The looming issue of climate change has far-reaching implications, not least of which are relevant to the financial and investment world. Today we spend some time considering these impacts, with a focus on the question of whether climate risk is a priced investment. The short answer, conferred by the numerous academic explorations into the subject, is yes. This answer, however, still leaves investors with many options and contrasting possible approaches as to how to act. We get into some of the different avenues to explore when considering your best route, taking into account both ethical constraints and returns, as well as a long-term vision of sustainability. We also talk about why big companies with less of a focus on ethics may be tempted to go green for financial reasons, how investors might enact a moral stance by investing in fewer green companies, and many more surprising possibilities that arise out of the current findings. Rounding out all this serious discussion, we squeeze in an interesting book review from Hans Rosling, some Talking Sense questions, and of course, bad advice of the week, all of which you are not going to want to miss.
Key Points From This Episode:
This week's book review, looking at Hans Rosling's Factfulness. [0:08:09.2]
Recent financial and investment news; penalties, TFSAs, and a big shift from Wealthfront. [0:14:36.7]
The question of climate change and markets connected to the use of fossil fuels. [0:19:04.5]
Expected rate of returns in relation to the costs of capital, and the idea of climate hedging. [0:26:46.2]
Looking at empirical evidence on the pricing of climate risk. [0:28:40.1]
Recent scholarly findings on the subject of whether climate risk is priced. [0:31:50.3]
Summing up the academic arguments for why and how pricing of climate risks operates. [0:38:35.7]
The cost of capital incentives for companies to reduce their exposure to climate risk. [0:40:19.3]
Participating in the transition of companies to greener and more sustainable practices by investing in them. [0:45:12.9]
Financial needs for different age groups, at the beginning and the end of a lifetime. [0:48:17.6]
Personal savings goals versus generosity towards loved ones. [0:51:47.2]
This week's Bad Advice of the Week: making inflation trades in cryptocurrencies and gold. [0:53:27.1]
Read The Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We are hosted by me Benjamin Felix and Cameron Passmore portfolio managers at PWL Capital.
Cameron Passmore: So, this drops on Thursday, July 1st, which is Canada day. Canada's birthday. So, happy Canada day to all Canadians.
Ben Felix: Very nice.
Cameron Passmore: And I'm wearing my red shirt, my red golf shirt positive for the last time ever. I'm not a big fan of the shirt, but it's red. I don't think I've worn a golf shirt in over a year. I haven't golf in over a year. Can you believe this heat? We were just talking earlier about how hot it is at Ottawa, but we set a record in Canada yesterday in Lytton BC at 46.1 degrees Celsius.
Ben Felix: It's unreal.
Cameron Passmore: We're 33, 34 here today in Ottawa, which is very hot for us. We have high humidity. But 46, I mean all through the Pacific Northwest, the temperatures have been unbelievable in the mid 40s.
Ben Felix: Yeah. Scary stuff. It's a good thing that in today's episode, I mean, maybe not a good thing, but we will talk about climate change. So, if that's related to these temperatures, then we'll give people some things to think about.
Cameron Passmore: I have a show for you. Don't know if you watch the Jeffrey Epstein series, but there's a new series that follows up on that called Epstein;s Shadow, Ghislaine Maxwell. And it's on Create, it's a three part series. Very interesting. Horrible story, obviously. And she's in custody now in the US but it gets into her background and the story of her family's fortune and what happened her father, then how she ended up in the US and meeting Jeffrey Epstein. So, it's a pretty wild add on story to the Jeffrey Epstein story. If anyone's interested in that. One Create in Canada.
Ben Felix: I don't know how you always have shows that you've reviewed and watched and can recommend, and insights from books. Blows my mind.
Cameron Passmore: You do just as much content and you've got young children.
Ben Felix: Yeah, I guess so.
Cameron Passmore: You crank all these papers out. I don't like cranking out the papers. Says the guy with the new book self bought and is loaded with books.
Ben Felix: You know what? I was putting those books away because I've moved in our new house. And I noticed that every time I would grab a handful of books from the box and put them on the shelf, I don't think that there was one handful that I grabbed where at least one of the books was not authored by somebody who's been on our podcast.
Cameron Passmore: Oh, wow.
Ben Felix: I thought that was pretty cool.
Cameron Passmore: I was talking to Angelica last week, she got her new Kindle and I love my Kindle. So, instead of having a bookshelf, I have like a little Kindle sitting behind me. So few books left in the house.
Ben Felix: That's probably more efficient. It is nice to go to grab a book and find the dog years and notes and stuff like that, though.
Cameron Passmore: That's the hard part. We spoke to you on a keep and go back and reread. Having the actual book is much easier to do that. So, the move went okay?
Ben Felix: Yeah. As far as moves go, I mean, not too bad. Not a fan of moving. Wouldn't do it again anytime soon. But yeah, we're in here now. We don't have a kitchen because it's being redone. I mean, we have a makeshift kitchen, but it's all right.
Cameron Passmore: So, we talked about rent versus buy a couple of weeks ago, and boy, does that ever bring other comments on YouTube?
Ben Felix: Yep. Somebody actually made this comment in the Rational Reminder community that there's a moral judgment that owning your home is a good thing. And that's another one of those things that can get very difficult to have a civilized conversation about because of that. Because some people believe that owning a home is a good thing that everybody should strive for, which not everybody agrees with. So, it can lead to heated discussion.
