The UN Conference in Copenhagen opened last week, an attempt to negotiate a follow-on agreement to the Kyoto Protocol which expires at the end of 2012. As is the norm for these meetings, no one is expecting as much to come out of the conference as was hoped when they were originally planned, but there have been some pleasant surprises from a pro-environmentalist perspective: several of the major emerging markets have agreed to set targets for themselves, and the United States seems much more ready to shoulder responsibilities at least mildly proportionate to the US’s environmental footprint.
This seemed like an appropriate moment to comment on sustainability as an investment theme. In my macro worldview, sustainability is clearly a theme that should be taken seriously and for which I expect a positive return over the long term.
There are two themes I would talk about in this posting, but only one will fit. The first is how the investment community’s position on climate and other environmental themes is unusual and and actually creates an investment opportunity with a potentially high payoff for those with the appropriate time horizon. The second is a more detailed discussion of how environmental and sustainability issues impact investment returns and investment risks, and why this makes ecological sustainability an important theme for macro portfolios, opportunity funds and asset allocators. I will cover the first topic in this post and will try to cover the second either in a later post or, more likely, in a separate white paper.
First, I should comment on my qualifications to discuss sustainability. For those who know me in my investments capacity, asset management is actually my second career. My first was an academic and practitioner career as a political economist working on sustainable development in emerging markets. This explains my current focus on emerging markets and on macro- related themes, since environmental political economy demands broad generalist knowledge, systemic thinking, and a focus on the interrelations between broad social and economic processes, combined with attention to scientific and technological developments. Much of the investment community is composed of industry and product-based specialization; it is the strategist and macro investing role that most benefits from the experience I bring from my earlier career.
Why is the investment community so skeptical of climate change?
Admittedly, this is changing with time, but I am struck by the vehemence with which much of the investing community attacks the climate change hypothesis. I don’t have the time or patience to compile hard evidence of this, but It is my distinct impression from discussions with colleagues, interview questions, and much of the financial press that the investment and trading community really wants to discredit evidence of climate change and other environmental concerns. Rather than spend time documenting this, I will simply assert it here with the following observations. In the investment community, when climate change topics come up, I tend to see:
- Dismissal of climate change as a lefty tree-hugger myth created to empower government regulators.
- Dismissal of evidence from disappearing glaciers
- Dismissal of evidence from melting permafrost
- Dismissal of evidence from meteorological records
- Dismissal of anecdotal evidence from people who have lived a long time and observed warming
- Attribution of media attention to the issue as based on “political interests.”
There are two big questions in terms of the temperature data: 1) do we observe global warming at all? and 2) are humans the cause of that warming? The first question seems much easier to answer, since it is simply meteorological observation, and some enormous proportion of the scientific community agrees with the conclusion that the world is indeed warmer on average than 50-100 years ago. Personally, I think the case is closed on this, but we should continue to monitor because 1) things could get worse much faster than expected, and 2) things might just turn out to get better after a while, and it would be good to know if it does.
Is the warming we observe human caused? That’s a harder question. Almost certainly some of it comes from causes we don’t directly control, such as sunspot cycles, declining arctic albedo, and the concentration of CO2 absorbed or released by the oceans. Yet the fact that “not all” global warming is necessarily human caused does not then mean that “a significant portion” of warming does not have our fingerprints all over it. It is very important to avoid that logical trap.
There is evidence of substantially higher CO2 concentrations in the atmosphere since the start of the industrial revolution, and we do know that the burning of fossil fuels releases carbon dioxide that has to go somewhere. It has been a while since I have looked at the data and I don’t know off hand if the amount of carbon that must have been released through two centuries of exponentially increasing fossil fuel use is enough to account for the increased concentration, but surely that data is out there and is within the ball park.
And, if our actions warm the arctic sufficiently to release large quantities of methane (with 8x the warming effect of CO2 per ton) trapped in melting permafrost, how do we attribute that effect? Is it human-induced because human-induced warming triggered it, or is it non human-induced because it did not directly feed any economic activity?
