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The other reason for divestment

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Higher education institutions that don’t divest from fossil fuel companies because it’s the right thing to do should divest from “stranded assets” because it makes financial sense, argues Robert Litterman.

This article originally appeared on Ensia.

Recently, higher education institutions have been asked by Bill McKibben and his organisation 350.org to consider divesting their endowments of fossil-fuel companies. Almost all of these institutions have rejected the requests.

The president of Harvard, Drew Faust, for example, recently wrote in a statement, “I do not believe, nor do my colleagues on the corporation [committee on shareholder responsibility], that university divestment from the fossil fuel industry is warranted or wise.” Harvard holds endowment assets to advance an academic mission, she explained, not to “serve other purposes, however worthy.”

And while it makes perfect sense to argue that acting solely on ethical or moral grounds is difficult to reconcile with the fiduciary responsibility to prudently invest the endowment, that may not be the end of the story. There is an opportunity for the Harvard endowment, and other investors, to tilt their portfolios in order to generate an attractive return while reducing climate risk if they consider the economics, not necessarily the ethics, of the situation.

It is well known that emissions markets have not yet priced climate risk appropriately, but what is not well understood is that today’s equity markets build in expectations that climate risk will not be priced rationally for a very long time. The market expects a slow increase in emissions prices over the next several decades.

But what the market does not yet realise is that this expectation, sometimes referred to as the “slow policy ramp”, is irrational — it does not appropriately take risk into account. The actual rational expectation for the price path of emissions is a sudden jump of global carbon emissions prices to a level high enough that incentives are created that will, with extremely high probability, eliminate any threat of catastrophic climate risk. Of course, no one knows what the future will bring, but I think this rational pricing of emissions is much higher and will come much sooner than the market expects.

Therefore an opportunity exists in going short certain equities, such as coal and tar sands, which under the slow policy ramp for emissions prices still have significant valuations, but which will actually lose value when it becomes recognised that carbon emissions will soon be priced rationally. Such equities are known as stranded assets.

The other piece of the puzzle is going long the broad equity market. Such an exposure can be easily implemented by institutional investors through a total return swap — a derivative that creates cash flows to the investor, positive or negative, equal to the total return that would be generated by owning a basket of specified long and short underlying equity exposures. This swap creates the equivalent economic benefit of selling stranded assets at current valuations and investing those proceeds in the broad equity market. It is a bet that stranded assets will underperform the equity market.

The reason a sudden jump in emissions prices makes sense is because the price of emissions is the brake society has in order to create appropriate incentives for emissions reduction. How hard should society press on that brake today? The answer requires application of a complex mathematical technique known as robust dynamic optimal control in a context with highly uncertain nonlinear responses — but simple intuition can be just as effective in helping to chart the course.

Consider two scenarios. In the first scenario you are racing down a mountain road with a sharp curve ahead. You are going fast, but you’ve been down this road many times so you know that you need to slow down significantly to get around that curve safely. And you know exactly how much distance it takes to slow down going into the curve. You brake slowly at first, increasing the pressure as you get closer to the curve. This is the profile of the slow policy ramp for emissions prices built into current equity valuations.

In the second scenario the situation is identical, except you have never been down this road before. In the instant you see the curve, you realise that you need to slow down, that there is a steep cliff off the side of the road and that you aren’t sure the speed at which it will be safe to round that upcoming corner — which is sharper now than it initially looked. As time compresses, you realise that you might be going too fast and you need to slam on the brakes.

The difference between scenario one and scenario two is uncertainty and risk aversion. In scenario two, you instantly brake hard enough that you expect to ease up on the brake as you slow down safely. That is the situation society is in today with respect to climate risk, and equity markets have not yet realised it.

Of course governments have shown very little ability to support rational climate policy lately, especially the US. Behavioural finance would emphasise the irrational behavior of individuals, the frictions that prevent appropriate policy and so on. And some investors think people are never rational.

But it turns out that behavioural anomalies, once understood, often disappear. It’s very possible that fear of catastrophic outcomes will lead to rational global pricing of emissions much sooner than the market has built into current prices of stranded assets. If this happens, stranded assets will underperform the market and those taking advantage of the swap will profit.

I think a savvy investor, particularly an educational endowment, recognises that people do become more rational over time. Such an investor would see the risk embedded in the stranded assets in their portfolio.