Cameron Passmore: So, in the conversation, some people were asking that we do time stamping. Any news on that?
Ben Felix: I don't have any news, but it's something that Angelica is aware of. And it's something that we're working on. I think it's time consuming because you have to go through, someone has to go through and watch it to do the timestamps. So, it's something that Angelica is trying to work into the post production processes.
Cameron Passmore: And the time between recording and releasing is pretty tight, I think for that. So, maybe-
Ben Felix: For sure. Rerecord on Mondays to get it out on Thursdays.
Cameron Passmore: And the latest on the Wes Gray video coming out that was recorded a few weeks ago in the community.
Ben Felix: Yep. So, we had the live event with West that went very well for a friend, a buddy that attended. It was a lot of fun. I think it was fun for you and I Cameron, to be sort of engaging with people in the comments while also talking to us. So, that was very cool. And yet the full video with a bit of edits, like there was a time West had to get up to answer the door. We cut that out. But for the most part on unedited. It's like an hour and 45 minutes long that is up in the community. You can access it and then we're going to release it on our public YouTube channel for anybody to see next week.
Cameron Passmore: Yeah, it's a really fun watch.
Ben Felix: And we're also going to actually, speaking of timestamps, that one does have timestamps, which is great because it's so long. But the other thing that we're going to do is create individual videos for a lot of those timestamps, because there are a lot of, West says, here's the question. And then he answers the question. And we think that, that could make a lot of good individual video clips.
Cameron Passmore: Great idea. Coming up next week is Rob Arnott from Research Affiliates. And then two weeks after that, Bill Schultheis, the author of Coffeehouse Investor Ground Rules, which is a great book we've mentioned a couple of times. And then two weeks after that is Katy Milkman is coming on. She wrote the book, How To Change, that we reviewed a few weeks ago. So, three phenomenal guests. We also have guests booked up pretty much through January now. I think we have an amazing lineup coming up.
Sales in the store have been slowing a little bit. So, we have lots of hoodies and shirts and mugs and stuff in stock. So, maybe we'll do a summer sale at some point, maybe talk to Angelica about that. But it's not like the stuff's very expensive and free shipping in North America, and we don't make any spread on it. Just barely enough to cover packaging and shipping. Interesting and pretty kind reviews people left for us. One was a senior student interested in research in machine learning said that he and his peers enjoy the academically influenced approach that we take to content creation. Much love from Toronto. That's from M. Brotos.
James says, "Keep it up guys. Instantly goes the top of my podcast list every Thursday." We hear that from a lot of people on Thursdays. Here's another person said, "Listening to the podcasts on Thursdays become their ritual, helps me calm down from all the crazy stuff that is going on in the markets and to stay the course of my financial planning. Each episode is like a new piece of the puzzle that makes the overall picture more clear. Thank you. You guys do a fantastic job." This is a Lupa228. So, that's kind of the point to be able to relax with all the craziest stuff going on.
Ben Felix: That's exactly the point. Yeah.
Cameron Passmore: Anything else to add?
Ben Felix: No, those were very kind reviews and we always appreciate getting them. We read all of them. And as far as we know, it helps other people find the show. So, anybody that's enjoying listening, feel free to write us a review. One of the people that wrote those reviews, you just mentioned. I saw somebody that said that they waited until they'd listened to every single podcast before writing the review. I thought that was pretty cool.
Cameron Passmore: Oh yeah.
Ben Felix: That's some serious due diligence. But much appreciated from us.
Cameron Passmore: But I must say the guests we've had on, I've started now to go back and listen to prior guests. The guests are awesome. I've listened any of what we call the us episodes, just you and I. But I go back and listen to the guests. I try to listen to one or two every week.
Ben Felix: You know the top three episodes. This is a cool stat. Top three episodes are us episodes.
Cameron Passmore: I know.
Ben Felix: Number four is Ken French.
Cameron Passmore: Incredible, and Andrew Hallam is up there too, I think.
Ben Felix: He might've dropped down a bit. He was up there for a while. Anyway, point is maybe you should go back and listen to the us episodes, Cameron.
Cameron Passmore: All right. With that, let's go to the main part of the episode.
Ben Felix: Welcome to episode 156 of the Rational Reminder Podcast.
Cameron Passmore: And yes, another week, another book. This book was recommended by our good friend, James who enjoy meeting up, or I enjoy meeting up for coffee with. So, he suggested that I read the book called Factfulness: Ten Reasons We're Wrong About the World – and Why Things Are Better Than You Think, by Hans Rosling. Have you read this book?
Ben Felix: No, I have not.
Cameron Passmore: It is really excellent, excellent book. It's an engaging read that shows how most people's perception of our world are wrong. He talks about how the world has experienced unbelievable progress for a very long time, but many people are not aware of that progress and he highlights that there's many reasons for this such as the basic news cycle shows much more negative news and positive news. And the news takes a snippet of reality and doesn't always give or have time to give long-term perspectives or pick up on the trends.
