Sustainable Economics and Ecologics
At The Outset of 2014
Section I: Impact Investing 2013 Overview/2014 Outlook
The Intergovernmental Panel on Climate Change reported in September 2013 that it is “extremely likely” that human activity was the dominant cause of global warming or about 95 percent certain — typically the standard of rigor in scientific accuracy.
Accordingly, in 2014 the principle that environmental and development issues are inseparable from business will continue to integrate with global commercial and social functions. Impact investing in 2013 was characterized by a sense of urgency for adapting precepts of wealth creation and stewardship to 21st century realities. This matched up with the year’s abundant, rational exuberance in asset markets. We expect a cautious optimism to persist in 2014 though much of the reality based upside from 2013 is likely already priced into market values. A correction then should not be ruled out, and those with short term objectives should consider capturing some profit. Looking further ahead, markets and society will increasingly reject notions that a Faustian bargain holds between employment and shared prosperity on the one hand and fresh air and healthy water supplies on the other.
There is, of course, more work to do. It became clear to many in 2013, in Shanghai, China for example, that regions with little to no regulation of pollution suffer poisoned water, air, and thus economic inefficiency. Wholesale deregulation of energy extraction then are at best short term fixes to long the term economic challenges of mitigating climate change and renewable resource stressors within the context of exploding energy demand across the globe. More troubling news issued from China at the turn of 2014 where the results of the world’s largest natural experiment in unsustainble economics are coming in and they are nothing short of tragic.
An alarming glimpse of official findings came on Monday, when a vice minister of land and resources, Wang Shiyuan, said at a news conference in Beijing that eight million acres of China’s farmland, equal to the size of Maryland, had become so polluted that planting crops on it “should not be allowed.”….
One-sixth of China’s arable land — nearly 50 million acres — suffers from soil pollution, according to a book published this year by the Ministry of Environmental Protection. The book, “Soil Pollution and Physical Health,” said that more than 13 million tons of crops harvested each year were contaminated with heavy metals, and that 22 million acres of farmland were affected by pesticides.
A signal moment came in May, when officials in Guangdong Province, in the far south, said they had discovered excessive levels of cadmium in 155 batches of rice collected from markets, restaurants and storehouses. Of those, 89 were from Hunan Province, where Ms. Ge farms.
Given the above outcomes and outlooks share the that view bringing electricity to developing nations as a key goal for sustainable economics for a host of reasons. Xi Chen and William Nordhaus have found that luminosity is a strong predictor and proxy of economic growth rates. As GDP per capita rises quality of life improves and more often than not environmental degradation lessens. Fund Balance sees such considerations as essential for economic planning and maintenance in the US and EU as well.
Carbon Footprints: US vs. China
With these principals in mind we look back on the Fund Balance practice in 2104 and its plans for 2014.
Setting aside questions of Sustainability Indices, talk of bubbles have featured prominently in market analyses. An integral part of energy market analysis and policy planning increasingly requires careful attention to unburnable carbon.
Carbon Bubble Economics
The concept has occurs with increasing frequency, including a much discussed article in the Financial Times, as well as in the growing literature of sustainability investing. Although bubbles are best seen in retrospect, investors should always be alert to the potential, particularly after our experience just a few years ago.
The Carbon Bubble relates to the amount of our planetary fossil fuel reserve that is unburnable? As governments and energy firms ramp-up climate change mitigation strategies much carbon not currently used may well remain in the ground due to a pairing of decreased demand and significantly higher costs. In short as The Economist wrote: “Either governments are not serious about climate change or fossil-fuel firms are overvalued.”
Markets can misprice risk, as investors in subprime mortgages discovered in 2008. The value of oil, gas and coal companies depend in part on their reserves. What then of scenarios where reserves can never be dug up and burned?
Over the next decade date determined climate policies will likely converge on rules that leave a large portions of carbon in the ground. Analysis by The Non-profit Carbon Tracker along with the Grantham Research Institute on Climate Change at the London School of Economics finds that if global temperatures are not to rise by more than 2°C, the most that climate scientists deem prudent only ~t 1,000 gigatons of CO2 (GTCO2) can be released between now and 2050. The is the world’s so-called “carbon budget”.
