February 12, 2007
The Market's Betting Against Climate Change Policy
The Economist suggests that the markets are not yet taking climate change into account:
THE scientific consensus in favour of man-made global warming seems clear. There is also evidence that voters are increasingly inclined to believe in the phenomenon, even in America. This might lead one to believe that politicians will be forced to take action. But, as Tim Bond, of Barclays Capital, points out, the futures markets appear to be saying something different. The forward curves for hydrocarbon fuels (such as oil and coal) are upward-sloping: higher prices are expected in future.><>
Some of this might be due to investment demand for commodities, which is usually channelled via the futures markets; but the bulk of this money is placed into contracts of less than 12 months’ duration. The forward curve points to higher oil prices over five or more years. Conversely, the price curves of cleaner alternatives are downward-sloping. This does not suggest investors are expecting a mass shift away from oil and towards green fuel sources such as wind and solar power. Perhaps this reflects understandable cynicism that voters will ever agree to changes that cause them real pain: higher gasoline taxes in America, for example. As one hedge fund manager recently remarked to your correspondent: "If the UK stopped all carbon emissions tomorrow, the Chinese would replace them within six months. So why should I give up driving my big car?">
Or perhaps investor opinion reflects the enormity of the task. As Barclays Capital points out, energy demand is expected to rise by 50% over the next 30 years. The industry needs to meet that target, while simultaneously reducing the 80% share of supply currently provided by hydrocarbons. The attempt to square this circle may have important repercussions for financial markets. As Tim Bond says, an enormous amount of new investment is needed to meet increased energy demand―some $20 trillion, at 2000 prices. The energy industry did double its capital spending in nominal terms between 2000 and 2005, but thanks to infrastructure inflation (the cost of oil rigs, tankers etc), this translated into a real spending increase of only 10-20%.
The way that markets have traditionally encouraged investment spending is by ramping up prices, which helps explain why the oil price tripled within a few years (before a recent setback). But there is still a problem.><>
First, companies are uncertain as to how governments will act on climate change. This may cause them to postpone investment programmes until the outlook becomes clearer>
. Second, uncertainty will prompt them to apply a high discount rate to future projects. These discount rates may vary wildly. If, for example, it was clear that governments were pushing the energy industry away from oil, and towards, say, wind power, the discount rate for the wind industry would drop and that for the oil industry would rise. So energy prices might be both high (to encourage investment) and volatile.
That is not great news for stock markets. For a start, volatility leads to uncertainty which investors dislike. Furthermore, Barclays has found a clear inverse correlation between oil prices and the multiple that the market applies to corporate profits (see chart). In other words, the higher the oil price, the lower the market rating. Back in the 1970s, when oil prices rose consistently, the energy sector was about the only place to earn decent returns. In America, real returns from oil averaged nearly 25% a year, whereas shares managed just 1.4%.
Most investors seem to regard global warming as a long-term problem unlikely to affect equities over the next year or two. But the Barclays analysis suggests they may be wrong to be so complacent.
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