Investment themes associated with climate change

As I began to work on this paper, I quickly realised that I faced a massive task. The subject is so big that I could easily write ten books about it. It is quite simply impossible to cover all aspects of climate change within the space that we allocate to these types of papers so, if anything in the following comes across as somewhat superficial, you now know why.

As far as specific investment themes to do with climate change are concerned, we have already identified seven such themes, and I am sure more will be added in the years to come. For those of you who are new to our work, let me outline what those seven themes are:

• Extreme Weather Patterns
• Running Out of Freshwater
• The Death of Fossil Fuels
• The Digital Revolution
• Electrification of Everything
• From Globalisation to Localisation
• Out-of-Control Public Deficits

I have written a great deal about some of them already, but more is to come, including how investors can benefit from them – a topic the financial regulator won’t allow us to discuss in the Absolute Return Letter, hence why we established ARP+. In this paper, I will only look at the bigger picture, though.

The naked facts

Carbon dioxide (CO2) emissions are rising fast in many parts of the world. 30 years ago, worldwide, about 22 billion tonnes of CO2 were emitted annually. Today, the equivalent number is about 35 billion tonnes, and it is expected to exceed 40 billion tonnes within ten years (Exhibit 1). As you can see, by far the biggest culprit is China, with the industrialisation of the world’s most populous country leaving some pretty big marks.

In 2019, average atmospheric CO2 was 409.8 parts per million (ppm), which was higher than at any other point in the last 800,000 years (Exhibit 4). The data behind Exhibit 4 is derived from ice cores in Greenland and Antarctica which provide a very accurate picture. In other words, even the harshest climate change sceptic would have to admit that Exhibit 4 is a fair reflection of reality.

The sharp rise in CO2 emission levels on the right-hand side of Exhibit 4 reflects developments since the beginning of the industrial revolution around 1850. It is estimated that about 75% of global warming since then is attributable to rising CO2 emissions (source: www.nature.org).

Warmed by sunlight, the land and oceans on planet Earth continuously radiate heat. CO2 is a greenhouse gas – a gas that absorbs and radiates that heat. Unlike oxygen or nitrogen which make up most of our atmosphere, greenhouse gases absorb the heat and release it gradually over time. Without this natural greenhouse effect, Earth’s average annual temperature would be below freezing instead of 15ºC.

Having said that, the extraordinary rise in greenhouse gases more recently has tipped planet Earth's energy budget out of balance, which has caused the average temperature to rise by approx. +1.1ºC since the industrial revolution (Exhibit 5).

Manmade or not?

As you just saw, it is beyond doubt that global average temperatures are on the rise. Having said that, a surprisingly large number of people continue to argue that there is no proof whatsoever that it is manmade. I suppose it depends on your definition of “proof”. CO2 emission levels began to rise sharply around the onset of the industrial revolution (see Exhibit 4 again), and it is proven beyond doubt that rising CO2 levels drive temperatures higher. That is good enough proof to me.

Whether global warming is manmade or not is actually quite irrelevant. I suppose you could argue that if global warming is not manmade, there is not much we can do, contrary to if it is manmade. The problem with that reasoning is that, according to people who know about these sorts of things, we are fast approaching the point of no return. If that is the case, the damage which has already been done will soon become irreversible and, for that reason, we should assume it is manmade and take immediate action.

How damaging is CO2?

CO2 is the most important of Earth’s greenhouse gases. It absorbs less heat per molecule than other greenhouse gases like methane (CH4) or nitrous oxide (N2O), but it’s more abundant and it stays in the atmosphere much longer. It is therefore a prime suspect when it comes to identifying the reasons behind the current climate change.

As I pointed out in Part II of our recent research paper on natural resource investing (which you can find here), CO2 is not all bad news, though. If we want to phase out fossil fuels, as mentioned earlier, we need to convert electricity to liquid hydrogen, as not all vehicles are suitable for electrification. That conversion shall require plenty of CO2. Suddenly, CO2 becomes a valuable asset rather than the liability it is widely considered to be.