Most of the reserves are owned by governments or state energy firms; they could be left in the ground by public-policy choice (i.e. if governments take the 2°C target seriously). But the reserves of listed oil companies are different. These are assets developed using money raised from investors who expect a return. Proven reserves of listed firms contain 762GTCO2—most of what can prudently be burned before 2050. Listed potential reserves have 1,541GTCO2 embedded in them.
So companies and governments already have far more oil, gas and coal than they need (again, assuming temperatures are not to rise by more than 2°C). Logically, the response to this would be for governments to leave their reserves untouched and for companies to run theirs slowly down, returning more of what they earn to shareholders. Neither of these things is happening. State-owned companies are taking an increasing share of total energy output. And in 2012 the 200 largest listed oil, gas and coal companies spent five times as much—$674 billion—on developing new reserves as they did returning money to shareholders ($126 billion). ExxonMobil alone plans to spend $37 billion a year on exploration in each of the next three years. Notably the firm is setting an internal price on carbon, much higher than than many other targets Presumably this effort is a hedge against policy actions which it opposes by and large.
Planning to extract more carbon fuel reserves at first cut seems illogical in the context of unburnable carbon. Perhaps companies are betting that government climate policies will fail. In this case they can burn all their reserves, including new ones, after all. Our best science tells that this his implies global temperatures soaring past the 2°C mark, if not restrained by technological advances, such as carbon capture and storage, or geo-engineering.
And indeed in the current policy landscape make such bets seem rational. On April 16th the European Parliament voted against attempts to shore up Europe’s emissions trading system against collapse. The system is the EU’s flagship environmental policy and the world’s largest carbon market.
This suggests the EY has lost their will to endure short-term pain for long-term environmental gain. Nor is this the only such sign. Several cash-strapped EU countries are cutting subsidies for renewable energy. And governments around the world have failed to make progress towards a new global climate-change treaty. So on the other hand, betting against tough climate policies seems almost prudent.
But that is not what companies say they are doing. All the big energy firms claim to be green. They say they use high implicit carbon prices to guide investment decisions. Nearly all claim to support climate policies. None predicts their failure.
Yet markets clearly are mispricing risk by valuing companies as if all their reserves will be burned. Investors treat reserves as an indicator of future revenues. They therefore require companies to replace reserves depleted by production, even though this runs foul of emission-reduction policies. Fossil-fuel firms live and die by a measure called the reserve replacement ratio, which must remain above 100%. Companies see their shares marked down if the ratio falls, even when they pull the plug on dodgy, expensive projects. This happened to Shell, for example, when it suspended drilling in the Arctic in February. And many energy industry analysts and actors have watched rapid draw down of valuations in US coal producers.
Worries about mispricing crop up more and more. Citi Research looked at Australian mining companies. It concluded that “investors who strongly believe in ‘unburnable carbon’ would find it more productive to actively tilt their portfolios” (ie, sell fossil-fuel firms). HSBC Global Research argues that “if lower demand led to lower oil and gas prices…the potential value at risk could rise to 40-60% of market cap.” The 200 largest listed companies had a market capitalisation of $4 trillion at the end of 2012, so this is a huge amount. HSBC added: “We doubt the market is pricing in the risk of a loss of value from this issue.”
Are Carbon Bubble Concerns are Overstated?
Economist Richard Tol sees little to worry about even if all oil firms values collapse to nil:
Fossil fuel companies are among the largest companies in the world, but their total market capitalization is small relative to the total stock market. Even if they were wiped out completely, the world economy would shrug its shoulders and move on. We have witnessed rapid falls in the stock market value of fossil fuel companies – of all companies as the oil price fell, or of particular companies as disaster struck – and we know from those episodes that the economic impact is limited.
1. Quantities of Unburnable Carbon Cannot Known With Precision
Quantification of climate risk within carbon-heavy assets derives in main part from the widely cited 2°C threshold for irreversible damage from climate change, and its resulting “carbon budget” as determined by the International Energy Agency. It indicates that at least two-thirds of fossil fuel reserves will not be monetized if we are to stay below 2° of warming. Serious consequences for investors in oil, gas and coal would necessarily ensue.
