Insulating Your Portfolio From The Effects Of Catastrophic Climate Change

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Includes: BA, BAYZF, CX, DD, LMT, MON, NOC, VMC
by: Tristan R. Brown

Summary

The world's financial markets are heavily exposed to the negative impacts of catastrophic climate change as global temperature anomalies continue to rise.

Widespread optimism regarding the world's ability to mitigate climate change can cause investors to underestimate the impacts that a failure to mitigate will have on financial assets.

Climate change's impacts are expected to be unequal, however, and a number of companies could experience positive earnings impacts as the world shifts its focus to climate change adaptation.

This article looks at a few of the sectors that are positioned to provide adaptation services as the climate changes.

One of my earliest memories is of spending an evening with my father listening to a news program on the radio. He had insisted that I take a break from building Legos to listen to the program, which was unusual given my young age. I distinctly remember the reporter expressing shock while describing a scene in which people were attacking a spray-painted wall with sledgehammers. At one point another voice on the radio mused that this event could make the world a safer place by reducing the likelihood that World War III would break out.

I didn't realize it at the time, of course, but I was listening to history being made as the Berlin Wall was torn down. The comment about World War III being averted recently came to mind, however, following a discussion that I had regarding catastrophic climate change and the markets. A colleague proposed that the world's ability to avoid a nuclear holocaust during the 40-year Cold War boded well for its ability to avoid anthropogenic climate change. After all, the U.S. and U.S.S.R. had enough nuclear warheads primed and aimed at one another for most of that period to trigger an extinction-level event, leading the Bulletin of Atomic Scientists to move its "Doomsday Clock" to only two minutes to midnight throughout the 1950s and four minutes to midnight in the early 1980s.

Now, of course, we know that the clock never reached midnight because of, rather than despite, the fact that the world spent so much of the Cold War on the verge of reaching it. The impossibility of a nuclear sneak attack ensured the presence of "mutually assured destruction" [MAD], as the guarantee that both the attacker and defender would be obliterated in any ensuing nuclear exchange became known. (Despite this, the vote of a single low-level Soviet naval officer was still the only factor that prevented the Cuban Missile Crisis from triggering a nuclear exchange and likely global holocaust, showing just how precarious the peace was despite the existence of MAD.) My colleague's argument is essentially that the darkest night is just before the dawn, and that humanity must force itself to the brink prior to preventing itself from going over the edge. Humanity avoided a nuclear holocaust, this line of thinking goes, which is evidence that it will avoid catastrophic climate change as well.

The financial costs of climate change

The prospect of climate change is one that all investors must be aware of for two reasons: its major global impacts and the manner in which these impacts will occur. A recent study by researchers at the London School of Economics estimated that the most likely climate change scenario would incur financial damages of $2.5 trillion, although the worst-case scenario would see this number balloon to $24 trillion, or 17% of today's global assets. The Bank of England, World Bank, and U.S. White House have all issued similar warnings to investors in recent years.

Note that I am just referring to global climate change, not necessarily the anthropogenic (i.e., human-made) variety. This is important because the notion that climate change might be caused by humans is what makes the topic so controversial, although a majority of both Americans and U.S. senators believe that this is indeed happening. Climate change on its own is less controversial, with the Republican-led U.S. Senate voting by a 98-1 margin early last year in favor of the statement that "climate change is real and is not a hoax" (apparently one senator was unable to correctly read a thermometer). Our climate is changing in a way that will likely bring an end to the relatively docile environmental conditions that spawned the rise of human civilization.

Unlike nuclear war, however, investors should pay attention to climate change because of the fact that they can actually take steps to mitigate its negative impacts on financial portfolios. Investors didn't worry about the Cold War turning hot because such a shift would have resulted in the instantaneous destruction of the world's financial centers: it would be hard to find buyers for put options following a 10-megaton airburst over Wall Street, for example. One of my professors in college worked in Manhattan on Black Saturday during the missile crisis, and he described leaving work on Friday not knowing if his office building would still exist on Monday. Climate change, on the other hand, is expected to occur gradually over the course of a century. In the words of former U.S. Treasury and Goldman Sachs head Henry Paulson, "Climate change is more subtle and cruel. It's cumulative."

Investors can take steps to insulate their portfolios from the effects of climate change, then. But is it necessary to do so if, as a majority of Americans believe, it is anthropogenic and can therefore be avoided? After all, the aforementioned LSE study calculated that keeping the global temperature increase below the 2 degrees Celsius threshold would mitigate the damages of climate change by a net $315 billion, even accounting for the expenses that such mitigation would incur. The world avoided a nuclear holocaust against all odds, so perhaps it can avoid anthropogenic climate change as well? Advocates of this contention point to the recent Paris climate accord in support.

Climate change isn't MAD

There is a major flaw with this viewpoint, unfortunately: climate change will affect the world, but the impacts won't be negative on balance for every country. In other words, mutually assured destruction does not exist when it comes to climate change. Much attention is being paid to the plight of disappearing island nations as ocean levels rise in response to melting polar ice caps. Fewer people are aware of the positive impacts of a warming planet that will be felt by specific regions of the world. Russia, China, and Canada are all expected to gain cropland as temperatures rise and growing seasons lengthen, for example; think less Russian tundra and more the American Midwest. Furthermore, global crop production is expected to falter at the same time, potentially leading to higher prices and improved incomes in those areas that don't suffer.

