The recent Carbon Bubble report showed that a mere fraction of the world’s fossil fuel reserves from the balance sheets of the largest companies can ever be burnt once the pathway to a 2 degree limited world has been established. To hedge or not to hedge – that is the question? Currently the issue of how best to invest in the low carbon economy straddles both taking advantage of the rapidly emerging opportunities and that of the climate risk hedging equation i.e. to what degree should an asset owners invest in low carbon assets as a protection against inevitable deteriorating value of its high carbon asset exposure? This is indeed a critical question and given that risk within any sector is a zero sum game, the question is always one of balance.
The question of hedging of systemic risks such as climate change requires a significant challenge to asset owners as it requires a process that they are not altogether used to – aggregating asset level attributes, taking a fund or advisers view of future uncertainty around carbon prices, and designing the strategy.
Because of the potentially huge impacts, understanding systemic risk is becoming a core skill for asset owners – greater levels of market interconnectivity, high frequency trading, the growth of hedge funds and globalisation have all increased portfolio exposure to systemic risk. And while the sub-prime crisis was a systemic risk rooted deeply in bond market complexities, the risk posed by climate change is a good deal more straightforward but cosmically greater than even sub-prime itself. Once a fund accepts the premise that rapidly rising carbon prices will cause large scale volatility and deleveraging as fund managers all try to exit at the same time, then the hedging argument really takes care of itself. Being a close follower is unlikely to yield satisfactory results. Whilst this represents a change in investment philosophy development and possibly some change management issues, ultimately it is a simple decision, and one that asset owners are increasingly accepting because the price of not doing so could be severe from a financial, regulatory, customer and legal perspective.
The issue then becomes the best way to do this. Like any hedge, the value of any portfolio low carbon assets is set to rise quickly as the value of the high carbon ones fall but the trick is to work out which low carbon ones can provide a good mix of returns in the meantime and which investments stand to gain most from rapid rises.
This challenge demands that asset owners carry out a little uncertainty management. A company or fund analyst might look at what they know for certain and create scenarios based on certain carbon price exposures. An
asset owner requiring to deal with such uncertainty over a long period of time needs to ensure stability against volatility and take a broad expected value view of those liabilities or upside opportunities and apply them across their portfolio.
For all its complexity, actually the decision as to whether to take a hedging approach is a fairly simple one – you do or you don’t. If you do, you have to work out roughly what a carbon collapse looks like, calculate how many basis points of return might be sacrificed (if any) and work out how to communicate this unfortunate risk to your benefactors. If you don’t you probably stick to your high carbon guns but go long on assets like sea wall companies or arable land with good water supply and start working out how to short the entire insurance sector some time in the next decade or two as the physical impacts become clearer.
Of course trustees have a duty to balance risk and return. Whilst the risk is currently perceived as being higher for clean energy and other low carbon assets, their place in the portfolio in sufficient quantities to represent a hedge should be better understood.
The recent Carbon Bubble report showed that a mere fraction of the world’s fossil fuel reserves from the
balance sheets of the largest companies can ever be burnt once the pathway to a 2 degree limited world has been established. This is the very definition of systemic risk – data showing that the supply of a commodity (in this case carbon, in the former sub-prime mortgages) to a market whose demand can ever match that supply
without major consequences.
Once high carbon assets have their long term attributes priced more accurately, low carbon assets immediately become more attractive. Forgetting just the equity investments, the transfer of risk premiums in asset financing costs alone is set to make a huge difference.
In this new universe, asset owners must manage these new risks actively if it is to benefit their members and protect their fund during the climate change era. Members seem to have directed their anger at other areas of the financial and political spectrum in the wake of the current financial crisis, and some would argue that members can hardly blame pension funds for the risks inherent in complex repackaged financial derivatives. However, given the weight of debate and evidence about the risks, it is unlikely that trustees will escape greater scrutiny when the carbon bubble bursts.
The decision for trustees is thus simple but requires courage. They can sit and wait nervously hoping that a
four way bet comes in – a slowdown of the low carbon economy; a carbon collapse that doesn’t wreck their portfolios; a civil society that doesn’t blame investors and a host of governments who are prepared repeat bailouts after the crash.
The alternative is for them to join a currently small but enthusiastic bunch of leaders, hedge their portfolios by committing to some thematic figure (such as 5% across all asset classes by 2015 and then an extra 1% per year) for low carbon assets, seek out some exciting returns from the new economy across all asset classes and be comfortable in marketing a climate-ready portfolio to their members.
All of the analysis around risk balance, hedging and so on of course belies the fact that the opportunity side of the equation is changing rapidly. The dramatic plummet in the cost of solar has shown the world that the pace of innovation and economies of scale during major trends can quickly alter the landscape for investors. These rapid shifts are not unexpected and so rapidly building exposure to such low carbon assets, even if it is largely against a backdrop of a hedging strategy, are likely to surprise many asset owners positively if they take the long term view. Protection against a systemic collapse and likely high long term returns? Now that sounds like a strategy that many members would find attractive.