What Carbon Bubble?

These woods were first the seat of sylvan pow’rs, Of Nymphs and Fauns, and salvage men, who took Their birth from trunks of trees and stubborn oak.

A couple of months ago, a post by Rhiannon Sowerbutts on Bank Underground revisited the question of a carbon bubble. This topic holds some interest to me. As someone who invests in tracker funds and entertains hopes to retire early, live long and prosper, I want to know what effect climate change could have on my plans for financial independence and early retirement.

The carbon bubble refers to the idea that decarbonisation of the developed world’s energy systems is likely to hit the valuations of fossil fuel companies and thus cause havoc in financial markets. This idea is not new: it’s been written about in papers, discussed by central bankers, think tanks, pension administrators, investment managers and oil consultants. The reasoning goes as follows:

  • The world’s governments have committed to limiting the global warming between now and 2050 to 2⁰C. In order to achieve this, atmospheric CO2 concentrations cannot exceed 450ppm.
  • Currently we’re at 395ppm1; this means we can only emit around 570 GtCObefore we reach the 2⁰C limit.
  • The carbon held in the world’s known fossil fuel reserves is equivalent to about 2,800 GtCO2, of which 745 GtCO2 is owned by publicly listed energy firms.
  • In order to stay within the 450ppm limit the majority of these reserves cannot be burned and are therefore impaired.

The problem is actually wide than this. The so-called “permissible” warming by up to 2⁰C is bound to cause a noticeable change in climate patterns. Some further sea level rise is already inevitable. Hence the term “carbon bubble” should also encompass the medium-term risk of stranded assets (e.g. loss of agricultural land, flooding of coastal property due to rising sea levels, the impact of prolonged droughts on water infrastructure) that is likely to occur even if the Paris climate agreement is implemented fully.

I’ll refrain from talking about the danger that global warming poses to 7 billion humans. The planet itself said it best, albeit its assessment is somewhat on the gloomy side. I’m sure at least some of us would survive – a bunch of tough monkeys we are. But other than recycling, composting, walking and cycling wherever practicable, limiting my flying, using energy efficient appliances and not wasting water and food (amongst other things), there’s not much I can do about the end outcome. So for now let’s focus on the investment aspect of what many, myself included, think of as the worst disaster in human history.

Consider two future scenarios:

  1. The humankind pulls its shit together and limits the global warming to 2⁰C above pre-industrial levels.
  2. It does not.

In the first scenario, any displacement in the financial markets would come from a rapid transition to a low carbon economy. Most of the impacts would be felt in the next 20 to 30 years, and they would be concentrated in energy, utilities and mining sectors. Let’s call it “the 2⁰C scenario”. The effects of second “business as usual” scenario would take longer to filter through to investment performance, but they would be both more severe and less predictable.

The 2ºC scenario

It is a truth universally acknowledged, that financial markets are not pricing carbon assets in line with the 2⁰C target. However, Mercer’s excellent 2015 study found that a transition to low carbon did not have to result in negative returns for long-term diversified global portfolios. At the portfolio level, poor returns of fossil fuel assets were balanced out by superior performance of other investments, such as renewables.

Quite interestingly, according to Mercer’s models, developed market sovereign bonds were virtually immune to climate change. Renewables had good outcomes under all scenarios.

When it comes to energy supply and demand, low carbon does not necessarily mean low on energy consumption. A reduction in carbon emissions will require a change in the energy mix, but 2⁰C is a significant enough increase in temperature, and a hot planet might turn out to be hungrier for energy than a cold one. The human population is projected to grow, albeit at a decreasing rate, for the rest of my natural life. These people will have to eat. Agriculture requires more energy in adverse conditions (both in terms of soil and climate), and if water becomes a problem, desalination and purification of marginal reserves is not going to be either low on energy use or cheap. Human beings must maintain a skin temperature below 35⁰C in order to effectively cool down and avoid heat stroke. Increasing weather extremes might mean that both more heating and more cooling is required.

The business-as-usual scenario

While past performance may not be an indicator of future performance in financial markets, when it comes to people, the best predictor of future behaviour is past behaviour. Politicians are people, and to date the politics of climate change have been abysmal.

In 2006 Stern published Economics of Climate Change, where he estimated that dangerous climate change could cause a drag on GDP of 5% to 20% per year.

What’s interesting though is that the relationship between the measured GDP and human utility is not linear. For global warming, the distribution of outcomes is bound to be uneven. In certain aspects climate change could very well end up being one of several examples of bad things that are good for business2. Much like crime, pollution and cancer, it could actually increase the profitability of some sectors, at least in the short to medium term.

Now take this empty glass. Here it is: peaceful, serene, boring. But if it is destroyed … Look at all these little things! So busy now! Notice how each one is useful. A lovely ballet ensues, so full of form and color. Now, think about all those people that created them. Technicians, engineers, hundreds of people, who will be able to feed their children tonight, so those children can grow up big and strong and have little teeny children of their own, and so on and so forth. Thus, adding to the great chain of life. You see, father, by causing a little destruction, I am in fact encouraging life. In reality, you and I are in the same business. [Jean-Baptiste Emanuel Zorg]
By the way, am I the only one who thinks that garbage robots in The Fifth Element were a bit rubbish?