And he also highlights the fact that many people, beliefs and currently surround the world, came from their training when they're at school, say 30, 40 years ago, and don't reflect any sort of updating of knowledge. And it can also reflect our parents' or our grandparents' views. But the subject matter that he asked people about are often anchored in information that's decades old. It's so interesting. Like for example, he talks about a memory of himself. He grew up in Sweden and he almost drowned as a child in a sewage pool in the street. And he lived in a working class part of Sweden, if you can believe it. So, his mother was ill with a very serious disease in the hospital. Father had to work far away from home. So, his grandmother's watching him and just happened to catch him and pull him out of this sewage pool and prevented him from drowning.
But this is very common when he was being raised in the 40s. So, this happened quite often back then. But it's basically been eliminated in that area since then. So, he went on to, he gives his own life as an example. He went on to getting a great education, create healthcare, he had a healthy family. He even presented at the Economic summit at Davos once. And the big point of his book is that there are distribution curves everywhere, but often the news picks up on the tales as opposed to looking at the average situation. And doesn't ever look at the average situation, how people's lives change over time. And he says, "No matter what happens, there's always going to be the tales and news will focus on the tails. But the tails are not the story. The middle is the story. The change in the majority of the population around the world should be the story."
So, a couple of examples. He talks about the richest 10% of the population of Brazil currently earns 41% of the total income. So, that storyline might jump out, but there's no long-term context. He says, yes, the number is too high. But it's a lowest level it has been in years. For example it was 50% in 1990. Another example he gives, the population that world is grown from a billion and a half people in 1900 to 6 billion in 2000 and most humans, when they hear that stat will assume that the growth rate will just keep going straight up, but it doesn't. The UN expects a population to level out at about 11 billion in a 100 years or so. But the increase in population is that middle group, the adults become a larger part of the population and the birth rate is slowing. So, it ends up leveling out in about a 100 years or so.
And he gives reasons for why that's happening. You don't have this greater need for children's support because of farming, things like that. Also, kids live longer and he talks about how families have many children because often some would die quite young. There's better healthcare around the world. There's more sex education. More contraception. So, for all these reasons there's fewer and fewer kids being born. One of the questions that comes up, he says, how do you fix these misconceptions about population in world? And he says, look at data, look for trends don't just digest the extreme. Think at levels, how has the average person in each of these levels shifted over time? Be very aware of averages. He also talked about, be aware of the view at the top. So, he talks about how many people, for example, in North America, who relatively wealthy societies ... And he talks about it as if you're the top of a building, looking down at the people on the sidewalk.
And he said, they look just like people. And he said, you may not be able to tell that their lives are getting better or not. But he said, there's tremendous improvement in living conditions, among the people around the world. If you look at access to healthcare, to clean water. And he said, that may not be easy to realize if you're in a typical North American situation. He says many people feel the world is getting worse. So, you said when you asked someone the life expectancy of the average person in the world more people would get that question wrong than a random guess by a chimpanzee. So, he asks a question, do you think the average life expectancy is 50, 60 or 70? He said that the correct answer is 72. But he said, most people get that question wrong. And he said, the more educated the audience he asked it to, the worst the guess. It's incredible.
Ben Felix: Yeah, that is.
Cameron Passmore: So, he cites examples in the book that have improved over time, fewer oil spills, lower HIV infections, costs of solar panels going down, lead and gasoline usage going down, literacy going up, scholarly articles published going up, electricity covers going up. Another neat stat he gives, guitars per million people has increased from 200 per million in 1962 to 11,000 per million in 2014.
Ben Felix: That is a very cool stat.
Cameron Passmore: How's that for cool stat, right? So, he says some people call him an optimist, but he didn't feel great about that. He prefers to be called a possibilist. Someone that neither hopes without reason nor fears without reason, and constantly resist the overdramatic worldview. He sees progress in his conviction that further progress is inevitable, which I think is a pretty cool way to live your life.
Ben Felix: Interesting. So, the world is getting better, but people don't realize it because they focus on the tales.
Cameron Passmore: Focus on the tales and they don't have the time. And the news doesn't necessarily give you the broader context. So, look for trends.
Ben Felix: But the world is getting better. Yeah, that is very cool.
Cameron Passmore: Under recent news. Cool story, I caught from the investment executive summarizing comments that CRA gave at a recent conference. So, if you have an overt contribution in your tax-free savings account, you'll be subject to a penalty of 1% per month of the amount that you're over your limit. But the question was asked, what if your TFSA goes to zero, you complete blow it up in bad stock-picking, does the penalty stop? And the answer is no, you have to wait for new room to show up in the coming years to soak that up.
Ben Felix: Yeah. I made that video on TFSAs a long time ago. I mean, relatively long time ago. That was one of the first videos on common sense investing that people actually watched. And I talked about how taking individual security risks and your TFSA is worse than doing it in your taxable account because you don't get a capital loss and you can blow up your room. But part of the point was that you use up contribution room by putting money in and you get it back the following year, if you take money out. But if you put money in and the value of it goes to zero, you've used up the room. There's nothing left to withdraw. The room is gone forever.
