Quantifying the Investing Risks of Climate Change (Episode 1, Dec. 9, 2021)

Welcome to The Green Investor Podcast powered by Investopedia. We are excited to launch this podcast and dive deep into the world of green investing. What does that even mean today, to be a green investor? We’re going to explore that on this show, but we are starting from the premise that there are investors out there who want to invest, along with their beliefs, about protecting the environment, investing in sustainability, the companies that are promoting, and slowing down and even reversing climate change.

The deeper we dive into the green investing theme, the more we’re going to discover that there is a lot of disagreement and confusion around and about it. There are debates about what fits in and what doesn’t? What’s greenwashing and what isn’t? What we’re also going to find out is that, in green investing, there isn’t a lot of black and white. It’s still evolving. And that’s what makes it so fun to investigate.

That’s what this podcast is all about: learning, discovering, questioning, probing, wondering, forecasting. We’re going to do all of that, with some of the smartest people we can find on this topic. Our guests will range from investors, policymakers, academics, entrepreneurs, C-suite executives, philanthropists, anyone who can help us gain a better understanding of what green investing is all about and where it’s headed.

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Meet the Host

Caleb Silver, Investopedia’s Editor in Chief, will be bringing you this podcast on Thursdays every two weeks. Caleb is a business journalist with more than 25 years of experience. He has led Investopedia since 2016. Previously he worked at CNN and Bloomberg, and he did work as a film producer. He got his start producing environmental educational videos and documentaries in New Mexico and South America.

Meet Spencer Glendon

Dr. Spencer Glendon has been studying climate risk for decades through his prior work with Wellington Asset Management and the Woodwell Climate Research Center. And he continues to focus on it, as well as solutions to the problems that climate change is presenting through the founding of Probable Futures, a platform for studying these issues and working on solutions.

What’s in This Episode?

At the core of the financial services and investment industry is the assessment of risk. How much risk are investors willing to tolerate in order to generate returns? How risky is an investment relative to other investments? How will political, economic, and behavioral risk impact returns over time? R-I-S-K, four simple letters that mean everything in this industry.

Climate risk is a new and critical component to investment returns and one the industry and policymakers have finally woken up to, but maybe they slept through their alarms. To discuss this further, we are delighted to welcome Dr. Spencer Glendon as our very first guest on The Green Investor Podcast. Welcome, Spencer.

Caleb:

“Tell us about Probable Futures. Why did you create it, and what is your mission with it?”

Spencer:

“Probable Futures is an endeavor to help people visualize in a resonant, meaningful, and useful way what climate change will bring, both the prospects that are unavoidable and also the ones that are avoidable in hopes of motivating, both preparedness, so managing the unavoidable, and mitigation, so avoiding the unmanageable. And it comes out of, as you say, a long history of my working on this topic. I used to work in finance in a very different capacity. I was hired by Wellington Management in 1999 in the wake of the Asian financial crisis. And Wellington didn’t know what to do about Asia. It had done very poorly, as many asset managers had, with the crisis, didn’t understand the region well, and hired me with a background in finance in odd places. I had been a banker in Central Russia, I had done things on the south side of Chicago, and I had a Ph.D. in economic history and urban economics, and I happened to speak Chinese. So they said, “Maybe you can figure out Asia for us because we don’t know what to do.”

“And so I had this unstructured job to consider what opportunities and risks might come out of a huge portion of the world that wasn’t very prominent in financial markets. And I had gone from that beginnings to becoming a student of how financial markets work, how financial research is done, and eventually, became the director of research at Wellington Management, where I was a partner for quite a long time. And I developed a practice for assessing issues that were not typically inside the boundaries of finance. Finance is extremely orthodox in its division of labor. You go to Goldman, UBS, any firm, they will have an auto analyst, an auto suppliers analyst, an oil analyst. There will be an analyst for each division. The same will be true in fixed income, but there was nobody to work on some topic.

