Climate change skepticism owes more to psychology than hard science. Whether real or imagined, climate change has important implications for investors.
In recent discussion threads on Seeking Alpha, more than 60 participants have argued heatedly about climate change, posting nearly a thousand comments. Proponents have pointed to evidence of trends in temperatures and sea levels, melting polar ice caps and extreme weather events. Skeptics have expressed doubts about the basic facts and questioned whether such things can even be measured at all, let alone attributed to human activity. The arguments on both sides are familiar and have been well rehearsed over the past decades.
What is striking about this (admittedly unscientific) poll of SA readers, is that skeptics have outnumbered believers by around 2 to 1 -- more or less the inverse of the proportions in the American public at large (Figure 1). Among climate scientists, the consensus is even stronger -- 96-98% agree with the Intergovernmental Panel on Climate Change (IPCC) that anthropogenic climate change is a reality with serious consequences that must be addressed (Bray 2010). In a review of 928 abstracts of papers published in refereed journals in 1993-2003, Oreskes 2004 found 75% explicitly or implicitly agreed with the IPCC, 25% were more methodologically oriented and took no position, while not a single one disagreed.
Figure 1 - Is climate change occurring?
Why would Seeking Alpha attract so many climate change skeptics? Surely, the answer is not that SA members are less intelligent or rational, or less well informed about a subject with important economic and financial implications. But neither did the exchanges bring to light any new data or research findings that would overturn the existing consensus. The next section proposes an answer to this puzzling question. Anticipating some readers may wonder about the relevance of climate change to investing, I go on to argue that there are both risks and opportunities and suggest three reasons why, skeptical or not, investors should make exposure to climate change part of their routine due diligence.
Who's skeptical about climate change?
Psychologists find that people differ in their willingness to accept technological and environmental risks. This may be because of cultural values, or because they feel more or less vulnerable to events beyond their control. What is relevant here is that attitudes are not randomly distributed across the population, but rather correlate with factors such as age, ethnicity, gender, and cultural and ideological worldviews. An intriguing and persistent finding is that white males, or at least a subset of them, are especially dismissive of these sorts of risks. Indeed, so persistent is this finding it has come to be known as the "White Male Effect" (see e.g., Flynn et al. 1994, Finucane et al. 2000, Palmer 2003, Kahan et al. 2007, McCright and Dunlap 2011a). White males are 'fearless' (as Kahan et al. 2007 puts it) not only about climate change, but about gun violence, nuclear energy, HPV vaccination, GMOs, lead paint, mad cow disease and more (Finucane 2000). Try Googling the phrase "white male effect," and see how many hits you get.
In fact, only a subset of around 30% of white males exhibit this fearlessness, so the explanation must be more sociopolitical than racial or biological. Using sample survey data, Kahan et al. 2007 attribute most of the White Male Effect to cultural attitudes. Specifically, they find that climate change skeptics tend to have hierarchical and individualistic worldviews -- meaning they believe the existing social order is just, and see individual success and status as being earned through competitive selection.
From a different perspective, McCright and Dunlap 2011a show a linkage to ideology and political affiliation: skeptics tend to hold conservative values and, in the U.S., to be affiliated with the Republican party, especially the Tea Party wing (Pew Center 2010). Interestingly, this politicization is a relatively recent phenomenon. Over the past couple of decades, the group identity of conservative white males has been reinforced by an orchestrated campaign to sow doubts about climate change, bankrolled by a (white male) conservative elite (the Koch brothers, Rupert Murdoch), disseminated through talk radio (Rush Limbaugh, Glenn Beck), conservative news media (Fox, the WSJ), think tanks (Cato Institute, Heritage Foundation, American Enterprise Institute), lobby groups (Chamber of Commerce, ALEC) and political leaders (George Bush, Dick Cheney, James Inhofe) (McCright and Dunlap 2011a,b, Walsh 2011, Pooley 2009, Revkin 2005). The success of this campaign is illustrated by the growing split in beliefs about climate change along party lines (Figure 2).
Figure 2 - Percent of Democrats and Republicans who believe climate change is occurring
But how do conservative-hierarchical-individualistic values translate to climate change skepticism? Psychologists argue that people confronted with complex or incomplete information process it using heuristic devices, that is conceptual models or shortcuts that reflect their prior beliefs. Though undoubtedly useful when being chased by wild animals across the savannah, these cognitive processes can lead to biased and erroneous conclusions, for instance, by discounting information that conflicts with other deeply held beliefs. Using this model, Kahan and others 2007 explain climate change skepticism by what they term "motivated" or "identity-protective" cognition. Conservative-hierarchical-individualistic white males are motivated to deny climate change because it challenges the legitimacy and sustainability of the existing social order. By contrast, liberal-egalitarian-communitarian white males, along with women and minorities, are less invested in the status quo and, at least in this case, are more likely to use heuristics that are compatible with the evidence.
As a test of motivated cognition we might ask, what happens as evidence accumulates of climate change? If skeptics were objective and impartial Bayesians, they would confront their prior beliefs with empirical evidence and end up somewhere between the two. However, both survey and experimental evidence indicates this doesn't happen. McCright and Dunlap 2011a asked climate change skeptics how familiar they were with the issues and found that those who reported to being very familiar were far more likely to be skeptical -- even though greater familiarity would surely include an awareness that the weight of scientific findings favors acceptance (Figure 3). Elsewhere, Kahan et al. 2011 and Feinberg and Willer 2011 conducted experiments in which skeptics were shown what was purported to be new and alarming evidence of climate change. Far from being convinced, instead they challenged the authority of the new information and/or became even more strongly skeptical than before.
