The Climate Short: how big a gamble?

It was only when I started working for a macro hedge fund, a decade ago, that I really understood “Franklin’s gambit”: the process of seeking evidence to support a decision that has already been made. Your biases are much easier to see when you are going against the mainstream, and widely-amplified consensus, and have a vested interest in a future market decline. This is an option that many market participants don’t have – to ‘short’ sell a currency, commodity, stock etc. and bet on prices falling – and it did provide me with a different perspective on my own intuitions and biases. Then again, knowing your own biases doesn’t necessarily make them simple to address.

When professional, and in turn personal, success is for a price to fall (rather than rise), it does uncover how anchored our ‘markets rising’ framing is within our economy and society. The news, for example, is littered with hopeful economic and financial phrasing, even when things aren’t going well, e.g.: ‘a price floor’, ‘turning the corner’, ‘technical recession’, ‘cyclical upswing’ and ‘green shoots of recovery’. Most of us ordinarily have a default interest in hoping for markets to rise and in a sense being ‘long’ our economy, as rising markets tends to signal the health of our companies, often our own asset wealth, and our broader economy.

Many of us are, therefore, subconsciously looking for signals that metrics are going to rise. If we step back, are we mainly looking for evidence to support the outcomes we would like to see, has the basic desire for upward momentum altered sound judgement? Certainly, when you are in financial markets, falling in love with your trades can be a dangerous, and often costly, game.

I have been wondering whether some of this thinking, and learning, could be transferred to decisions surrounding climate action.

As many of you will know, I have been in a sense ‘long’ climate action for almost 20 years: in that I would like more of it, I wish for the pace of action to increase each year, and I am keen that action is increasingly global, for the benefit of people and our planet. Furthermore, I do believe that the transformation from high-carbon to zero-carbon will be a major economic growth driver of the 21st Century following and interacting with the digital revolution that has transformed our economies and societies over the past 30 years.

Given the strong climate action that I would like to see, however, am I now in danger of Franklin’s gambit, in searching for evidence that will support the outcome I desire? Have I fallen too much in love with climate tech and its potential? Have I exaggerated the ability of our economies to transform? Am I relying on hope to finance the transition rather than the breadth of evidence available?

These questions have been on my mind for some time. They have come to the fore over the past year in a period of relative fossil resurgence, which led me to a thought experiment: ?imagine I am asked by a macro hedge fund, for some initial advice, about a potential climate short / fossil long fund that they are considering starting. The owners feel that energy security now dominates, since the Russia – Ukraine war and that in the medium-term, at least, fossil is the main game in town. They believe this is particularly true given the challenges of fossil-alternatives, from securing planning, to deploying solutions rapidly, to scaling infrastructure nationally. They also feel that countries and companies will be disadvantaged by moving more quickly than society. In addition, they sense that since net zero targets have been set, companies and countries, are sometimes looking for solutions that will support a ‘net zero’ implementation decision without properly analysing whether that is an optimal strategic choice commercially, or nationally.

The (hypothetical) macro hedge fund wishes me to consider a range of options to ‘short’ climate action and be ‘long’ fossil fuels. I have been asked to explore how this strategy might work.

I’m intrigued, putting purpose to one side, to test my own biases, so decide initially to think through the macro factors that would come into play. One of my main learnings from working in a macro hedge fund was that it was not usually the proximate drivers that would knock you off course, as you are often looking deeply for short-term tailwinds to boost your position, and those may well be in the news and covered by analysts. But you can miss the less obvious, and less talked about, structural headwinds that could derail the portfolio.

Let’s just assume that the investors have done a lot of analysis on their long fossil position and are really wanting me to explore the other, but related side, i.e. being short climate action, and want to know my major considerations and concerns.

In a nutshell: if they ‘short’ climate action, how big a risk are they taking?

I would start with the major macro drivers that will inexorably influence the landscape we are all operating within over the five to ten years:

