Environmentally Resilient Portfolios and the California Wildfires

This blog post continues my series on environmental risks and how to make portfolios environmentally resilient.  You can find my previous posts here.

The Environment as the Ultimate Rhizomatic Risk®

Most investors, no matter how sophisticated, have portfolios that are shot through with environmental risk. What's worse, environmental risks frequently make what were thought to be uncorrelated assets, correlated.I call this phenomenon Rhizomatic Risk® because the assets are connected in an unseen way, the same way the root system of a rhizome is connected underground. You can read more about Rhizomatic Risk® here.

The California Fires

Besides the devastation from the loss of life and the destruction of thousands of homes, the biggest losers from the California fires are the utility companies (and their stock and bondholders), which face liability from having potentially started the fires with downed power lines. If downed power lines did cause the fires, it raises a separate question: downed power lines have been a feature of modern America for 100 years, why are they causing such massive fires now? The answer is simply global warming and the associated climate change. It's been 210 days since Paradise, CA received even a half inch of rain.[1] With low rainfall and low humidity, along with high winds, California has become a tinderbox ready to ignite. Any spark will do, and sparks just happen to be a bug for the power generation and distribution business.The record high temperatures, prolonged high heat, and drought conditions have dried out the land and vegetation in California.  The New York Times recently reported:[2]

"What has been really unusual in the Western U.S. this summer has been the sustained heat, said Alex Hall, a U.C.L.A. climate scientist. "It really pulls water out of vegetation, and that sets up conditions for big fires."... lingering weather that is 15 to 20 degrees above normal is something else. That was the situation in much of the state in July, including in Redding, where daytime temperatures did not drop below triple digits for 14 days straight.

NOAA Drought Monitor Chart[3]

Obviously, most of the Western United States is either abnormally dry or in some form of drought stress.

The Permanence of Environmental Risk

Environmental risk is now a permanent feature of the investing landscape.  However, few investors, or their advisors, are thinking about it. Because of this lack of awareness, environmental risks are hitting investors in places they didn't expect.For instance, the California fires have cut the market capitalizations of PG&E and Edison International by about 46 and 22 percent, respectively, in the past week.

PG&E and Edison International Price Charts[4]

This is remarkable because utilities have historically been very safe investments that have legal monopolies and regular rate increases. Now, global warming has seemingly turned them into unwitting arsonists who are liable for billions of dollars of fire-related damages.PG&E faces liabilities from the Northern California fires last year as well as the Camp fire this year. Combined, these could total $30 billion, which more than doubles its current $13.3 billion market capitalization. These potential liabilities have caused some of PG&E debt to sell off, including municipal bonds backed by the utility.

Chart of PG&E Municipal Bond Price[5]

Oil

Investors have been taken back by the swift decline in the price of oil, oil producers, and oil service companies. They shouldn't be. The assets of oil producers that are warehoused in the earth will become stranded.  Their balance sheets are a myth.For example, in Exxon Mobil's 2017 Annual Report, they show 8,922 billion barrels of proved crude oil reserves.[6] At today's price of $55.65 per barrel, that's worth $496.5 billion. Exxon Mobil's current market cap is $330.2 billion.Anyone can do this math.  Exxon Mobil, and the whole oil industry, are heading towards zero. Not today, or in a year, but it is inevitable.If all the oil producers in the world were to extract all their reserves and humans were to burn it, we would make the earth uninhabitable. Furthermore, renewable energy has not only closed the gap, but is now cheaper than most fossil fuels. Oil is simply up against an opponent that it cannot defeat: the transistor. Solar photovoltaic (“Solar PV”) technology is nothing more than a transistor and thus subject to Moore's Law, which states that the number of transistors in an integrated circuit doubles roughly every two years. Such dramatic advances mean the price of transistors tends to come down by 50 percent every two years as well.

Chart of Trend in the Cost per KwH of Renewable Energy[7]

In the chart above, the dark green band is the fossil fuel cost range. As can be seen, renewable energy and especially Solar PV is already cheaper that many fossil fuels, by 2020, they will likely be cheaper than virtually any fossil fuel. Oil is a physical commodity and thus heavily constrained by physical laws. Solar PV energy is a technology and while it is also constrained by physical laws, they are lite in comparison. There are decades of efficiency improvements ahead for Solar PV. In fact, after the initial capital expenditure, Solar PV could not only be free, but through net metering, could turn households into profit centers.Oil has no answer for this, just as whale oil had no answer for kerosene.

Chart of U.S. Whale Oil Imports[8]

Please do not interpret this as me being anti-oil. My family has cars that burn gasoline (and one hybrid) and we heat our house with oil. We will always have oil production. However, it will be like whale oil production is today, a tiny and anachronistic industry. It is the past, and one that investors must get away from. There is no growth in it, only decline. My family’s next cars will be electric and most likely so will yours. Certainly your children will never own a combustion engine car. To that end, most car companies are replacing gasoline and diesel models with hybrids and electric vehicles in the next 10 years. That’s half of global oil demand.

Environmental Resilience and the Portfolio

Investors must build their portfolios to be environmentally resilient. Almost none do so now.An environmentally resilient portfolio requires a different approach to risk management and capital allocation.  Investors must examine their direct and indirect exposures to environmental risks and weight their portfolios accordingly. Direct exposures include those from where an investor lives, works, and those of their employer, as well as the investor’s portfolio. Indirect exposures include upstream and downstream risks to supply chains and end-users to those same elements. Bantam builds environmentally resilient portfolios through custom indexes and other portfolios. We also provide analyses of environmental risks for investors with existing portfolios in stand-alone reports. To access the podcast version of this and all my blog posts, please visit iTunes.