Table of Contents
The scale of the problem
Regardless of your political or scientific views on global warming and whether it is the result of human activity, a massive body of evidence now drives the global consensus among scientists and world leaders that climate changes are coming on a grand scale and that even under the most optimistic scenarios, attempts by humans to mitigate them will have only minor impact.
Global warming was not even on the radar screens until the late 1900s when concerns arose over the ozone layer and the level of carbon dioxide in the atmosphere. When scientists began collecting data, the inevitability of a warmer planet came into view. Once they began building models to forecast how that warming would alter global climate, the alarm bells went off over the magnitude of the problem and the time frames in which they would materialize.
During just the last decade, the thinking has changed dramatically on two climate issues. First, scientists discovered that the planet’s warming process is much more complicated than originally thought and that feedback mechanisms such as the albedo effect (heat reflection from ice vs. land and water) and the warming of the oceans were not only accelerating the warming process but rendering it more or less irreversible.
Second, the realities of getting a highly disparate world order to agree and collaborate on reducing carbon emissions made it clear that the magnitude of the response on a global basis was not going to be sufficient to ward off potential changes to the planet’s climate system, much less reverse the problem. This led us to the position we are in today, where we bear witness to the initial effects of a planetary climate change that the world is ill-equipped to cope with.
Occasional bad weather can be devastating enough, but climate change is unlike any other phenomenon we have ever encountered, both in scope and scale. Destructive weather events such as droughts, floods, fires, and storms will increase dramatically and occur in entirely new places (e.g. fires in Hawaii, floods in Vermont, and tropical storms in Palm Desert).
But more importantly, even a few degrees of warming jolt the planet’s weather patterns permanently out of kilter. As a result, we can now expect that sea level will rise and whole swaths of agricultural and developed land may become unviable.
It is therefore not an overstatement to say that climate change will be unlike anything experienced by human civilization. The planet is already warmer than it has been for as long as humans have existed. For perspective, previous climate changes have contributed to the five mass extinctions known to have already occurred in Earth’s history.
Climate change is global in scope, highly complex, probabilistic, and likely to extend far into the future. The upheavals of the two world wars will pale in comparison. Furthermore, it will not be a single event, but a cascade of events over decades, which together will cause permanent changes to habitats and food and water sources for all living creatures on Earth.
In past climate change events, the species that survived migrated toward the equator as the planet cooled and toward the poles, as the planet warmed. Even if climate change produces as many newly habitable areas on the planet as those rendered uninhabitable, the prospect of migrating millions of people will cause political, economic, and social upheavals on a scale never experienced in recorded history.
Behind the scenes, scientists, governments, and academics have been hard at work collecting data and trying to estimate the time and scale of anticipated changes in global climate. The effort has yielded a great deal of information but has been stymied by the complexity of building planet-wide climate models, the difficulties in achieving global collaboration, and the sheer amount of data involved. One such predictive model has 125,000 lines of computer code and takes almost a month to make a single run. The task is so big that most models usually focus on just one particular aspect of global climate.
The public reaction
The public is only just beginning to grasp the depth of the problem, and in addition to the resistance of a vocal minority, there are typical cognitive illusions that hinder people’s reactions. Most people, for example, cannot easily grasp the imminence of an event that takes centuries to unfold and occurs only once in tens or hundreds of thousands of years. For another, humans have no reference points in their lives for what a change in climate represents, save for singular weather events they may have previously been exposed to.
In addition, people have an illusion about what climate change actually represents. The models are forecasting only a few degrees of warming throughout the planet. So, to many people, having an average daily temperature where they live rise from say 70 to 73 or 74 raises no particular alarm, and might even be considered a welcome change. But that’s not how global warming works. At an average increase in temperature of just 2 degrees Celsius, the polar ice sheets disappear, causing the sea level to rise many feet and the planetary ecosystem as we know it to change radically. At 6-7 degrees, it changes catastrophically. During the last ice age, the average temperature was only 6 degrees Celsius colder than it is now.
Meanwhile more and more carbon enters the atmosphere, temperatures are as warm as they have ever been in recorded history and the debate rages on about what can be done. As early as 2005, the Kyoto Accord was proposed, but the US would not join it. In his attempts to sway the US to join the accord, British Prime Minister Tony Blair said “It’s plain that the emission of greenhouse gases is causing global warming at a rate that began as significant, has become alarming, and is simply unsustainable in the long term. And by long-term, I do not mean centuries ahead, I mean within the lifetime of my children certainly, and possibly within my own. And by unsustainable, I do not mean a phenomenon causing problems of adjustment. I mean a challenge so far-reaching in its impact and irreversible in its destructive power, that it alters radically human existence.”