Here’s one example. More than 17% of all infectious diseases are vector-borne. Most of these vectors are bloodsucking insects fond of heat and humidity. If, say, malaria moves far enough north, rich European countries will have to dish out on vaccinations. That’s good news for the pharmaceuticals sector.

Overall though, under the business-as-usual scenario, climate change would increase the divergence in returns on capital and labour, which in turn would further economic inequality – both within any given country and between countries.

According to the Mercer’s study, if we aren’t able to stay below the 2⁰C target and end up heading towards 4⁰C, the result is likely to be more market volatility, higher inflation, and, in the long term, lower overall returns due to higher production costs. Poorer countries would be impacted earlier and more severely, hence Emerging Markets equities would underperform as an asset class.

The full effects – financial and otherwise – of this scenario would begin to manifest in 50+ years, by which time I’d be in my late 80s. That’s not an ideal point to run out of money in retirement. Going back to work wouldn’t be much of an option then.

So what’s it all mean?

None of the reports I’ve read suggested that in the face of the global warming active portfolio management was set to outperform indexing. The only claim that active fund managers (Schroders and Caz. So, basically, Schroders) made for themselves was that investors who wished to take action on climate change by allocating capital away from carbon intensive industries had to rely on active portfolio management to effect divestment of carbon assets. I think, at least at present, this is true. While we have several S&P Fossil Fuel Free indexes and a few clean energy indices, there’s a lack of low carbon index tracker funds. Given McNabb’s recently publicised views on divestment campaigns, it’s quite unlikely that Vanguard et al will enter this market in foreseeable future.

For us lazy indexers, Mercer’s study gives some comfort that investments like VWRL can withstand the effects of carbon emissions reduction over the next 20 to 30 years if as the world’s governments work towards the 2⁰C target. If, however, it begins to look like we’re set to overshoot the two degrees, a slug of US Treasuries in the portfolio should be a good bet. And, since a larger increase in global temperatures appears to be associated with higher market volatility, the 4% SVR might come under pressure. I personally think something closer to 3% could be more appropriate, whatever the climate outcome.

It appears that, despite our best efforts, we’re going to live in interesting times.


    1. Based on 2013 data.
    2. The Bento Rodrigues dam disaster created an extensive clean-up operation and a huge amount of work for lawyers; cancer generates inexhaustible demand for pharmaceuticals; and crime not only provides employment to thousands of law enforcement, detention and judiciary personnel, but also fuels demand for home and industrial security systems, insurance services, and replacement goods.

4 thoughts on “What Carbon Bubble?”

  1. > Overall though, under the business-as-usual scenario, climate change would increase the divergence in returns on capital and labour, which in turn would further economic inequality – both within any given country and between countries.

    I suspect this may also increase your running costs, possibly earlier than the effects on the oil sector component of your index funds, because there are other trends which are amplifying the split between capital and labour. There’s some argument that the strength of feeling about immigration that swung the Brexit vote may have been a result of increasing inequality – this has made imports 10% dearer for us in the coming years.


    1. I fear you are right.
      Particularly so as we seem to be heading towards representation without taxation. I think you wrote a post about it some time ago — universal income, etc. As an aside, I don’t have a problem with universal income per se, except that it does come dangerously to the panem et circenses socio-economic model, which has been tried already.
      I sometimes wonder how much of our Brexit tale will turn out like the fable about the maids and the rooster.


  2. Nice blog, always interesting to see how the financial world view the future.

    The 2 Degree C warming is important for reasons that not everybody seems to be aware of. The evaporation rate of standing water increases in a non-linear fashion with respect to temperature since the air can hold more water so a degree causes a lot more evaporation than you might assume. This is important for agriculture since so much of the worlds agriculture is irrigated.


    This is not going to take 50 years either – Middle East countries are already suffering:


    (no water = no wheat) . They also grow rice in the desert which is about as smart as it sounds.

    Similar situation in Iran, Syria etc.

    Aquifers are being drained everywhere and they (despite what is assumed) don’t refill on a timescale that is relevant to mankind. It is also worth studying what happens, from a systems point of view, when wells run dry. In Africa this happens in times of drought and it creates a systemic issue where the next functioning well sees an increase in its demand and runs dry or the equipment breaks faster than it would at its typical demand. This makes predicting the available water difficult/uncertain. The same applies when rivers run dry and no longer reach the sea. The next water source gets tapped. The geography books will have to be rewritten not to confuse the kids soon.

    If I were to look at stocks I would look at big food/water and big agriculture. Maybe “vertical farming” but the model is not there yet to make it pay.

    Malaria was in Europe in the past but was eradicated by environmental means – they drained the swamps. Malaria transmission also requires a critical mass of infection before it can spread as a female has to bite twice to transmit (one infected person and a subsequent victim) so even with the vector here the rapid use of antimalarial tablet stops the spread. There is no known vaccine for malaria currently and bed-nets and education seem to be quite effective. West-Nile and Dengue are another story.


    1. Thanks for an interesting comment and the links. You may be right about big agriculture. I’m not sure about water, though. Monsanto can sell its rice that grows in brackish water anywhere where there is need for such. Water infrastructure can’t be as easily moved …


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