Historically, we have seen that human induced chemicals have created ozone holes over the arctic and the antarctic, and the phase-out of CFC production (which is also a greenhouse gas) since 1988 appears to have slowed the growth of the hole dramatically. One could dismiss this as mere coincidence (as one could dismiss virtually any statistically-based conclusions), but the ozone evidence shows that human beings are plausibly capable of changing the atmosphere on a global scale. If it can be done with a highly specific chemical that is used in relatively few products, why is it so hard to believe it could be the same when massively increasing the emission of a chemical involved in virtually ever commercial and home activity.
“Climate Denial” vs. “Scientific Paradigm Shifts.”
Let me be clear that I am not advocating dogmatism on climate or climate science. Science advances through challenges to status quo thinking, and I think it is legitimate to ask whether the evidence for climate change makes sense or is defensible. Thomas Khun argues in The Structure of Scientific Revolutions that science goes through advances in fits and starts, a period of gradual accumulation of knowledge, the collection of a number of “anomolies” that cannot be explained by “normal science,” the emergence of a competing scientific paradigm, and then (if it is a good paradigm) the eventual replacement or integration of competing paradigms, most often the result of simple generational change wherein the new paradigm is no longer perceived as radical or revolutionary and new professionals are more open to its message and possibly more objective.
In some ways, I think the investment community is going through this change too, where sustainability was previously regarded as an issue for socialist tree-huggers, but a new generation of talent schooled at a time when these issues were becoming discussed more often no longer finds the concept of sustainability or climate change so unusual.
Nonetheless, I could sense palpable glee from investment colleagues at this year’s holiday parties when talking about the leaked emails where two scientists discussed how to massage data to reduce the perception of climate cooling. I am saddened to learn that this took place, but I also have to ask myself if people who deliberately hacked into these scientist’s email accounts might have had a political agenda themselves and might have “cherry picked” their evidence to fit their conclusion that climate change thinking is a broad conspiracy by scientists to… …to do what, exactly? Get grants? Surely anti-climate grant money is far more lucrative than public grant money, no?
Are we really to believe that someone who’s ethics justified hacking into private email accounts are then going to be extremely ethical and “fair and balanced” about revealing what they find?
I can understand the position of these scientists, who are concerned about the fate of humanity in the face of global warming and are concerned that the data might be questioned in a way that will create delays that may make the difference between a workable solution and “missing the boat.” Or maybe they are simply trying to build their careers by making as big a “splash” with their research as possible. I can’t condone their actions, but I do understand them. Yet it is an amazing leap of faith to go from those emails to the conclusion that some of the main conclusions of climate science over the last 20 years were really the result of an elaborate hoax coordinated… …coordinated from where, exactly? to serve what purpose?
Why is this a strange stance for the investment community?
I find the vehemence of climate denial by the established investment community to be extremely odd, because professional investors – unlike much of the anti-climate crowd – are generally very pro-science. In investment thinking, scientific knowledge generally helps to advance technological development, which in turn tends to enhance economic productivity. Those productivity improvements will typically produce profitability for companies early in the deployment cycle, and as profit margins get competed away, the benefits of scientific and technological development shift to consumers in the form of lower prices for improved goods and services. These lower prices generally leave consumers with larger consumer surpluses that free up resources for other investment and consumption, stimulating growth in the economy as a whole.
So for investors, scientific knowledge is something to be respected – not uncritically, of course, but certainly taken seriously. Understanding scientific and technological developments and their deployment is an important source of value-creation and investment strategy outperformance. It is strange, then, that thinkers who are so in favor of understanding science and technology in most areas would be so eager to suggest that climate science is “bunk,” that the evidence is “politically manipulated,” that the scientific community is engaged in one coordinated attempt to manipulate data in order to (I presume) keep grant money flowing.
Fear of Regulation Trumps Critical Evaluation of Evidence
I think the main reason that the investment community finds climate change evidence difficult to swallow is because if one accepts the human-induced climate change hypothesis, it is hard to escape the conclusion that governments are going to have to increase their involvement in the economy through regulation and industrial policy. To most market practitioners, the thought of government interventions is so anathema to their idea of efficiently functioning markets that it must be rejected outright, with whatever arguments might stick, without much consideration of the merits of the science behind it.
