More than 40 years since a senior NASA scientist told US Congress of concerns about human activities disrupting the climate, experts are warning of an impending climate catastrophe and the financial sector is wrestling with the implications.
Think of the energy created from igniting 15,000 tonnes of TNT; that’s the size of the explosion made by the atomic bomb dropped on Hiroshima in 1945. Scale up the blast 400,000 times and you have the daily global energy imbalance that is causing the world to warm and threatens environmental breakdown.1
Grappling with this unsettled former NASA scientist Dr. James Hansen. After retirement, he joined Columbia University’s Earth Institute and has become a leading climate campaigner – but his message is not one everyone wishes to hear. He claims efforts have been made to silence him as he highlights the impact of humans on the planet.2 In particular, by burning coal, oil and gas to release energy, carbon locked up for millennia has been released, sending atmospheric carbon dioxide (CO2) to its highest level for 800,000 years.3
“Adding CO2 to the air is like throwing another blanket on the bed,” Hansen says. “It reduces Earth’s heat radiation to space, so there’s a temporary energy imbalance. More energy is coming in than going out, until Earth warms up enough to again radiate to space as much energy as it absorbs from the sun. So, the key quantity is Earth’s energy imbalance. Is there more energy coming in than going out?”4
Yes, is the short answer. The daily global energy imbalance is about six-tenths of a watt per square metre. “That may not sound like much, but when added up over the whole world, it’s enormous,” says Hansen. “It’s about 20 times greater than the rate of energy use by all humanity.”
With humans “throwing blankets on the bed” at some pace, the world is tending to warm5 and natural equilibria are being altered. Methane, an even-more powerful warming gas than carbon dioxide, has been increasing too, leaking from modern gas distribution networks, rotting food and ruminating animals. Fluorinated gases and nitrous oxide are also being emitted from various industrial processes, with a notable ability to warm.6
The evidence that the climate is changing is overwhelming. And the evidence that humans are a major – if not the main cause – is also overwhelming
“The evidence that the climate is changing is overwhelming,” says Professor Richard Tol from the University of Sussex, a former member of the Intergovernmental Panel on Climate Change (IPCC) and joint winner of the Nobel Peace Prize for contributions to knowledge on global warming.7 “And the evidence that humans are a major – if not the main cause – is also overwhelming. We see that through different lines of evidence. We see it in the paleo record and in the instrumental record. We’ve seen it in well-calibrated, complicated climate models, and we see it in simpler models that are essentially based on the first principles of physics. All these lines of evidence indicate that climate is changing and that humans are the main cause.”
Just like Tol, most scientists dismiss the idea human-induced climate change is a hoax, as US President Trump once famously suggested.8 (Nevertheless, Tol rejects the widely-publicised claim that “97 per cent of scientists agree”9 on climate warming. He says that is “bogus”, because of the way the net for sample data was cast.)
The consensus view is that human actions have shifted the climate into a new era – the Anthropocene10 – where humans are in the driving seat. In this phase, atmospheric CO2 has reached “the dangerous zone”, according to Hansen, more than 15 per cent above the “long-term safe” level of 350 parts per million.11
The pace of change is startling. Although the earth has experienced phases of heating and cooling over millennia, atmospheric temperature is increasing around ten times faster than ever before, too fast for many plants and animals to adapt.12 And the processes triggered have some way to run, because so much of the Earth’s surface is covered in water.
Most of the heat we have been putting in the atmosphere actually disappears into the ocean
“Most of the heat we have been putting in the atmosphere actually disappears into the ocean,” Tol explains. “Essentially, what we are doing is heating up the ocean very, very slowly. Even if we were to stop emitting CO2 now, the world would continue to warm for another 50 or 100 years. The same is true of the oceans. Sea level rise is essentially driven by the heating of the ocean, and the expansion of sea water. We have set something in motion that will take at least a millennium to work through.”