Climate change and financial markets
While the public, lawyers, politicians, and corporate execs debate the impact of climate change in boardrooms, courts, and social media, there is one place where, for better or worse, climate unknowns will be quantified – the financial markets.
Public attention right now has been focused largely on the science of global warming – the ice melt in Antarctica, the level of carbon in the atmosphere, the rising sea level, and the floods, storms, and wildfires that result from these changes. Only scant attention has thus far been given to the financial implications. The focus, however, will likely shift from climate science to climate economics in the very near future.
The markets have already embraced numerous new investment opportunities in green energy, plant-based foods, carbon capture projects, and other climate-related ventures. You can also invest in ETFs such as the Hartford Climate Opportunities Fund (HEOIX) or Blackrock’s iShares Global Clean Energy ETF (ICLN). What you can’t find are financial instruments for dealing with the risks of climate change to existing assets or businesses.
This is not surprising for several reasons. First, the ventures that are being funded now are largely being conceived as well-intentioned mitigations to the amount of carbon being added to the atmosphere. The risks are naively assumed to be a long time off in the future and most have not even been identified, much less quantified. As such, the current risks of inflation and recession are far more pressing to near term valuations.
Second, the risks from climate change are very different from those of traditional financial risks. As such, current financial models cannot yet build them in. The nature and magnitude of climate risk will not look like the financial risks we typically evaluate today. It will not be a question of soft earnings, losing market share, or lowering a dividend. A new set of risks — supply chain risk, real property risk, business disruption risk, health risks, capital risks (borrowing) – will rise to the surface.
Companies will eventually be rated for climate safety as opposed to ESG criteria The risks will focus more on outright sustainability and viability. In the near future, we will need to know whether a company’s main facility can withstand fire or flood, whether it can rely on importing its raw materials from overseas, or whether its products and services might even be restricted from sale in some jurisdictions. In short, risks will become potentially more serious and, in some cases, may be existential.
The financial industry is already working on a climate risk rating system that will be applied to all public companies. It will be somewhat similar in nature to ESG ratings today, except that ESG rates companies on how well they are doing on social and environmental issues. Climate ratings will focus on how much risk they have to their business or assets from climate change. All public companies will likely be rated at some point and their prices will reflect their ratings.
Wall Street firms, however, will not be well-equipped to give investors the protection they need for all their assets. For one thing, the industry revolves almost entirely around public securities, so it will not be much help to investors with regard to other types of assets, such as your car, house, boat, collectibles, or cryptos.
More importantly, the securities industry is biased. (Trust me, I worked in it for 25 years.) It makes its money by selling and managing investments and by trading and market-making. These ends have always been best served by keeping investors optimistic and fully invested. Wall Street firms are well known to avoid outright ‘sell’ recommendations except when the horse has already left the barn. Raising alarm bells over climate change would run counter to the industry’s self-interests.
Internally, however, what Wall Street does with its own resources is something else. Remember, Goldman Sachs was shorting mortgage securities in 2007 even as they happily sold them to the public.
One thing is clear. Finance and investing represent a forward-looking paradigm built on a foundation of risk, reward, and probability. The time horizon for most investments spans a few months to as long as 30 years. As a result, even the hint of change during that time horizon will make its way into financial models and expectations. Reinsurance companies for example, have already raised rates over the last several years to begin building a larger contingency for eventual losses.
Many climate models are predicting dire circumstances as early as 2050. That is only 27 years from now, meaning that significant changes in climate will have begun within the time frame of mortgages and insurance policies that are being issued today.
The first pass at assigning climate risks was based on region. We are already seeing this play out in the insurance industry where companies are simply refusing to insure properties in specified locations or states that may have elevated fire, flood, or coastal risk. Ultimately, the industry intends to assign risk to specific assets. That means every home or business structure will be assigned a risk rating due to climate change. The markets will then reassess valuations across the board accordingly.
Think about that for a moment. You could be living in a house near the ocean that is worth more than one million dollars today. What will happen to the value of that house if no bank is willing to write a 30-year mortgage on it and no insurance company is willing to insure it? Now multiply that by the number of homes or apartments in the US that are within a few miles of the coast.
