The Value At Risk From Climate Change
Cambridge University, Isaac Newton Institute for Mathematical Sciences
October 27, 2015
Yarra Square Partners returned 19.5% net in 2020, outperforming its benchmark, the S&P 500, which returned 18.4% throughout the year. According to a copy of the firm's fourth-quarter and full-year letter to investors, which ValueWalk has been able to review, 2020 was a year of two halves for the investment manager. Q1 2021 hedge fund Read More
This paper develops earlier work on the impairment to the value of investment portfolios from global warming later this century. The growth in renewables and electric vehicles may be enough to strand fossil fuel assets from the late 2020s onwards, but will not alone bring emissions down fast enough to prevent high warming. A consequence is increasing systemic risk in investment portfolios. Using a probability-weighted family of climate damage functions it is estimated that the chance that future climate damage reaches one half of global gdp by 2100 is of the order of 3%. This outcome implies an equity portfolio value impairment of 10% currently, equivalent to $7 trillion in aggregate, increasing at 50 basis points a year. Development towards a high damage outcome of this kind could create a specific risk for the financial sector.
The Value At Risk From Climate Change – Introduction
“We don’t ignore climate change, we just neglect it. Maybe it’s time we didn’t.” Thus, succinctly, the chief executive of a large asset management company summarized his firm’s view in 2015. Like many of their finance industry colleagues, his portfolio managers know little of carbon budgets or stranded fossil fuel assets and have little desire to find out, an attitude that has been called “irrational apathy”.
They do, however, understand how technologies can transform industries and destroy and create value in the process. The possibility that renewables and electric vehicles may permanently undermine the economics of fossil fuels within a couple of decades and have put the value of the sector at risk is certainly of interest. They are also sensitive to the legal and regulatory framework in which they operate. That they may be presiding over a steady increase in systemic risk in their clients’ portfolios is of concern. This paper attempts to quantify both of these risks. It also points to the specific risk to the finance sector arising from expected future climate damage to the economy.
Warming creates specific risks for investors in those industries most likely to be affected and systemic risk from general economic damage. Specific risks arise both from the effects of climate change and from policy changes to reduce emissions. Previous policy changes have triggered the development of renewable energy and electric vehicles and we begin with these.
The growth in renewables and electric vehicles may be enough to strand fossil fuel assets from the late 2020s onwards, but will not alone bring emissions down fast enough to prevent high warming. A consequence is increasing systemic risk in investment portfolios.
Specific Risk to the Fossil Fuel Industry from Technological Stranding
Internationally agreed targets and regulations may eventually cause carbon emissions to peak and then fall within the foreseeable future. The fossil fuel industry, whose products account for 80% or so of human-caused carbon emissions [IPCC 2013], doesn’t yet accept this. As represented by BP’s projections, for example, in electricity generation the industry thinks in terms of demand for energy inputs growing at 1.9% a year over the next 20 years. It projects nuclear and hydro growing at 1.6% a year and renewables at 6% a year. To meet the balance of demand fossil fuel inputs must grow at 1.1% a year. In transport, even though fuel efficiency and modest growth in biofuels constrains demand from a light vehicle fleet projected to grow at 3.5% a year, oil use still grows at 0.8% a year [BP 2015].
There is, however, a technology revolution underway in electricity generation and light vehicle transport and this has the potential to upset these projections. In the last decade wind and solar grew by 20% and 40% a year respectively and now jointly account for just under 5% of electricity generation [GWEC 2015, EPIA 2014]. Significantly, they are at or approaching cost parity in many markets and their costs are expected to go on falling [Shah 2015, Lazard 2014]. The advent of cost-effective domestic batteries and the development of smart metering in the early 2020s are expected further to boost demand for domestic solar. Industry projections of long-term average growth in annual installations of generating capacity are in the range 0% to 4% for wind and 5% to 10% for solar [GWEC 2014, Fürstenwerth 2015].
Cost-effective batteries are also expected to bring the capital cost of electric vehicles below those of petrol vehicles in the early 2020s with life-time ownership costs expected to be significantly less. Sales of electric vehicles are expected to increase by around 40% a year in the next five years, taking their share of light vehicle sales from less than 0.5% now to around 3% [Hummel 2014]. The introduction of autonomous vehicles in the 2020s and their use with taxi hailing apps has the potential to transform urban light vehicle use and potentially reduce the growth rate (or even the size) of the global vehicle fleet [Greenblatt and Saxena 2015]. This is likely to boost the share of the global light vehicle fleet taken by electric vehicles provided that their long-term ownership costs are by then lower than those of comparable petrol vehicles.
To assess the risk that these developments pose to the fossil fuel industry we start by asking how fast renewables and electric vehicles would need to grow to eliminate growth in fossil fuels in generation and transport respectively and whether such growth rates are plausible.
For generation we take BP’s projected growth rates for aggregate demand and for hydro and nuclear for the next two decades as given but we assume that renewables are sufficiently price-competitive to displace the demand for fossil fuel generation that BP projects so that renewables generation grows at rates consistent with the projections made by the renewables industry. Once assumptions are made for the growth in renewables, fossil fuels then become the balancing item in inputs to generation. On this basis, the growth rate of renewables that would eliminate the need for growth in fossil fuels in generation is 10% pa over 20 years.
See full PDF below.