The future pathway

Let’s assume we do virtually nothing to arrest the current trendline. In that case, as early as 2050, parts of the world, particularly in the Northern hemisphere, could be facing average temperatures 5-7ºC higher than pre-industrial times (Exhibit 6). Given the fact that both Greenland and Canada and many of the world’s glaciers are located in the area likely to be affected the most, the implications of such a rise in average temperatures would be quite severe.

As seawater levels rise, parts of the world may become uninhabitable. According to one estimate (provided by the Economist), as much as $200 trillion worth of seaside property could be at risk of flooding by 2100. Since 1993, when reliable satellite measurements began, global seawater levels have risen over 90 mm (Exhibit 7). Ground data going back to 1870 (which is somewhat less reliable) suggest that seawater levels have risen almost 250 mm in the last 150 years (source: NASA). The rise is caused mostly by melting ice caps in Antarctica, Greenland and Canada.

Manmade or not, it is therefore obvious that something serious has to be done, and therein lies the investment opportunity. In 2015, at the Paris Climate Conference, 196 countries agreed to keep the warming to max. 2ºC above pre-industrial levels (that agreement is the one President Trump withdrew from in 2017). Three years later, the Intergovernmental Panel on Climate Change (IPCC) – a body under the stewardship of the UN – agreed to limit the acceptable temperature increase to 1.5ºC above pre-industrial levels, as it quickly became apparent that the Paris agreement didn’t go far enough.

Whether +1.5ºC or +2ºC is the target, it is going to be hard and very expensive to meet, and I am not making a political statement here – pretty much everybody agrees on that. Take the 2ºC target set in Paris in 2015. As pointed out by Angela Hsu and Amy Weinfurter in 2018, the national pledges made in Paris add up to only one-third of the emission reductions required to meet the 2ºC target from 2015 (see here).

As I pointed out earlier, we are already 1.1ºC above pre-industrial levels and, in order to reach the 1.5ºC pathway as recommended by IPCC in 2018, the world would have to decarbonise immediately (Exhibit 8), and that may not even be soon enough but more on that below. Under all circumstances, immediate decarbonisation is very unlikely to happen. More realistically, rising living standards in most EM countries will continue to drive CO2 levels higher, which will cause global temperatures to rise further.

I would like to make one last point on the future pathway. On the 22nd September, the supreme leader of China, Xi Jinping, surprised everybody when he declared that, in addition to halving China’s rise in CO2 emissions by 2030 (a target which he set some five years ago), China is now aiming to be carbon neutral by 2060.

This will be a huge challenge for China and one which they are unlikely to deliver on if the benchmark is OECD countries and all the (mostly) empty promises they have made on climate change in recent years, but China is not like most other countries. If the political leadership in Beijing really wants it to happen (and the jury is still out on that), it probably will happen.

If you take another glance at Exhibit 3, it is obvious that China accounts for a significant part of the rise in CO2 emissions. According to the Economist, China is now the source of 27% of global CO2 emissions, and Chinese carbon neutrality by 2060 could knock 0.2-0.3ºC off global temperature estimates for 2100 (see here).

Finally, I should point out that carbon neutrality is not the same as climate neutrality, which EU leaders have committed to by 2050, but it is still far better than doing little or nothing, which has been the US approach under Trump. Allow me to explain. Carbon neutrality implies that ‘CO2 in’ equals ‘CO2 out’. In other words, you may still emit plenty of CO2, but those emissions must be offset, for example by planting more trees. Also, when going carbon neutral, you focus exclusively on CO2 and not on the other greenhouse gasses which also contribute to global warming. The EU’s commitment to go climate neutral covers all greenhouse gasses.

The impact of climate change

The impact of global warming is far more severe than many realise. Needless to say, it affects precipitation patterns; it affects extreme weather patterns, and it affects the availability of freshwater, all of which are very problematic, but farming – the world’s food chamber – is affected badly in another way too. Let me share an example with you.

As pointed out by McKinsey & Company (see here), the direct impact on agricultural output of temperature changes is nonlinear. Take for example corn – its reproductive growth rate begins to drop when the temperature climbs over 20ºC and reaches 0% at 30ºC (Exhibit 9). If nothing is done to arrest the current trend, average temperatures will be about 3ºC higher than now by 2100. As you can see in the chart below, such an increase would translate into about a 40% drop in corn’s reproductive growth rate which would be disastrous.

