The unavoidable march of climate change policy

Since the discovery of the hole in the ozone layer back in 1982, there has been a growing realisation that human activity as a species, especially the industrial activity that has fuelled the prosperity of the post war epoch, has profoundly changed the face of the planet. Yet while the truth around this impact has been known, especially in the scientific community, for decades, actual traction in addressing its root causes has been far less consistent.

The Montreal Protocol, ratified in 1987, is arguably one of the most successful ecological protection treaties ever signed, banning the use and manufacture of Ozone depleting substances. Yet since then, endeavours to build on that initial success in tackling the drivers of climate change have met with limited success: everyone was agreeing “in principle” but very quickly dishing out “exceptions” when it came down to implementing policy changes that may compromise their national, political or industrial interests. This is starting to change.

Climate change has gone from being a subject that is “nice” to talk about, largely the preserve of environmentalists and activists, to being a core issue: for politicians and businesses alike. For us, it is fascinating to look back and realise that we have been watching, in real-time, a shift in the zeitgeist, as an issue that was very much a niche gradually moved into the spotlight. As the zeitgeist shifts, so too do revenues, earnings, capital flows and policy. What was at the fringe is now taking centre stage, and we would all do well to pay attention.

As described by Tim Urban in another one of his brilliant notes in his series The Story of Us, The American Brain, the shift around the thinking on climate change has been gradual over the decades, but the public narrative – what is said about the topic – has remained static.

To quote Tim’s post: Saying what everyone is thinking but not saying is a form of leadership. It formalizes a Thought Pile shift that has already happened, clearing the way for everyone else to start saying those things too. A few bold speakers with big platforms are usually all it takes for the whole Speech Curve to shift and realign with the Thought Pile.

Perhaps it was Greta Thunberg? Perhaps it was something else.

We will leave it to the historians of the future to look back and pinpoint the “archduke moment”, but to us one thing is clear: the narrative is on the move, and that creates opportunities.

Meaningful impact

At the end of the day, money talks. For decades, companies around the world have been resistant to making any efforts to deal with climate change. After all, mitigating environmental impact was going to cost them, and as long as their customers didn’t mind, all was well.

Attempts to mitigate externalities saw limited impact, especially when the costs of non-compliance were far outweighed by the potential profits from flouting/ignoring the rules. Economic theory around pricing for externalities has existed for decades, starting with the work on externalities of Ronald Coase, “The Problem of Social Cost” in 1960, for which he won the 1991 Nobel Memorial Prize in Economics, but putting them into practice was a different matter.

One could argue that the weak point was political – after all, just as consumers didn’t really care to pick the environmentally friendly choice over the cheaper, more convenient option (e.g. plastic vs paper bags/straws), neither did they care to vote for politicians that were rushing to slap tariffs on industrial production which would ultimately threaten their employers’ profitability, and by consequence, their jobs.

The consumer zeitgeist ultimately drives two things: 1. Business decisions by virtue of where their consumption goes; and 2. Political decisions by virtue of where their votes go.

What Tim says is that an idea begins small, gains traction through a population and eventually given the way democracies work, politicians get voted into power with a mandate to make policy around the zeitgeist of the time. He gives the examples of shifts in public opinion regarding smoking (moving from “harmless” to “bad”) and interracial marriage (moving from “immoral” to a fundamental right). The same is happening with climate change, amongst a host of other issues with the ground shifting beneath them.

No evidence is more compelling than the way companies reach out to consumers via advertising, for example this advertisement in the London tube for Ikea featuring a glass jar:

Although we do have one question: do these jars come pre-drilled with holes at the bottom, lest the inside of the jar become a swamp? 🤔

The next big thing

In that context, we see climate change developing into one of the most significant investment opportunities of our generation – both on the long and short side, as we’d briefly touched on in our note from some time ago. And it is happening right now. The modus operandi is the same as always: long winners and short losers.

