Climate Volatility represents a predictable increase in forward economic volatility that can be hedged. We have a short window to act by pivoting social systems towards sustainability and implementing the Climate Volatility Hedge.
Climate Volatility is driven primarily by scarcity and high waste streams and, in particular, that of greenhouse gas emissions of carbon dioxide and methane. (CV Factors). The impact of CV Factors is evident today and future negative impacts is locked in. Concentrated and decisive action taken today can avoid the most catastrophic impacts of Climate Volatility.
A collision of CV Factors with social systems risk factors due to rising inequality in developed markets and a rising middle class in developing markets sets the stage for the increase in forward economic volatility.
It is important to understand that our problems are founded in mathematics and not ideology. So, too, are the solutions.
The Climate Volatility Hedge must be approached three ways:
- Infrastructure: Localized indoor agriculture, domestic industry built on renewable (and biodegradable) fibers and renewable energy provides community security, jobs and affordable access at a profit. Sustainable asset ownership acts as a hedge, with predictable bond-like cash flows plus upside optionality. Demand is rising for the production of these assets, and, is inelastic in the case of food and energy. Investors can benefit from dependable cash flows while providing food and energy security.
- Liquid Markets: Business models built on extraction of non-renewable natural capital, with long supply chains and high environmental externalities are at risk. Derivatives markets are under pricing this, with many companies in conventional food and energy businesses trading low implied volatility. A relative value hedge is the starting point with selective shorting of at-risk industries locked into subprime carbon/scarcity strategies. Additionally, there will become a pivot point in the valuation of coastal real estate values exposed to sea level rise. The longer the market ignores these risks that more value investors may find in shorting highly exposed REIT’s, owning targeted CDS and shorting insurers with un-hedgable exposure. Corollary: Those insurers in turn become the ideal investors in the Climate Volatility hedge.
- Stable Society: Clean food and energy assets, that are in part community owned, are an imperative to social restoration. Our current model incentives the erosion of the labor base without asking the question, “What then?”. We are at a critical point where automation, microchips and private capital investment strategies are eliminating labor capacity faster than society can adapt, re-train and re-tool. Sustainable Infrastructure and localization strategies are a key hedge against societal breakdown.
The concept of volatility is important in that it is a concept well understood by risk managers and investors. Volatility is the standard deviation or amount of predicted change over a given time period vs. some qualified expectation (the mean). In sustainability, Climate Volatility is dictated both by scarcity and high waste streams, and carbon waste in particular. Climate Volatility is the running average of weather variables like temperature, rainfall, humidity and the like, with further qualifiers for weather events, like excessive heat, hot wind or hurricanes, which trigger discrete losses for the economic. More volatility weather in general (CV) can disrupt agricultural productivity, supply chains and consumer behavior.
By predictable, the thesis also points to a mispricing. Although the impact of scarcity and high waste streams are highly probably, with impacts occurring earlier than expected, they are not being priced in by capital markets and investment flows. The predictable effects of climate volatility are not being communicated effectively by governments, businesses or educational institutions. This aberration will create the largest ‘unseen’ bump in forward economic volatility. It also tells us that an arbitrage exists.
Arbitrage conditions allow us to hedge Climate Volatility for a lower cost than we will pay in the future.
New Equilibrium: Understanding the Critical Need
In order to execute the hedge at the scale required, we must raise awareness and come to consensus on the root causes, impediments and solutions to our climate challenges.
One way to raise awareness is to continue to promote data driven arguments supporting the climate volatility thesis.
Data from NASA shows us that we have exited the old equilibrium with climate and are searching for a new one. Graphs from NASA inserted below depict; 1.) Carbon emissions as a % of atmosphere have risen beyond their long-term range,
2.) In the short-term, CO2 emissions has steadily increased,
and 3.) Average Temperatures are rising.
Higher temperatures have predictable results including the melting of polar ice, rising sea levels, storm and drought intensification, extended periods of excessive heat, ocean acidification and more.
The downstream effects of these first order effects are clear and include; crop failures, mass die-off of livestock and ocean life, population displacement through forced migration, social conflict due to food and water scarcity and more.
In the simplest sense, we point to the science of Climate Volatility as the relative displacement of water and heat between soil, air and ocean and the impact of this displacement on forms of life. To understand the interaction of heat-trapping gases, like Carbon, and cooling gases like Oxygen, click HERE.
