Investing in extreme times

The energy sector, including giants like BP, Shell and ExxonMobil, is overvalued to the tune of trillions of dollars and the entire industry—if not the global economy itself—could be thrown into crisis with the stroke of a pen. At least that’s the prediction of those who ascribe to the theory of a global carbon bubble. The thinking is as follows: the world is hurtling toward a climate change crisis and any serious global effort to prevent it will render a good chunk of recoverable oil reserves essentially unburnable.

While it sounds like an idea dreamt up by student activists over a few beers—and, indeed, several oil majors dismissed it as such—the warnings are being taken seriously by some high-profile people. Mark Carney, Canada’s former central banker and the current governor of the Bank of England, raised the issue at a World Bank conference earlier this year (he prefers the term “stranded assets”) and has since tasked the U.K.’s central bank to study the issue. “It’s encouraging for us that he’s taking up the battle,” says James Leaton, the head of research at Carbon Tracker Initiative, a U.K.-based non-profit that’s been pushing the carbon bubble idea since 2011. “But how far he’s going to run with it, I don’t know.”

Carney may not even need to put on his sneakers. The recent emissions deal between the United States and China, two of the world’s biggest carbon emitters, has raised hopes of a global climate deal being reached at the UN conference in Paris next year. If such a pact indeed comes to pass, energy companies would just be one of many industries that could take a serious hit. Of course, any agreement to limit emissions growth would turn on the policies actually implemented to achieve the promised targets—an area where previous commitments have tended to fall apart. But investors shouldn’t necessarily assume that they will be saved by the weak knees of politicians. Many firms are already being impacted by rising global temperatures, whether they acknowledge it or not. Studies suggest that, as the mercury climbs, so do the chances of destructive weather events, like the 2.1 metres of snow that recently collapsed roofs in Buffalo, N.Y., California’s record-breaking drought, or the floods that submerged Alberta in 2013—events that can cause millions or even billions of direct and indirect losses, ranging from property damage and failed crops to closed airports and shuttered stores.

Both U.S. and Canadian regulators have issued guidance about how public companies should report such climate-related risks, but the response from corporate boardrooms has been spotty. For one thing, it can be difficult to quantify. Moreover, many executives don’t like talking about such a politically fractious issue, lest it draw attention to their own carbon-heavy footprints. But all of that could change in 2015. With high-profile people like Carney demanding more transparency and little evidence to suggest global warming is going away, companies will have a difficult time avoiding conversations about the nasty weather, and what the regulators that oversee them plan to do about it.

Carney’s initial statements back in October were focused mostly on the seemingly dry (unless you’re an accountant) topic of integrated reporting, a holistic way of valuing a corporation that takes into account everything from financial performance to social and environmental issues. Since then it’s been revealed that Carney may view the issue of “stranded carbon” as an economic threat. In a letter to the U.K. government’s environmental audit committee released in December, he said the Bank of England was “deepening and widening our inquiry into the topic” and that he expected the financial policy committee “to also consider this issue as part of its regular horizon-scanning work on financial stability risks.”

Not surprisingly, oil giants Shell and BP have dismissed the idea outright, citing the world’s overwhelming dependence on fossil fuels. But activists like Leaton say the recent plunge in oil prices has demonstrated just how vulnerable the industry has become in an era of energy-intensive exploration—fracking, steam-assisted oil sands excavation and deep-sea drilling. “Suddenly, the economics of these projects have become a lot more questionable,” he says. And while oil prices will no doubt rebound eventually, Leaton says a more important question is what global rules on carbon will look five years from now. “The issue for the oil sands is that you’re making decisions today to invest capital, but you can’t start producing until 2020. A lot can happen between now and then.”

In the meantime, there’s no shortage of other climate-related risks for investors to ponder. While it’s impossible to link any single weather event to climate change, studies suggest the increasing frequency of severe droughts and 100-year storms are indeed correlated with—and most likely caused by—rising temperatures. Moreover, a recent report from the World Bank argued some of those changes are already baked in—regardless of whether the temperature rise can be limited to 2° C above pre-industrial times, the current goal of climate change negotiations. “Everyone will feel the impact, particularly the poor, as weather extremes become more common and risks to food, water, and energy security increase,” the UN agency warned.