“So, in 1999, that topic was China. No one worked on China because there was nothing to buy or sell. And I discovered that, if I worked on China, I could find insights that the narrow experts didn’t find. I followed that up by working on other topics. And about 10 years ago, I started working on climate change because it didn’t fit. That was my interest was because it didn’t fit in finance, it might have opportunity. And what I discovered was actually that the models that climate scientists had made in the ’70s, ’80s, and ’90s were phenomenally successful. I worked in an industry where, if your models were right 60% of the time, you could become fabulously wealthy. And I found this suite of models that had been excellent at predicting this entire suite of outcomes, not just average temperature but that nights would be hotter proportionally than days. There would be more record-hot nights than record-hot days because the greenhouse effect would trap the day’s heat. They had said where the temperature would rise more, near the poles than near the equator. They had talked about how that would change storms and other phenomena. There was this whole long list of things that were accurately predicted.

“And I realized these models are really useful and no one’s using them. And so I set out to figure out how to close that gap. And Probable Futures is as an endeavor to close that gap by making the results of climate models really tractable and really useful, whether it’s for financial purposes or for city planning, for agriculture, for understanding the bounds of nature, or just for imagining how we might live differently. And my conviction was I could have done it within a firm and had proprietary access to it. But what markets and society really needed were tools that everyone could share. You need common information for society to work, both as a civilization and as markets. And so this is a free platform that allows everyone to know what’s coming, and actually, where we’ve been because the data started in the late 20th century in a way that orients us to the physical changes the climate represents.”

Caleb:

“You mentioned Wellington Asset Management, where you began your career. That was also Jack Bogle’s original firm, the godfather of index investing. It’s been around for decades. And in that sort of an institution, where they’re thinking about value and long-term investing and index investing, the models for something that appears new or there are new data, like climate change, I can see that not fitting so well. Did you feel like you had to leave that industry to be able to do the work you wanted to do?”

Spencer:

“It’s a great question. And I’m grateful to my former firm for giving me this opportunity in a sense because my wife and I have been able to finance Probable Futures because of my good fortune in finance. But you ask a very good question. The people in finance who have been successful did so under a set of so circumstances and saying, “Hey, those circumstances are going to change. The world is going to change” is not a very welcome message to people who have been successful under one environment. So one of the things I say to people is that now, in finance, there’s really no one left who’s even experienced rising interest rates. Interest rates have been falling for their entire career. And so one of the things that I felt was necessary was finding ways to express how unprepared the entire system is, not just one firm, for the changes that climate change will bring.

“One of the ways I would say that is that people in financing, the United States, in particular, have been tremendously successful during what I would say was the easiest time in human history to be successful. Everything conspired to be extremely tranquil. So your listeners and readers are aware of low volatility for the last many years and falling interest rates, which raised asset prices. This whole suite of things, markets grew in all kinds of ways, and capital markets were rewarded. This is a kind of environment where the imagination for what constitutes a bad outcome gets limited. So if you read Ray Dalio’s books, you would think the 2011 European banking anxiety was one of the worst things that ever happened, but most people can’t even remember it. But for Dalio, his life experience is in a very narrow range of outcomes. But what I knew from working on economic history and reading longer history and having worked in places like China and Russia is, really bad things can happen, but those bad things are really outside the experience of the leaders of today’s institutions.

“So I found myself looking for more ways to reach people who could stretch the bounds of their imagination and could consider systemic risk, in particular. And I think that’s what you see when you look at the tools we have in other places is some tools or some ways of approaching climate change would be say, “Well, let me just look at my portfolio and see where the assets are. Oh, they’re going to stay dry. They’re fine.” But if you look with enough scope, you realize “I’m part of a system.” Everything is part of a system and that system is under strain. And if the system breaks, if you’re the only dry house in a neighborhood that’s flooded, your house is impaired. And this ability to back up, consider the scope, consider the system itself, led me to want to make connections with people who were connected to the wider world and who were willing to take a stand for governance for, as you say, sharing data and for collaborating. And I’m encouraged that since I left Wellington, they’ve been more collaborative, open, and pushing for governance. And so I’m hopeful that my career change was good for them as well.”

