The upside of carbon risk

The future is now closing in on us rapidly and the resulting shifts in investment markets are gathering pace. When Phil Preston and I started working on the paper we released here last week, Carbon Induced Financial Disruption, the idea we were advocating – of disruptive change in financial markets driven by market’s pricing in carbon risk – seemed like a radical one. That was just March this year, yet six months later similar ideas are taking hold across the mainstream market and in the business press.

In June this year, Deutsche Bank said they thought that, in Europe, “coal is basically out of the game as a new build choice with carbon prices above €30/tonne”. This level now seems inevitable if we’re to come anywhere close to agreed policy targets for emissions.

As reported in Climate Spectator last week, analysts from Citigroup have started doing analysis on how individual company share prices might perform if governments take strong action on carbon emissions. I think such action is inevitable if we pursue the 2 degree temperature target governments have already adopted. We are even seeing major global coal miners like BHP Billiton acknowledging the inevitability of a carbon price and encouraging it to be brought in sooner rather than later to ensure countries like Australia can maintain competitiveness in a low-carbon economy.

The mainstream business press is also starting to raise the future of climate policy as a consideration in investment decisions. In Australia, the offer documents in the planned privatisation of Queensland Rail through a public float features the coal they carry as the key selling point. They proudly point to the enormous volumes of coal that underpin the business – around 200 million tonnes in 2010. The business press meanwhile is raising the risks such a focus on coal poses to investors if strong carbon pricing is put in place, quoting analysts views on the subject. While it is true that most analysts still believe coal has a rosy future, the fact that it is being incorporated into their thinking at all is a major shift compared to just a year ago.

Of course if governments can offload carbon-exposed assets to investors that’s good news for taxpayers, but its bad news for investors who don’t take account of carbon risk.

Another interesting development is that some of the luminaries and elder statesmen of the investment world are stating to pay attention to these issues. In July this year legendary contrarian investor, Jeremy Grantham published his views on climate change. With his company GMO managing around $US100 billion in funds, other investors take his views very seriously.  While Grantham acknowledged it was still tough to know how to make money out of climate change, he made the case that investors need to rapidly answer that question because “global warming will be the most important investment issue for the foreseeable future.”

Then, last week, Bob Litterman, the former head of Goldman Sachs' quant group and an MIT economics professor, suggested in a speech to sovereign wealth fund managers that unpriced carbon risk could be the next financial crisis to grip global markets. The speech makes for fascinating reading for those who want a financial analysis of carbon risks in the global market and why, when change happens, it is likely to be sudden and dramatic, as Phil and I argued in our paper, not slow and steady as most investors assume. If you want to see Litterman’s full analysis you can read it here.

Of course, as I have written many times before, there is more to climate investment issues than risk. Billions are now flowing into renewables, getting ready for the now inevitable boom that will be driven by the transition away from fossil fuels. With over $100 billion invested per year in both 2008 and 2009, we are now talking serious money. Of perhaps even more significance is that in both years, more money was invested in new renewable power capacity than in new fossil fuel capacity, indicating a tipping point has been reached.

The context here is important. We haven’t actually decided to fix climate change yet, with political action stalled both globally and in key markets like the United States. What this means is that all this action just provides a small taste of what’s to come when we really get moving. Then hold on for the ride but make sure your investment portfolio is ready for the bumps along the way.