Cameron Passmore: Yeah. And now something from the, are you kidding me file. I wouldn't mind chatting with you about this. So, and arguably, this should be in the bad advice of that week in an article at RIABiz, which is a trade publication entitled wealth front in its six pivot as a firm reduces its robo-advisors role and puts decision-making power where it belongs with retail investors. I thought this was an incredible story. It's about Wealthfront, the big robo-advisor in the US is making a shift, allowing their clients to make self-directed trades in crypto. So, becoming much more like Robin Hood, which I believe is going to, they're expected to IPO later this summer with a potential valuation in the $40 billion range. At Wealthfront is five years older than Robin Hood and has worked by some estimates only about a billion dollars.
So, is this a drive to make Wealthfront more valuable, but it's certainly a huge shift away from what they've always promoted and represented, which is modern portfolio theory, efficient market hypothesis, Burton Malkieled that whole narrative. But what they're doing here is not that they're swapping out full portfolio management for clients who offer more control and they're swapping in conscientious oversight, I guess, as their value proposition for this. But what they've discovered is that a lot of their clients have a lot of money held elsewhere. I think Wealthfront has about $25 billion of assets, but their clients have $50 billion elsewhere. They'll be allowed to hold up to 20% of their portfolio in crypto.
Ben Felix: Interesting. I mean, it looks a lot like, I'm not intimately familiar with a Wealthsimple's business model, but they were early to do a lot of this stuff, right? Because they had the low fee indexing model, but they added all sorts of other products as time marched along. So, we were always skeptical of the business model of the super low fees and what is often a fairly high service business, at least if you want to keep clients around. But Wealthsimple, and it sounds like Wealthfront now are making it work by adding other revenue streams, which of course makes sense. But I mean, you put people in the seats by offering this low fee indexing thing, which was a very attractive at the time. And yeah, I mean, of course they have to tack on other services to make it a viable business. It doesn't seem too surprising. But to your point about this being potentially bad advice, yes.
Cameron Passmore: Swapping in conscientious oversight, you go from modern portfolio theory to swapping in conscientious oversight. Really?
Ben Felix: Yeah. Lots of business, right? Index funds are a commodity. You can't sell a commodity and have a viable business. And clearly consumers see what Robin Hood's value proposition is as a value add to their lives. Even though we would say it's detracting from their lives, but not enough people see it as a value add that they're willing to pay, Well willing to pay any ... With Robin Hood I don't even think people realize that they are paying because of the way that they're making their profits. But anyway.
Cameron Passmore: If you're not paying, you are the product.
Ben Felix: That's right.
Cameron Passmore: As you said, many times.
Ben Felix: Yep.
Cameron Passmore: Okay. On to the investing topic.
Ben Felix: Yep. So, like I mentioned in the introduction to the episode with the heat wave that we're going through, this is maybe a timely topic to talk about. Climate change is a question that, I did a live event for some Europeans a couple of weeks ago, and then one of their questions was about climate change. And on the same day, I got a question from one of our clients about climate change. So, I figured maybe it was a good time to dive into the topic and see what kind of research has been done. I mentioned those two questions that I got, but I think that this is on the minds of a lot of investors. We keep hearing on, it's kind of like the tales that you just talked to a Cameron in the news cycle, we keep hearing about these really bad possible outcomes and how the climate is worsening more than expected and all that kind of stuff.
So, investors worry that if things do get a lot worse from that perspective than a lot of businesses, but potentially businesses that investors own could have some serious troubles. A lot of that ties back to fossil fuels as people know. I probably don't even need to say that. But like you mentioned with progress, Cameron, a lot of that's been related to at least, or driven by fossil fuels. That the huge surge in economic development over the last couple of 100 years is coincided with energy from, and energy use derived from burning fossil fuels. And one of the results of that has been the rising levels of carbon dioxide and other greenhouse gases in the atmosphere and an increase in the mean surface temperature of the earth. Scientists expect more temperature increases and the socially, if you started digging into ... Someone sent me a video. I can't remember what it was now, but it was someone talking about how this could go down potentially in terms of the social and economic impacts.
And you can paint a pretty scary picture and I'm not saying that's the wrong picture to paint. It could be the right one. But the point is a lot of it's not good news related to climate change. Now from investors who are deciding today, knowing that these risks exist, investors who are deciding today to allocate their capital. The concern is that if you allocate capital to, for example, businesses that rely on fossil fuels or produce fossil fuels, that you might end up taking a total loss or a big loss, if the world moves to eliminate or reduce its dependence on fossil fuels and other businesses that are affected by climate change. In the literature on climate change, there are two main risks are summarized as physical risk. So, that's businesses and communities being affected by things like changing weather patterns, previously habitable areas becoming uninhabitable.
That video that I mentioned that I can't remember what it was now. They talked about some areas I believe in Africa, if I remember correctly where the heat and the humidity combined, and this is I guess, in the relatively near future, this is expected to happen where the heat and humidity combined will make it so that people will just die in the heat because you get so hot, but because of the humidity, your a sweat doesn't evaporate and you just, that's it. People cannot survive in that climate. So, anyway, that would be a physical risk. If a business was located in that area, then that doesn't bode so well for their future. And then flooding is another example of the physical risks of climate change. So, a physical risk that's one segment or categorization of risk.