Caleb:

“Well, I’ve heard you speak about the fact that so many products and services in the investment industry have been set up without consideration for the impacts of climate change and continue to be marketed and sold to customers today as if the planet is not heating up and sea levels are not rising every year. I’ve heard you talk about the 30-year mortgage that comes to mind. Tell us more about these dangerous omissions or just the fact that they were never considered with the fact that we have a planet that is heating up, and we have climate change.”

Spencer:

“Sure. So I think that the most important thing I can convey to your listeners is something I didn’t know until I started this work about 10 years ago. And that’s that, for 12,000 years, the Earth’s climate was perfectly stable. Until that time, the Earth’s climate was all over the place. And humans emerged about 200,000 years ago into a climate that was wild. And that’s why they were nomads. Early humans followed good weather. They had to chase the nice places because the nice places kept moving, but starting in about 10,000 BCE, the climate stabilized. And it stabilized at a level that was just perfect for us. Nowhere on earth was too hot for a human being. Some places were hotter than you and I might prefer, but nowhere threatened our health. So there was this very narrow band starting about 10,000 BC that continued into the industrial age that was so docile, so smooth that it founded the basis for civilization. The nice places stayed nice.”

Spencer:

“And we started thinking about the world. You can say, “Well, New York is this way.” And what you mean by it is, it is this way. It’s hot in the summer and cold in the winter. That implies it always was and it always will be. It’s a permanent is. Well, that kind of permanence is embedded in every part of civilization now. So the building you’re in has engineering standards. They were all based on backward-looking data. Now, backward-looking data about how hot it would get, that determines the HVAC system size. How much rain you would get, well, that determines the size of the sewers and the drainage, and the height of the curves. All of those things are actuarial because it turned out if, in a stable climate, if you look backward, you know the future. So we have all of this physical infrastructure around us that is built on the assumption the future will be like the past. And that assumption we now know is wrong, and we can do better than that assumption by planning.

“But if you look around the world… So take the United States. There are grades of cement or concrete that are for roads. And in the south, they are for hotter temperatures. In the Midwest, in the middle latitudes, it’s for milder temperatures. And in the higher latitudes, it’s far colder. So they’re grades of concrete that change with latitude as you move from Mississippi up to Minnesota. All of those grow raid of concrete and asphalt are now probably obsolete because they were built for a range of standards that are now being violated. And those violations are happening in all kinds of things. Now, some people say, “Well, we can just adapt.” Well, we could adapt. We’re not adapting much. And my point, with regard to adaptation, is we can do way better if we look ahead.

“So you asked about the 30-year mortgage. Let’s take Florida as an example. Florida is built on porous limestone. It’s basically all crushed coral reefs. And as Jeb Bush once said to me, “When the ocean rises, it pushes harder.” It’s heavier. It pushes harder on that limestone and infiltrates. So Miami now floods not from coming over South Beach but from the sewers. Now, that’s an infrastructure challenge that the whole state faces because their aquifers can become saline. They have all these other problems. Plus, it’s becoming hotter and wetter there. Well, the implications of that, people say, “Well, insurance is going to disappear.” Now, that may be true, but insurance companies have made no commitment to anybody.

“They offer you a one-year term that they can change every year. The real risk is what’s not insurable. And so I’ve talked to people at big reinsurance companies about this, who are among the most insightful about this. And they say, “Look, the first time there’s a storm or a flood, it’s an insurance problem. The second time, it might be an insurance problem, but the third time, it’s an equity problem and a debt problem,” because what happens is the insurance for the building you’re in, for example, which is probably very valuable, the insurance is just to replace the windows and the doors, maybe to de-mold the basement. But the real value is the land.