Many of the economic and social challenges of Climate Volatility are evident today but will increase dramatically in the future.
Impacts of Climate Volatility
We list below a few of the 14+ Climate Volatility impact areas raised by reports from the Intergovernmental Panel on Climate Change (IPCC) along with examples of impacts occurring today:
- Food Production and Security: Just this year, a major South American Agriculture company, Adecoagro, reported a 30% loss in yield of corn and soy due to excessive heat. Across the globe conventional crops are pushing there temperature maximums with potentially disastrous results.
- Vulnerable Societies: It is now widely understood that the Syrian conflict was sparked and intensified by a record drought that forced millions of refugees into urban areas after livestock die off and crop failures. Syria may be the extreme but these events are playing out across the world in Africa, China and parts of South America. Most models expect drought conditions in California to persevere for the foreseeable future and to be joined by record drought conditions in the dust bowl region. The northeast US too, has been in drought for much of 2016.
- Extreme Weather: No storm is normal anymore. We are seeing epic rainfalls that often fall at rates of 1-3 inches per hour. Recent examples include;
- Dec 2015: A 1-in-a-1000 year rain floods parts of South Carolina dropping up to 2 feet of rain on places like Charleston in a single day.
- Mar 2016: Record rainfalls in Louisiana trigger massive flooding with up to 26 inches of rain falling in a four day period.
- May 2016: almost 9 inches of rain fall in two hours in Austin Texas.
- July 2016: up to 10 inches of rain pummels parts of the Midwest bringing tornadoes and destruction from flooding.
- Aug 2016: In Ellicott City, MD, a 1-in-a-1000 year storm drops 6.5 inches of rain in about 3 hours.
A small sample shows 5 1-in-a-1000 year events in an 8-month period. There are many more such events to pull from in that same period. The Volatility estimate is wrong.
- Human Health: In 2016, an unprecedented heat wave met with intense drought in India to decimate livestock and crops, melt roads and cause human casualties.
Citibank estimates climate change inaction would cost $44 trillion globally by 2040. We think this is conservative – Climate change inaction could make money obsolete
The costs of Climate Volatility will be considerable and even more so if the dialogue remains muted and held back in places. What may be most alarming is collectively we a pursuing a broken food and energy strategy that exacerbates the risk.
A RISKY FOOD AND ENERGY STRATEGY
We currently have a risky food and energy strategy in that these systems are:
- Concentrated: Our food and energy comes from large, centralized facilities that focus on intensification (doing one thing at scale). Long supply chains add to social costs and increase risks of systematic breakdown.
- Energy: Another sniper attack against a major electrical sub-station, similar to the Metcalf Incident, was reported in 2016. The Metcalf incident could have knocked out power to parts of Silicon Valley for a period of months.
- Food: Drought in places like California, responsible in 2014 for 32% of domestic fresh fruit and vegetable product, causes price spikes and shortages.
- Productivity Challenged: In the conventional system, costs are rising with less and less output. It’s a classic industrial death spiral that has been distorted by structural impediments in the form of laws, investment structures and culture that favors the conventional model.
- Carbon Intensive: Conventional Agriculture, Transportation and Electricity are the three main sources of Greenhouse Gas emissions, including CO2 and Methane
- Embedded with Systematic Risk: One needs to look no farther than the implosion of coal equity and near total closure of capital markets to new development to understand the risks embedded in trillions of dollars of Fossil Fuel market cap. UK bank head Mark Carney and former US Treasury Secretary Hank Paulson have been vocal in their warnings about subprime carbon. In short, there could be up to $28 Trillion of subprime carbon assets, unburnable and held on the books of oil and gas companies today.
Citibank goes one step farther, reporting that the total size of the carbon bubble could be upwards of $100 Trillion.
Our only hope is avoiding catastrophe is making peace with the facts, upping the dialogue and taking immediate and decisive action. Financial Engineering can help.
Financial Engineering A Climate Solution
Trillions of dollars in the investment community are tracking and following indicators known as factors to make trading decision. More than 1/2 of these decisions are fully automated. Factors dictate everything from short-term decision making on through to managing portfolio risk over long horizons. What if the factors understood Climate Volatility?
One way to educate the factors is by using well-understood concepts, like volatility and arbitrage to show the optimal portfolio includes the Climate Volatility hedge.