• Technological change: technological progress will continue apace, and while that will influence both fossil and climate technologies, I would be concerned that many fossil molecules work on mechanical systems, whereas clean electrons work on electrical ones. More of the value chain of electrical systems can be digitalised, and then optimised using AI. So, while technology maturity might be more advanced for the fossil ecosystem, the climate ecosystem may well catch up and eventually overtake. This will particularly be the case when the network effects are large enough to provide increasingly powerful networks and economies of scale. Moreover, carbon capture, and any associated breakthroughs for clean molecules, become relatively less attractive if the world progressively electrifies. Elsewhere, other sectors beyond power and mobility could follow similar innovation and adoption s-curves that have been seen in renewables, notably solar and wind over the past fifteen years, where costs have come down by two-thirds to four-fifths, according to the IEA. This has helped renewables become so much more cost-competitive with conventional sources and reach critical mass in many areas. What if that big cost improvement, and critical mass, expands to other fossil source competition from transport to heating to industry?
• Climatic change: the climate will continue to change over coming years and extreme weather events are likely to increase in intensity over time, with bigger human and financial impacts, exacerbating the rising trend that we have already seen over recent decades. More adaptation, and rebuilding, will be needed in an increasing number of countries that are, and will be, subject to extreme weather and climatic events. There were only three global thunderstorms that cost more than $1bn in the 2000s, for example, that rose sharply to 10 in the 2010s and we have already had six in the 2020s according to Swiss RE. What if governments and populations become increasingly concerned about the rising cost of climate change and start to push harder for compensation, and broader climate action, and in turn become more forceful about fossil use in parallel too?
• Demographic change: North America and Western Europe have been hugely shaped by the baby-boomer generation since World War 2 (born 1946-64) which, despite the influence of the two current US presidential candidates, is starting to wane in power across many of these economies. Millennials and Gen Z are expected to have a much bigger influence as we reach 2030 and beyond. For example, the European Union is home to nearly 125 million people between the ages of 10 and 34, and in the US, Millennial and Gen Z household spending is already about 30% of the total, according to the Economist. Moreover, these generations will be around to see a much broader sweep of climatic change and, therefore, have much more invested in the post-2050 climate and how comfortable it is to live and work in.

These inexorable macro drivers of technology, climatic change and demographics, will of course be shaped, and mediated, by policy. While at the current time, fossil fuel subsidies, for energy security and energy independence, are around $600bn (or around 0.5% of global GDP) according to the IMF, that subsidy number is large and is currently one-third of total clean energy investment – around $1.8 trillion (1.5% of global GDP) according to BloombergNEF. For comparison, fossil fuel investment is still around $1.1 trillion per year, according to the IEA.

Might certain tipping points be reached in the coming years even though it looks as though oil and gas companies, in the main, have had a relatively good few years? For example, the investment ratio of fossil to clean used to be 1:1 and it is now 1:1.7; how far are we along the energy transition in reality?

While we don’t know the outcomes of several important public elections being held across the world this year, we can say that these macro drivers will have their direct impacts. How drivers are shaped by policy will be a function of many factors, including how big an impact they are expected to have, the scale of the voice wanting action, the power of vested interests, and the cost of the alternative solutions being deployed, as well as the impact that solutions can have.

Moreover, these macro forces are not independent of one another and are correlated: so, for example, if technology costs fall it is easier to provide stronger policy support for cleaner alternatives, and in turn societal preferences could then shift more quickly too. These types of combinations could result in swifter, or sudden, change. An evolution could rapidly turn into a revolution, and different countries, and sectors, may be subject to these forces in different ways.

Which brings me to my final point about timing, which was my main lesson from working for a hedge fund. The trends are often widely known, the crucial timing of when changes are visibly influencing markets less so. Furthermore, markets tend to focus on one big issue at a time and look some months ahead. When will climate be the centre of focus? Could the inexorable underpinnings of structural change elicit action? In the end the facts stick.

So, based on this initial exploration, what about the fund idea? It could perhaps work short-term, but positions would need to be carefully chosen, and timing would always be important. Betting against solutions that have matured along the industrial s-curve and reached critical mass would be difficult. Nonetheless, as complex systems change is often inadequately coordinated at a macro level, the fund could potentially capitalise on bottlenecks to the transition – where supply doesn’t meet demand, and vice versa. For example, bottlenecks are likely to occur on the pathway to electrification, as we have already seen in renewable power, across aspects of generation, distribution, and storage, as well as in mobility across elements of electric vehicle adoption and charging infrastructure rollout.

As the transition gathers momentum markets will increasingly bring forward, and price-in, impacts that are now beyond the horizon. As a clean economy encompasses additional sectors and geographies, more tipping points will be reached, and further network effects will be realised. I would guess, therefore, that a ‘short climate’ strategy is likely to become a bigger and bigger gamble. As a comparison: few are ‘short digital’ now that digital transformation is so mature and embedded, but many were in a very late-stage analogue world in the 2000s and early-2010s, or so I would wager.

Overall then, having challenged myself to think about climate action from a different perspective through this thought experiment, I still see ‘long climate’ as the winning macro bet. The fundamental dynamics, and inexorable forces, take you there. But then again, you know my underlying interests, so perhaps I have written this all under the guise of my own biases and Franklin’s gambit.

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Acknowledgements

With sincere thanks to James Rydge, Dimitri Zenghelis, Lucy Carlyle, Sid Lall, Tom Hyner, Kiran Sura, and Ollie Potter who commented, and made valuable suggestions, on earlier drafts of this article. All views are my own, however, and this article is written in a personal capacity.

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