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Three Flawed Assumptions in Climate Risk Models
- By John Ploeg, ESG Specialist
- November 18, 2021
A few weeks ago, the UK faced a severe shortage of CO2. At a time when dramatic cuts in emissions are needed, that sounds like good news. In fact, it threatened a food shortage, as CO2 is used for a variety of applications, including beverage carbonation, preservation, and slaughterhouses. The chain of events preceding this scare provides a cautionary lesson for the increasing number of investors and regulators employing top-down, passive models to measure climate risks in fixed income portfolios. Although such models appear sophisticated, they suffer from at least three major flawed assumptions and serve as another reminder of the risks involved with passive approaches to research and portfolio management.
Flawed Assumption #1: The Energy Transition Will Be Smooth and Painless
Investors’ focus on supply shortcomings certainly includes fuel supplies as decarbonization policies have contributed to a global reduction in natural gas investment of about 28% since 2015 (Figure 1). In the UK specifically, investment in natural gas storage has dropped, coal plants have been shut, and the fossil fuel divestment movement has picked up steam. Unfortunately, these reductions in fossil fuel supply have not been met by equal reductions in demand.
FIGURE 1: THE DECLINING GLOBAL INVESTMENT IN NATURAL GAS PRODUCTION…
The economic rebound and recent extreme temperatures sent natural gas demand soaring. When combined with supply chain bottlenecks and lower than usual wind speeds, the price of gas in the UK more than doubled this year (Figure 2).1
FIGURE 2: CONTRIBUTED TO THE SPIKE IN EU NATURAL GAS PRICES
So, although fossil fuel consumption is expected to decline over the long-term, demand spikes and troughs (and corresponding price volatility) are likely to recur.2 Further, Spain’s recent attempt to address its energy crunch by imposing a windfall tax on renewables demonstrates that clean energy may not face a smooth ride either. Yet, a one-directional shift in demand for fossil fuels and renewables is exactly what most climate risk models assume.
Flawed Assumption #2: Climate Risks Can Be Isolated
The UK’s recent food scare stemmed from the idling of two fertilizer plants due to high energy costs. These plants, it turns out, generate the majority of the UK’s CO2 supply as a byproduct. Even if climate risk models had predicted that decarbonization efforts would contribute to an unexpected increase in fossil fuel prices, how many would have foreseen this leading to a shortage of ham and crisps?
Last winter’s polar vortex in Texas, which contributed to the deaths of more than 100 people and left 4.5 million without power, serves as another example. Although a warming Arctic may have contributed to the event, how many climate risk models consider a deep freeze as a major risk of global warming at all, let alone in Texas? Further, how many models could account for Texas’s uniquely less-regulated energy market and the failure of power producers to cold-proof their facilities?
Other potential ripple effects are even more concerning. Climate change is expected to greatly exacerbate migration, conflicts, and social upheaval. Indeed, the UN and U.S. Intelligence refer to it as a “threat multiplier.” It would be inappropriate to blame these types of incidents entirely on climate change, and the media tends to attribute them to more immediate and tangible events. Therefore, they get little attention from climate risk modelers. However, as climate change intensifies, its ability to amplify indirect threats will grow, and the damage they inflict could be orders of magnitude greater than that caused directly by storms and rising seas. Worse, such risks can rarely be predicted, and green assets are just as vulnerable to armed conflict as brown ones.
Current climate models cannot capture these types of chain reactions and complex interactions, so they are essentially ignored. But they will arguably consist of the most severe impacts investors will face from climate change.
Flawed Assumption #3: Climate Risk Models Are Precise
The appeal of climate risk models is that they appear precise. However, that is generally not the case. Predicting future emissions and the resulting global temperature change already entails a high degree of uncertainty. For most emissions trajectories, the range of potential warming outcomes is itself wider than 1.5°C.3 Translating these predictions to local weather events and fossil fuel use, then into social and economic consequences, and ultimately into financial impacts on individual issuers is infinitely more complex. Hence, the models’ imprecision—they attempt to anticipate the entirety of the world economy, years into the future based on a few, very uncertain assumptions.
