Climate Change Lessons for Your Portfolio

Should disaster scenarios be discounted less?

That example illustrates Wagner’s and Weitzman’s argument for using a low rate to discount the future costs of climate change disaster scenarios. The discount rate that should be used to calculate the present value of the costs of climate change, which may be borne in 100 years or more, has been at the center of a raging debate among climate change researchers since a 2006 report commissioned by the British government. This report, the Stern Review on the Economics of Climate Change, was named after its principal author, economist Nicholas Stern, chair of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics. In that report the researchers used a very low rate, 1.4%, to discount the future costs of climate change. The result of that low rate of discounting future costs is that the price that emitters of carbon dioxide (CO2) should pay now should be high. Wagner and Weitzman say it should be at least $40 per ton of CO2, approximately doubling the cost of burning coal. Other modelers of the economics of climate change, such as William Nordhaus of Yale University, believe in using a discount rate much closer to the competitive market return on capital, such as 4%. This leads to a much lower price to emit carbon.

Wagner and Weitzman argue that pricing carbon should be viewed chiefly as insurance against the most unbearable future climate catastrophes – by which they mean global average temperature increases exceeding 6°C (11°F) eventually (in a century or more). They believe there is as much as a 10% chance of this scenario occurring. Since the rate of return on investments in insurance contracts is generally very low and often negative, the discount rate should be very low – perhaps even negative.

Does their argument make sense? It does if you look at it in the context of your portfolio. Some argue (myself included) that at a later stage in life, one should use a portion of one’s assets to buy a simple annuity for safety-net income, lasting as long as the purchaser survives. If you calculate the expected real rate of return on an annuity, you’ll find it’s quite low and often negative; but it assures at least a minimum level of economic survival as an insurance contract against the possibility of outliving your assets.

Once you’ve purchased that insurance to cover the extremely adverse, remotely possible lower tail of the probability distribution of portfolio returns, you can devote the rest of your portfolio to seeking higher returns. Hence, in a sense, you are using a different, lower discount rate for the most negative scenario than you are using for the rosier ones.

For climate change disaster scenarios, what is that insurance contract?

Wagner and Weitzman have backgrounds well-suited to the writing of this book. Wagner is lead senior economist for the Environmental Defense Fund, an organization that generally adheres faithfully to a long-time motto, “good science, good economics.”¹ Weitzman is a professor of economics at Harvard who has written extensively about “fat tails” and the social cost of carbon. Their writing reflects an intimate knowledge of the subject, as well as a few revealing insights they have gained in the course of exploring it.

One of those insights has to do with the concept of “geoengineering.” Geoengineering encompasses ways to alter certain features of the earth in order to counteract global warming. Given what slow progress the world has made in limiting or reducing emissions of greenhouse gases -- the most common of which is CO2 emitted by fossil fuel-fired power plants, industrial boilers and vehicles used for transportation -- geoengineering is a tempting and seemingly inevitable solution.

Geoengineering includes such tricks as spraying sulfur particles into the atmosphere, as a volcano does, to screen out the sun and reduce its incoming energy. Another trick is to seed the ocean with iron, driving the process of photosynthesis and thus facilitating the uptake of CO2, causing the ocean to “bloom” – to create more bioorganisms, some of which will eventually die and fall to the bottom burying their carbon with them.

According to Wagner and Weitzman, spraying sulfur particles into the atmosphere is very cheap and effective. Then why not keep that solution at the ready and rest easy with carbon emissions in the meantime?

Wagner and Weitzman tell the best cautionary story against geoengineering as a fallback that I have seen. For one thing, spraying sulfur into the atmosphere does nothing to solve the ancillary problem of ocean acidification, which occurs as a result of more CO2 being absorbed into the oceans. Seeding the ocean with iron would help to ameliorate that problem, but it is more costly, less effective at solving the climate problem and may have other side effects.

It is the other scenarios that could accompany geoengineering, however, that are particularly compelling. The most intriguing – and ultimately scary – is one involving “Greenfinger.”

Who is Greenfinger? He is a shady and sinister character, analogous to the James Bond villain Goldfinger, possibly operating as a secret agent of a tropical agricultural country (you might imagine Bangladesh). At a cost of a mere few billions, he commands a fleet of small aircraft, which deposit sulfur particles into the atmosphere that cool the whole earth. All that his funding sources really care about, though, is cooling their own country, to mitigate the blistering heat and droughts.