In another example of positive economic impacts, the gradual disappearance of the Artic's sea ice is opening the region up to new oil and gas exploration. The Artic is believed to hold 13% of the world's undiscovered oil and 30% of its undiscovered natural gas in the form of underwater reserves, and its recent accessibility has prompted countries such as Norway, Russia, and Canada (among others) to expand exploration efforts and drilling leases there. Russia has even gone so far as to plant a Russian flag on the seabed under the North Pole's ice cap via submarine in that most basic form of territorial expansion. Low energy prices have caused some companies to reduce their exploration efforts in recent years, but the scramble for the North Pole's hydrocarbons continues among the countries that border the Artic.

Both developments have the potential to worsen anthropogenic climate change. The millions of square kilometers of new cropland that are expected to appear in the coming decades currently sequesters vast reserves of soil carbon that will ultimately undergo oxidation and release as carbon dioxide when that virgin land is plowed. Likewise, the Artic's hydrocarbons will contribute to the global atmospheric carbon dioxide concentration if extracted and combusted. Anthropogenic climate change, in other words, is expected to beget more anthropogenic climate change.

At the same time, the fact that some countries expect to derive benefits from a warming planet makes it more difficult to arrive at a global emissions reduction agreement. Even the vaunted Paris accord, which came together after nearly a decade of fraught negotiations and previous failed accord efforts, is expected to have only a minimal impact on global temperatures. The Doomsday Clock continues to be only three minutes from midnight despite December's Paris announcement.

Planning as an investor

Investors have a number of routes available to them in terms of hedging their portfolios against the negative impacts of climate change. This is something that all investors should examine, most especially those who believe that climate change is not caused by humans, such skeptics being well represented here at Seeking Alpha. After all, if climate change is occurring and humans aren't causing it, then climate change mitigation is hopeless, in which case adaptation is inevitable.

Climate change adaptation is likely to take multiple forms. First and foremost, new crop varieties will be needed that are capable of surviving extreme weather conditions such as droughts and floods (yes, both, although not necessarily in the same regions). These new varieties will need to be developed at a time when conventional breeding techniques are losing their effectiveness, however. Opposition to GMOs and non-organic foodstuffs is likely reaching its highwater point, and in the coming decades humans will begin to realize that continued productivity increases under adverse environmental conditions will be needed to generate sufficient calories to meet global demand. Monsanto (NYSE:MON) and DuPont (NYSE:DD) continue to be America's main seed development companies. Seeking Alpha contributor Dana Blakenhorn recently portrayed the proposed purchase of the former by Bayer (OTCPK:BAYZF) through the lens of GMO innovation (in the U.S.) and acceptance (in Europe).

The agricultural sector will not be the only area to require increased resilience as the climate changes, however. A study published in the prestigious Proceedings of the National Academy of Sciences [PNAS] in 2014 calculated that every country with coastline will need to build seawalls around their coastal urban centers by the end of the century to prevent catastrophic flooding and human habitat loss. The researchers further estimated that, while the cost of these protective measures could reach into the tens and even hundreds of billions of dollars, the prevented losses would be an order of magnitude higher. Seawalls require vast quantities of cement and asphalt to build. Among U.S. companies (and international companies with large U.S. operations), CEMEX (NYSE:CX) and Vulcan Materials Co. (NYSE:VMC) are two of the main producers of the necessary materials.

Finally, the combination of extreme weather events, resource degradation, and habitat destruction is expected to spur mass migration, especially in the developing world. A number of mass migrations in history have been attributed to climate change - the Germanic migration of the 4th and 5th centuries that culminated in the fall of the Roman Empire, for example - and the 21st century is expected to witness similar climate-driven movements of peoples. Such migrations have also been historically associated with international conflict and national insecurity, especially when they are caused by resource degradation. It is further expected that the U.S. military will shoulder an increasingly large share of this burden as migration reaches critical levels.

Far from being a problem for future decades, the Pentagon recently went so far as to say that climate change already requires "immediate action" on the part of the U.S. military. In the short-term climate change's security impacts are expected to be felt in the areas of terrorism and asymmetrical warfare. Beyond that, however, the security impacts will likely take the form of more traditional security concerns. Russia, China, and even India have all increased their military spending above the rate of inflation in recent years, for example, offsetting reduced spending in the developed world. In the event that U.S. military spending growth resumes, I expect that the country's largest arms producers will derive the most gains to earnings growth. Lockheed Martin (NYSE:LMT), Boeing (NYSE:BA), and Northrop Grumman (NYSE:NOC) are responsible for close to a combined majority of total U.S. arms sales.

Conclusion

Climate change, whether of the anthropogenic variety or otherwise, is unlikely to be avoided. Unlike other major threats to global human health and safety, climate change is expected to be unequal in its impacts, complicating efforts to take global action to prevent it. Unlike the threat of nuclear war, however, climate change's slow-burning nature means that investors can take steps to minimize the negative impacts of global warming on their portfolios. I make no attempts to guess at market timing or to determine the underlying valuation of the securities discussed in this article, but I do believe that they are all positioned to outperform as the world adapts to climate change. I am especially interested to know which equities other investors consider as hedges against its effects, so feel free to sound off in the comments section.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.