EDHECinfra Post
An Open letter to Stuart Kirk
Publication date: 2022-05-30

Dear Stuart,

It takes courage to express non-conformist views to a room full of evangelists. During your now infamous speech at the FT, your annoyance with those who have found refuge in the ascetic ideal of decarbonisation, kicking for touch with net-zero pledges, was palpable. We understand.

Still, we usually think that opinions on climate change are divided between those who believe in man-made climate change and those who do not. We now have a third type of interlocutor: those like you who believe in climate change, but do not care.

Now, when making claims about asset prices (and the future of the world), we believe that a minimum amount of theoretical and empirical consistency is in order. This is the purpose of this open letter. It may sound sarcastic or provocative at times, but we felt that it is the most appropriate format to respond to your arguments, which challenged both the importance of climate risk and the intentions or competence of those who devote their work to it.

Markets do not process information that they do not have

Unfortunately, your argument for the primacy of fact over fantasy includes a common fantasy, namely that one can explain anything with a line chart. You are not the first one to use a picture as a proof of correlation, and a claim to demonstration. Your slide linking the progression of cumulative returns to the increase in the volume of very negative news on the climate is not a serious asset pricing test. First, it is meaningless because it compares a flow (the news) and a stock (a wealth index). But as a former student at Cambridge, you should be aware of Keynes’ teachings on spurious correlations. We suggest a visit to the library before the next alumni dinner.

Your methods may be weak, but your understanding of finance theory is even weaker. You say that markets have “not reacted to warnings of climate impacts” and that this is proof that either everything is all right and priced in, or that the market as a whole is wrong, which is highly unlikely. However, this is a false equivalence: markets are indeed efficient, but only at transforming all the information available today into prices. The nature of climate risks is such that they are not known well at all today and cannot be priced. Moreover, extensive research has shown that the market tends to provide correct pricing of average, i.e., frequently observable, risks, rather than extreme risks, which are infrequently or, in this case, never yet observed, even if their potential realisation is recognised. This is one of the fundamental reasons that justifies the intervention of the regulator. If climate risks were known, they would be priced and could indeed be managed from the comfort of a Bloomberg terminal. But this is not the case today and may not even be the case tomorrow.

The need to measure climate risk better and to integrate it into the investment decision is the very reason why investors have been increasingly demanding access to non-financial data on climate risk. In a forthcoming EDHECinfra survey about the reasons why asset owners and asset managers want access to non-financial data, “risk-management” is the most important reason, well ahead of “reporting to regulators” or “stakeholder management.”

Infrastructure investment is a case in point: infrastructure assets and activities can be linked to 70% of global emissions, and investors in infrastructure equity or debt are exposed to transition and physical risks. Huge research efforts are currently underway, including at EDHEC, to develop the relevant non-financial data and document the exposure and the potential impact on asset values of climate risks precisely because investors do not have granular and robust information to determine what they should do about these risks, let alone how to price them. The reason for this lack of investment knowledge is that the work on climate risk has so far been done at such a high level of generality that no one knows what the impact on individual assets will be.

Climate models and scenarios are not telling us what we want to know

You say that climate models do not show a large impact of climate change on asset prices in the future, so why worry? But thinking that the consequences of climate change can be summarised in an aggregate and limited loss of GDP is unfair to the research on the next-generation models for estimating the economic and financial consequences of climate risks, including the research done by our colleagues at EDHEC.

In effect, too many estimations of the economic losses relating to climate change do not take account of feedback loops and all the unintended consequences of all the unpredictable policy decisions (or absence of policy decisions) that are yet to come. Moreover, giving a monetary value to famine and the destruction of homes and nature to offset it with the gains from the potential winners from climate change is neither realistic nor truly responsible in our view.

Many hypotheses are being discussed today whether involving perfect isolation of sectors or continents protected from climate change, irreversibility effects and their corollary of the non-substitutability of goods and natural resources, and of course thresholds. We share your concern to avoid a catastrophist discourse not supported by facts. But when you use the results of IPCC models to pick these facts, please be honest and cite the models‘ limitations, which the researchers themselves acknowledge in their presentations.

Crucially, these models are designed to make predictions at the level of continents! The downscaling of high-level climate models to country, let alone sector or company level is a fundamental question today to which no one has a satisfactory answer. The consequences of climate change on transport networks for instance are unknowable today. First, because numerous impacts are possible, from heat making airports, roads, or rail unusable, to water and fire disrupting or destroying these assets in many, many, many different places. Second, because the knock-on effects on economic activity are likely to be dire.