As if that weren’t bad enough, the most devastating implication of rising temperatures is the effect it has on access to freshwater in parts of the world. Access to freshwater is affected by climate change in a number of ways. For example, the rise in temperatures changes weather patterns (more droughts), and it converts drinkable freshwater to non-drinkable seawater.

To raise sea levels by just 10 mm requires for 3 trillion tonnes of ice to melt, which is an awful lot of ice. As I mentioned earlier, since 1993 when reliable satellite measurements began, global seawater levels have risen over 90 mm. In other words, almost 30 trillion tonnes of ice have melted in the last 27 years.

Should all ice in the world melt, sea levels would rise about 70 metres, which would in effect be the end of civilisation on Earth, but that will not happen any time soon. A more likely scenario is that part of the ice cap in Greenland and Canada will melt if no action is taken. The ice cap in Greenland is the biggest deposit of ice outside Antarctica, and sea levels will rise over seven metres, should it all melt, but that is not likely to happen either.

More likely, if we continue to do little to address this problem, part of the ice cap in Greenland will melt, and even 5-10% would do enormous damage. With almost 70% of Earth’s population (about five billion people) living within 100 miles of a coast, should seawater levels rise by 70 cm, life-threatening conditions for billions of people will arise unless they migrate. It is therefore a given that some action must be taken. You can find an interesting account of the situation in Greenland here.

Another problem to do with climate change and its impact on freshwater resources is the precarious situation in North Africa and the desire many North Africans have to migrate to Europe. Freshwater scarcity across North Africa has already added to the number of Africans, looking for an opportunity to slip into Europe, and that problem can only intensify if access to water becomes a life-threatening issue. It is estimated that more than seven million Africans live in refugee camps along the coastline of North Africa at present, wating for an opportunity to cross over the Mediterranean.

The North African country with the lowest freshwater resources is Egypt. With almost 100 million people in Egypt and freshwater resources fast running out (estimated to happen within 4-5 years), tens of millions of Egyptians could suddenly look to migrate to Europe, making recent years’ refugee problems around the Mediterranean look like a walk in the park.

What can be done?

If we need to arrest the continuous rise in temperatures, we must decarbonise quickly. No less than 87% of all anthropogenic CO2 emissions can be traced back to our use of fossil fuels (Exhibit 10) so, first and foremost, we need to reduce our consumption of coal, gas and oil.

Coal is the most environmentally damaging of the three fossil fuels, and four very populated countries – Russia, India, China and the US – all use enormous amounts of coal every day (Exhibit 11). In other words, a big step towards decarbonisation could be taken if those four countries could be persuaded to use other fuel types.

Of those four countries, the one that is growing the most rapidly is China, and much of the industrialisation of China is seemingly supported by coal-fuelled power plants (Exhibit 12). I say “seemingly” as Exhibit 12 is based on coal production, not coal consumption as Exhibit 11 is, but I have assumed the two are highly correlated in China. What is also apparent from Exhibit 12 is that decarbonisation is already well underway in some of the bigger countries, particularly the UK where both coal production and coal consumption are virtually non-existing these days.

In the context of decarbonisation, the German story is not as good as Exhibit 12 may lead you to believe, and the reason is fairly straightforward. Following the German decision to phase out nuclear in 2011, consumption of coal has risen, which is not reflected in Exhibit 12 as all of it has had to be imported. German coal deposits are declining fast, and over 90% of all coal used in Germany these days is imported (mostly from Russia). In Exhibit 13 below, you can see that Germany is one of the biggest per-capita consumers of fossil fuels, and Germany’s largest source of fossil fuels is coal (see here).

In other words, the Germans have a big job to do before they can argue that they are on the road to decarbonisation. I find it particularly ironic that electric vehicles (EVs) are selling so well in Germany despite a very high percentage of all German electricity coming from coal-fired power plants. 52,449 new EVs were sold in Germany in 1Q20, up 125% from 1Q19, making it by far the biggest market for EVs in the EU (source: Best-Selling-Cars.com).

How fast can we decarbonise?