For now, the changes in the cryosphere are most obvious in shrinking sea ice and calving glaciers. Satellite images of Greenland suggest around 278 gigatonnes of ice is melting each year, releasing enough water to fill more than 110,000 Olympic swimming pools.13 As the Earth is exposed, it can absorb more solar energy than the ultra-reflective ice surface it has replaced.
Facing a warmer, more volatile world
With more energy in the atmosphere, circulation patterns are changing, bringing hotter and drier weather in places, but more extreme rainfall and flooding in others. Extreme temperature events have become about 20 times more likely since 1950,14 with a number of new records set in the last decade.15 The idea of temperatures literally reaching “off the charts” raises the prospect that current heat indices may need to be revised.16
With higher temperatures, hurricanes intensify more quickly, rapidly swelling with water vapour
With higher temperatures, hurricanes intensify more quickly, rapidly swelling with water vapour.17 US academics Michael Mann and Andrew Dessler say that made Hurricane Dorian “bigger, wetter and more deadly”, for instance, bringing a devastating storm surge and winds raging over 220 miles per hour.18
Meanwhile, population growth is changing the nature of the natural world, exacerbating the warming trend and contributing to “biological annihilation”19 (see Biological annihilation: The facts behind the threats to biodiversity and ecosystems). Felling forests and clearing peatlands release CO2 and reduce future uptake through photosynthesis, with less CO2 absorbed and less clean oxygen released. As we clear around one football pitch of forest every second,20 the Earth’s potential to self regulate is being diminished.
We need to pay as much attention to how good the natural environment is at soaking up carbon as to how much we’re emitting
“We need to pay as much attention to how good the natural environment is at soaking up carbon as to how much we’re emitting,” says Dieter Helm, professor of economics at the University of Oxford. “When it comes to that, the climate change story is much worse than people are currently projecting. Until recently, you didn’t hear much discussion about the scale of destruction of rainforest, huge carbon sinks of natural sequestration. What’s going on in the Amazon, the Congo, the Mekong Delta and elsewhere is very, very serious.” Now the race is on to protect vast carbon stores like the Congo’s Cuvette Centrale peatlands, recently discovered to be much larger than first thought, holding the equivalent of 15 years’ worth of US fossil-fuel emissions.21
With ecosystems degrading, extinction rates are said to running more than one hundred times faster than the “background” rate, where one to five species are lost a year. Some estimates put the figure even higher.22 Erosion and soil degradation are widespread, with topsoil being lost around ten times faster than it is being replenished.23
So, multiple parts of the biosphere are being altered simultaneously, ringing warning bells for those watching the natural world.
Figure 1: Hotting up: Levels of atmospheric carbon dioxide
Assessing the environmental fallout
Several major impacts could follow. First, large parts of the globe may become so inhospitable that human ecosystems are disrupted. Rick Stathers, responsible investment analyst and climate change specialist at Aviva Investors, says signs of this are evident already.
“Think of the recent groups of migrants leaving Syria for Europe or the Central American migrant caravans heading to the United States that President Trump has been so vocal about. Drought is certainly not the only factor, but it has played a part,” he says.
