Arbitrage Won't Stop Climate Change: Kate Mackenzie

(Bloomberg) -- The world’s biggest asset manager has a plan for avoiding the worst effects of climate change.

The way BlackRock Inc.’s chairman Larry Fink described it earlier this month, his decision to put climate change at the center of decision-making around the company’s $7 trillion portfolio is about giving clients better ways to manage risk. “Climate change is  now becoming an investment risk,” Fink said in an interview on Bloomberg TV, making it no different than looking at the yield curve. “It was very clear to me now we need to bring forward better risk tools.”

It’s an enticing vision. The costs of climate change will very likely be vast and pervasive, but could strike in wholly unpredictable times and places. California utility PG&E Corp. went from a market capitalization of $25 billion to bankruptcy over the space of a couple of months after one of its transmission lines sparked the disastrous 2018 Camp Fire. By combining historical weather information with forecasts generated by global climate models, it might be possible to produce a map indicating where global warming will do the most damage—and set prices for insurance, municipal debt and commercial finance accordingly.

The concept has been around for perhaps a decade, and was arguably preceded by the use of catastrophe modeling in the reinsurance industry. But it’s become wildly popular only in the last year or two: In 2019, Moody’s acquired 427MT, a privately held California company that specializes in using climate and catastrophe models to create actionable financial analysis. AllianceBernstein, with $592 billion under management, is requiring senior portfolio managers and analysts to undergo training about climate science. Neuberger Berman, with $356 billion, has three climate scientists on staff. At least a handful of additional companies doing so has emerged in the past few years, some with venture capital funding.

BlackRock, too, has been exploring this new form of financial information. In a report with consultancy Rhodium Group last year, it attempted to lay out “detailed, actionable information” to identify where climate change posed the greatest risks to buildings, people, crops and infrastructure.

For a huge investment manager such as BlackRock, the allure of highly complex weather and climate models, together with big data on physical assets, is obvious. It’s a perfect example of information arbitrage opportunity, one that favors those that can outspend smaller rivals. But investors hoping that a large enough dataset will be able to eliminate their climate risks are likely to be disappointed. Ask any short seller whether knowledge that an asset is mispriced is sufficient for an investor to make money from the mispricing.

The longer-term problem is that BlackRock, and others in the business of managing or advising on vast financial assets portfolios, might not be able to make this climate impact arbitrage work for very long. For a while, BlackRock and other investment managers could take a “best in breed” approach: the utilities that are more resilient due to better equipment or governance and the municipal bonds and commercial mortgage-backed securities that aren’t in such places, say, as Miami, where sea levels could be nearly three feet higher than historical levels by 2060.

Even in the short term, identifying those investments will be tricky—but the more important question is: What happens when the climate-safe assets run out? Problems in one municipality are likely to lead to contagion in others that are adjacent or have similar characteristics. Expensive bailouts from higher levels of government for one district will leave less funding for adaptation in other regions, even as perceived risks go up everywhere.

The one-way nature of climate change makes this even harder to cope with. As Reserve Bank of Australia Deputy Governor Guy Debelle noted last year, economies have in the past tended to bounce back from disasters because such catastrophes are cyclical, with the situation returning to normal afterward. As climate shocks increase with atmospheric warming, that ability to recover is less certain.

The bushfires that have burned through more than 10 million hectares of Australia in recent months are an example of just such an event. Australia boasts many eminent scientists who’ve done pioneering research into extreme heat, rainfall patterns and other climate factors that can exacerbate fire risk, and has heard warnings since at least 2007 of increasingly long and intense fire seasons manifesting as early as 2020.

If these represent problems for Australia—one of the world’s richest countries, with top marks from all major ratings companies—they’re going to be even more profound issues for emerging economies that have poor access to capital markets as it is. Insurers have long warned that climate change could shrink the “insurable universe,” and this is an industry that has paid more attention to climate change impacts than to asset management. It’s not clear what might happen when even the most nimble, risk-tolerant investors are scrambling for climate-safe assets.

The best solutions to the problems facing us will be not purely technocratic but systemic. If BlackRock really wants to help clients to minimize climate risks whether they’re using active or passive products, it might focus less on picking winners and losers from global warming and more on halting climate change’s advance in the first place. While the firm has committed to curtailing thermal coal-based securities in its actively managed funds, that narrow exclusion is unlikely to shift the needle dramatically when commercial miners are already a rapidly shrinking sector. Reviewing its appraisal of the role of natural gas in a shrinking carbon budget and taking a closer look at other sectors such as transport and industry would be far more significant. Using its proxy voting power on climate change-related resolutions, rather than hiding behind opaque engagement and protestations about agency, would be another. Such actions would be understandably uncomfortable for BlackRock, but leadership in a warming world is unlikely to be easy for anyone.

Kate Mackenzie writes the Stranded Assets column for Bloomberg Green. She advises organizations working to limit climate change to the Paris Agreement goals. Follow her on Twitter: @kmac. This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the editor responsible for this story: Jillian Goodman at jgoodman74@bloomberg.net

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