But our political moment, in the midst of financial and economic crisis, is very likely an inflection point in the regulatory zeitgeist that began in the developed world with Ronald Reagan and Margaret Thatcher and spread to the developing world in the Washington Consensus. The deregulation of markets that began in the 1980s has in part led us to the brink of disaster in 2007-2009, and it is clear that – on many fronts – the argument that government has a constructive role to play in the economy, in risk management, and risk sharing is coming back.
There are many ways regulation can go wrong, be overly intrusive, be slow to respond to new data, or too heavy handed when new data arrives, and all of these are indeed things to be worried about. But to define regulation as bad simply because it is the exercise of public power misses the point.
Environmental issues are especially tricky for the investment community, because economics does not require large intellectual contortions to justify the use of public power for managing market failures and internalizing externalities. Indeed, fairly mainstream economic literature argues that economic output is demonstrably inefficient when costs of resource use and/or degradation are not paid for by the same parties that buy or sell a product. As a result, those who feel the need to resist regulatory efforts must fight not on the ground of whether intervention is uneconomic, but instead on whether the background science is sound enough to justify intervention in the first place.
The Investment Opportunity
There are many ways to turn climate change (and other environmental issues) into investible themes. And not all of them require accepting climate change orthodoxy hook, line, and sinker. For example, whether one believes that climate change is real or not, one can look at the constellation of political powers and conclude that government interventions of various sorts are coming down the line, and that some companies will be better poised to adapt to those regulations than others. This is an investment strategy that does not depend on accepting climate science; merely an analysis of the political moment.
On the other hand, if one does believe that climate change is happening, one might be dismayed by the lack of action, or the fact that much of that action seems hardly sufficient in comparison to the magnitude of required changes if one truly takes the threat seriously. In this case, one realizes that humanity may not avert climate change and simply need to adapt to a warmer world. The investment strategy here looks at changing climate needs in different ecoregions and identifying the companies best positioned to meet them profitably. One can also look at companies that are exposed to climate change risks, such as insurance companies or coastal real estate developers. Climate change may demand a reevaluation of the risk/return ratios and therefore the appropriate level of allocations in an investment portfolio.
Traders often comment on the need to avoid crowded trades. When much of the investment community is on one side of a particular theme, it may be best to avoid it, unless one can find a justifiable way to take the opposite side of the trade. For example, if one thinks that the dollar is headed downward because printing our way out of debt may be the only politically feasible option, yet everyone else is also short the dollar too, it may make sense to abstain from the trade even if one thinks the fundamental argument for a week dollar is justified. Why? Simply because when the market is all on one side of a trade, small bits of news can create large stampedes out of the trade. In short, although the return on that trade may be positive, the risk of holding that position has now increased, perhaps to the point where it no longer make sense to keep it in your portfolio unless you have a long time horizon. Indeed, if you have reason to expect a short-term change or correction, the risk/return for taking the opposite trade can be quite lucrative.
So if so much of the investment community is so keen to discredit climate change, but their arguments are not compelling, the interesting question is whether the climate change deniers have put their investment money (as opposed to their lobbying money) where their mouth is. An important investment mentor of mine – who might not even know I consider him an important mentor – once said: “I don’t see the need to argue with an idiot when I can simply bet against him.” Of course, stampedes of idiocy can rule the short term, and Keynes noted that “the market can stay irrational longer than you can stay solvent,” but if your investment horizon is long enough and your position sizing is appropriate, you simply don’t argue with idiocy, you bet against it.
If my hypothesis – that the bulk of the investment community is irrationally opposed to the evidence for climate change and is drinking their own kool-aid (I’m less sure of the second than I am of the first) – then current investment is overly tipped toward “business as usual,” and sustainable industries are underpriced for their long term returns and therefore pose a more attractive risk-return ratio than their historical performance would suggest.
Those who remember their high school chemistry titration experiments might remember how – after pouring much sodium hydroxide into their solution – their beaker suddenly turns pink after just one or two drops. We have started to call these types of small change/dramatic outcome situations “tipping points,” and anyone who remembers their experiments know just how quickly a system can change from one state to another. There are many reasons to believe that climate may have similar tipping points, and that means that – although all climate change investments may be risky, those that are based on sound science may are likely to generate outsized positive returns. To develop a full climate change strategy is beyond the scope of this post, but the main message is that there are many reasons to expect climate change investing to be an important component of a thoughtful investment management and allocation process.