Low-lying areas of China, India, Japan, Indonesia, Bangladesh and the United States are all high-risk zones
Second, floodplains and coastal areas might be threatened if extreme weather events become more common and sea levels continue to rise. Vulnerable areas include those housing some of the world’s megacities – vast conurbations, each populated by more than ten million people. Low-lying areas of China, India, Japan, Indonesia, Bangladesh and the United States are all high-risk zones, with concentrated populations living close to today’s sea levels.24
Conversely, well-used waterways like the Rhine, one of Europe’s longest rivers, may decline and become impassable to shipping if the glaciers feeding them continue to shrink and European summer temperatures rise. (The impact has already slowed goods transport, hitting German GDP in 2018.) In fact, many areas of economic activity may need to be wholly rethought; the IPCC has called for “rapid, far-reaching and unprecedented changes in all aspects of society”.25
Not all climate impacts will be negative: that will depend where you are, what you are doing and what timeframe you are looking at
Significantly, not all climate impacts will be negative: that will depend where you are, what you are doing and what timeframe you are looking at. Professor Solomon Hsiang from the University of California, Berkeley, thinks the best way to visualise this is to imagine a U-curve, with temperature on the x-axis and impact on the y. In very cold temperatures, negative impacts tend to be elevated – for example, as people experience poor health in cold weather. Equally, very high temperatures tend to be problematic. The sweet spot is where the base of the curve falls away, in the mid-zone. Higher temperatures will shift the curve to the right; the outcome will vary in each case, depending on where the trajectory began.26
This is a crisis…
One uncomfortable thought is that the poorest are most vulnerable in periods of environmental upheaval. The UK’s Institute of Public Policy Research (IPPR) has declared, “This is a crisis”, something mainstream political debate has utterly failed to address.27 The language used by the IPPR marks a step change in the climate debate, where discussions were once carefully worded and laced with caveats. Like Extinction Rebellion, whose environmental campaigners have been gluing themselves to public transport and using drones to disrupt air transport, the IPPR believes the time for tiptoeing around the issues is over.
People need to be aware of the fundamental risks, and we need urgent and transformational change to address them
“We are not alone in using increasingly bold, but perhaps more truthful, language now,” Luke Murphy, head of the IPPR’s Environmental Justice Commission, says as he flags the policy vacuum. “In the past, the messages were not so strong, and there was a sense that people did not wish to scare. The idea was that we might be able to make incremental changes to address environmental issues, and that was the best way to move forward. Not anymore. People need to be aware of the fundamental risks, and we need urgent and transformational change to address them.”
For some, the only solution is a less growth-driven world, where aspirations are modest and excessive consumption is frowned on. Is the way forward “bottomup”, where billions make small-scale changes, eating food produced locally to reduce unnecessary energy consumption, insulating buildings to prevent heat loss, and recycling? Or will the human tendency to focus on the present scupper change? (see Apathy, anger, action: The psychology of climate change).
The alternative response would be strongly top-down, through state-imposed price or quantity controls such as carbon quotas or taxes, to internalise the externalities (see ‘Sticking’ it to carbon: The pros and cons of taxing emissions). Past experience suggests market-based systems could trigger green innovation as well.
The introduction of the European ETS led to a 30 per cent rise in clean-patent filings from companies impacted by the policy
“The introduction of the European Emissions Trading Scheme (ETS) led to a 30 per cent rise in clean-patent filings from companies impacted by the policy,” assistant associate professor Antoine Dechezleprêtre from London’s Grantham Institute of Climate Change and the Environment points out. “The policy is EU-wide, only impacting selected industry sectors. There is no uncertainty about its future; the only uncertainty is the carbon price. At the beginning it was around €30 a tonne, and that drove lots of innovation. Then it fell to €5-10 a tonne, and filings dropped because at that level companies don’t feel it. But it shows economic incentives work.”
Where carbon taxes have been introduced, most governments have pitched way below the “severe mitigation” scenario set out in the Paris Agreement, intended to cap temperatures at below two degrees Celsius above pre-industrial levels. (The “severe mitigation” scenario gives a 50 per cent chance of meeting that two-degree cap.)
“The Paris Agreement was made on the basis of countries making voluntary commitments,” says Steve Waygood, chief responsible investment officer at Aviva Investors. “When you add up all of those commitments, they do not get us anywhere near two degrees; they get us nearer to 3.2 degrees.” Meanwhile, policy conflicts abound: it is not unusual for an administration to negotiate a carbon tax, but have fossil-fuel subsidies running alongside.
Some are hoping new technologies will emerge to reverse or counter the impact of the build-up of warming gases
With the outlook rather opaque, some are hoping new technologies will emerge to reverse or counter the impact of the build-up of warming gases. There are discussions around geoengineering – deliberate, large-scale interventions in natural systems to counter climate change. They range from using space reflectors to block incoming solar energy28 to compressing and injecting CO2 deep underground. (The latter has already been carried out at small scale by the Norwegian energy company Equinor,29 but there are fears that scaling up might trigger earthquakes,30 ultimately allowing the gas to leak back out.)