At the World Wildlife Fund, where I chair the investment committee, we voted last May to use a simple total return swap as described above to hedge the stranded assets embedded in the funds in which we have investments, without otherwise disturbing the portfolio. Since then, stranded assets have underperformed the market.

Similar actions by educational endowments might actually uphold the responsibility to prudently invest the endowment while also serving the interests of the broader society to mitigate climate change. Moreover, there is no economic reason to size the swap simply to hedge existing exposures.

A more sophisticated investor might recognise that an even larger exposure to this stranded assets swap would create some risk, but would also potentially represent a return-generating opportunity — all while aligning the interest of the endowment with that of the institution and encouraging rational behavior with respect to climate risk.

Robert Litterman is the chairman of the Risk Committee and of the Academic Advisory Board at Kepos Capital.

Further reading:

Investors worth $3tn put pressure on fossil fuels industry to rethink future

Yes, we too can profit by killing the planet because… we’re Harvard

Fossil fuel divestment campaigns can help ‘stigmatise’ industry

Climate change a ‘firmly established’ material risk for mainstream investors

The Guide to Climate Change 2013

Economy

Will Self-Driving Cars Be Better for the Environment?

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self-driving cars for green environment
Shutterstock Licensed Photo - By Zapp2Photo | https://www.shutterstock.com/g/zapp2photo

Technologists, engineers, lawmakers, and the general public have been excitedly debating about the merits of self-driving cars for the past several years, as companies like Waymo and Uber race to get the first fully autonomous vehicles on the market. Largely, the concerns have been about safety and ethics; is a self-driving car really capable of eliminating the human errors responsible for the majority of vehicular accidents? And if so, who’s responsible for programming life-or-death decisions, and who’s held liable in the event of an accident?

But while these questions continue being debated, protecting people on an individual level, it’s worth posing a different question: how will self-driving cars impact the environment?

The Big Picture

The Department of Energy attempted to answer this question in clear terms, using scientific research and existing data sets to project the short-term and long-term environmental impact that self-driving vehicles could have. Its findings? The emergence of self-driving vehicles could essentially go either way; it could reduce energy consumption in transportation by as much as 90 percent, or increase it by more than 200 percent.

That’s a margin of error so wide it might as well be a total guess, but there are too many unknown variables to form a solid conclusion. There are many ways autonomous vehicles could influence our energy consumption and environmental impact, and they could go well or poorly, depending on how they’re adopted.

Driver Reduction?

One of the big selling points of autonomous vehicles is their capacity to reduce the total number of vehicles—and human drivers—on the road. If you’re able to carpool to work in a self-driving vehicle, or rely on autonomous public transportation, you’ll spend far less time, money, and energy on your own car. The convenience and efficiency of autonomous vehicles would therefore reduce the total miles driven, and significantly reduce carbon emissions.

There’s a flip side to this argument, however. If autonomous vehicles are far more convenient and less expensive than previous means of travel, it could be an incentive for people to travel more frequently, or drive to more destinations they’d otherwise avoid. In this case, the total miles driven could actually increase with the rise of self-driving cars.

As an added consideration, the increase or decrease in drivers on the road could result in more or fewer vehicle collisions, respectively—especially in the early days of autonomous vehicle adoption, when so many human drivers are still on the road. Car accident injury cases, therefore, would become far more complicated, and the roads could be temporarily less safe.

Deadheading

Deadheading is a term used in trucking and ridesharing to refer to miles driven with an empty load. Assume for a moment that there’s a fleet of self-driving vehicles available to pick people up and carry them to their destinations. It’s a convenient service, but by necessity, these vehicles will spend at least some of their time driving without passengers, whether it’s spent waiting to pick someone up or en route to their location. The increase in miles from deadheading could nullify the potential benefits of people driving fewer total miles, or add to the damage done by their increased mileage.

Make and Model of Car

Much will also depend on the types of cars equipped to be self-driving. For example, Waymo recently launched a wave of self-driving hybrid minivans, capable of getting far better mileage than a gas-only vehicle. If the majority of self-driving cars are electric or hybrids, the environmental impact will be much lower than if they’re converted from existing vehicles. Good emissions ratings are also important here.

On the other hand, the increased demand for autonomous vehicles could put more pressure on factory production, and make older cars obsolete. In that case, the gas mileage savings could be counteracted by the increased environmental impact of factory production.