As already mentioned, the EU is committed to going climate neutral, and most EU countries are committed to phasing out coal relatively soon with only a handful – mostly in the East – not yet committed to a specific date (Exhibit 14). The question is whether this is fast enough? You may recall my earlier point that it will be a struggle to meet even the 2% target set in Paris in 2015, and I strongly suspect that current phaseout plans will have to be accelerated. Otherwise the environmental damage from rising temperatures will be too severe.

The problem in a nutshell is that wind, solar and most other renewable energy sources (ex. hydro) are not yet ready to completely replace fossil fuels – partially because the technology is not yet good enough and partially because electricity based on renewables is still too expensive. Calculations made by BP suggest that consumers who live in countries where renewables already account for a high percentage of the primary energy mix pay more for their electricity than consumers in countries where the energy mix is tilted towards fossil fuels (see also Exhibit 16 later).

Precisely for that reason, it will probably take many years before we have completely decarbonised, meaning that average temperatures will continue to rise, and so will sea levels. According to EIA (which regularly updates its longer-term forecasts), by 2050, consumption of natural gas, when measured as a % of the primary energy mix, will hardly have changed, and the use of coal will still be significant (Exhibit 15).

A very different way of looking at the cost of climate change

When assessing the cost of climate change, it is important to recognise that there are in effect two types of costs. First, the costs associated with the economic damage caused by global warming, which is the one that most focus on, but it is a mistake to ignore the other one – the costs associated with the various policies and programmes put in place to keep the temperature rise under control.

The second one was what the Paris Climate Conference in 2015 was all about – to get countries from all over the world to commit to a set of policies and programmes which would limit the increase to 2ºC above pre-industrial times.

The global authority on climate change is Professor William D. Nordhaus of Yale University who was awarded the Nobel Prize in Economic Sciences in 2018 for his work on climate change. According to Professor Nordhaus, if we do absolutely nothing, by 2100, average temperatures will be 4.1ºC above pre-industrial times – obviously a great deal higher than what was agreed in Paris.

If, on the other hand, we throw absolutely everything that we have at the problem, according to Professor Nordhaus, temperatures will still be 2.1ºC higher by 2100. In other words, we have already passed the point of meeting the Paris commitment, let alone the IPCC target of +1.5ºC from 2018.

Professor Nordhaus has calculated the cost of global warming at various temperature levels between +2.1ºC and +4.1ºC. Obviously, the economic damage at +4.1ºC is the most severe, but there is no cost attached to the policy programme, as there is no such programme. Not surprisingly, Professor Nordhaus found that doing nothing is not the most expensive option we have, if we include both types of costs. He also found that +2.1ºC is far from the cheapest outcome, although climate activists will tell you that is the only viable solution.

According to Professor Nordhaus, the optimal temperature rise (from an economic point of view) is +3.75ºC by 2100 – not miles away from the ‘do nothing’ outcome of +4.1ºC. I should stress that this is not a conclusion he reached lightly. Many people will have to be moved from low-lying parts of the world, and massive amounts of money will have to be spent on dikes and other protective measures. Having said that, the $125Tn that +3.75ºC will cost according to his models is dwarfed by the $350Tn that +2.1ºC is likely to cost.

Investment implications

Based on Professor Nordhaus’ work, I have reached the conclusion that, although the environment will benefit more from full decarbonisation, the economic impact of such measures could be quite severe. Although I have not looked into his models in detail, I actually reached the same conclusion, coming from a slightly different angle.

My assessment was based on the fact that, across Europe, electricity prices are higher, the higher solar and wind’s share of the power mix is (Exhibit 16). In other words, despite the renewable industry constantly arguing that they can now compete with fossil fuel prices, there is factual evidence to suggest that you still pay more for your electricity in those countries that have converted the most.

If renewable-based electricity is more expensive than fossil fuel-based electricity (and that is a fact), all the capital tied up in the conversion to electric transportation and electric heating is, at least from an economic point of view, akin to misallocated capital which will slow down GDP growth over time.