“There is no insurance for that piece of land, that location. And the reason it becomes an equity or a debt problem is what happens to that house in Florida or in New York or elsewhere is expectations about the future go down, and the willingness of other people to take 30-year risk goes down. The willingness of other people to make commitments of 30 years goes down. If you’re buying it, you’re a prospective buyer, to whom you’re going to sell it in the future, you have to wonder how much confidence they will have in the future when you are ready to sell. And so what I try to tell people is that climate change, in finance terms, is about duration and location.

“The more climate change we face, the less reasonable it is to offer duration because there is more risk, more uncertainty in the future. And that risk is proportionate or depends on where that location is. And one of the bad things that modern finance has done, that modern society has done, in general, is abstract from place. So I’ve worked with lots of banks and insurance companies, and often, they don’t really know where any of their assets are. Then, you take Fannie Mae and Freddie Mac, the big mortgage agencies run by the U.S. government, they have rules for what is a conforming mortgage that have nothing to do with place. They are just abstract. And so I think bringing place back into the conversation about assets and then talking about duration, are ways to get people oriented around climate change.”

Caleb:

“You can see it in the money flows into what we call ESG, Environmental Social Governance funds, or SRI, Socially Responsible Investing, these related assets. Even though these acronyms and investment vehicles are being sold, they’re rife with inaccuracies, and there’s some greenwashing in there, but you can’t deny that some investors want to put money to work in a way that aligns with their environmental and ethical principles. How does the industry encourage that in the right way that’s not greenwashing that is relevant to the science that you are seeing and exploring?”

Spencer:

“It’s a great question, and I think it’s not yet fully answerable. I don’t know what the answer will be. What I would say is that the quick answers people have sought have been really unsatisfying. And so what you describe as greenwashing, I think, is very accurate. Another is why we created Probable Futures the way we did. I actually provide pro bono consulting to institutions that are willing to do things publicly for the public good. So I provide guidance to some CEOs and some other organizations, not that I’ll get any credit for it or get paid for it, but on the condition that the work we do together be made public. And I can’t stress enough that it’s fine for people to change their portfolios or incorporate some new data to improve returns, but changing the system is what has to change.

“We need better regulation. We need better benchmarks. We need better standards. And those need to have public data associated with them, not some private black box that says, “Oh, we hired somebody and they’ve looked and our portfolio is clean, or we hired somebody to get us to net zero. We haven’t changed our behavior in any way, but somebody somewhere has planted something, and it gives us the permission, the offset, to expel carbon.” And so I think there are two things that are essential in the financial markets. One is much better disclosure and sharing of data.

“The other, I think this may be controversial, but I think climate change should be taken out of ESG. ESG is a complicated set of ambitions, and climate change, while it can fit in those set of ambitions, is very clean scientific data. It is physics, essentially, as opposed to a set of social behaviors. And so considering climate change on its own and climate science as an input, having it be a standard input, whether it’s in a Bloomberg terminal or on Investopedia, having climate science and climate implications, as well as carbon emissions, just be an orthodox input, not part of a special sauce that is sometimes applied, I think is essential.”

Caleb:

“Spencer, you’ve worked in the industry. Are wealthy investors ready for this kind of change? This is the way they know how to invest. This is where their money is. And even though energy is a much smaller component of the S&P 500 and energy stocks are smaller than the big tech stocks that are out there, this is where a lot of money lives. Are wealthy investors going to be ready for this kind of change, or ready or not, it’s coming?”

Spencer:

“Oh, I think ready or not, it’s coming. I’ve spent now four years outside of the investment business working on these issues, from different angles, still in contact with the industry. And I would say that the finance industry is less of a leader than some people might want to think. So you’re in Manhattan, and a lot of that infrastructure that’s around you was built by regulation. So the ’40 act, for example, created the pension industry, the retirement industry, the mutual fund industry. Without those kinds of regulations, you wouldn’t have an industry the way you do. And so I think that financial markets can be very responsive to changes in rules. Will they be responsive to changes in opportunities? Some of the time, but I actually think they’re more responsive to changes in rules. And so my main interest is in whether those wealthy investors, who want some outcome in the future, are willing to politically, not just financially, to say, “We need rule changes in order to keep enjoying the civilization that took so long to build.” Whether they’ll do so or not will dictate a lot of not only what happens but how they’re remembered.