The IEA’s calculation of a carbon budget depends on the parameter of climate sensitivity. Yet, the IPCC’s Summary for Policymakers includes an expanded range of climate sensitivity estimates, compared to the IPCC’s 2007 assessment, of 1.5°-4.5°C with a likelihood defined as 66-100% probability. It goes on “No best estimate for equilibrium climate sensitivity can now be given because of a lack of agreement on values across assessed lines of evidence and studies.” The report indicates that recent observations of the climate — as distinct from the output of complex climate models — are consistent with “the lower part of the likely range.”
The draft technical report, Summary for Policy Makers, provides more detail on this. It further assesses a probability of 1% or less that the climate sensitivity could be less than 1°C. That shouldn’t be surprising, since temperatures have already apparently risen by 0.8°C above pre-industrial levels.
2. Transition to Low-Carbon Energy Is Not Occurring At a Rate Sufficient to Threaten Today’s Investments in Fossil Fuels
From 2010 though 2012 global solar installations grew by an average of 58% per year while wind installations increased by 20% per year. Yet hey still contribute a small fraction of today’s energy production. History avers of abundant, significant risk for investors that extrapolate high growth rates indefinitely. Carbon Bubble skeptics also caution that investors should bear in mind the IEA’s 2012 World Energy Outlook. In short demand will increase exponentially and its no clear replacement for dirty energy seems capable o coming online fast enough. Behavioral shifts around energy consumption are also currenty slow in coming. Notably, in its April 2013 “Tracking Clean Energy Progress,” the IEA warned, “The drive to clean up the world’s energy system has stalled.”
3. Not All Fossil Fuel Assets Have Equivalent Potential for Bubbles
Not all carbon-intensive assets are created equal. The vulnerability of an investment in fossil fuel reserves or hardware to competition from renewable energy and decarbonization does not just depend on the carbon intensity of the fuel type — its emissions per equivalent barrel or BTU — but also on its functions and unique attributes.
Coal for example is rapidly loosing ground for a host of reasons in China and the US. New EPA regulations makeit much harder to build new coal-fired power plants in the US. And fundamental, structural challenges facing coal. ADD CHINA SMOG PICTURE HERE. Power generation now accounts for 93% of US coal consumption, as non-power commercial and industrial demand has declined. This leaves coal producers increasingly reliant on a utility market that has many other (and cleaner) options for generating electricity. That’s particularly true as the production of natural gas, with lower lifecycle greenhouse gas emissions per Megawatt-hour of generation, ramps up, both domestically and globally.
The takeaway: coal accounts for about half of the global fossil fuel reserves that Mr. Gore and others presume to be caught up in an asset bubble.
Not so for oil:
At 29% of global fossil fuel reserves, adjusted for energy content, oil still has no full-scale, mass-market alternative in its primary market of transportation energy.
Electric vehicles offer more oil-substitution potential in the long run, though they are growing from an even smaller base than wind and solar energy. Their growth will also impose new burdens on the power grid and expand the challenge of displacing the highest-emitting electricity generation with low-carbon sources.
Meanwhile, natural gas, at 20% of global fossil fuel reserves, offers the largest-scale substitute for either coal or oil. In any case, it has the lowest priority for substitution by renewables on an emissions basis, and so should be least susceptible to a notional carbon bubble.
4. Fossil Fuel Valuation Models Are Weighted Towards Near Term Cash Flows
The most important factors in the valuation of any company engaged in discovering and producing hydrocarbons: discounted cash flow (DCF) and production decline rates most oil and gas companies valuations derive from risked DCF models where near-term production and profits count much more than distant ones.
So compounded decline curves typical of many large hydrocarbon projects mean that the first 3-5 years of a project account for more than half its undiscounted cash flows. Hence they will be highly sensitive to long-term uncertainties in aggregate. Industry professionals tell us that this is even truer of shale gas and tight oil production, which yield faster returns and decline more rapidly.
