Ten years on from the financial crisis, it only seems appropriate to discuss another market failure of similar proportions. In August 2007 few could have foreseen how Wall Street banks would manage to move the goalposts of capitalism on a universal scale.
It was then that BNP Paribas opened Pandora’s box, informing the market about the freezing of three funds exposed to US subprime-related securities due to “the complete evaporation of liquidity”.
Yet the day of reckoning only came for taxpayers (i.e. the ECB immediately pumped €95 billion to fix the mess), and ever since they have been forced to step in to the rescue. But pension funds also felt the heat, for example, CalSTRS’ net assets decreased 27%, from $161.5 to $118.4 billion, by 2009.
Such kind of market failures is possibly what makes CalSTRS’ CIO Chris Ailman sleep like a baby at night (waking up in the middle of the night screaming, as he said recently) knowing there are thousands of retirement checks to be paid monthly.
Now, when the clock is ticking to meet the Paris Agreement’s 2° goals, another market failure is brewing: carbon pricing, or perhaps lack thereof. As Ailman put it to that very same audience: “First give me a price on carbon, and then I’ll start worrying about stranded assets”.
This comment was made in passing, and was picked up by RI from his lecture at the CFA Institute in Chicago, entitled ‘ESG – Does it add value?’ immediately prompted reactions from our readers.
One remarked to RI: “Does Chris Ailman really need a dollar amount labelled ‘carbon price’ before he’ll worry about stranded assets? You already have an effective price on carbon across the market. It’s like the parable of the flood…”
So, what did Ailman really mean and what would his answer be?
“Your magazine and readership are important to me. I would answer them: I either need global regulatory action or some price. I don’t need a specific price but some price on carbon emissions, otherwise people will continue to burn, to pump up those assets,” Ailman says.
For Ailman, a self-declared “market guy”, there is not much hope that politicians, “who are going to change constantly” would have “the guts” to solve a problem, which primarily involves changing market behaviors.
“Right now burning carbon is free. When people in the US pay a fee to dispose of water waste, they start paying attention and managing it. We believe market mechanisms work and are stronger than any governmental agency action.”
But how can CIOs like Ailman discover some indication of prices, in the absence of a specific one or at least one that captures the scale of the problem?
“You are seeing a price with California’s carbon exchange, Europe has one, there was one generated for a little while in the US…but nobody has come and said that you have to pay a price. There aren’t enough enforcements.”
He adds: “The Paris Accord was a wonderful achievement but we all knew, as we celebrated, that now all comes down to implementation – and elected officials who actually adopt these regulations and take action.”
The scale of the market failure and the challenges ahead are well documented, for example by the World Bank and Ecofys in their report Carbon Pricing Watch 2017. Currently, 85% of global emissions are not priced and about three quarters of the emissions that are covered by a carbon price are priced below $10/tCO2e.Below that $10 threshold are the EU ETS and the eight Chinese pilot schemes deployed so far. Not much further up, at about $14/tCO2e, are the mutually linked systems of California, Québec and Ontario.
The notion of market failure is also suggested in the report of the High-Level Commission on Carbon Prices, co-chaired by Nobel laureate Joseph Stiglitz and Lord Nicholas Stern.
The Commission was set up to “explore explicit carbon-pricing options and levels that would induce change” in investment behavior to deliver on the Paris objectives as well as the Sustainable Development Goals.
The report touches on the need to consider “market and government failures other than the climate externality” and concluded that “the explicit carbon-price level consistent with Paris temperature target is at least $40-80/tCO2e by 2020 and $50-100/ tCO2e by 2030”.
The Stiglitz-Stern Commission, as well as Ailman, emphasize the importance of political and institutional leadership to “develop readiness” for the carbon-pricing agenda to advance at the domestic level.
While Ailman says “Paris isn’t dead” despite the US having “a president who is going the opposite direction, celebrating coal”, many will look to Ailman and his peers at the top of leading investors for leadership.
Notably, the Commission calls for the removal of fossil fuel subsidies ($650bn globally in 2015, according to IMF estimates), which it describes as being “perverse policy incentives” and an important part of carbon pricing.
At a time when the divestment movement is gaining traction calling on institutional investors to fully decarbonise their portfolios, it’s not far-fetched to draw an analogy between states’ subsidies and investors’ fossil fuels holdings.
Worth noting is that Washington DC’s $6.8bn public employee pension fund already divested its $20 million fossil fuel investments, yet reported a net return of 9.3% for the 2016 financial year.
Ailman, however, is not for such an investment strategy, which he dubs as a last resort; he is, rather, a staunch supporter of engagement.
He explains: “In the US we buy the whole market in an index fund, and so it is not that we choose to specifically own one oil company over a technology company, but we engage them to try modify their behavior.”
Ailman continues: “Divestment in the last 30 years has not brought about any social change. People want social change, which I applaud, but they have to go by other means. You are not going to starve these companies of capital, there is so much capital in the world. You have to bring about consumer change.”
Tackling the question on carbon pricing, Mark Campanale, Founder and Executive Director of Carbon Tracker, the organisation that popularised the concept of stranded fossil fuel assets, says: “There is of course widespread and common acceptance of the need for a carbon price, so that markets have something tangible to see deployed that might reduce demand for fossil fuels.”
But carbon pricing, he says, is “a simple tool”. “In our view, asset stranding can occur and it doesn’t necessarily happen because of a carbon price.”
The second part of this article will look at the CDP, the Taskforce on Climate-Related Financial Disclosures … and look ahead to COP23.