One needs only to ask residents of California what the future might feel like. The Golden State is three years into one of its worst droughts on record. Farmers are leaving fields fallow. Golf courses are pulling up turf. Residents found hosing down their driveway pads risk being fined $500. Already the state’s agriculture industry, the world’s ninth-biggest in value, is estimated to have suffered $2.2 billion in losses. Recent drought conditions in the southern U.S. are blamed for rising food prices across the continent, while Tim Hortons’ November decision to raise the price of a coffee by about 10 cents was linked to a drought in Brazil.

Nor are farmers and food companies the only ones being affected. In 2013, Canadian insurers paid out a record $3.2 billion in claims following the Alberta floods, another flash-flood event in Toronto and the ice storms that wreaked havoc on the electricity grid in southern Ontario and Atlantic Canada. In the U.S., meanwhile, recent surveys done by CDP—a non-profit group supported by big institutional investors, formerly known as the Carbon Disclosure Project—showed a litany of climate and weather-related expenses being racked up by big American firms between 2011 and 2013. Among the highlights: New York utility company Consolidated Edison shelled out more than $431 million to repair damage from superstorm Sandy two years ago; Union Pacific, a U.S. railroad, “managed record snowstorms, a snow avalanche, a record flood in the Midwest and a record drought in Texas” in 2011; tech giant Hewlett-Packard said severe flooding in Thailand impacted its ability to source disk drive components; retail giant Sears said it paid $14.5 million to repair or replace buildings damaged in severe weather events, and another $8.7 million to repair flood-related damage.

There are, of course, those who stand to benefit from erratic weather. California’s hot, dry 2014 was good for local wineries (even as a changing climate threatens historic winemakers in France) and last year the Danish-owned bulk carrier Nordic Orion saved hundreds of thousands by making the first-ever commercial trip through the increasingly ice-free Northwest Passage. In Canada, meanwhile, changing climate conditions have made it possible for farmers to grow crops that were previously unheard of in most of the country. Mike McGuire, the president of Monsanto Canada, the agriculture and biotech giant, says more than one million acres of soybeans are now grown in Manitoba (previously they were confined to southern Ontario, with its longer, warmer summers) and Ontario corn farmers now enjoy higher yields per acre than their peers in the U.S. Corn Belt. “Farmers are growing crops today that used to grow as much as 200 miles further south,” McGuire says. “The other things we’re seeing are more violent storms, colder starts to the season and shorter planting periods.”

Yet, even the benefits come with hidden costs. An official from Canadian Pacific Railway told a conference last year that erratic weather made it more difficult to forecast demand for railcars, generally based on five- or 10-year crop averages. And food processors are being forced to invest in more technology to keep products like french fries consistent at time when potato crops show more variation. “There’s an adage in the food industry that it can be consistently bad or consistently good, as long as it’s consistent,” says Martin Scanlon, associate dean at the University of Manitoba’s agriculture and food sciences department.

Pity the poor investor trying to make sense of all of this. While the U.S. Securities and Exchange Commission asked companies to disclose the impacts of climate change back in 2010—a move mirrored by the Ontario Securities Commission—a recent report by Ceres, a non-profit group that advocates for more sustainable business practices, found 41 per cent of companies in the S&P 500 index didn’t disclose any climate-related information in 2013 whatsoever. Other surveys have suggested a similar low rate of response in Canada. And even among those companies who do make an effort, the information tends to be all over the map, since it’s up to companies to decided what is “material” to their businesses. “The problem for investors is that the information is not integrated into the reporting,” says Philip McIlkenny, an associate professor at the University of Ottawa’s Telfer School of Management, who has studied the issue. “And it’s currently voluntary because there’s no unified code.”

Some aren’t waiting to see how it all plays out. Dozens of public pension funds and university endowment funds have participated in carbon-divestment campaigns, with Norway’s government pension fund the latest to threaten to eliminate “climate offenders” from its portfolio. As for the rest, there are growing signs of unrest on Wall Street. An October study by PricewaterhouseCoopers found that 58 per cent of investors were “dissatisfied” with U.S. companies’ understanding of climate change risks—a figure that rose to 64 per cent among investors managing more than US$100 billion in assets.

The debate about climate change and what to do about it rages on. But one thing’s for certain: it’s no longer business as usual.