be? What countries should be given more priority to spend it on? For instance, will a developing country like India be able to use their coal to develop their economy to bring the level of many of their inhabitants to a higher standard of living while, in so doing, use a large portion of the world’s carbon allocation relatively inefficiently? Or will some developed countries, like the US, be able to spend a good deal of that allocation on shale oil and gas that are known to be carbon-intensive to keep their economy humming on the grounds that the US economy affects the entire world? Or shouldn’t we find the most efficient way to manage this budget? This means using the least carbon intensive fossil fuels (i.e., conventional gas and some oil) first to fuel the economy until we transition to a 100% renewable energy based world economy, as the Carbon tracker results suggest? The consequence of such an approach is that we will leave some fossil fuels in the ground and some of those left will be in the developing world, in countries that might need energy the most. Following such paths would take us into what Carbon Tracker calls the “danger zone”. That is the emission zone that would take the world to a much higher temperature than the climate can afford, if we don’t manage our carbon resources efficiently.
In any case, it is clear to everyone now that some fossil fuels will have to remain in the ground if the temperature increase is to be limited. Naturally, this is a hard fact to face for economies that rely mostly on fossil fuels for their survival or for those who rely on fossil fuel for their growth, at this moment in time. And this constitutes a risk for investors if their investments are not made with full knowledge of that risk. That means that fund managers have to recognize the risk and require that the companies in which they invest analyze what may happen to them when considering those stranded assets. They will have to perform some form of stress tests to assess their risk in relation to the 2ºC constraint. What will they become in that new world?
What will the consequent effect on people investing their savings in a retirement fund be? Let’s take the case of a pension fund for a category of employees like teachers or civil servants or workers in a union. In California this type of pension fund can have huge assets of the order of a couple 100s of billions in the US Union pension funds reach a few trillions of dollars. Every year the funds must pay benefits in millions of dollars to their pensioners and that is what these people count on to live. If the managers are wrong in their estimates or in their assumptions for running the workers’ money or if there is high volatility in the market, the ramifications might be severe and we’ll have to find more money for these pensions and more likely than not that that will mean tax payers money coming from the citizens. So this may affect everyone. If there is a market implosion resulting from the stranded assets, it is not just that institutions that will fall, it will also be about workers’ pensions. It is because we are dealing with such a long-term risk that climate change speaks loudly to the managers and the investors and not only those investors of state or unionized employees. This would also affect any 401-k or 403-b people have made as part of their employment and on which they count for their retirement.
So, is there something investors should do to protect themselves? That is a complicated question that will require much thinking. In a first step, however, investors should probably demand that their fund managers be aware of the issue of climate change and start thinking of its potential effect on the market in 20 or 30 years when it is time for these investors to retire.