This is the minefield policymakers must navigate. Although human-induced climate change has been described as “the greatest market failure that the world has seen”,31 initiatives to find solutions are far from consistent or co-ordinated. Witness the events at the 2019 United Nations Climate Change Conference (COP25), where UN climate expert Alden Meyer reported an “almost total disconnect” between the science and what negotiators delivered.32
What happens next?
Meanwhile, academics are grappling with the processes that drive the climate to improve insights into what might happen next. In the last four decades, the models and variables being considered have developed enormously, as shown in Figure 2.
Figure 2: Thinking connectedly: climate modelling
“The climate is very complex,” says Professor Chris Budd, a mathematician at the University of Bath, whose interest in using partial differential equations for problem solving has taken him deep into the operations of the Met office.33 “It is hard to get good data, especially of the initial states. The equations for climate are hard to solve and may have multiple solutions. Chaotic behaviour is always present, and it can be hard to distinguish natural effects from human intervention.” Nevertheless, progress is being made, using supercomputers that carry out around 14,000 trillion arithmetic operations per second.
In a typical forecast, there are about a billion discrete equations
“In a typical forecast, there are about a billion discrete equations,” Budd explains. “Errors can arise in the way that the physics is represented, the algorithms used to solve that physics, the coding up of those algorithms, the data that is fed in to the calculation, and the initial conditions used to start the whole system off.”
The undertaking is riddled with uncertainty, and that includes anticipating the way in which companies and consumers might adjust their choices. So far, comparatively few in developed economies have changed their high-carbon ways, something psychologist Per Espen Stoknes blames on people’s inability to handle doom-laden visions of the future.34 The problem, he believes, is “apocalypse fatigue” – we are simply exhausted by the prospect of disaster. But if large numbers perform a volte-face, the equations could change radically.
Combine this mega-unknown with how climate might vary anyway, and the differences in the way individual climate models function, and you can appreciate why the range of potential outcomes is large (see Figure 3).
Figure 3: What do we know? Uncertainty in mean temperature projections
Furthermore, as climate science evolves, large numbers or ensembles of simulations are being used to address the problem of climate attribution. This is a comparatively new field, designed to disentangle the drivers of natural disasters. “A dice may be loaded to come up six,” explains Dr. Friederike Otto from the Environmental Change Institute at the University of Oxford. “But it might have come up six anyway without the loading.”35
The question is: what exactly have we, as humans, done? This is a sensitive area, with major implications for companies, governments and others with a duty to plan.
Probabilistic event attribution involves modelling how often an extreme weather event might occur in experiments representing the world as it is, then comparing it to a scenario with human impacts removed (allowing for uncertainties).
Computing power has become available, so you can run large ensemble simulations of climate models; not just once or twice, but several hundred times to actually look at weather
“Since I have been working on this, it’s changed from being something that people had suggested you could do theoretically to actually doing it at scale,” Otto says. “The main thing that was necessary for that to happen was that computing power has become available, so you can run large ensemble simulations of climate models; not just once or twice, but several hundred times to actually look at weather.”
Recent findings show there are certainly cases where human actions have contributed to “loading the dice”. For example, Otto’s work suggests human actions made the 2019 heatwave that saw the temperature hit 45 degrees Celsius in France near Nîmes at least five times more likely.36 With European summer heatwaves, her work shows human activities have been a game changer. Conversely, there are situations where human actions seem to be making extreme events less likely; less spring-time flooding associated with snow melt, for instance.37 In others, it is simply not possible to say.
The blame game: Acts of God or acts of man?
Given what we know now, is it possible to allocate blame, if human actions contribute to more extreme weather and losses follow? The answer from climate modellers – where researchers have looked at both country and company-level attributions – is a qualified yes.