The fact is that investors will begin to see the financial impact on investment assets long before the actual effects on those underlying assets are experienced. In other words, you won’t realize the financial risk of climate change on the value of your home when it burns, floods, or falls into the sea – you will realize it when the mortgage underwriters stop writing mortgages on it and the insurers stop writing new policies on it. That will happen when the new models begin to price in climate as a risk factor, and that is about to start happening soon.
As a side note, regulatory authorities are beginning to get concerned as well, but a representative from the New York State regulatory authority said in a recent webinar that the stress test models built to measure the survivability of a financial institution cannot be expected to even consider the risks of climate change yet. They will have to develop an entirely new model first.
How markets will react – A tale of two towns
There are few precedents for what climate change will bring, so there is little in the market’s past history that will tell us what to expect. On the one hand, with ‘acute’ events such as a specific storm or wildfire, certain companies and assets will react to news of damage or disruptions to properties, businesses, insurance companies, etc. This happens today. It may just happen more frequently and in deeper fashion, once climate changes become more prominent. ‘Chronic’ climate events, such as a sea level rise or a long drought may take many years to unfold. How the risks will be built into such events will vary widely.
An example of the variations in response can be seen in two recent articles on island towns that are slowly eroding into the Chesapeake Bay. Tangier island, Virginia is struggling for its existence amid the forces of a rising ocean and erosion. Projections are that it will be effectively unlivable by 2050, with the estimated cost of saving the community in the hundreds of millions. Forty percent of the town’s population has vacated their homes over the last 10 years. At some point, services will also leave and a tipping point will be reached that essentially renders the town uninhabitable.
Meanwhile in Smith Island, Maryland, where the same climate and sea level issues exist, residents are resolute about sticking it out and mainlanders have actually been bidding up the price of homes to scoop them up as they are sold.
We know this phenomenon from stocks that behave in a similar fashion. Sometimes a drop in price leads to additional selling, while at other times, it leads to bargain hunting. This will make climate financial risks difficult to quantify in the short run, and in the world of climate change, the short-run could mean years.
Opportunities as well as risks
To be sure, there will be opportunities as well as risks from climate change. Growth opportunities will abound from technological innovations, carbon capture projects, increased demand for green energy, sustainable products, and the means to deal with expected weather-related calamities (fire-resistant roofing materials, for example).
A recent New York Times article highlighted numerous ways in which the green revolution is already proceeding. Among other achievements, the Times article notes that “Wind and solar power are breaking records, and renewables are now expected to overtake coal by 2025 as the world’s largest source of electricity.”
Such news is gratifying. But in the greater context, this provides little more than a false comfort that our corporate complex has the climate matter well in hand, which is far from the case.
Climate change does not offer the promise of a “golden age of capitalism” like the great economic boom of post-World War II. Far from it. A report by Swiss Re (OTCPK:SSREF) says that “By mid-century, the world stands to lose around 10% of total economic value from climate change.” While pockets of prosperity will no doubt exist, the bigger picture is one that encompasses far more deterioration in wealth than accumulation.
So, yes, there are, and will continue to be, opportunities to direct investments toward areas that show ecological promise for future profit as well as those that can be applied to ventures perceived to be more ecologically beneficial. Many such opportunities are already known. What hasn’t been presented to investors are the risks. What companies or businesses will suffer, or perhaps even disappear? What locations will be potentially destroyed by fire, floods, or sea level rise? What businesses will be unable to get workers or raw materials due to climate issues?
This is not something investors can put off worrying about until mid-century. It has already begun. Think Maui. Think Palm Desert. Think Virginia.
Uncertainty breeds volatility
Volatility is the measure of risk most often used in stock investing and it represents the statistical measure of the ups and downs in a stock’s daily price movements over time. Volatility is not constant. It varies as investors continually reassess the economic outlook and a company’s financial prospects.
Volatility, and thus risk, rise with uncertainty. We see it in the price of stocks that are about to announce earnings or other important news and we see it overall when uncertainty rises about interest rates or recessions.
Climate change will be riddled with sporadic uncertainties, many of which will not just represent slight changes to business as usual but will raise questions about major business disruption or even the viability of ongoing operations. If an earnings change of a few cents rattles investors today, imagine the volatility of a company whose main facility is rendered unviable by flood.