Sweden and Finland – relatively sanguine about the prospect of warming (except that the consequent ocean rise may drown Stockholm) – launch a counterattack. They deposit quantities of hydrofluorocarbons (HFCs), a powerful greenhouse gas, into the atmosphere to warm it back up.

As Wagner and Weitzman put it, “Let the climate war games begin.”

Whether or not this scenario is plausible – and it does not seem all that implausible – Wagner and Weitzman also give other reasons why geoengineering, at least in such forms as spraying volcanic dust, is a severely suboptimal solution to the problem. If the CO2 concentration in the atmosphere continues to climb as it has and will continue to do, as soon as you stop spraying volcanic dust the temperature will snap back to very high levels. You – that is, the world – will be addicted to spraying volcanic dust into the atmosphere. What will happen if it is found to cause some other serious problem? It will be hard to stop.

Not that Wagner and Weitzman think that geoengineering should be shunned completely. They believe that some research should be done. Perhaps a solution can be found that will be relatively benign. But the pursuit of geoengineering also reduces the time that researchers have available to find ways to reduce emissions, like advancing low-carbon energy technologies. And reliance on geoengineering should not dilute the commitment to that pursuit.

Hence they – like most other seekers of solutions to the problem of climate change – believe that the premium payment for insurance against potential climate catastrophes should be applied chiefly to reducing greenhouse gas emissions, not to counteracting them through geoengineering.

Catastrophists versus dynamists

Wagner and Weitzman are less compelling when it comes to a central issue surrounding not only climate change but the question of whether economic growth as we know it can rescue us from the dilemmas that it tangentially causes. This is also a question that bears on the selection of the proper discount rate – though the idea that a lower discount rate should be applied to disaster scenarios may still hold in any case.

New York Times columnist Ross Douthat has identified this issue as the argument between dynamists and catastrophists. According to Douthat, “Dynamists are people who see 21st-century modernity as a basically successful civilization advancing toward a future that’s better than the past. They do not deny that problems exist, but they believe we can innovate our way through them while staying on an ever-richer, ever-more-liberated course.” Catastrophists, on the other hand, believe that “things cannot go on as they are: That the trajectory we’re on will end in crisis.”

That is why dynamists believe in using the market return on capital as the discount rate. They believe that the incentive presented by the market return on capital will spur innovations that will ultimately get us out of whatever mess we may be in through the miracle of economic growth. Catastrophists, on the other hand, believe that eventual crisis is inevitable unless we do something quickly; that’s why we need a low discount rate to force us to foresee the crisis in time.

Wagner and Weitzman are plainly catastrophists. They dispense with the dynamist argument by saying that “not all environmental damages can be offset so easily just by increasing GDP… if the global food supply suffers from climate change, boosting GDP by building more iPhones won’t do much for those who are starving.”

This is not a good analogy. Food production has certainly been increased by the growth of technology. Even the spread of mobile phones has improved it by enabling small farmers to determine where the markets are for their produce, at what price and even what they should grow.

Investment dynamists and catastrophists

Does the same divide hold for investors? Do dynamists, believing that the world can only get better and that GDP growth will solve everything, put 100% of their investments in equities? Do catastrophists allocate more to safe assets? It would make for an interesting research study – perhaps correlating levels of belief in the likelihood of catastrophic climate change with allocations to equities.

Wagner and Weitzman argue for a high level of investment in climate change aversion. This high level of investment is to be accomplished by a “carbon tax,” charging emitters of CO2 (and other greenhouse gases) a high price per ton, at least in part as insurance against the worst-case climate change scenarios.

By the same token, even if one is a dynamist and believes that humanity is very likely to solve every problem and continue sustaining high levels of economic growth in the future, one may hedge that bet by purchasing insurance against worst-case scenarios, in the form of allocations to fixed income and annuities.

In both cases, the high cost can be made understandable if regarded not as an ordinary investment, but as the purchase of insurance against a worst-case scenario.

Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a principal and chief strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, has just been published by Berrett-Koehler.

Read more articles by Michael Edesess