In climate risk models, the problem of complexity is “solved” via simplistic proxies. For instance, most assume a global carbon price as a proxy for transition risks. But this ignores critical nuances, including the use of other climate policies (e.g., efficiency standards), customer absorption of decarbonization costs (e.g., from regulated utilities), and issuers’ general ability to adapt their climate change strategies. Crucially, none of these proxies can anticipate the ripple effects from future emissions to financial impacts on issuers as laid out above.
Conclusion
Investing history is rampant with examples when overreliance on imprecise models led to risk complacency, a failure to spot emerging threats, and blindness to tail risks (consider those used to rate subprime CDOs in the 2000s, which were arguably much more straightforward). More bluntly, some managers may now be more tempted to outsource their job to a woefully oversimplified black box instead of devoting the considerable time and analysis needed to understand the complex risks posed by climate change.
Such models also dissimulate the fact that many climate risks (especially those that are indirect) cannot be predicted or hedged—the only way to mitigate them is to mitigate climate change itself. This cannot be done in a simplified manner either. Cutting fossil fuel supplies without ensuring that fossil fuel demand falls at least as fast will not result in decarbonization. It will result in price spikes and unexpected shortages that eventually lead to political backlash and social upheaval.
Our solution to these challenges is to remain focused on fundamental analysis. Instead of applying a blanket assumption to entire sectors or markets, we prefer to consider the specific channels through which climate risks are most likely to manifest themselves for each issuer, taking into account its particular circumstances and its overall risk profile. Similarly, we prefer to consider the climate impact of each issuer instead of whole sectors, while recognizing that issuers contributing to fossil fuel demand are just as important as those responsible for fossil fuel supply. No approach is perfect, but we believe a bottom-up approach can capture at least some of the complexity and nuance of climate change risks that top-down, passive models cannot.
This material reflects the views of the author as of November 18, 2021 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income. The comments, opinions, and estimates contained herein are based on and/or derived from publicly available information from sources that PGIM Fixed Income believes to be reliable. 2021-8802
1 The rise in carbon prices in the UK and Europe this past year added another ~£10/MWh to gas electricity as well, or 5% of current UK power prices.
2 Indeed, despite the calls at COP26 to “consign coal to history,” US coal miners are currently “sold out” through 2022 and China’s coal production recently hit multi-year highs.
3 These ranges also do not incorporate the risk of triggering feedback loops and abrupt tipping points. The IPCC highlights such risks in its recent report on the physical science of climate change, noting that although they are low likelihood, they are “associated with potentially very large impacts” and “cannot be ruled out.”
John Ploeg, CFA
John Ploeg, CFA, is a Vice President and ESG specialist for PGIM Fixed Income, based in London. As part of the Firm’s ESG specialist team and a member of its ESG committee, Mr. Ploeg is involved in all aspects of its ESG approach, including the maintenance and enhancement of its ESG ratings methodology, ESG engagement activities, and tracking ESG-related market and regulatory developments. During the year, before taking on the role as ESG specialist, Mr. Ploeg attended Sciences Po’s Paris School of International Affairs, where Mr. Ploeg received a Masters in Environmental Policy. Previously, Mr. Ploeg was head of the firm’s European CLO product management team, where he was responsible for all business aspects of the firm’s European CLO platform. Prior to relocating to London, Mr. Ploeg was a member of the firm’s US CLO product management team in Newark. Before that, Mr. Ploeg worked in the CIO department of PGIM’s parent company, Prudential Financial Inc, first in the department's Alternative Assets Group, and later in its Modeling & Analytics Group. Mr. Ploeg received a dual BA degree in Computer Science and Economics from Brown University in 2007, and currently holds the Chartered Financial Analyst (CFA) designation.
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