“When we did the study looking at different countries, you could use all the emissions since the beginning of the Industrial Revolution,” Otto explains. “Or you could say, ‘Well, you can’t say that people really knew about climate change at the time. Are they really responsible for it? Maybe we only take the emissions from 1990, when the first IPCC report was published.’ You can do that as well, and of course you will get a different number. There is a large difference between the two. Scientifically you can do both, and both make sense, but which one is the one you might want to use in court, or for any other purpose?”.
Proposals are now being developed for the allocation of climate-related damages
Proposals are now being developed for the allocation of climate-related damages. The first of these suggested damages might be allocated by market-share theory (i.e. CO2 contribution, multiplied by the damages caused by the climate-related event). This approach assumed CO2 emissions and climate events have a linear relationship. In fact, climate events may have other kinds of relationships to atmospheric CO2 levels; they may be more extreme, so the impacts increase rapidly or exponentially, or sigmoidal in shape (like a stretched out ‘S’).38
Analysis of these relationships is quite new, and the implications of integrating non-linear relationships in emissions and impact profiles are significant.39 For example, if you take an S-shaped emissions profile, the impacts change markedly through time. Depending when the calculation is carried out and when emissions are released, the attributable damage liability might be lower than that calculated from a linear profile or more than three times greater.
Tracking and understanding these sensitivities is becoming increasingly important for decision makers around the world. The implications run deep for insurers and other asset owners: there are specific physical risks associated with the changing climate; there are litigation risks that might come from those who believe they have suffered losses; and there are transition challenges that will come from the shift to a lower-carbon economy.
A wholesale reassessment of prospects could destabilise markets and spark a sell off, bringing a climate Minsky moment
Transition risks might be especially acute in a rapid-change scenario – the “too late, too sudden” shift European regulators are concerned about.40 A wholesale reassessment of prospects could destabilise markets and spark a sell off, bringing a “climate Minsky moment”, as the outgoing Governor of the Bank of England Mark Carney has warned.41 It is not unreasonable to imagine a rapid shift in attitudes could see the value of carbon-heavy investments change quite substantially (see Stranded! When assets become liabilities).
“If we take the Paris targets seriously, the implication of that is massive destruction of capital,” Tol points out. “Coal-fired power plants have a lifetime of 40 to 60 years; for gas-fired power plants it’s 20 to 40 years. Chemical plants – their lifetime is also measured in decades. If we are serious about getting emissions down, it means a whole lot of existing capital will have to be prematurely retired, long before the end of its technical or economic life.”
In financial markets, bond investors have already changed the frame of reference for assessing earnings prospects for oil exploration and production companies, as renewables have become more competitive.
They used to talk about cash flows ‘at some point’, now they’re talking about free cash flows
“They used to talk about cash flows ‘at some point’,” says Tom Chinery, investment-grade credit portfolio manager at Aviva Investors. “Now they’re talking about free cash flows. There is much less focus on the future and what might happen because of the uncertainty derived from people’s thoughts on climate change and new technology. The production cost of renewables makes oil in five years’ time a little less certain. The way people look at it has changed. It doesn’t mean they’re not buying, but the confidence further out is diminished.”
In the new environment, the number of institutional investors committed to cutting fossil-fuel assets out of their portfolios has risen more than six-fold, from around 180 in 2014 to more than 1,100 in 2019.42 Among the major asset owners changing course is Norway’s sovereign wealth fund, which will divest from oil and gas explorers but retain exposure to clean-energy technologies.43
Adapting to the transition
These changes imply there is detailed work to be done by financial institutions around Value-at-Risk, as they seek to understand what the changing environment will mean. How might assets be impacted, and how might institutions’ actions influence others?
There are several companies working on granular analysis, designed to establish how climate change could affect asset values, security-by-security
There are several companies, like Carbon Delta, working on granular analysis, designed to establish how climate change could affect asset values, security-by-security. “Carbon Value-at-Risk (CVaR) tends to capture Scope 1 emissions only at the moment,” says Aviva Investors’ Stathers. “That’s the emissions generated by a company directly; there is no consideration of the risks in the value chain.”