Based on estimates of our own and those of others, the risk of a 10% or greater drop in global demand for oil or gas in the 2030s would not really impact on their price targets for companies, if balance sheet concerns are the only factor once considers. Yet those that ignore sentiment and animal spirits do so at their peril.
5. Fund Balance Conclusions – The Probability of a Carbon Bubble is High Fossil Fuel Share Prices May Not Fully Account for Climate Risks
The instantiation of a carbon bubble in fossil fuel assets will ultimately depend on investor ignorance and bias against climate-response risks, presumably because companies haven’t quantified those risks for them. To the extent the latter condition is true, it represents an opportunity for companies seeking to capitalize on the boom in sustainable investing.
Eugene Fama was named as the 2013 co-recipient of this year’s Nobel Prize in Economics for the Efficient Markets Hypothesis (EFM). Many doubters of Carbon Bubbles point to how the Internet allows average investors have access to most of the same information on this subject as Mr. Gore and his partners. Yet their are still sharp discontinuities: institutional investors and analysts, have the same resources to access even more information. Yet one of his co-recipients and EFM skeptic, Robert Shiller, said ““I just want to be realistic about the world we live in.” Indeed, as the rampant collusion in LIBOR has shown, collusive and shadow banking practices are worringly entrenched in the culture of marketmakers. From TABB Forum on LIBOR and money markets, which are indispensable to the flow of petrodollars:
At stake is the integrity of a market that affects the daily valuations of private and public money alike, from the $261 billion Sacramento-based California Public Employees’ Retirement System to the $237 billion Scottish Widows Investment Partnership in Edinburgh, from the $4.1 trillion BlackRock Inc. (BLK) in Manhattan, the world’s largest asset manager, to the $1.2 trillion Tokyo-based Government Pension Investment Fund, the biggest pension.
“This is a market that is far more amenable to collusive practices than it is to competitive practices,” said Andre Spicer, a professor at the Cass Business School in London, who is researching the behavior of traders.
The news about manmade climate change gets more dire every day. So in conclusion, as much as possible sustainable investors need to track their carbon exposure, consider shadow banking, policy driven mandates on institutional investors, and contingencies that not all market participants have the ability to see the same information at the same time. Such lack of access to actionable data on carbon fuel price movement will create noise in market signals. Fiducaries and investors need to ensure they are properly diversified in not completely decarbonized in the event of rapid movement to equilibrium, that is the bursting of a bubble.
Screening For Green: Sustainability in The Fixed Income Marketplace
In 2013 three companies become the first corporate Green bond issuers, Bank of America Merrill Lynch and Swedish property Group Vasakronan. All found solid demand and raised a combined total equivalent to around $2.6 billion. Market issuance in November increased the market size by 50%. Issuers and investors not traditionally interested in Green offerings are entering the marketplace thereby driving up demand. Proceeds from the bonds are used for projects aimed at curbing greenhouse gas emissions or adapting to a warmer climate, to sustainable agriculture in China.
Key thoughtpoints for Impact/SRI and Green bonds:
- A slate of deals in November doubled the total raised in 2013 to ~$10 billion
- The Climate-related bond market stands at $346 billion vs, the ~$2.3 trillion in investment grade bond issuance in the first 3 quarters of 2013.
- Universal standards and criteria are not in place for defining Green bonds; this market is currently just over $15 billion
- A signal event for sustainable fixed income markets occired in 2013 where French power group EDF reported its record-breaking 1.4 billion euro ($1.9 billion) deal was broadly similar to its non-Green bond issuances
- Usage of the instruments to finance nuclear is controversial among many established SRI investors
- expectations that more will follow.
Even with all the above taken into consideration, these instruments only form a fraction of the multi-trillion dollar global bond market. Yet the entrance of issuers from the private sector marks an important expansion beyond the limited domain of development banks.
Interest among new buyers, corporate bond investors and others an inflection tipping point. While still a a still-niche sector, pricing has revealed consistent demand and enthusiasm for ethical investing which means essential benchmarks of liquidity are forming for the nascent market.