The Bottom Line

Right now, there are too many unanswered questions to make a confident determination whether self-driving vehicles will help or harm the environment. Will we start driving more, or less? How will they handle dead time? What kind of models are going to be on the road?

Engineers and the general public are in complete control of how this develops in the near future. Hopefully, we’ll be able to see all the safety benefits of having autonomous vehicles on the road, but without any of the extra environmental impact to deal with.

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Economy

New Zealand to Switch to Fully Renewable Energy by 2035

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renewable energy policy
Shutterstock Licensed Photo - By Eviart / https://www.shutterstock.com/g/adrian825

New Zealand’s prime minister-elect Jacinda Ardern is already taking steps towards reducing the country’s carbon footprint. She signed a coalition deal with NZ First in October, aiming to generate 100% of the country’s energy from renewable sources by 2035.

New Zealand is already one of the greenest countries in the world, sourcing over 80% of its energy for its 4.7 million people from renewable resources like hydroelectric, geothermal and wind. The majority of its electricity comes from hydro-power, which generated 60% of the country’s energy in 2016. Last winter, renewable generation peaked at 93%.

Now, Ardern is taking on the challenge of eliminating New Zealand’s remaining use of fossil fuels. One of the biggest obstacles will be filling in the gap left by hydropower sources during dry conditions. When lake levels drop, the country relies on gas and coal to provide energy. Eliminating fossil fuels will require finding an alternative source to avoid spikes in energy costs during droughts.

Business NZ’s executive director John Carnegie told Bloomberg he believes Ardern needs to balance her goals with affordability, stating, “It’s completely appropriate to have a focus on reducing carbon emissions, but there needs to be an open and transparent public conversation about the policies and how they are delivered.”

The coalition deal outlined a few steps towards achieving this, including investing more in solar, which currently only provides 0.1% of the country’s energy. Ardern’s plans also include switching the electricity grid to renewable energy, investing more funds into rail transport, and switching all government vehicles to green fuel within a decade.

Zero net emissions by 2050

Beyond powering the country’s electricity grid with 100% green energy, Ardern also wants to reach zero net emissions by 2050. This ambitious goal is very much in line with her focus on climate change throughout the course of her campaign. Environmental issues were one of her top priorities from the start, which increased her appeal with young voters and helped her become one of the youngest world leaders at only 37.

Reaching zero net emissions would require overcoming challenging issues like eliminating fossil fuels in vehicles. Ardern hasn’t outlined a plan for reaching this goal, but has suggested creating an independent commission to aid in the transition to a lower carbon economy.

She also set a goal of doubling the number of trees the country plants per year to 100 million, a goal she says is “absolutely achievable” using land that is marginal for farming animals.

Greenpeace New Zealand climate and energy campaigner Amanda Larsson believes that phasing out fossil fuels should be a priority for the new prime minister. She says that in order to reach zero net emissions, Ardern “must prioritize closing down coal, putting a moratorium on new fossil fuel plants, building more wind infrastructure, and opening the playing field for household and community solar.”

A worldwide shift to renewable energy

Addressing climate change is becoming more of a priority around the world and many governments are assessing how they can reduce their reliance on fossil fuels and switch to environmentally-friendly energy sources. Sustainable energy is becoming an increasingly profitable industry, giving companies more of an incentive to invest.

Ardern isn’t alone in her climate concerns, as other prominent world leaders like Justin Trudeau and Emmanuel Macron have made renewable energy a focus of their campaigns. She isn’t the first to set ambitious goals, either. Sweden and Norway share New Zealand’s goal of net zero emissions by 2045 and 2030, respectively.

Scotland already sources more than half of its electricity from renewable sources and aims to fully transition by 2020, while France announced plans in September to stop fossil fuel production by 2040. This would make it the first country to do so, and the first to end the sale of gasoline and diesel vehicles.

Many parts of the world still rely heavily on coal, but if these countries are successful in phasing out fossil fuels and transitioning to renewable resources, it could serve as a turning point. As other world leaders see that switching to sustainable energy is possible – and profitable – it could be the start of a worldwide shift towards environmentally-friendly energy.

Sources: https://www.bloomberg.com/news/articles/2017-11-06/green-dream-risks-energy-security-as-kiwis-aim-for-zero-carbon

https://www.reuters.com/article/us-france-hydrocarbons/france-plans-to-end-oil-and-gas-production-by-2040-idUSKCN1BH1AQ

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