Regular readers would by now know our view that flows are the main driver of market price action in the liquidity-fuelled status quo. The changes we have observed so far seem to be a Main Street phenomenon, but unlike many other trends that come and go, we believe that this change in zeitgeist is structural rather than, to borrow some Fed vocabulary, transitory.

As we’ve argued above, the “thought pile” – what people think but don’t necessarily say – has shifted significantly enough to allow the recurrence of voices calling for change to gain mass traction, saying what people are thinking but not saying and turning into thought leaders.

Climate Change is just one segment of the wave of change that’s coming our way. The investment community calls it “ESG”; our view is that “ESG” is only the first iteration of markets coming to grips with trying to quantify the non-monetary impact of economic activity. Economists have had a word for it for a long time – “externalities”. Whether it’s about pollution, fair wages or ensuring equality of opportunity, the broad-based awareness of the need to account for externalities that has grown within the global population is starting to cause a convergence between what the market perceives as private benefit (“what I get out of it”) and cost (“what I pay to get it”) with social benefit (“what do we get out of it”) and cost (“what do we pay to get it”).

The convergence may not be absolute, but where enough of the market believes it to be so, it is so. And this is not just a Main Street phenomenon – it shows on Wall Street too. If money talks, then money is saying everyone needs to care, with Bloomberg expecting ESG-related AUM to make up 1/3 of global AUM by 2025:

Source: https://www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum/

The will of the consumer, gradually shifting over the years, has therefore translated itself not only into real and tangible changes in demand for goods and services, but also made its way up the echelons of politics and finance. Politicians are elected to enact the will of their democracies, and enact it they shall, from subsidies on electric vehicles vs restrictions on internal combustion engine production, to extra charges for plastic bags to incentives for recycling. In fact, China, whose leaders don’t need to rally for votes, is leading the push in environmental protection and restoration globally – because at the end of the day, happy people make for a happy country.

Investment mandates marketed in the same vein attract more allocations than others. And while the sceptics argue that screening criteria are flawed and some of the wrong companies slip through the cracks (including, for example, the oil majors), or that returns aren’t particularly compelling, the confluence of policy, investor/consumer demand and flow can change that dynamic quickly.

The European Emissions Trading System, for example, has seen much reform put through, with these changes effectively reviving a cap-and-trade system that had been in place since 2005. Impact wise, it finally seems to be working, based on these numbers from the European Environment Agency:

Source: https://www.eea.europa.eu/data-and-maps/data/data-viewers/greenhouse-gases-viewer

And what about making money off it? Well, here’s a nice, tradeable chart of European Carbon offset futures:

Ways and means

As far as externalities go, Climate change is perhaps the one with the most developed market of them all, possibly thanks to the hole in the Ozone layer (which has, thanks to years of globally coordinated efforts, actually CLOSED this year according to the World Meteorological Organisation) which started it all.

Yet it is not inconceivable that an entire host of externalities of other forms be addressed in the same way as emissions, by the implementation of government policy and the subsequent use of the markets to incentivise the right kind of actions without heavy centralised planning.

Finally, we of course keep at the back of our minds the potential for the use of crypto tokens as a means of allowing widespread ownership and trading of instruments designed to influence economic decisions around these externalities. After all, at the current price of around €58/tonne of CO2 and a minimum lot size of 1,000 contracts traded on margin, it’s not exactly an investment for the everyday investor.

Introducing fractional ownership of these assets, coupled with the widespread, decentralised distribution of fractions of such instruments, would allow investors around the world to express their views even more materially on such issues – not just with their wallets, but with their investment accounts. The space is nascent, but projects like Klima DAO (creating tokens that are backed by verified carbon offset credits) are interesting initial attempts at bringing this hitherto specialised market to the masses.

Executed properly, such instruments can have substantial impact on their underlying investments – and tangible effects on companies’ costs of business, whether positive or negative.

Once again, the ground beneath our feet has already started to shift.