Sensitivity varies quite considerably – according to a company’s footprint, sector and business mix, based on a 15-year horizon. The data is not comprehensive, but it is a start.
Carbon Delta has back-tested notional portfolios of shares differentiated by CVaR to see whether there are performance implications from following lower-carbon strategies. It took buckets of global equities, divided by their sensitivity to a two-degree policy environment, then compared cumulative returns with a MSCI World exchange-traded fund. With regular rebalancing, the lowest-carbon strategy outperformed strongly between 2013 and 2018, by around ten per cent over five years (see Figure 4).44
Figure 4: Might a low carbon strategy pay off? Back testing 2°C CVaR
This suggests investors may already be re-evaluating the earnings potential of companies with carbon-heavy assets, but the results also conceal important underlying market trends. In Carbon Delta’s study period, oil and commodity prices were under pressure (not wholly related to the climate debate), while technology, a sector that tends to score well on carbon metrics anyway, performed strongly.
“Some investors are already comparing the oil and gas sector to the tobacco situation,” says Frédérique Nakache, European equity portfolio manager at Aviva Investors. However, she believes that excluding these companies from investment portfolios – as some have – could be overly simplistic. “In my view, the sector will play a key role in the energy transition as it brings knowledge and resources to bear in key areas, including the transition from thermal coal to gas, and from conventional energy to renewables and to bioplastics.”
“Excluding fossil fuels will not make as much difference as you might expect,” says Jaime Ramos Martin, global equities portfolio manager at Aviva Investors. “The carbon intensity in other parts of the economy is also quite high.” Instead, he advocates an approach that does “much, much more” than exclusion, concentrating on companies providing solutions to reduce carbon emissions or helping other parts of the economy to adjust.
We need to reduce the carbon intensity of the global economy by at least 60 per cent by 2050
This means appreciating the dramatic shift in orientation being flagged by academics like Dechezleprêtre at the Grantham Institute to meet the IPCC’s target. “The change will have to be massive,” he says. “We need to reduce the carbon intensity of the global economy by at least 60 per cent by 2050. That will require a seismic shift. It’s not the direction we’ve been taking so far. There isn’t a single country where there has been that large a drop in emissions; it’s not been done anywhere yet.”
Equity market valuations of some “climate transition” players are already quite elevated, like small European independent power producers. “They are not cheap,” admits Françoise Cespedes, equities portfolio manager at Aviva Investors. “We need to bear in mind they are project companies, with a huge backlog of projects. We can’t talk about a bubble in valuations yet, given there is a backlog and these companies are growing very fast indeed. But part of the re-rating of these stocks has been driven by massive inflows coming from the recent development of climate equity strategies – hence some caution is needed when considering new investments.”
Climate change feels like the proverbial elephant in the room: something everyone is aware of but no-one has managed to tackle. Beyond the deniers, it has suffered from the tragedy of the commons and bystander problems: why act when others will hopefully act for you? But as evidence builds of how painful – or even impossible – “business as usual” might be, it cannot be ignored.
Complex models are being used to explore questions of human action and causation and detailed mapping to track risks under various scenarios
There is now a sense of urgency, with complex models being used to explore questions of human action and causation and detailed mapping to track risks under various scenarios. Opportunities to reshape the inner workings of the economy, to create a world where growth is achieved with a lighter environmental footprint, are also vast.
AIQ has previously covered the need to think more intelligently about the role of public and private institutions when tackling big social and environmental challenges. And while we know markets can fail (climate change perhaps being the most severe example), when guided in the right direction, the creative powers of markets are nothing short of staggering. By fusing this with a deeper understanding of the psychology behind human behaviour, as well as more transparent data collection and effective insight generation, there is still cause for hope.
“Make no mistake, this is without question the biggest issue we need to contend with this century,” says Waygood. “Our whole society is at risk; it is only by harnessing the powers of capitalism that we stand a fighting chance”.