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Climate Volatility: A Predictable Increase in Forward Economic Volatility that can be Hedged.

Climate Volatility: A Predictable Increase in Forward Economic Volatility that can be Hedged.

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, in particular of greenhouse gas emissions of carbon dioxide and methane. (CV Factors). The impact of CV Factors is evident today and a dramatic increase in negative impacts is locked in’. Concentrated and decisive action taken today can avoid the most catastrophic impacts in the future.

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:

  1. 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.
  2. 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 at implied volatility less than the S&P 500. A relative value hedge is the starting point with selective shorting of at-risk industries locked into subprime carbon/scarcity strategies.
  3. Stable Society: Clean food and energy assets, that are in part community owned, is 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. In sustainability, climate volatility is dictated both by scarcity and high waste streams, and carbon waste in particular.

By predictable, the thesis also points to a mispricing. Although the impact of scarcity and high waste streams are inevitable, 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,

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2.) In the short-term, CO2 emissions has steadily increased,

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and 3.) Average Temperatures are rising.

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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

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  • 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 frameworks for valuation using Real Options and CAPM Extension methods.

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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.

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. It’s less risky.

The Coal industry is a good example where the transfer of assets has become 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 $1 trillion in infrastructure alone, 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.

susassethypo

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. 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?”. Our decisions right now 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.

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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 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 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.

Future Bright

Future Bright

Future Bright’s focus has been on evolving pathways for institutional investment into sustainable infrastructure, equity and credit strategies.

By focusing the farthest upstream on the supply of food and energy these solution areas unlock shared savings for higher value added economic growth downstream.

For investors, the concept can be described as localizing our food and energy dividend using proven technology that reduces supply chain risk.

The three pillars of food and energy localization are energy efficiency, renewable energy and controlled environment agriculture a.k.a. Vertical Farming. For Infrastructure, the investments must satisfy three conditions.

Infrastructure Focus

  • Growth Markets with compelling economics
  • Markets where structure and financial innovation can unlock value
  • Investment that offer co-benefits / risk mitigation of social and environmental issues

Energy Efficiency assets are created when third party finance funds invest in energy efficiency retrofits for commercial, residential or industrial hosts. The retrofits can include LED lighting, insulation, HVAC and smart grid technologies The fund vets energy services companies and approves projects within the pipeline that meet criterion for credit quality, project scope and investment viability. The market size for C&I retrofits in the US alone is estimated to be around $300B, capable of unlocking shared savings of over $1T. Energy Efficiency Assets solve a market inefficiency and deliver returns in the form of highly predictable shared savings with upside optionality to investors. Returns attributable to investors can range from high single digits to the 30%+ on individual projects. As the market evolves, securitization, strategic buyers, improving technology and policy mandates will drive growth and sustain returns.

Additional co-benefits include keeping retrofits off-balance sheet, improved Quality of Life improvement for building occupants, cost predictability in capital budgeting, a reduction in carbon footprint and unlocked downstream savings to spend on higher value economic growth.

See Future Bright, ‘The Sleeping Giant’ for more on Energy Efficiency as an asset class.

Renewable Energy projects represent one of the fastest areas of growth for infrastructure worldwide. The deployment of proven technology in wind and solar PV is creating an investable asset class in the form of project equity, tax equity and project finance debt that can deliver attractive returns to investors. Additionally, the elimination of an operational supply chain and close to zero marginal cost of productivity are core de-risking features for renewable energy investors. Revenue is predictable and visible often for decades into the future. Renewable Energy project returns vary by class, location, size and other factors but generally can range from high single digits to mid-20’s unlevered with aggregate portfolios targeting returns in the low teens. Annual investment is averaging around $300B.

Additional benefits include a reduction in the carbon footprint, predictability in energy costs, job growth, energy security and access.

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Solar and Wind made up >60% of US installed capacity in the first 9 months of 2015. Oil, Hydro and other sources were zero or sub-1%.