In the area of climate change, it is not so much that any of these impacts taken individually is so bad that the world economy, let alone humanity, could not adapt. What the likely incidence of climate change really means is irreversible and chaotic change to the physical system in which we operate as a civilisation. A series of network effects, unintended consequences, correlations (not the spurious type) and covariances that neither you nor anyone else knows about. It may not mean extinction, but it is unlikely to be a side show either.

You may be right or not that climate stress test models are useless. But the conclusion that climate risk does not exist is yet another fallacy. Unknown unknowns are a thing. As often, the main risk factor in the area of risk management is being a bit too confident about our ability to measure these risks. It is often excessive confidence (i.e., ignorance) that makes risk amplification practices such as leverage (always designed to magnify lower, well-diversified risks) play an important role in financial crises.

And if the world did not adapt?

In this anxiety-provoking context, we would like to share your optimism on adapting to what we could call, if we follow your reasoning, a new climate order, like the new geopolitical order that followed the Second World War. Unfortunately, like you, we believe in facts, and we must confess that your graphical demonstration on the subject did not convince us. Showing that stock markets have always progressed despite crises and wars makes no sense when it comes to climate. None of these events was irreversible in nature, and this is indeed what fundamentally distinguishes the subject of climate change from other ones. The proposition that humans can adapt to a new irreversible event by observing instances of adaptation to past reversible ones makes little sense.

With such naïve approaches to adaptation, we could have considered nuclear war seriously! We almost accepted the destruction of the ozone layer by CFC gases using similar reasoning. The US government opposed the signature of a binding protocol using a similar ‘net benefit’ approach, and even suggested equipping us all with caps, creams and anti-UV clothes to limit the risk of skin cancer, because the economic calculation justified it… Fortunately, an Oxford alumna, Margaret Thatcher, who could not be suspected of not believing in markets, had also studied science and was able to convince her friend Ronald Reagan to accept the Montreal protocol.

Infrastructure tells a story

Investments in infrastructure are a good case of why the long-term is no small matter: first, infrastructure is very important. Without it, there is no economic activity worthy of a bank’s loan book. Infrastructure itself is also a big consumer of bank debt (approx. USD300bn a year of net origination). What characterises infrastructure is that it requires sinking a lot of capital into the ground with no alternative use and without prospects for a quick payback. Only because infrastructure can provide a service like transportation of energy provision for multiple decades is it possible to finance it, hopefully on a cost-recovery, ideally on a profit-making basis.

In fact, infrastructure is so important that it is amongst the highest priority targets for all the armies of the world. What if the evolution of the climate led to the regular disruption, undermining and even destruction of many of the world’s infrastructure assets?

You might say it is only a small part of investors’ books… but this is not the point. Just like an invading army takes out bridges and railways to paralyse its enemy, the impact of climate change in infrastructure will be to disrupt the entire world economy and to shrink it into a smaller pie.

Of course, infrastructure assets can be reinforced, and flood walls and heat-resistant runways already exist in many places. But this is the crux of the matter: not that humans or infrastructure assets cannot adapt to a harsher and less predictable climate, but that the more the climate changes, the more adaptation will be costly. This adaptation is a risky bet and may not be a good story.

This long-term is costly and unfair

The consequences of climate change may be hard to predict, but one of them is not: higher costs. Higher operating costs, higher insurance costs, higher capex, higher energy costs, higher transport costs, and a higher cost of capital for many businesses that will be faced with more uncertain prospects.

You say that central banks have spent too much time thinking about climate change and not enough about the return of inflation. But climate change is inflationary.

One wonders why you seem so surprised or outraged by the use of higher interest rates in central bank climate stress tests. You argue that central banks are doing this on purpose to tank the models and claim the headlines. But in a high-inflation, more uncertain world, why would the time-value of money not increase?

These increases in costs are also unlikely to be fairly distributed. Climate change may be a tragedy of the common people and climate action a struggle with the biggest collective action problem of all time, yet as you say, for all the talk of emergency, not everyone will face the same consequences. Climate change is highly regressive. Poor nations and people will suffer the most. Africa, Asia, and Latin America will take a beating and lose many of the development gains they achieved in the past century. 2050 could be the new 1850.

But opium trading is not what it used to be, even for Far Eastern banks. In a more dislocated, costly world, the benefits from international cooperation could fade. Trade is only a better alternative to war as long as the terms of trade remain mutually beneficial. There are plenty of periods of human history which fit that pattern: high costs and the likelihood of bankruptcy lead to underinvestment, a zero-sum game view of trade and the geopolitics that go with it.

The exact scale of these problems is a direct function of the extent of climate change. Whatever that is, it is not going to help pension funds stay funded. Probably there will still be bankers, but there could be far fewer of them (and no more sustainability marketing budget).