Having said that, given the facts that not everything in life can be measured in dollars and cents (as Professor Nordhaus attempts to do), and that continued global warming will have serious implications for billions of people, something must be done, and that brings me back to the point I made much earlier – that the solution should be found through innovation. It is by far the most sustainable resolution to a very serious problem, and it is also likely to be (much) cheaper than anything else we can come up with.

Specifically, as far as decarbonisation/climate neutrality is concerned, my (informed) guess is that, in Europe, the political elite is prepared to sacrifice economic growth in the short term for answers that work longer term. In other words, expect Europe to be the first continent to go climate neutral.

In the US, much will depend on who the next tenant of the White House is and which of the two parties take control of Congress on the 3rd November. A Biden win will probably make the US follow the model already being pursued in Europe, whereas a Trump win will most likely give us four more years of ‘do nothing’ in the US as far as climate issues are concerned. If the power in Congress is split down the middle as has been the case in recent years, not much will happen, irrespective of who the next president is.

The biggest question has to do with EM countries, though – to what extent they are prepared to suffer economically to do what is environmentally correct. On one hand, one could argue that they should indeed be entitled to the same prosperity as OECD countries have enjoyed since the industrial revolution. On the other hand, there may not be much of a future to enjoy for quite a few unless they restrict themselves. It is a tricky one, but at least the Chinese have now set the tone.

The very last point I would like to make is about risk vs. opportunity. Climate change is obviously a risk, but it is also a massive opportunity so long as solutions are found through innovation rather than higher taxes, so that is where we will zoom in. In the months and years to come, our focus will be on new, investable technologies that can effectively deal with climate change.

Niels C. Jensen

7 October 2020

Appendix

Climate Change and associated investment themes

As we always do when identifying a megatrend, we zoom in on all the associated investment themes which are the result of the megatrend in question. In the case of Climate Change, we have (so far) identified no less than seven such themes (Exhibit A1). As the impact of global warming intensifies, more doors will open, we believe.

Although the impact of climate change is already significant, we are still in the early stages with policy makers all over the world increasingly being forced to take drastic action. Global warming and the implications thereof will affect pretty much everything – how we live and for how long, what we eat, how we move around, etc. etc. – and with most investors paying more and more attention to this issue, the impact on asset prices could be dramatic.

Extreme Weather Patterns

One particular field of climate-related research focuses on the human fingerprint on extreme weather (such as floods, droughts, heatwaves and storms), and it has emerged that the human fingerprint is becoming stronger and stronger. Some examples (source: CarbonBrief.org):

• 69% of the 355 extreme weather events registered between 2011 and 2019 were found to be made more likely or more severe by human-caused climate change.
• A total of 78% of the 355 events experienced some human impact.
• Of the 125 studies that looked at extreme heat, 93% found that climate change had made the event more likely or more severe.
• Of the 68 studies that looked at flooding, 54% found human activity had made the event more likely or more severe.
• Of the 61 studies that looked at drought, 61% found human activity had made the event more likely or more severe.

As is evident from Exhibit A2 below, extreme weather events in recent years have occurred mostly in densely populated areas, further supporting the thesis that the human fingerprint is growing. I should add that, even away from extreme weather patterns, the human finger print from climate change is getting thicker and thicker. Take for example the growing loss of biodiversity, or think of the deforestation that happens every day, some of which is due explicitly to human activities, but climate change is also affecting the world’s forests.

Running Out of Freshwater

We have recently published a research paper on the pending water crisis which you can find here.

The Death of Fossil Fuels

Global warming is driving governments all over the world to introduce new laws and regulations that will force fossil fuel users to switch to alternative sources of energy. Take for example the global car fleet. The conversion to EVs is already in full swing and is expected to accelerate further as petrol and diesel cars are banned in more and more places.

In the 2020 edition of the annual Energy Outlook from BP, which was released last month, the company conceded (for the first time) that global oil demand will never regain the levels seen in pre-Corona times. In the 2020 report, 2019 is now considered to be the year of Peak Oil – something which wasn’t expected to happen for another 15 years or so (Exhibit A3).