Put-Call Parity is a well known relationship that has guided the growth and evolution of the derivatives industry. Put-Call Parity describes a relationship between the cash market (today) and the forward market (the future). It’s derivation also includes valuation of individual options (to account for opportunities or risks that exist based on future conditions).
Below we insert a simple idea that Put-Call Parity, arbitrage concepts and other derivatives math can be used, in part, to begin to financially engineer a solution to Climate Volatility. We note the simplification of what’s presented here provides a basis for a discussion in this vein. Future Bright has also designed securities valuation frameworks for valuation using Real Options and CAPM Extension methods.
The left side of the equation represents the ability to invest in the CV Hedge today and the option that this investment becomes more valuable in the future. The right side represents current valuations for conventional industry, which we are told takes into account all available information. We argue that all available information and, in particular, information on climate risk is not being accounted for. The longer it takes to account for this risk, the more exponential the impact will be. This is known as gap risk.
The Put Option in the right side of the equation represents the option mature industry has to sell assets. We argue that the option accounts for a large portion of current and future valuation but it is overvalued.
If you were building a society today to compete globally, would you add more of the left side of the equation or the right? This thought analysis lies squarely in the pathway to paradigm shift. Would you build with clean, resilient assets that provide security and jobs to support society or would you build centralized production dependent on scarce resources and subject to price volatility, that contributes to economic instability and higher health costs? With no embedded interests, you would likely choose the former. Sustainable assets are less risky and more efficient. They have high visibility on costs and often revenues as well. From a portfolio construction perspective, sustainable infrastructure offers better risk-adjusted returns.
How quickly can the Put option go to zero? Just ask Coal
The Coal industry is a good example where the transfer of assets quickly became prohibitive, effectively reducing equity value to zero. Other factors, outside of the market for company assets, can affect the valuation in today’s market. A key variable to watch is market demand failure for conventional goods. For example, food produced using pesticides is under increasing global scrutiny from consumers of all types. Whole countries are banning the use of certain pesticides and extending these bans to genetically modified crops (GMO’s). Consumer segments than can, are choosing away in increasing numbers. In fact, access and affordability are key impediments that keep more consumers from pivoting away faster from products they deem harmful to themselves and the planet.
The Climate Volatility Hedge delivers profits today and solves the problem of access and affordability.
The Climate Volatility Hedge
Controlled Environmental Agriculture: With crops failing and livestock dying due to excessive heat, an essential part of the CV hedge consists of a massive effort to build localized controlled environment agriculture. Future Bright estimates this opportunity, which includes Aquaculture, Greenhouse Hydroponics and Vertical Farming, exceeds $600 Billion in infrastructure alone over the next 20 years, and is capable of both environmental and social restoration. Controlled Environment Agriculture can produce millions of jobs, provide food security, meet increasing demand for clean, healthy, local and organic product and, maybe most importantly, reduce the water demand of agriculture. Controlled Environment Agriculture uses up to 99% less water than conventional and is profitable at market prices around the world. Controlled Environment Agriculture provides stable cash flows and profitability today with embedded upside due to climate volatility, potential supply chain disruption and food and water shortages. We depict this potential in the graph below.
Renewable Energy: Renewable Energy provides predictable cash flow with upside optionality. When the centralized grid model is disrupted due to storms or attack, renewable energy assets increase in value. When we realize the impact of water intensive energy strategies, long supply lines and high waste streams, renewable energy assets increase in value. The Renewable Energy revolution is already underway, with prices falling below conventional sources across the world and over $1 trillion in investment in the past 3 years, but a greater acceleration is needed. We need a ten-fold investment for both developing and developed markets. The technology is viable, we only need the political and corporate will to build an energy infrastructure that creates a viable path for survival.
Renewable Fibers: Everything made with fossil fuel based polymers and long replacement cycle resources like trees, can be made with hemp, bamboo and other renewable fibers. With afforestation of paramount importance to hedging climate volatility, breaking down structural impediments to renewable fiber farming and domestic manufacturing should be viewed as a tremendous opportunity. Both bamboo and hemp have yearly harvests (vs. decades for trees), sequester more carbon and emit more oxygen than trees.