To a casual observer, this dynamic describes the behavior of SA climate change skeptics who were clearly not swayed by the evidence put forward by believers, but if anything, became increasingly resistant. Moreover, since conservative-hierarchical-individualistic white males seem likely to be an overrepresented demographic on Seeking Alpha, the "White Male Effect" is a plausible explanation for prevalence of climate change skepticism on the site.
Why should investors care about climate change?
Objectively, anthropogenic climate change is virtually settled science. It may yet turn out to be a massive hoax perpetrated by the UN and an international conspiracy of scientists, but each passing year makes this seem less likely. The economics of climate change is less settled because the costs and benefits of different actions are hard to estimate and are dependent on model specification and choice of discount rate (see e.g., Nordhaus 2007, Pindyk 2011, Weitzman 2011). Nevertheless, a consensus view is emerging here, too, that climate change mitigation would likely impose moderate, but manageable costs on the global macroeconomy.
Those who remain skeptical might reflect on what the 2008-09 global financial meltdown showed about the dangers of ignoring systemic risks. But even for diehard skeptics, here are 3 reasons why every investor should pay attention:
(1) For policy, perception is more important than reality: Voters in industrial and even emerging market countries are increasingly willing to support public action and so are many of the world's biggest companies, including some with large carbon exposure such as Alcoa (AA), Ford (F), Caterpillar (CAT), Exelon (EXC), and Shell (RDS.A) (U.S. Climate Action Partnership 2009). No doubt these companies want to look like good corporate citizens, but they also likely see opportunities as well as challenges, and prefer a stable and predictable policy environment (especially if they have some input to the design).
Whether climate change is fact or fiction, policy trends will increasingly shape portfolio performance. The U.S. has resisted international initiatives such as the Kyoto protocol, however since 2010, the Federal Clean Air Act has set standards for greenhouse gas emissions, complemented by growing numbers of regional, state, and city initiatives. California's first auction of carbon emission permits was held in November 2012. Recently, the Obama administration announced a progressive increase in CAFE mileage standards to 35.5 mpg by 2016 and 54.5 mpg by 2025. U.S. multinationals are further affected by increasingly stringent environmental regulations in other jurisdictions.
Policy uncertainty has a dampening effect on industrial economies by deterring technological innovation and investment in infrastructure to limit greenhouse gas emissions. As a result, scenarios that maintain business as usual for as long as possible followed by sharp cuts in emissions to put the planet on a sustainable path generate the worst possible outcomes. According to Mercer 2011, climate change may account for 10% or more of total portfolio risk in the medium term, most of it due to uncertainty about future policy directions. Indeed, the study concludes that policy uncertainty is far more costly than mitigation.
(2) Climate change has implications for strategic asset allocation: As well as macro impacts on inflation, interest rates and equity risk premiums, climate change has sectoral and regional implications. Aside from the obvious (tail risks in REITs that invest in beach hotels), there are risks and opportunities for asset classes ranging from equities to real estate and sectors from agriculture to insurance.
Investors with significant direct or indirect carbon exposure will need to monitor innovation in low carbon technologies, as well as trends in energy efficiency, physical changes in the environment and policy directions. The implications may be subtle and nuanced. For instance, climate change mitigation will raise the price of carbon, which intuitively should be negative for energy intensive sectors such as utilities. However, allocating emission permits based on current emissions (as in the EU's Emissions Trading System) may actually increase profits of firms with large carbon footprints by raising entry barriers to potential new competitors. In any case, downstream users of electricity such as aluminum producers will also face higher costs (Llewellyn 2007).
(3) Climate change risk is becoming part of routine due diligence, and it's getting easier: In addition to strategic considerations, carbon exposure and preparedness increasingly figure into asset valuation. In a 2011 survey of institutional investors managing over $12 trillion in assets, 57% conducted climate risk assessments on their portfolios and 26% made changes to their investment strategies as a result. Climate change policy factored into manager selection for 78% of investors, and over 60% of them invested in climate solutions (IIGCC 2012). The good news is that monitoring is becoming easier. In 2010, the SEC released guidance on disclosure requirements for material risks and opportunities related to climate change stemming from physical impacts or regulatory decisions (SEC 2010). Meanwhile, the International Standards Organization (ISO) has developed standards for measuring and communicating greenhouse gas emissions under its ISO 14000 series, aimed at standardizing information available to investors.
So far, there is little evidence that going green has had much effect on returns. Ziegler et al. 2011, found no significant difference in the stock performance of companies with more complete disclosures and/or better carbon management policies, though there was some tentative evidence that the benefits increased over time. However, anecdotal evidence suggests there are risks to moving too soon as well as too late. Procter & Gamble (PG), already a leader in environmental sustainability, committed itself in 2010 to move to powering its plants with 100% renewable energy and using 100% renewable and recycled materials in its packaging (see P&G 2010). The timing may have been unfortunate, as conventional energy prices have since tumbled and P&G has underperformed the market. Nevertheless, these are early days yet.
Climate change skepticism is rooted more in psychology than ecology, and as a result, skeptics and believers tend to talk past each other. Of course, liberal-egalitarian-communitarian males are no less prone to cognitive biases and group-think than conservative-hierarchical-individualistic ones. However, they have science on their side. Skeptics would do well to recognize that while they busy themselves with fearless attacks on the scientific consensus, the rest of the world is moving on. As Finucane et al. 2000 puts it bluntly, "Attempts to re-align risk perceptions according to the white male view of the world are likely to be unsuccessful."
Fortunately, conservative-hierarchical-individualistic investors are not condemned to remain skeptical forever, but can flip the switch from what Daniel Kahneman calls "fast" to "slow" thinking (Kahneman 2011). Lighting up new areas of the brain takes an effort, but should pay off over time in better investment returns.
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