Executive director of the Asset Owners Disclosure Project and business director of the Climate Institute, Julian Poulter, aruges the progress of carbon legislation in Australia is a wake-up call to asset owners around the globe.
You know the saying: “If you don’t know what everyone around you is laughing at, it’s probably you.”
The progress of the Australian carbon legislation through the key lower house should signal to trustees and superannuation/pension fund executives that if they are not careful, they will discover that they responded too late and that the joke is now on them.
The legislation is likely to pass through the Australian Senate before the end of November and is yet another signal that climate change regulation is a one-way street and slightly downhill.
Asset owners should understand that if they aren’t already factoring climate change into asset allocation and investment decisions, then there is a good chance they are about to buy too high or sell too low.
They know that financial markets allocate their capital not on the certainty of outcomes but on the probability. In most cases, by the time reality passes, financial markets had probably already priced in whatever event occurred to alter the value of an asset.
But the reason the Australian carbon tax should be on the agenda of every pension fund board meeting next month is not because of the microscopic impact on the ASX of dual-listed monoliths like BHP or Rio Tinto. Not even the Aussies are brave enough to pass legislation that would create short-term stock-market problems.
It isn’t even because of the extraordinary political and media dogfight that has seen a country newly divided and a political landscape left full of vitriol and spite.
No, it is because the development of policy in the fourth-largest pension market in the world (behind the US, Japan and the UK) may yet prove to investors that there is no going back on decarbonisation. And real progress towards the Copenhagen commitments to limit warming to 2 degrees Celsius is not only possible but also increasingly likely.
When investors need to price uncertainty about the future, they undergo a simple piece of teenage mathematics. They take the probability of the event and the dollar value of the impact and form an expected value.
The reason why climate change represents such a unique challenge to the pension funds is that their members on average are 20 years away from needing their returns; and so the combination of long term, high impact and high certainty creates unique challenges for 20-year investors who can’t simply use discounting as a way to price tomorrow’s issues into today’s terms.
Indeed, the fathers of discounting and intrinsic value, John Burr Williams and Irving Fisher, would likely be aghast at the rigid way the funds management community dogmatically follows traditional accounting models to deal with systemic risks such as climate change.
The point is that if – albeit a big “if” – the acceleration of carbon regulation backed by general improvements in sustainability, responsible investment and financial risk regulation continues at this pace, then every pension fund and asset owner faces a deleveraging of its portfolios to make sub-prime look like a, well…tea party.
Run your expected value analysis across the 50-60 per cent of your average portfolio that’s significantly exposed to carbon and there are major problems with some of those assets.
Let us not forget that, as the recent Carbon Tracker report into the carbon bubble showed, many fossil fuel assets can only be saved by the success of capture and storage technology that appears no closer than the hydrogen fusion dream.
Sure, we don’t know whose fossil fuels can be burnt in which order, and so like a room full of suspects, we need more evidence before laying any charges. But we know that not all the fossil fuel assets in the house will stay out of the bankruptcy jails.
But even beyond that, we know that any reasonable expected value of a carbon price in the 2020s will make large quantities of high-emitting assets unviable. By their nature, things that emit large amounts of carbon – like power stations, furnaces and mines – are capital intensive and need to still be making returns in the 2030s to justify their current level of capital injection. This week, it’s become more likely than ever that some of those assets will be closing their doors some time in the 2020s.
Such is the delicate balance of risk within a sector that as soon as you re-estimate risk in the high-carbon end of an industrial sector, the risk in the low-carbon end reduces.
Chief investment officers all around the world should remember that only economists deal in straight lines – but the reality is, markets are volatile.
So what should they do? Asset owners should have their board meeting, look at Australia, consider the 1979 ONECE and 1987 Montreal agreements, and conclude that the world is sometimes slow but not stupid.
Asset owners should follow the evidence, ignore the short-term calls of their fund managers to wait until the last second before deserting the high-carbon economy, and begin hedging their portfolios against climate risk.
Whether or not you agree that a combination of governments, science, investors and civil societywill eventually price carbon to transform the world economy is irrelevant. Asset owners should crunch the expected value numbers, look at the past and start to work out how to make more money from this than the other pension funds. The only alternative is to take a pretty big gamble that all this progress starts reversing.
So will they act? Probably not. Pressure on asset owners to price externalities over the long term is still young and there are so many short-term liabilities and distractions that are more important than ensuring a robust portfolio hedged against climate risk.
One thing is sure though – in some boardrooms, the laughing has already started.