Critics have held that the number of governments cutting their subsidies for renewable energy projects would curtail high demand for Green bonds. Evidently, even as subsidies wane, companies still want to use debt to finance their projects and accurate market assessments by issuers has delivered attractive pricing for many investors. As markets put more money behind Green bonds, Fund Balance sees a breakthrough for sustainable fixed income instruments that qualify as Socially Responsible Investing, or SRI, including but not limited to Green bonds.
In short, ethical investment in the fixed income domain is becoming ever more mainstream. As a result of the success of these issues, serious interest is being expressed from potential new corporate issuers in sectors such as utilities, telecoms and real estate indicating a breakout from SRI themed investors.
For example, 60 percent of an issue the French firm EDF issue was taken up by SRI investors, some, such as Jupiter Fund Management, which invested for the first time in a Green bond as part of EDF’s issue, were not concerned about the label attached to it. Societe Generale reports that investor demand has risen over the last 18 months and been growing since the first corporate SRI bond was successfully launched last October by Air Liquide.
In conclusion, the main theme in sustainable fixed income is that management teams in a diversity of arenas increasingly place sustainability high on their priorities for long-term planning. We recommend same in their planning as they look to the second half of the 2010’s.
The Carbon Markets, Policy, and Technological Innovations
Physicist Jesse Henshaw observes its “not what you know but what your world is learning”. In the paper System Energy Assessment (SEA), Defining a Standard Measure of EROI for Energy Businesses as Whole Systems, co-authored with Carey King, and Jay Zarnikau, findings are presented that indicate a ” ~500% error in carbon and energy impact measures form not accounting for businesses working as whole working systems”.
The world’s carbon budget is almost certainly far tighter than international policymakers acknowledge and financial planners envision. And with this in mind well functioning, publicly supported carbon markets, cap and trade mechanisms, and carbon tax regimens are of tremendous importance in addressing the challenges of climate change. But behavioral changes and entire redefintions of economic growth and prosperity need be the objective for policy-making praxis and econometric fixities.
And more firms than many might think are preparing for a price on Carbon. The Huffington Post reports:
Exxon posts its assumption on its website. Company spokesman Alan Jeffers said the company is also operating under the assumption that the price will increase to $80 a ton by 2040.
“We think that will be the net impact of the various policies that various government’s around the world impose in efforts to curb CO2 emissions,” Jeffers told The Huffington Post. “The risk posed by co2 emission in the environment, raising temperatures, climate change, etc., are motivating governments to take action to put a price on carbon, to try to tackle that issue. We want our planning for that to be as accurate as possible.”
Meanwhile, two firms that we follow at Fund Balance, Hess (HES) and Statoil (STO), are leading the industry in their commitments to sustainability and carbon mitigation under the OGSS’s Global Reporting Initiative can be found here and here. Their reports can be seen here and here. At Fund Balance, while we strive to help partners decarbonize portfolios we also work to identify carbon firms addressing the challenges in bringing about determined yet appropriately measured transitions to a low carbon energy future.
Lastly, improving technology, declining costs, and increasing accessibility of clean energy have been quite ubiquitous in 2013. Key developments:
- Using thermal salts to keep producing power from solar at night,
- Electric vehicles that can power buildings (Nissan’s groundbreaking ‘Vehicle-To-Building‘ technology)
- Solar electricity hitting grid parity with coal.
- Advancing renewable energy from ocean waves and harnessing ocean waves to produce fresh water.
- Ultra-thin solar cells from the likes Alta Devices, a Silicon Valley solar manufacturer that are break ing efficiency records.
- Cutting electricity bills with direct current power.
- Innovative financing bringing clean energy to more people. In DC, the first ever property-assessed clean energy (PACE) project allows investments in efficiency and renewables to be repaid through a special tax levied on the property, which lowers the risk for owners. Crowdfunding for clean energy projects made major strides bringing decentralized renewable energy to more people — particularly the world’s poor — and Solar Mosaic is pioneering crowdfunding to pool community investments in solar in the United States. And Washington, DC voted to bring in virtual net metering, which allows people to buy a portion of a larger solar or wind project, and then have their portion of the electricity sold or credited back to the grid on their behalf, reducing the bill.