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Oct 10, 2018

IPCC Recommends Economy Overhaul, Markets Don’t Care (Yet)

This week’s United Nations global warming report should’ve caused an uptick in the stocks of solar and wind energy companies. So why didn’t it?

Monday was the first day U.S. stock markets were open for trading after the weekend release of the IPCC “Global Warming of 1.5 Degrees Celsius”report. In the report, the world’s most eminent scientists warned us that we face catastrophe if we don’t largely decarbonize the economy by 2030 and completely by 2050. The IPCC—which receives contributions from thousands of scientists—warns that the global temperature has already risen approximately 1 degree Celsius (1.8 degrees Fahrenheit). Failure to keep that rise below 2 degrees Celsius (3.6 degrees Fahrenheit) will cause oceans to rise at least four more inches, farming yields to plummet, and freshwater to become scarce. All this would cost up to $15 trillion dollars, according to the report. Three and a half degrees Fahrenheit of warming is still (barely) avoidable, say the scientists, but we need to make dramatic changes to the economy, and we need to make them right now.

This past Monday morning, though, every solar and wind company owned in Green Alpha strategies—meaning many of the world’s leading, publicly-traded firms in those industries—was negative, in some cases as much as 4 or 5 percent. The markets and business world are shrugging off or flat out ignoring the implications of the IPCC report in deference to going about business as usual.  Rather than responding to the material risks presented by the IPCC, many investors went off to buy oil and Exxon Mobil, both of which were up on Monday morning.

In terms of the existential and economic risk it represents, the IPCC report should be the only thing in the media this morning. It should be the defining issue of the coming midterm elections. The markets should be pricing the causes of and the solutions to these risks as though they are real and they matter. Instead, as far as markets are concerned, they’re going almost entirely ignored.

How can this be? The story has two narrative drivers. First is the now well understood fact of climate science denial, largely caused by the disinformation campaigns of those who benefit from causing climate and health risks.

Second, and perhaps less well known, is that investment management and portfolio construction are presently structured to favor the business as usual narrative. Indeed, the investment industry and business as usual economics are currently in a mutually reinforcing and self-sustaining cycle.

You’re probably participating in this cycle, even if you understand that there is human-caused, dangerous climate change. Why?

First, the conflation of index investing and efficient market theory has convinced most of us that the wisest way to invest and to save for our retirements is to index, probably in a vehicle tracking a major benchmark, like the S&P 500. This has the effect of sending lots of purchase orders to the stocks in the S&P, driving them up, and reinforcing the idea that they’re “good” companies and safe long-term bets. In reality, many of the current S&P constituents practice business in ways that create the risk-riddled near-future scenario that the IPCC warns us about.

At the same time, solar and wind companies are largely not present in the S&P 500, and thus do not benefit from this windfall, no matter that their long-term prospects are much, much better than those of fossil fuels. Never mind that the global economy “could install more than a trillion watts of renewable power over the next five years,” according to Bloomberg (and published about the same time as the IPCC release).

Because the driving narrative of the last 15 years has been to “index and forget,” combined with indexing being defined as the measure of investment risk, it has been difficult for clean-tech innovation to win in the markets in the short term. This is partly because many of the investment flows are monopolized by the mega-caps, many of which are legacy economy causes of our now obvious, big risks.

The position of the approximately 60 fossil fuels companies and other legacy companies in the S&P 500 may be more tenuous than is generally appreciated. Businesses must adapt, otherwise they risk diminishing revenues and ultimately being dropped from major indices. They must adapt as companies have always had to adapt in the face of more competitive innovations (think of horse breeders in 1910 or Kodak in the early 2000s). Only now, there’s the additional imperative of an energy and economic transition to a lower-risk system. Even though they attract most of the investment flows, many S&P 500 constituents are a few cycles behind in innovation, meaning they don’t represent future growth. If investing is about growing your money for tomorrow, why would you invest in an index of yesterday’s winners?

The antidote to the “index and forget” paradigm keeping us all locked into our fossil-fuels-based and resource-degrading investments is to invest exclusively in what’s next: in the solutions to, rather than the causes of, the risks the IPCC is waving a red flag about. This has always been our mission at Green Alpha. This approach is seen as radical by the indexing crowd because it’s different; this integrated way to evaluate risk is new, and it requires that we be agnostic to statistics comparing us to the old economy’s benchmarks. But that’s the way we like it. You have to look at the world differently to have a shot at earning alpha, at outperforming markets and peers.

When you’re at the tip of the portfolio theory spear but you know you’re in line with scientifically objective reality, you can have a high degree of conviction. While global sentiment still favors oil over renewables, even in the face of a blaring alarm, you have to buy what’s next with both hands and hold for the long-term. When the worm turns and “business as usual” has changed to mean a de-carbonized and significantly de-risked world, it will be too late to catch it. We see today a clear-cut case of an inefficient market caused by information asymmetry. The time to act, for climate activists as well as investors, is now.  

Is there enough patient capital to allow forward-looking managers like us to persevere during this transition? Asked another way, can the market headwinds from legacy business as usual keep innovation from having real impact?

We believe that the simple fact of the truth of climate change, combined with the demonstrable economic superiority of renewables over fossil fuels, combined with other productivity-generating advances economy-wide, will change this narrative. Coal has largely already disappeared from the S&P 500. Over the coming decades, oil and natural gas companies, together with their service providers, will also either adapt or disappear. The beneficiaries of this transition will be renewables and their enabling technologies. A carefully selected portfolio of the best global firms in wind, solar, energy storage and their associated industries, is then a wiser long-term investment than oil and gas.

What’s clear in the IPCC report is that the scale of this problem can only be met with a total overhaul of global energy and economic systems. We can see that as something to be ignored or as an opportunity. Since we’re going to have go all out to avoid warming of 2 degrees Celsius (3.6 degrees Fahrenheit), the question for asset managers emerges: As we make the attempt, who will benefit?

When necessity arises, narratives change. Markets are slower to respond than the scientific community, but they will respond. When it comes to allocating capital, we will keep reminding the world that there is a way to do it that is better for the economy in the long run, and therefore a better—and safer—way to invest.

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