“And I think the people who are concerned, principally, with their financial wealth and not their reputational wealth, not their relational wealth, not their relationships with other people are going to be very sad. Perspectively, I can’t tell you how many people in finance come up to me and say, “I just want you to know my daughter’s studying ecology. I just want you to know my son is studying climate science. I just want you to know that my child is doing this thing about climate change.” And I ask them “Well, what are you doing?” I said, “Well, I’m just proud of my son or I’m proud of my daughter.” I said, “Well, I don’t know if that’s going to be enough for them because you have power. They don’t. They’re the ones in school.” And so people exercising this moral responsibility, this ethical responsibility that happens also to be self-serving in terms of maintaining the financial system, I think is very powerful.

“I gave a speech at a conference in front of hedge fund investors in New York a couple of years ago, and all of these famous hedge fund investors came up to me afterward, and they all told me about their children and their summer homes. That’s what the conversation was about, not their portfolios. And I think one of the things that have been hardest about climate change, for people in finance, is it’s the first issue that comes home with you. Having a view about Pepsi versus Coke or IBM versus Wang, computer or Apple versus IBM, well, those take fortitude. Being an investor will give you ulcers. It is stressful. It is hard, I fully acknowledge. I felt those feelings in that work, but at the same time, that didn’t really have anything to do with your life at home. Whether you were long or short, Pepsi or Coke didn’t affect your relationship with your kids or your siblings or your other loved ones or strangers.

“Climate change isn’t like that. And I’ve had portfolio managers come up to me and say, “This is the first thing I’ve had to do that’s really serious.” Finance sits on top of a set of rules and regulations, which sits on top of nation-states and governments, which sits on top of cultures and customs, which sits on top of communities, all of which sits on top of climate stability. And if the very bottom gets rocked, the top is going to fall hard. And so thinking about this less as a finance and more as a civilization problem can be clarifying. And I hope some of those wealthy families realize that the way to act isn’t just through their portfolios but to act as citizens.”

Caleb:

“Currently, Spencer, there’s an intense debate about net-zero approaches, which move polluting around but doesn’t really diminish overall emissions, and carbon trading is in that camp. And those who say, “It’s an ineffective strategy. “We don’t have enough time for this.” Where do you fall on this?”

Spencer:

“I think that we are at a point now because the glaciers are receding so much because already there are fires in the forest we need to rely on, that our approach forward has to be a lot of everything. There was a period of time when just a carbon tax might have been enough to steer us away from many of the worst outcomes. We’re beyond that point. Even if there were now an aggressive carbon tax imposed, it’s very unlikely to be effective or sufficient in the scope that we need it. It is part of a solution. Lots of things are part of a solution, building codes, other things like that. What is clear is there is no one way to just pay somebody else to take care of it for you. There is not the capacity to net-zero everything without changing behavior radically.

“I think that the first wave of people into net-zero buying offsets are going to quickly find that the door may have closed behind them very quickly because there aren’t that many offsets to buy, or that they need to spend a lot more money to invest in technologies that might possibly have that effect but that being a first-mover allowed you to maybe buy some real carbon credits and expand some forests somewhere. But very quickly, that opportunity set dries up, often literally in the form of drought, and new avenues have to be explored.

“The last thing I’d say about it is people are learning to use this term net-zero, and I think that’s fine, but the net isn’t that you get your own net-zero and I get my own net-zero. It’s that the planet has to be at net-zero. And so I’m at net-zero, but somebody else is not a solution even to my problem. And because now there are emissions from permafrost and there are emissions from forests, humans have to start targeting net negative. And we can’t get there immediately. We don’t know how to get there immediately, but I think setting our sites on a very ambitious goal, as opposed to a small amount of engineering, is going to be important because, for financial markets, in particular, we need to start conceiving of huge amounts of money to be invested, trillions and trillions of dollars, so more money than used to go into energy all together to make this happen.

