Investing and trading climate change Part 1

Climate change opportunities are difficult to play 

•  Climate change is generally viewed as a longer-term phenomenon (decades), but most investing has a shorter time horizon (1-3years).

• Science research shows warming trend and increase in weather variability regardless of the cause. More natural disasters or hazards related to weather will occur.
• Higher volatility makes any investment decision riskier given the uncertainty in shorter-term weather and longer-term climate environment.

• Investments with direct links to weather and climate variability are limited, so any decision to protect or exploit climate change is limited.

Alternatives in the investment space are limited

§Fixed Income

•Catastrophe bonds?

-Put option approach to climate change – pay-off if nothing bad happens; limited upside and illiquid

•Exposure to general interest rate risk

§Equities

•Which industries?

-Many “green” industries are  supported through subsidies; high risk if change in policies

•Exposure to general equity market risk 

§ Commodities

•Passive, long-only investing can result in long drawdowns during weather favorable to high commodity production

•Active trading can exploit optionality (higher volatility) from climate change

Climate change investment should be viewed like a real option

§A climate change real option provides exposure to investments which will be more sensitive to climate change effects.

•A financial 'option' is a right, but not an obligation, to make an investment decision. 

•A real option is a right, but not an obligation, to undertake some business decision, typically the option to make a capital investment.

•Real options capture the value of managerial flexibility to adopt decisions in response to unexpected market developments.

§A portfolio invested in asset sectors with more sensitivity to climate change factors will have an opportunity for potential upside.

§The commodity sector may have the most sensitivity to climate change given the direct link between production risks in agriculture and demand uncertainty in energy markets. 

The choice of commodities as a option on climate change 

 

§Many commodity markets offer direct price link with the weather.

•Generally, higher volatility means greater price trading ranges

-Higher upside and downside return potential

•Focus on energy usage (heating and cooling degree days)

•Focus on agricultural growth cycle (weather patterns affect supply)

•Less focus on metals for climate change

§However, given climate change increases variability, long-only commodity investing is not necessarily the correct choice.

•Downside risk is still present

•Optionality  through active investing may be more appropriate 

Climate change will have price effects 

Climate change and the impact on commodity investing 

 

 

The number of natural disasters has been trending higher

 

Weather extremes exist all over the world across all commodities 

 

 Weather extremes are more likely 

 

§The Annual Climate Extremes Index (CEI) shows that U.S. climate has generally been getting more extreme since the early 1970s, but that the 2010 climate was just slightly more extreme than average. On average since 1910, 21% of the U.S. has seen extreme conditions in a given year (thick black line), and in 2010 this number was about 24%. Image credit: National Climatic Data Center.

 

The Climate Extremes Index (CEI) is based upon three parameters:

1.Monthly maximum and minimum temperature

2.Daily precipitation

3.Monthly Palmer Drought Severity Index (PDSI)

Global temperatures have been increasing