Impax blog

A new and troubling source of systemic risk?

2 Sep 2014 - by Ian Simm

There are signs that environmental risks, particularly extreme weather and government regulations to reduce pollution, are becoming both more material but also systemic, with the potential to affect large swathes of investment portfolios.  Asset owners should pay more attention to these developments, improving their knowledge and seeking out suitable hedges.

Investors generally welcome risk:  at least the sort that both offers the prospect of a decent return and is also uncorrelated with other risks, such that a portfolio of affected assets has a low level of vulnerability to individual events.  However, the financial crisis has reminded us of a more sinister side of risk:  systemic risk that affects multiple assets in a similar fashion, where diversification is impossible.  Many investors are now actively on the hunt to identify such risk in other areas. 

Traditionally, environmental risk has been seen as similar to many other sorts of risk, i.e. specific to a particular asset, with independent events and the probability of occurrence defined by a bell curve or "normal" distribution of outcomes; in many cases, these risks are acceptable to investors within a diversified portfolio.  For example, in early April 2010, most investors had investments in BP stock similar to the level in a generic stock market index; a few had researched BP's health and safety practices and track record and had reduced their holdings in the stock accordingly.  When the Deepwater Horizon oil rig exploded on 20th April with the loss of eleven lives, the share price of BP dropped 53 per cent over the following ten weeks.  Investors had taken a view of the stock-specific risk of holding BP and suffered accordingly, comforted that the explosion was unlikely to affect much of the rest of their portfolios. 

Yet there are signs that outcomes in some areas of environmental risk are following a different profile, in which events are no longer independent and/or the normal distribution is no longer valid.    For example, the rapid spread of mountain pine beetle across the Pacific Northwest and Rocky Mountains, has frustrated attempts by many holders of US timber to diversify their portfolios by buying assets across the country.  Last winter, rainfall in the UK was reported as one of the worst since reliable national records began in the mid nineteenth century1, and several analysts report that a statistically significant change in the pattern across several years2

Equally, the potential for government responses to environmental problems can introduce new dimensions of risk.  Since the 12th Five Year Plan, which prioritised air and water pollution control and environmental protection, was introduced by the Chinese Government in October 20103, national suppliers of thermal power plant equipment have significantly underperformed the market4: for example Dongfang Electric by 65%, Harbin Electric by 55% and Shanghai Electric  by 55%.  Similarly, the 2011 decision by the German government to phase out nuclear power by 2022 without compensation to incumbent generators, has been a major contributor to the dramatic underperformance of the stocks of both RWE and E.On5.

Climate change threatens to compound systemic risk in both areas.  Last year's IPCC report from the United Nations indicated that the phenomenon is both "extremely likely" to be caused by human activity and will get worse unless emissions are reduced.  Investors should therefore expect that historical weather patterns will lose relevance in predicting the weather of the future, and that "extreme weather" will increasingly feature as a systemic risk across portfolios.  In many cases, it will be difficult to mitigate these risks through diversification:  the shifting of climatic belts can sharply reduce (or enhance) the agricultural productivity of specific land banks; more frequent tropical storms can render certain coastal areas effectively uninhabitable; and a precipitous decline in snowfall can lead to the permanent depletion of water courses that have sustained population centres for millennia. 

In parallel, there is a rising probability that policy makers will act to reduce greenhouse gas emissions.  The European Union was for many years the only major economic bloc to limit carbon dioxide emissions; however, China is now experimenting with schemes in seven regions, while the US Environmental Protection Agency is developing regulations that will impose limits across all fifty states.  In the language of investment, it is rational to ascribe a higher risk premium to the ownership of assets that will be negatively impacted by so called "carbon prices" - a second source of systemic risk affecting a portfolio.

In response, investors should give priority to action in three areas.  First, learn more about these trends and analyse how they may impact their holdings; for example, recent work by the UK's Environment Agency Pension Fund has illustrated how asset owners can assess their exposure to fossil fuel assets.  Second, explore options to invest in the opportunities that are being created by these developments; for example, a portfolio of stocks of companies providing energy efficiency services can preserve investors' exposure to retail energy prices while avoiding the reduction of wholesale prices that could follow from new "carbon prices" (or the equivalent).  And third, engage with policy makers to ensure that the transition to a low carbon economy is managed optimally, ensuring that policy to reduce emissions is economically efficient (to minimise the risk of unnecessary value destruction), clearly signposted (to give investors as much time to adapt as possible), and consistently implemented.

1Wikipedia; http://en.wikipedia.org/wiki/UK_rainfall_records  #cite_note-1 and UK rainfall records and H.J.E. Rodda, M.A. Little, R.G. Wood, N. MacDougall, P.E. McSharry (2009). A digital archive of extreme rainfalls in the British Isles from 1866 to 1968 based on 'British Rainfall'. Weather, 64(3):71-75   http://www.maxlittle.net/publications/Rodda_Weather_09.pdf

3Formally approved in March 2011

4Versus the Hang Seng index

5Some observers argue this latter event was a true "black swan", i.e. very low probability but high impact, and therefore impossible to rationalise; however, political support in Germany for nuclear power has been fragile for a long time, so smart investors may have valued E.On using a high risk premium.

 

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