Credit Crunch versus Climate Crunch
In this post from the book NET-ZERO:
What are tipping points? When complex systems move so far from their original state that small impacts can create large system changes.
What are the physical tipping point risks from climate change? The risk of a weakening land-ocean sink, melting tundra, Amazon rainforest dieback, ice sheet collapse, and the breakdown of ocean circulation currents.
What does the credit crunch have in common with climate change? Underestimating tail-risk, sub-system collapse, and systemic breakdown - why the carbon crunch could be ten times worse than the credit crunch.
Problems with Predicting the Future
The climate, the economy, and the structure of society are complex systems. With so many interconnections, dependencies, feedback loops, and self-referencing dynamics, they are impossible to precisely model and predict.
Despite the huge development in computer processing power, we simply cannot fully capture every interaction in these systems. Instead, we must simplify the system so we can make good short-term predictions and identify longer term trends.
But at some point, our original system moves so far from its original state that it hits what’s called a tipping point and becomes completely unpredictable.
Tipping Points & Unmanageable Change
Thomas Shelling, a Harvard economist, was the pioneer in modelling tipping points. His 1971 work on racial segregation of neighbourhoods suggested that when neighbours of a different colour, settling in a predominantly white neighbourhood, reached a certain threshold, this created a “tipping” or acceleration towards total segregation as white residents began to rapidly leave.
He described the tipping point as a small change in some variable which results in a large system change.
The idea of tipping points or accelerated change is common across many systems from banking runs to political endorsements, or rapid changes in ecosystems. But the more complex the system, the more difficult it is to identify at what point the system will tip.
Just as we struggle to predict economic crashes and election outcomes, so we are likely to miss many of the possible outcomes of climate change and here are just a few:
Underestimating Tail Risk Gaussian distribution functions or bell curves are often used to describe the probabilities and risks of a natural system. A good example is the frequency of temperature anomalies in the Northern Hemisphere. Unusually hot or cold days are distributed around an average temperature in the form of a bell-shaped curve. Over the last 40 years the whole curve has moved higher by 1⁰C (the average temperature increase), but the curve has also widened: the chance of extreme heat events has risen exponentially from 0.2% to over 10%. Get the exact shape of the bell curve wrong in forecasts and we underestimate the tail risk of physical events such as extreme weather and natural catastrophes.
Sub-System Change As temperatures rise, this impacts all aspects of life. Management consultancy Mckinsey define the five key sub-systems for sustaining life as: liveability & workability, food systems, physical assets, infrastructure services, and natural capital. The change in these sub-systems is unlikely to prove linear and equal. As temperatures and physical stresses increase, regional sub-systems will not simply deteriorate at the same rate, but they will at some point completely collapse. Global averages become meaningless if individual regions break down, and forecasts could prove materially wrong.
Systemic Breakdown Rising physical change, exponential tail risk, and sub-system collapse will at some point push the entire economic and social system past a point at which we risk either accelerated physical change, economic crisis, pandemic, or global conflict. Even a combination of all four. This means our estimated death toll and economic burden skyrocket. It is the risk of this unprecedented, unpredictable change which skews our damage predictions for climate change into two binary outcomes – manageable change or unmanageable change. This could be the difference between human civilisation continuing to drive increasing prosperity or spiralling back into the Malthusian poverty trap.
Left shows distribution of anomalies in summer temperatures over different time periods. Right shows sub-systems. Adapted from Mckinsey Global Institute
Will the World Tip?
The consensus amongst scientists is that tipping points for many physical climate systems lie somewhere beyond 2-3⁰C warming. This is where the rate of change could accelerate due to biosphere feedback mechanisms which include:
A weakening of the land-ocean sink which has so far removed about half of the CO2 humans have pumped into the atmosphere. Less CO2 removal means more warming.
Melting of The West Antarctic Ice Sheet from warmer waters below and large areas sliding into the ocean, accelerating sea-level rise.
A large release of methane from the melting arctic tundra. Leading to faster than expected temperature increases.
Amazon rainforest dieback as rising temperatures disrupt the natural evapotranspiration systems which maintain the forest’s humidity.
Weakening of the Atlantic Meridional Overturning Circulation (AMOC) as fresh water melts from the polar ice sheets and disrupts the system of ocean currents reliant on salinity and temperature variation across the world’s oceans. This could rapidly alter the weather for Europe and large areas of the World.
Whilst the risk of accelerating physical change is all too real, the risk of social and economic tipping points also looms large, and could perhaps arrive even sooner. Financial markets don’t operate on what happened in the past, but rather what is expected to happen in the future. If the physical effects of climate change arrive sooner than financial markets expect, this will very quickly become reflected in lower prices for real estate, shares, and commodities. If it happens too quickly, this can destabilise the whole system – a so-called carbon crunch.
The Credit Crunch
The financial crisis or credit crunch in 2008 serves as a good analogy to the unknown economic risks of a changing climate.
In the run up to the financial crisis, the global economy had been through a period of rapid expansion. Confidence was high. Consumers, business owners, and governments saw no end to the strong growth and continued to borrow more money to spend on houses, industrial equipment, and infrastructure.
Investors, banks, and mortgage companies were also caught in the boom mentality and more than happy to extend more credit or lending in order not to miss out on ever greater returns. Incomes were rising, house prices were increasing, and share prices kept beating all-time highs. The economy was in a positive or amplifying feedback cycle – more growth, more confidence, more credit – a bull market.
But with every debt cycle there comes a point where that extra borrowing returns little extra income. You already bought the new car to get to work faster, the new machine that builds widgets faster, or the new shipping terminal to export more goods. Soon the additional debt repayments start to outweigh the additional income and growth grinds to a halt – it turns to a negative cycle of slowing growth, reduced confidence, and credit dries up further, thus shrinking the economy – a bear market.