“There are productive things to do with it, and there are real opportunities to do with it, but they need to grow fast. Thus far, what I would say is that people have tried to seek net-zero without it costing them more than a subscription to something. We need real capital allocation on a very large scale, and we need very smart people to figure out how to do that. And so, if you want to think about a way that capital could really change, it’s financing large-scale carbon reduction, energy transition in ways that aren’t being done now and don’t look anything like the first passes at net-zero but are moving trillions of dollars into new opportunities that can provide stability going forward.”

Caleb:

“Let’s go out on this because this is The Green Investor Podcast, investors, as you know, especially younger investors, seem to want to invest along with their environmental and ethical values. We’ve surveyed our readers. There are so many of them out there that want to do this and do this right, but how would you guide them to do this the right way or at least begin the research process the right way so they’re headed down the right path.”

Spencer:

“I think the simplest way to start… I give this advice to young people. It happens to be the exact same advice I gave when I worked at Wellington and talked often with chief investment officers of some of the largest pension funds in the world is that not financing fossil fuels may seem simple, but it’s a really big deal. And the reason it’s a big deal is that it’s breaking away from the idea of the index. And what I said to chief investment officers was “You’ve committed yourself to every part of the market by choosing this benchmark, and fossil fuels are the one industry I can tell you, with high confidence, has a zero terminal value and high volatility.” Now, if I tell you there’s an asset that had zero terminal value and high volatility, why would you forcibly dedicate a big chunk of your portfolio to it? Then, what’s happened in the ensuing years is that that index has gone down and down and down. Now, for a truly seeking profit-only investor, maybe it’s not an absolute. Maybe you say, “Oh, this is high volatility and when prices are very low, I’ll jump in and jump out.” But being committed to financing an industry that is going towards zero is a pathology we don’t need to follow.

“The same is true about geography. So I’ve talked to people in insurance industries and in lending and they say, “Well, would you just recommend we stop lending in places where the future is uncertain?” I said, “Yes, just stop doing that.” They say, “But we have to be everywhere.” Well, this compulsion to be everywhere and in everything is a product of modern portfolio theory. It’s one of the core tenants of index investing. I understand why it has worked well, but it worked well in a time when everything worked when everything was stable when the future was truly unknowable, but the future is now much more knowable thanks to climate science. And you can avoid the worst of it.

“I think the second part of this is that getting investors to ask good questions, to change the norms of finance, I don’t think that impact investing has had much impact or that ESG investing has changed the world very much, but people pushing for those things has changed the mentality of corporations, and they need to keep pushing. So being satisfied and saying, “Well, I’ve found the best of the lot of not very good social investment funds” is probably the best thing to do for a young person who cares about these issues with their money, but with their emails, with their time, keep pushing like, “I will buy this, but I want something better. I will invest in this, but I demand a higher standard.” And so I think that pushing those standards, pushing that expectation, the people in these C-suites are influenceable. They care what you think. They care what you think as an investor. They care what you think as a customer, and they care what you think because young people are going to take over, and they will judge their predecessors.

“Within firms, within the business, I tell young people to approach management directly. And what I say to management is, if you’re in a room full of people who are all over 45 years old, you’re probably making bad decisions. If you’re not including young people who will live with the consequences, you’re giving yourself a break that you don’t deserve and that the institution doesn’t deserve. And so investing can be part of it, but this is a participatory problem, and the good news is everybody can participate.”

Caleb:

“We are all in this together one way or the other. And hopefully, the investing industry is also waking up to this. And we really appreciate your time and insight. Spencer Glendon, the founder of Probable Futures. Check it out. We so appreciate you joining us for our inaugural episode of The Green Investor. Thanks so much.”

Spencer:

“You’re welcome, Caleb. Thanks so much. Best wishes.”