And then the other one is transitional risk. The transitional risk of climate change is the response of consumers and governments to climate change. You think about consumers demanding lower carbon. We've seen this, we've seen this lots. Consumers demanding lower carbon impact from products and services. Governments introducing regulations or taxes to reduce emissions. Both of those create pretty meaningful uncertainty for businesses. So, that's the transitional risk. That's the risk of a bad outcome for a business as we transition to an environment where we're hopefully mitigating the changing climate. So, from an asset pricing perspective, we know asset prices, stock prices, bond praises, they reflect expectations about future cash flows, discounted at a rate, reflecting their expected return. So, risk year assets have a higher discount rate, higher expected return, safer assets, lower discount rate. If you think about physical and transitional climate change risks, they're probably going to affect both of those components of asset prices.
They're probably going to affect expected cash flows, and they're probably going to affect the discount rate. So, you expect lower cash flows. You expect more risk, more uncertainty. So, both of those together, or either one of them, I guess, on their own puts downward pressure on asset prices. And then the other channel separate from risk explicitly that can affect prices is the taste of investors. So, we've talked about this a few times ourselves, and we've talked about it with Ken French who authored the 2007 paper that introduced this idea with Eugene Fama, that's, Disagreement, Tastes, and Asset Prices. And that's just the idea that investors who are willing to own, or not willing to own an asset for reasons unrelated to risk and expected return. That they have a taste for that asset. And if enough investors in a group avoid allocating to that to an asset or choose to allocate to an asset due to that preference, it can affect prices and expected returns.
So, if a lot of investors want to avoid owning an asset for reasons unrelated to risk, they can push down its price and up it's discount rate, even though it's not necessarily riskier. So, investor tastes can be another big mechanism that affects the discount rate, which again, affects prices. So, for carbon intensive, fossil fuel intensive firms, a lot of investors, and this is, we've seen this through the growth in ESG investing. A lot of investors just don't want to own those companies separate from any reasons related to risk. And that can cause their prices to decrease. There's a 2020 paper from Lubos Pastor, who of course we had as a guest on the podcast, and we talked about this paper with him, Sustainable Investing in Equilibrium. And he applied this concept of tastes for green assets. So, green in his paper are firms that generate positive externalities for society and brown firms is what he uses as the opposite of green firms.
They generate negative externalities. So, in Lubos' model, investors prefer to own green assets, which leads them to accept a lower expected return. And in the model, it's also implied that green assets have lower expected returns because they hedge climate risk. And this one's really interesting. So, there's a taste channel and there's a climate risk hedge. And I'll explain what that means. If there's an unexpected worsening of the climate, consumers may exhibit greater demands for the green goods and services that we mentioned earlier. Government regulation could push the demands even further. I guess that's different from demands maybe, but they could increase that effect even further. An investors tastes for green assets could get stronger if the climate worsens faster than expected. And all of those combined to decrease the cost of capital for green firms. So, if the climate gets worse than expected, green firms, theoretically act as a hedge and therefore have lower expected returns, because they're not exposed or they're a hedge for that specific type of risk. Does that make sense? The climate hedging part?
Cameron Passmore: But they could have in the near term, higher unexpected returns as their costs of capital reduces.
Ben Felix: Correct. So, that's if the climate unexpectedly worsens.
Cameron Passmore: The demand for that hedge, the tastes that edge increases, raises the near-term unexpected higher returns, which Ken French talked a lot about unexpected portion of the total return. But that would leave the companies having lower costs of capital on the other side, which you would want, and which would give you another personal or emotional dividend because those companies making a positive difference that have lower cost of capital, lower expected return. But they're going to have a greater impact on the world.
Ben Felix: Yeah. And it's a bit of a flywheel that can happen there, but who's footing the bill. It's the investors owning the lower expected returning assets because of the positive externalities. But you don't get to stick those externalities in your bank account. And that's one of the trade-offs, and I'm not saying that it's wrong to prefer to own green assets, any ways. So, green firms, theoretically benefit from an unexpectedly worsening climate, which makes them safer to own with respect to climate risk specifically. And in theory, again, they have lower expected returns for the two big reasons, which is the taste, investors want to own them regardless of risk and expected return. And because they're a hedge for climate risk.
Cameron Passmore: Does this also assume that the brown firms don't improve?
Ben Felix: That's a good question. Presumably the brown firms would want to improve, because their cost of capital would decrease if they were to do so. I am going to touch on that a little bit more once we've covered some of the empirical stuff. So, that was all theory that we just talked about, the tastes and preferences and hedging climate risk from Lubos Pastor. But the big question that we have to ask is, okay, that's cool in theory, but what does the empirical literature say on whether climate risk is actually priced? Because if it's not priced then I guess none of the theory really applies. If it is priced, then we would expect green assets to have higher prices and lower expected returns than brown assets. And we would expect if the climate deteriorates as expected, because everyone is kind of on the same page at this point that the climate is worsening.
That's no secret. So, if the climate deteriorates as expected, not worse than expected, green assets should realize all else equal lower returns than brown assets. All else equals a big statement because like you said, Ken French described to us that the unexpected return dominates the outcome. But we're talking about expectations for now. If the climate deteriorates more than expected, then the hedging property of the green assets would become valuable. And we've maybe even seen some of that where last year, for example, green assets did exceptionally well. So, you can look at that and say, well, I want to own those because they did well last year. Or you can look at those and let's say, wow, though, the expected returns on those assets are really low for the prices shot up. Now over weighting green assets with the hope of profiting from their hedging property would be an active bet against market prices.