Waste Reduction: The Consumer Leverage Point is of utmost importance here but so is the response of corporations in delivering viable consumer solutions. There are easy choices like using reusable bags and Klean Kanteens, supporting CSA’s and patronizing businesses committed to waste reduction. Harder it seems, is to get automobile companies to deliver electric vehicles that consumers want, banks to fund community microgrids and sustainable agriculture, investors to do the same, governments to support transition and re-training of fossil fuel workers, education systems to reach consensus and teach preparedness, markets to mobilize and penalize high waste activity in favor of clean and sustainable.
Liquid Markets & Financial Structures: We continue to see innovation in circumventional finance to give consumers the ability to support sustainability with their savings. Major impediments remains with large institutions making slow progress in the creation of investment vehicles and pathways for deployment. Crowd Equity is making progress but a $1M limit is too low to affect real change. Consumers and Investors should demand transparency and move their money to institutions capable of meeting the critical need. It is far easier to raise investment for abstract consumer technology than it is for food security. That’s backwards and must change for our survival.
Moonshot towards Deployment: We need a WWII scale mobilization from society and business to deploy renewable energy, storage and controlled environment solutions. Elon Musk tells us in Leonardo DiCaprio’s excellent documentary, ‘Before the Flood’, it would take 100 Tesla Gigafactory’s to power the world. Tesla can’t do it alone, but the Fortune 500, at the demand of employees, shareholders and a global public call to action, could.
The defining question of of our time is: Will we make the sustainability pivot and hedge climate volatility?
A Time of Action
We live in a time of action. One could view it as the last true time of action. It is also a time of great opportunity. We are the ones we are waiting for.
If we continue on the same path and do nothing or even worsen the problem, we lock in the baton pass from human impact to climate chaos. This dark horizon awaits our grand children with many, many challenges in between.
There are many structural impediments to action. World leaders who question science, intuition and global pleas from citizens everywhere. Corporations vying to protect short-term profits and manage legacy books of coal, oil and gas assets. A broken system of healthcare and consumption that can be viewed from a high-level as nothing short of self-cannibalization. Make no mistake, making the sustainability pivot and hedging Climate Volatility will be the most challenging task ever undertaking by humanity, except for one…
The only challenge greater than hedging Climate Volatility today is living through the consequences if we don’t.
Pivoting towards sustainability and making the hedge involves re-engineering our food and energy systems, re-thinking our systems of education and equity, and creating a global economy around local opportunity with access for consumers and businesses to make good choices. It is the only way to restore environmental and social systems to lasting prosperity. The window is short – action is required today.
But it’s possible. Possible and profitable.
The solutions and technology to build a resilient, inclusive and secure society rest at our finger tips. Across the world, millions are rising up, educating themselves and demanding swift change. They are entrepreneurs, artists, scientists, business people, politicians, activists, mothers, fathers and children.
Yes, in today’s world of ubiquitous information, the children are becoming aware of the problem, the solutions and of our collective inaction. They are asking the question, “Why?” “Why won’t we act?”. The decisions we make today will craft our legacy in their knowing eyes. We have the unique ability to answer firmly, ‘We can and we will’, from a perspective of both economics and morality.
Now, more than ever, we need market-based solutions that address climate volatility and strain in social systems.
Future Bright’s Climate Volatility Hedge represents a profitable today and a prosperous tomorrow.
About the Author:
After 13 years in High Frequency Options Trading, I noticed something troubling. The technology we were developing was making labor obsolete. Coupled with a growing awareness of environmental issues and a focus lent from the realities of the financial crisis, I pivoted towards sustainability and formed Future Bright, a think tank, consultant and portfolio of start-ups designed to represent a hedge for Climate Volatility.
In my learning, I’ve tried to apply my understanding of closed loop systems and systematic trading (HFT), which blend behavioral finance with rules based systems and derivatives, which inform us about exponential risks within an oft-thought-of linear system to understand climate challenges.
The impacts from the automation of the trading environment are now being repeated in all other industry under the titles, ‘AI, Robo brokers, One-Click fulfillment and more’. The result is as predictable as it was for the trading world.
The impacts of a incomplete economic equations are causing the rapid liquidation of our life support system: the environment. In its place are an enormous waste stream and billions of under served people seeking purpose and survival.
The more I learned, the more I became convinced of the need for a lifelong commitment to sustainability. You can learn more about Future Bright’s efforts to build food security assets, increase access and awareness of sustainability risks and opportunities HERE.
This article presents the Future Bright thesis and hedge for Climate Volatility based on 5 years of research, observation and work with practitioners in clean food and energy, investment funds and banks.