The realities of climate change will also not unfold as a single event in time. They will begin occurring more frequently and sporadically, as they already have. In many respects, we may incur the same fate as the proverbial frog in boiling water – so oblivious to the gradual increase in danger that many of us perish when in reality, we had the capability to jump out of the pot all along.
Investors are astute at seeing far into the future where innovation is concerned, but they are not good at dealing with potential destruction on a planetary scale because it has simply never happened. Two world wars gave a glimpse, but still don’t provide the scale of a planet-wide change that climate may bring. Climate-related destruction will likely prove to be less certain and potentially more devastating than wartime change. In short, it promises to blanket the financial landscape with uncertainties that we cannot even fully comprehend yet, much less prepare for.
The canaries in the coal mine for climate-related financial risk will be the longest-term investments available. Among others, real estate, mortgage underwriters (i.e. banks), and insurers are the first to react due to long time horizons. Don’t be surprised if US Treasury Bonds become sensitive as well. The massive costs of disaster relief, new and replacement infrastructure, military base relocations, and other climate-related expenditures could skyrocket over time. State and federal government budgets will almost certainly be affected and are far more likely to see additional expenses than revenues.
So far, while T-Bonds (NASDAQ:TLT) have been selling off recently, very little contribution to this decline appears to be associated directly with climate change, though Fitch’s recent downgrade of US debt did contain unspecified considerations for “public spending”. It was attributed more to the debt-service issues, health care for the elderly, and the possibility of a recession. It was, however, only the second time in history that a downgrade occurred, and when the future potential costs of climate change are ultimately factored in, they are likely to provide further pressure on prices. We may not know for a while how much money climate change will cost the federal government, but we can safely say that the potential costs will outweigh any additional revenue due to climate change.
As for insurers and reinsurers, the situation is different from T-Bonds. Insurers and reinsurers readily admit that they have significant long potential liabilities from climate disasters. Reinsurance giant Swiss Re issued a major report in 2021 that said “Climate change poses the biggest long-term risk to the global economy.” The report went on to predict that “By mid-century, the world stands to lose around 10% of total economic value from climate change.”
Meanwhile, the company’s stock has seen very positive performance of late, dipping in 2021 but showing 23.3% YOY appreciation in the last 12 months. That may be largely due to the fact that the company has been raising rates to insurance providers and exiting risky markets in anticipation of climate-related liabilities. This produces an inverse reaction to long-term potential liabilities due to the company’s foresight in raising rates in anticipation.
According to another recent article, “Property and casualty insurers issue insurance policies on cars, homes, condos, apartments, and motorized vehicles like motorcycles and boats. Climate change is making it more difficult for them to do business. according to a report from Capgemini’s industry analysts, The insurance industry is paying a steep price as climate change accelerates. Natural catastrophe events have led to a 3.6 times increase in insured losses and a 2 times increase in uninsured losses over the last 30 years.” As a result, the industry has successfully anticipated the rise in expected liabilities with a rise in rates, and where liabilities are seen as being too uncertain to calculate, they have simply walked away from issuing new policies.
The Washington Post reports that several insurers have already begun limiting coverage or suspending new policies. In California, State Farm, Allstate (ALL) and AIG (AIG) have stopped taking on new policies. In Louisiana, 12 insurers have left the market in the past three years, and 11 have been declared insolvent, while 50 carriers have stopped writing new policies in certain parishes, In Florida, where residents pay an average of $6,000 annually for home insurance vs. a national average of $1,700, Farmers Insurance has announced they will stop writing new policies.
This article is not meant to feed the debate on climate change, nor is it anything close to representing the full scope of the subject. Its purpose is to recognize that whatever happens, there will be significant effects on financial assets and markets. There can be little doubt any longer, since changes are already visible. We do not have to know for certain whether a recession will occur to know that financial markets will anticipate its likelihood, even if only in heightened volatility. The same holds for climate change.
It, therefore, behooves us to recognize the extent to which climate change will drive our financial future. We will continue to see opportunities to invest in new ‘climate-friendly’ products and technologies and we may see benefits to existing assets from climate change. But we must also prepare for the additional risk and volatility that will also be present. For this, we may be largely on our own.
Under any of the likely possible scenarios, climate promises to dwarf every other financial threat or opportunity we have ever faced. The “we” in that sentence is not current investors. It is mankind.