If this happens slowly and is well managed, most people will barely notice, and the economy can reset. But the intersection of risk factors in 2008 meant that the economy hit a tipping point and that forced unmanageable change.
Wall Street (Unsplash by lo lo)
The first mistake was underestimating tail risk in the housing market. Mortgage companies had started lending money to high-risk borrowers without the proper checks to ensure they could meet their repayments: sub-prime mortgages. This debt was being offloaded to investment banks who would combine it with debt from cars or credit cards to create collateralised debt obligations or CDOs. The idea is sound – different streams of repayments mean the chance of a large number of defaults in one CDO is lower. Overall the debt is less risky. Rating agencies could rubber stamp CDOs as investment grade and the banks could sell them on for a fee.
But the problem was not with the idea but in the maths. Derivative risk is calculated using Gaussian functions or bell curves – just like impacts from climate change – and bankers had underestimated the risk of default. CDOs with too much exposure to bad housing debt or CDOs made of bundles CDOs (CDO squared) skewed the maths and these investment products were way more dangerous than everyone thought.
“Derivatives are financial weapons of mass destruction”. Investor Warren Buffet writing in a 2002 shareholder letter,
Next came the sub-system collapse with the downfall of Lehman Brothers, a US investment bank founded in 1850. Lehman’s had been aggressively expanding and had built up a massive sub-prime and CDO business. When homeowners ran into trouble on their repayments and mortgages started defaulting, the financial world realised the value of those CDOs was significantly lower than originally thought. The price of CDOs or any asset (houses, shares, bonds, gold, or currency) is simply the last price agreed between a buyer and a seller. So as the confidence in the investment return of CDOs fell apart everyone rushed to sell at the same time. With no buyers in the market, prices crashed. Lehman’s had underestimated the risk; they weren’t holding enough cash or liquid capital to weather the losses and the bank collapsed.
No private financial bail-out was found to save Lehman’s and the government took the view the bank should be allowed to fail. What the authorities didn’t realise was this event would prove to be the tipping point, the final straw, which would lead to systemic breakdown.
The financial sub-systems lost trust in one another, transactions ground to a halt, liquidity dried up, no-one was willing to extend credit to the economy, and the initial slowdown in growth turned into an economic collapse or credit crunch. The total collateralised debt obligation market was worth $2 trillion dollars at peak and an estimated half of these products defaulted. Global GDP declined by 5%, millions of people lost their jobs, and the value of global stock markets halved.
The Carbon Crunch
Returning to our climate change analogue we know there is tail risk, sub-system risk, and ultimately systemic risk of socio-economic collapse. But how does the value at risk compare if we turn our focus on to climate?
Let’s start with fossil fuels. If we discount the future revenues from coal, oil and gas reserves over the reminder of this century, that’s a total of $100 trillion of sales in today’s money.
There are 1,000 billion tonnes of coal, 200 trillion m3 of gas, and 1,700 billion barrels of oil reserves which have been discovered and can be easily extracted. Enough to last out the century based on our peak emissions profile and worth $90 trillion, $25 trillion, and $130 trillion of revenue, respectively.
Assume the fossil fuel companies can make a 10% profit and that’s $10 trillion to the bottom line. Burning these reserves would release 4,000 billion tonnes of CO2 into the atmosphere and raise temperatures by over 3⁰C. To keep warming below 1.5⁰C we could use at most half the oil and gas and just 10% of the coal. That’s $75 trillion of revenue and $7.5 trillion profit left stranded.
But fossil fuel write downs are just the beginning. Fossil fuel power stations and generation equipment add another $15 trillion of assets. There are $20 trillion worth of cars, trucks, and planes which run on oil. Coal and gas-powered industrial equipment is worth more than $20 trillion. Plus another $5 trillion worth of gas boilers, cookers, and general equipment. A total of $60 trillion of assets which run on fossil fuels – how many will have to be decommissioned before the end of their useful life? Will there be even more stranded assets?
The carbon crunch is a scenario where inaction or rapidly accelerating physical change forces the world to switch away from fossil fuels in an extremely short time frame. The transition would be chaotic, with energy shortages, skilled labour shortages and businesses, governments, and consumers unable to adapt fast enough. The result: a large devaluation of that total $70 trillion pot.
Beyond this first wave of destruction, future damages (already locked-in) become increasingly ominous. Our discounted damages to 2100 add up to more than $160 trillion dollars; does the world simply write-off the coastal property, agricultural lands, and human capital in the worst exposed areas? The carbon crunch could lead to mass job losses, bankrupted businesses, failed governments, and breakdown of financial systems.
Tail risk, Sub-system collapse and systemic breakdown events for the 2008/09 Credit Crunch and the potential elements of a Carbon Crunch. CDO = collateralised debt obligation. Post Lehman losses reflect market declines immediately after Lehman Brothers collapsed. Lost Wealth is the reduction in Global household wealth between 2007 and 2008. Fossil fuel stranded assets are 70% of the future $10 trillion profits on fossil fuel reserves (in today’s money). Fossil fuel reliant assets are the present value of power plants, vehicles, industrial equipment, and home/commercial appliances which rely on fossil fuels. Damages from warming represents the present value of future climate damages to 2100 under a baseline inaction scenario using a 3% discount rate.
“Companies that don’t adapt {to climate change} will go bankrupt without question”. “The longer the adjustment is delayed in the real economy, the greater the risk that there is a sharp adjustment”. Mark Carney, the former head of the Bank of England and now the UN envoy for Climate Action.