Controlled Environment Agriculture (CEA) or Vertical Farming is a growth area targeting rising demand for clean, local and secure food supply. 15 commercial scale farms are in operation in the US with dozens more expected to come online in the near future. Falling technology costs, improved growing methodology and the need for resource efficient solutions in agriculture is driving growth and economics for CEA. An economic baseline has been reached for about a dozen varietals of leafy greens with value added potential in nutriceutical and consumer packaged goods (CPG’s) markets. The market for local fruits and vegetable was $7B in 2014. To reduce the carbon footprint of grid tied CEA, both renewables and efficiency can be applied.

Benefits include food security, health benefits, consistency, urban renewal, reduces water and transportation costs.

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Join the Future Bright distribution list or reach out for more on the CEA space.

Turning now to equity and credit themes, the focus becomes a factorized approach to both positive and negative drivers with respect to sustainable business models. Increasingly, investors are recognizing sustainability or ESG factors as being important to current bottom lines and future viability. Future Bright expects a long-term tailwind to shape both equity and credit market valuations guided by these and other factors:

Sustainability Factors

  • Energy / Revenue: Businesses can achieve a strategic advantage when they lower their cost per unit of energy required for one dollar of revenue. With renewable energy integration, many corporates are recognizing this benefit (see, Solar Power Growth Story).
  • Water / Revenue: Water supplies are increasingly at risk and strained throughout the globe presenting a particular risk to social and environmental system. High water user and businesses predicated on high water use are at risk. Efficiency technologies and business that create revenue with lower water intensity are set to benefit.
  • Useful Life / Replacement Cycle: With resources running out, businesses need to pay close attention to the replacement cycle for natural capital stocks their operations depend on. Sustainable fibers can right-size the useful life mismatch for industries in paper, plastics and other durable goods.
  • GHG Footprint / Revenue: It is recognized that increasing the intensity of carbon, a heat trapping gas, in the atmosphere increases the volatility of weather including rainfall and raises the probability of drought conditions and powerful storms. These factors affect economic activity directly. The global community is moving to address this risk to economic, social and environmental systems. Businesses that get ahead of the carbon curve will experience less disruption. Solution providers will benefit.
  • Future Waste Liability: Companies with high waste stream and large extraction footprints should be moving to address scarcity and detrimental waste impacts. Awareness is growing as to the health impacts and costs of toxins in food and energy systems.
  • Physical Supply Chain: Globalization only works when environmental and social systems are unaccounted for. However, these systems are required for healthy economic systems. Localization feeds vibrant economies while reducing transportation, health care and storage costs. Long supply chain credit is at risk.
  • Subsidy Risk: Subsidies exist in nearly every major industry. In mature industries they are embedded downstream with consumers, in developing industries they are embedded upstream with project developers.Carbon
  • Political Transparency: Sustainability is becoming a political issue as facts about health costs, climate change and public governance become more transparent. There is no reason to expect this trend to reverse given increasing access to information. Political systems can take decades to reshape but the early stages of recognizing the private sectors impact on social and environmental capital is taking shape. Businesses that recognize scarcity and waste streams, as a mathematical driver and risk factor should benefit. Politicians that do the same will be increasingly supported. It’s time to remove ideology from progress towards prosperity, by focusing on the math; we can.

 

Future Bright is looking for its next assignment. Does your organization want to explore these mega-trends in detail, build models, meet practitioners, make investments, design product and forge private-public partnerships? Let’s collaborate. ken@futurebrightllc.com

Disclosure: Future Bright is a think tank and advisory in sustainability and investing. Future Bright has worked with renewable energy developers, energy efficiency funds, assets managers and vertical farms on progressing solutions towards sustainability. This note is not an offer of services or investment of any kind. This is a blog post for informational purposes only. Those interested in consulting services, design work or industry analysis should contact Future Bright directly. (www.futurebrightblog.com)