Because in that case, we're saying, okay, climate change is climate risk is priced, but I think climate risk is greater than what the market is pricing in, therefore I'm going to bet against market prices, overweight green assets with the expectation of profiting, which interestingly is, and I hope I'm not mis-characterizing the argument. But I believe that's the argument that Tim Nash, the sustainable economists made when he was on her podcast, that it is a miss pricing. So, some people will make that argument. I would say that like most predictive actions in the stock market, the payoff is going to be questionable.
Markets are pretty good as we tend to talk about. Pretty good at processing information. And they align incentives in a way that makes investors want to do everything that they can to be the first to bring new information to the market and an aggregating all of the investors competing to do that makes it a pretty tough game to win if you're one of the investors that's trying to do it. So, to address that empirical question, though, the question of is climate risk priced? I was able to dig up a ton of really interesting papers that take a bunch of really creative angles on answering the question.
Cameron Passmore: And you say, I read a lot.
Ben Felix: Well.
Cameron Passmore: Yeah, well. Point made.
Ben Felix: Yeah. That's fair. I take your point.
Cameron Passmore: I have not read these papers.
Ben Felix: That's fair. The point is taken. I won't bring it up again.
Cameron Passmore: I just sit on the front porch Oscar and I every morning we get an hour outside the front porch. He has his treat. I have my book. We're all happy.
Ben Felix: That does sound very nice. Okay. So, for the pricing of physical risk, there's a 2019 paper, Market Expectations About Climate Change by Wolfram Schlenker and Charles Taylor. They looked at whether futures contracts traded on the Chicago mercantile exchange between 2002 and 2019. And they found that over their observation period, the predictions of climate models, warming trends inferred from futures prices. So, climate models, the warming trends inferred from traded futures prices and observed temperature changes. They all coincided. So, the models, the implications from futures prices and the realized temperature change all coincided over their observation period. So, the climate scientists making the predictions through the models and market participants had similar expectations that over this period, those expectations ended up lining up with reality. So, that's kind of interesting. Another one that took a, this is one of the pretty creative angles I think. They looked at the municipal bond market.
If you think about it, municipalities are this interesting laboratory, because they can't relocate. I mean, municipality can't get up and move because they are their geography. The hypothesis in the paper is that municipalities with more exposure to climate risk through flooding or weather pattern changes or whatever, have a higher cost of capital. That's a hypothesis.
Cameron Passmore: It's really interesting.
Ben Felix: Yeah. So, it's 2020 study by Marcus Painter, An inconvenient cost: The effects of climate change on municipal bonds. They find that higher exposure to sea level rise is associated with higher municipal bond yields. Fascinating, right? And it's mostly driven by longer maturity bonds, which suggests that investors are pricing long-term expected effects of climate change. And then another good one is a real estate market similar to municipalities. You can't move real estate. So, the 2019 study by Bernstein, Gustafsson and Lewis Disaster on the Horizon: The Price Effect of Sea Level Rise. They find that houses exposed to sea level rise, sell at a 7% discount to comparable properties that are not exposed to the same risk.
Most of the discount is driven by houses not at risk of being flooded for another 50 years or projected to be flooded for 50 years. Again, suggesting that investors are taking a long-term view of climate risk. They find a smaller 4% discount in prices among properties that are not projected to be flooded for a 100 years. So, for the longer-term view, the discount is smaller. They found that the discount has grown over time and it's driven by sophisticated buyers and by communities worried about global warming. This piece is a real kicker for me. They found no relation between sea level rise exposure and rental rates, which reinforces the idea that the pricing discount is due to expectations about future damage and not the current quality of the property. How fascinating is that?
Cameron Passmore: Wow.
Ben Felix: Yeah, so I thought those were pretty cool for pricing the physical risk of climate change. For transitional risk there's a 2015 paper, Science and the stock market: Investors' recognition of unburnable carbon. And in that paper, the authors find that the stock prices of the 63 largest US oil and gas energy firms fell by 1.5 to 2% after the publication of a landmark paper in the journal Nature. And that paper argued that most fossil fuel reserves would need to remain untouched in order to keep warming under two degrees by 2050. The finding of that paper of the paper in Nature implied that fossil fuel reserves could become worthless if aggressive regulations to combat climate change were put in place. Now, the interesting in this paper is that they found that markets reacted to the findings of the paper three days after it was published. Even though the media didn't pick it up until much later, like three years later.
So, this paper comes out in the journal Nature saying we can't touch fossil fuel reserves if we want to keep warming under two degrees. And within three days, the prices of the 63 largest US oil and gas firms fell by 1.5 to 2%. Thought that was pretty good, pretty good evidence. Another one, 2015 paper, Environmental Externalities and Cost of Capital by Chava. They found that investors demand significantly higher expected returns on stocks that are excluded by environmental screens, such as hazardous chemicals, substantial emissions and climate change concerns compared to firms without such concern. So, higher cost of capital, which is what the models from Lubos would predict. And Chava also finds that lenders charge a significantly higher interest rate on bank loans issued to firms with those environmental concerns. And they've got lower institutional ownership in the options market.