Of the three most common fossil fuels, coal will probably be the first to be phased out, and the same will happen to natural gas over time. Until recently, I was of the opinion that oil will not disappear anytime soon, as it is needed in the manufacturing of plastic products. Having said that, a new technology (which I discussed in more detail in a recent research paper – see here) allows you to convert electricity to fluid hydrogen, which can then be used instead of oil when manufacturing plastic products. As a result of this new technology, I wouldn’t be surprised if BP’s latest estimate on oil demand (about one-quarter of peak demand by the middle of the century – see Exhibit A3 again) is still too high.

The Digital Revolution

The Digital Revolution was born when the internet was first established in the mid-1990s, and it gained further momentum with the launch of the smartphone in 2007. We are now on the cusp of the next stage of the digital revolution with the amalgamation of advanced robotics and AI, the Internet of Things, driverless cars, blockchain and other, new digital technologies.

At first glance, the link between climate change and the digital revolution may not be that obvious, but think about the need to digitise many functions in society. Otherwise we cannot electrify everything and, if we cannot do that, we cannot phase out fossil fuels.

Electrification of Everything

Electrification of the global car fleet is not automatically going to lead to a cleaner environment – that will depend on the source of the electricity that is used to power those cars. As I pointed out earlier, many countries continue to generate much of its electricity in coal-fired power plants, and simple calculations have demonstrated that EVs in those countries are actually a bigger liability on the environment than (modern) petrol and diesel cars are.

The conversion to EVs must therefore be closely aligned with a conversion to either renewables or nuclear, and renewables will struggle to fill the shoes of fossil fuels anytime soon. The prospects for nuclear are therefore much brighter than perceived, and that is particularly the case as we begin to roll out the next generation of nuclear reactors – Small Modular Reactors or SMR reactors.

A few words on the SMR technology: according to the World Nuclear Association (see here), the Chinese are furthest along in developing the SMR technology with Chinergy having already started the construction of the first SMR power plant in China, but the British, the Canadians and the Americans are all quite advanced in developing their own SMR programmes.

Apart from many added safety features and much lower construction costs, a great advantage of SMR when compared to conventional nuclear is that it can easily slot into a brownfield site in place of a decommissioned coal-fired power plant. It is estimated that US coal-fired power plants scheduled to be retired between 2015 and 2025 average 145 MWe of electricity output. An SMR power plant is typically designed to do 2-300 MWe, but that number can be adjusted upwards or downwards depending on how many modules you add together.

Globalisation to Localisation

In the context of economic affairs, globalisation refers to the increased economic inter-connectedness between countries. As countries all over the world have become ever more interconnected, globalisation has effectively created the current global economic order.

Now, COVID-19 is toppling this economic order, but it would be incorrect to suggest that the pandemic is solely to blame. In fact, globalisation was already under pressure before the outbreak of COVID-19. More and more people – particularly young people – have encouraged (or even demanded) that we should all buy more local produce rather than shipping it from one end of the world to the other.

Global CO2 emissions are expected to decline about 8% in 2020 from 2019 emission levels (source: IEA – see Exhibit A4). The obvious reason for that decline is the COVID-19 outbreak, but the reduction in CO2 emission levels, and the noticeable improvement in air quality that followed, is now used by influencers to encourage people to travel less and to buy fewer goods from the other end of the world. Over time, that will favour localisation over globalisation.

Out-of-Control Public Deficits

According to Professor Nordhaus, whom I quoted in the main text to this paper, the worldwide cost of climate change will amount to somewhere between $125Tn and $350Tn, subject to which model is followed. By comparison, annual US GDP is about $20Tn, so it is not exactly pocket money we are talking about.

Regardless of climate change, there are (at least) two reasons why public deficits will continue to grow. Firstly, the political arena is overloaded with populists these days, and populists always overspend. And populists will most likely gain in popularity for as long as the middle classes’ living standards continue to deteriorate (as they currently do).

Secondly, the economic impact of the Coronavirus will be with us for much longer than we thought only a few months ago, causing governments to continue their spending programmes. Given the amount of public debt in many countries, one could argue that it is a reckless strategy but, on the other hand, when the economy is in as deep a hole as it currently is, even responsible governments increase public spending.

Now, on top of all that, if you throw in trillions of dollars of additional debt to deal with global warming, it is not unfeasible that entire countries, many of which are already deeply leveraged, could be driven into default.