Beware Investor Responses to the Climate Crisis
It is in vogue to argue that, due to political inaction vis-à-vis the climate crisis, any progress that institutional investors can make to mitigate corporate climate change is advantageous. As the argument tends to run, it is in the financial interests of both active and passive institutional investors to reduce emissions across their portfolios. In this post, I argue that, at least for the moment, this is a very dangerous idea to promote.
Our departure point is to decouple the ‘institution’ and ‘human’ components. On the one hand, perhaps it is in institutions’ interests to accurately and systematically price climate risks and account for the expected damage to long-term portfolio-wide returns. After all, the impacts of climate change are inevitable and institutions are, theoretically, immortal. On the other hand, however, it is fundamentally not in the interests of those currently at the helm of these institutions. Individual decision-makers’ incentives are a function of the duration of their professional careers and by extension their short lifecycles. It is not rational for the humans inside these institutions to forego returns that can be spent or reinvested in their lifetimes, especially when the risks have yet to fully manifest themselves. All else being equal, the majority of humans running these institutions today have greater incentives not to do so.
True enough, some noteworthy climate change has already taken place and is irreversible. To put this in perspective, the pre-industrial carbon dioxide abundance in the atmosphere was about 600 billion tonnes. We have since added approximately 500 billion tonnes to that amount. What this essentially means is that the climate that originally wrought human life is gone, forever. Our leaving the Holocene has had quite serious physical consequences for humans. But they have not been dramatic enough to ripple across the capital markets and engender a paradigm shift.
The more pernicious risks, which undoubtedly will force widespread reassessments of equity prices, are time-delayed and yet to come. What do I mean by this statement? There is only so much science we can address, so I will limit myself to a few observations. The Earth’s surface temperature does not react immediately to the energy imbalance created by rising levels of carbon dioxide (and other greenhouse gases). There is a delay, due to the time it takes for the Earth’s oceans to heat and for that heat to then be released back into the atmosphere. Even if we halted emitting right now, global warming would continue for many decades, perhaps centuries, before temperature stabilisation—in its atmospheric state carbon dioxide can linger for several hundred years. Thus, although the global warming effects we have observed so far are certainly not insignificant, the real socio-economic pain will not begin to show for three decades or so, maybe more.
If you have been following along, most, if not all, of the humans we have been discussing will have by then exited the investment profession. If the editors would permit it, this is the juncture in the post where I would swear repeatedly. Not unlike the moral hazard on display in the 2008 financial crisis, there is a gross misalignment of incentives, in this case because of the above-mentioned climate system inertia. This matters since we are already over a 1° Celsius increase in temperature, and it will only take roughly another ten years before we eclipse the 1.5° Celsius threshold, if emission rates remain, generally, constant. Why is this significant? Whilst no global warming is ‘safe’ by any stretch of the imagination, if we had remained below 1° Celsius of warming it might have been possible to avoid the worst impacts of climate change. That this is no longer an option means humanity now faces the prospect of runaway climate change.
Some suggest that the temperature ceiling for runaway climate change is 2° Celsius.
However, we ought to be mindful that this is merely a political target. Indeed, a Yale economist—William Nordhaus—‘thinking aloud’ in a 1975 paper about what a reasonable limit on atmospheric carbon dioxide levels might be for the purposes of forecasting economic costs initially proposed it.
In reality, anything over a 1° Celsius increase in temperature is catastrophic. This is not simply because of climate system inertia and the idea that the temperature will only stabilise in the very long term, after 2100, at a higher figure. The more we travel away from 1° Celsius, the closer humanity gets to activating certain tipping points. These tipping points would further raise the temperature and activate other tipping points in a domino-like cascade. If this happens, climate system inertia and our baking in future heat with present emissions will no longer be the central problem. The speed at which the tipping point feedback effects trigger will become the priority concern, as this may occur at a rate of change that makes it, potentially, very difficult, or impossible, for humans to adapt.
More broadly, if we remain on the present ‘business as usual’ track, by 2100 we are due for between 3 and 4 degrees of warming. This signals, for example, the death knell—the total, irreversible collapse—of the Earth’s ice sheets. The flooding that would ensue is enough to bury cities like Hong Kong, Miami and Shanghai in a watery grave, along with countless other population centres on the globe. Therefore, it should not surprise us to hear that some studying global warming call the 22nd century the Century of Hell.
With that said, the next years are absolutely crucial if we are to somehow keep warming below 1.5° Celsius. In this regard, the EU’s Sustainable Finance Disclosure Regulation 2019/2088 and the Taxonomy Regulation 2020/852 may go towards gradually nudging equity prices to properly reflect climate risk (for more information on both click here and here). However, neither are in effect at the time of writing, and, at any rate, it will take a while to determine whether they will be helpful in bridging the chasm between mitigating corporate emissions and individual decision-makers’ extremely misaligned incentives. Until we have a clearer picture, when institutional investors signal—via their human operators—that they are pursuing the environmental sustainability of their portfolio companies, we must assume that they are peddling snake oil. Remember, the human operators will not be around to answer for their actions when the real socio-economic pain unfolds. As such, we academics must be cautious in making claims about ‘sustainable capitalism’ and the perceived efficacies of market responses to the climate crisis that are dissociated from the dialogue taking place in the scientific community and the realities of human nature. Doing otherwise only provides intellectual and moral cover for institutional investors to masquerade as ‘good capitalists’, but continue to opt for returns in the here and now. It cannot be overstated that the actions of the current generation of humans within these institutions—literally—have apocalyptic implications for our species.
J S Liptrap is a research associate at the Centre for Business Research at the Judge Business School, University of Cambridge.
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