Look at the risks of your clients

While interest rates are likely to increase with climate change, you say that you do not care because the duration of your book is six years and what happens in the seventh year is not your main problem. However, banks are only financial intermediaries. The financial system is made of USD100 trillion in assets under management entrusted to pension funds, insurers, sovereign wealth funds and other private wealth managers. In other words, HSBC AM’s clients are longer-term investors than HSBC, because they have long-term liabilities like pensions and life insurance. For them, diversification and long-term liability-hedging are at the core of what asset management should be all about.

Your clients are concerned with the robustness of their liability hedging: we are not talking here about a 6-year duration, but about the very long term (GPIF has an investment horizon of 100 years). To better hedge their liabilities, more and more institutional investors have resorted to unlisted assets, from which they not only receive an illiquidity premium, but also benefit from cash flows that are considered stable and have very long lifespans. Unlisted investments in infrastructure projects are a good example of this strategy, with lifetimes of 30 to 50 years and thus horizons at which climate risk has serious practical implications. The first of these is that the asset still be capable of generating cash flows in 50 years, and therefore that it does not default.

Moreover, when we look at these investments in real assets, we find that they are generally quite concentrated, either geographically, by sector or both. The large lot size of individual investments, combined with the illiquidity of infrastructure companies (most of which are not for sale) and the urgency with which investors have had to deploy large tickets in the past decade all conspired to make the real asset portfolio of institutional investors look like anything but the well-diversified version that portfolio theory would suggest.

As a result, when climate risks materialise, many investors will find themselves over-exposed to asset-specific risks and potentially booking large losses. Understanding and better managing these risks today is not a small question that investors should “not worry about.” Quite the opposite.

Live stress testing: watch the news!

These days, if we want to have an inkling of what a disrupted climate future looks like for investors, we just need to turn on the news or look at your terminal. We have just lived through two disorderly transition dress-rehearsals in quick succession.

The first one, Covid lockdowns, which are the equivalent of a mandatory production and consumption cap imposed overnight and without warning. Without travel or workers, the economic impact was immediate. At one point, on a mark-to-market basis, investors in airports were losing 30% of the value of their investment (EDHECinfra). Still, the expectation was that lockdown would end and in the end the impact was limited because restrictions only lasted for so long. But what if they had remained in place forever? With climate change the disruption of airports is permanent and irreversible, capex and operating costs are permanently higher, but there is just less business (because of the weather!) and less profit. Perhaps none.

The second one: The invasion of Ukraine led to a 40% increase in the price of gas, power, and petrol, i.e., a de facto carbon tax very few politicians would have the courage to suggest, and one that was also imposed overnight. This is not only politically unbearable but also acted as the trigger for energy-driven inflation. Imagine telling investors in 1973 that they should not worry about an impending oil shock even though it could be predicted to last for the next 10,000 years… should they not have cared?

We are already in a world in which climate change proxies have consequences for investors.

And, to conclude, be aware that…

…your clients care about Miami and not only Miami!

What is most surprising in your position is that you seem to be alone in defining what is important.

You complain that as head of responsible investment you spend too much time on the topic of responsible investment when there are so many other more important subjects like cryptocurrencies or inflation. Denying the essence and the importance of one’s own mission in that way is perhaps brave. But this is not why your company decided to employ you. Working on sustainability matters because it is part of the investment objectives that are entrusted to your company by its clients.

Today, institutional investors see their very existence in many jurisdictions as conditioned by their ability to take the non-financial consequences of their investment into account. In this context, the climate issue is of primary importance. HSBC AM as a company has understood this and wants to be one of the preferred partners of institutional investors who are not only concerned about the consequences of climate change on the value of their portfolios but also on the impact of these portfolios on the climate, as well as its dramatic consequences for the future of the planet and its inhabitants. Such double materiality considerations are no longer just an idea: they are embedded in the rules, especially in Europe, whether it is issuers (CSRD and especially DPEF) or investors (SFDR). Double materiality concerns are also a market that justifies the investments that asset managers make to satisfy it.

Many journalists and even politicians have expressed concern about your suspension by HSBC AM, arguing that free speech is important in the public debate. We sincerely believe that they are missing the point. You did not enter the debate as journalist — who should be free to make any kind of comments as long as they have solid sources — but as a high-level representative of a company that, through you, wishes to take its share in serving investors concerned about investing responsibly. What could be more normal than suspending you from a function that you do not really wish to perform?

 

Noël Amenc, Ph.D.

Associate Professor, EDHEC Business School & Member of Advisory Board of EDHEC Infrastructure Institute

Frédéric Blanc-Brude, Ph.D.

Director, EDHEC Infrastructure Institute & CEO, Scientific Infra Ltd

 

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