This one, again, is some of these papers, you read the findings and it's just like, wow, that is so cool. Just thinking of the question to ask and then being able to answer, it's impressive. Like you said, the world getting better with the amount of papers that are available now, it's just unbelievable. If you want to learn about something, the insight that's available. Anyway, getting off track. So, in the options market Ilhan, Sautner and Vilkov in their 2021 paper Carbon Tail Risk that uncertainty related to the future climate policy needed to combat climate change is priced. So, they're looking at the options market. They found that the costs of downside protection, downside tail risk protection is larger for firms with more carbon intensive business models. And the cost of downside tail risk production is magnified for those firms at times when the public's attention to climate change spikes. If you want to protect the downside of a stock, it's more expensive to do it if it's a carbon intensive firm and even more so when the public's attention is on climate change.
Then I got a 2020 paper Climate Regulatory Risks and Corporate Bonds by Seltzer, Starks and Zhu. They found that firms with poor environmental profiles or high carbon footprints tend to have lower credit ratings and higher yield spreads, particularly when they're located in a state with stricter regulatory enforcement. And they use in this paper, they use the Paris Agreement as a shock to expect the climate regulations and shocks like that can be used as evidence of a causal relationship. So, they did that. They used the Paris Agreement to show a cause of relationship between climate regulatory risks and bond credit ratings, and yield spreads, and changes in the composition of institutional ownership for firms. So, that was a lot of literature. I hope people aren't bored. Probably the opposite, knowing our listeners. But based on that, based on those papers and their findings, I'm pretty comfortable saying that climate risk is priced.
And I think that should be reassuring for investors for a couple of reasons. If prices reflect current climate risks, investors are expecting returns commensurate with the risk that they're taking. It's not some Black Swan risk that you're not getting compensated for. Your expected returns are reflecting the risk that you're taking due to climate change. If you want to protect yourself from that risk, if you say, okay, cool, it's compensated, but I don't want to take that risk. Or it's compensated, but I don't think it's priced properly. It's misspriced. Okay. So, then you own green firms. You own ESG funds that align with your views and values or whatever. And those green firms will be a hedge. They're expected to be a hedge anyway. But the hedging property comes at the cost of lower expected returns. That's inescapable even if you get high realized returns, all that's doing is pushing down your expected returns more going forward.
I also think that the evidence of climate risks being priced is good news for the world because it suggests that there really is a cost of capital incentive for firms to manage their exposure to climate risks. Now I'm sure at this point that many of our seasoned listeners and maybe our new listeners too, are thinking well, hey, if climate risk is priced, maybe we should be building portfolios that load more heavily on carbon-intensive firms to increase our expected returns. We'll build a concentrated carbon intensive portfolio-
Cameron Passmore: The brown factor.
Ben Felix: Yeah, the carbon factor. But that is the obvious followup question. At least it's the obvious follow-up question if you've been listening to our podcast for any amount of time. If climate risk is a unique source of priced risk, then loading more heavily to it could make sense. But it leads us to another empirical question, which has to be answered before pursuing that type of strategy, which is, does climate risk tell us anything more about expected returns that other known risk factors don't tell us?
So, we take factors like size, company size, relative price and profitability. Those are all very well known factors. If exposure to climate risk produces an alpha after controlling for those factors, then hey, maybe there is some excess return to be had. I was able to find a 2020 paper by Wei Dai and Phillip Meyer-Brauns Greenhouse Gas Emissions and Expected Returns. And they looked at data for US developed XUS and emerging markets from 2009 to 2018 for evidence. They found that measures of emissions had no reliable effect on returns after controlling for firms size, relative and profitability for stocks and forward rates for bonds. And they found that cross-sectional differences in greenhouse gas emissions failed to predict cross-sectional differences in future profitability once current profitability is controlled for. So, talking about those two different mechanisms that can affect prices, the discount rate, and expected cash flows and using profitability as the current profitability, as the predictor for future profitability.
If you add in greenhouse gas emissions, you don't get any better predictive power for future profitability. So, their findings suggest that the impact of climate change on the expected returns of high emissions firms is already well captured by existing prices and proxies for expected future cash flows. I know that news may be disappointing to some people that we're ready to load up on carbon intensive firms. But I also don't think it should be surprising. Like I mentioned before, the market's a pretty difficult opponent to beat in an asset pricing competition. And even though our models for understanding how the market prices assets are imperfect, which is true for any model, it's not because we have bad models. It's just their models, they're imperfect. The models we have are pretty good.
I mean, you take the Fama-French 5-factor model it explains the majority of differences in returns between diversified portfolios. And as we just heard from that paper, it's no exception if we're talking about portfolios constructed based on greenhouse gas emissions. Yeah. So, if you're hoping to increase expected returns by tilting toward riskier assets with priced risks, then the good old size value and profitability tilts are still probably the way to go. They seem to subsume any price risks for climate specifically. There was one idea that I want to leave everybody with. We talked about the cost of capital incentive for companies to reduce their exposure to climate risk. They take green companies, companies with low exposure to climate risk. They've got lower expected returns because investors want to own them. And because they offer a hedge against climate risk. Their higher prices reflect that, they reflect their hedging capacity and they reflect the tastes that investors have to own them.
So, if you say, I want to make the world a better place. So, I'm only going to invest in green companies that means expecting lower returns. Now the other companies, the ones that we're not going to call green, the brown companies, they have higher expected returns because they're more exposed to climate risk and because investors don't want to own them. But the other piece of this is what you mentioned earlier, Cameron, that if companies turn greener over time, their cost of capital should decrease and their expected cashflow should increase, which increases their price. Now why would bad evil companies want to turn green? We don't even have to make a moral argument here. They want to lower cost of capital. If companies want a lower cost of capital than they have to mitigate their exposure to climate risk. So, incentives are kind of funny like that.
I think as an investor, it might not feel good to own green companies. It might feel good to own green companies and to be okay with accepting lower expected returns for doing so. But I kind of liked the idea. And in Wes Gray mentioned this when we had our live webinar discussion with him, I kind of liked the idea of owning less green companies and not targeting them because we just talked about, that's not necessarily going to give you a benefit. But owning the less green companies and participating in their transition toward being greener. Now I'm not suggesting that all companies are going to turn around and become green or aligned with each investor's values. But I think the initiatives from asset managers like Vanguard and BlackRock who have such concentrated power at this point because of their scale, they've been exercising that power through engagement with companies and proxy voting with the views of managing climate risk.
Now, it's also interesting to note that this isn't just Vanguard and BlackRock catering to what's hot. They're not just doing this to look attractive to investors. I'm sure that plays a role. But if you look through their stewardship reports, their statements say that they're and dimensional takes a similar position, but their statements say that they're fiduciaries, which they are. And their clients are exposed to climate risk because they fully acknowledge the science of climate change and the transitional and physical risks that could materialize and in their role as fiduciaries they are required to engage with companies that are most exposed to climate risk. And they've reported on very transparently their records of engagement and proxy votes. BlackRock even provides case studies of how they've engaged with companies and what the impact has been. So, if you own the brown companies and put pressure on them, even if I can't do anything to put pressure on an oil and gas company. But BlackRock or Vanguard can and they are. They are doing it.
And I think investors in aggregate have, and just that the world at large has voiced its view that climate change is a real risk and things are going to need to happen to mitigate it. So, owning those brown companies and holding them through to their transition to being greener is I would argue a better way to do well by doing good than owning just the green firms. So, that's the thought I want to leave everybody with. Owning the brown firms and seeing them through to their greener futures may be a better way to change the world than ignoring the brown firms and saying, I'm just going to own the green ones.
Cameron Passmore: And that's a very counter-intuitive position to take.
Ben Felix: Yeah. So, anyway, that's it. I think climate risk is real, but it's priced. So, as investors, we don't need to, you don't need to do anything special unless you want to take the active position that it's priced incorrectly, and then maybe you want to hedge by owning green firms. But otherwise I think that as much as it is a risk and I agree that it is, it's a priced risk and we as investors are being compensated for taking it. And even though it is priced, it's subsumed by other known risk factors. So, targeting it on its own, wouldn't make sense because you'd end up with a less diversified proxy for the other known risk factors. So, it's kind of, I guess, as usual people may get bored eventually. We conclude with the same thing. But that's it.
Cameron Passmore: Okay. That was awesome. On talking sense, those great cards from the University of Chicago Financial Education Initiative.
Ben Felix: Where are we with our talking cents cards?
Cameron Passmore: Coming. Angelica says they're coming. She talked to them last week, so they should be in the store hopefully soon. We'll let you know as soon as they get here. Ooh, here's a good one. How are the financial needs of a 10 year old and a 65 year old different? How are the financial needs of a 10 year old and a 65 year old different? Wow.
Ben Felix: You usually go first.
Cameron Passmore: Thank you very much. I mean, what comes to mind? I mean, there's things like, I mean, money gives you freedom, money gives you control. I remember when I was 10 dreaming of a stereo, we used to go to Eden's every Friday night. I used to see the stereo every Friday night when it was 10 years old. And on my little worm business, I dreamed of saving up for this stereo. I saved and saved and saved. I learned that the power of compounding and the planning at that young age to go and buy a completely crazy consumer item. But still I learned the lesson of the power of what money can give you. Is that different though than a 65 year old who's at the end of your savings career?
Ben Felix: I think you just hit the nail on the head. I think that's the way that I would answer this question. The financial needs are different because the value of the human capital of the 65 year old is say zero. And the human capital value of the ten-year-old is astronomical, potentially. Wide range of outcomes, I guess. I would say the needs are different because the 65 year old is less likely to be able to earn income, but maybe that's not true. But say 65 coincides with retirement. They're less likely to earn income.
Cameron Passmore: But their needs of a 65 year old are much more important because you don't have greater room for error.
Ben Felix: I think that's related to the human capital piece. I think that the ten-year-old has lots of room to make mistakes and earn. And the 65 year old doesn't. They've done their earning and they're now reliant on financial.
Cameron Passmore: But it's just as important for a ten-year-old to learn the good lessons, something as simple as compounding. I can remember being on my paper route, and maybe I've told this story on the podcast. I remember being on my paper route discovering the rule of 72, just going between houses on Cliff Street in my hometown of Lennoxville. And I remember it was just like 10 cents. And I remember doing the simple math of a hundred dollars to be 107. That'd become like whatever, 115 would become 123. Like how many years did it take that double right?
Ben Felix: Hmm. I don't thing you've ever told that story. That's a cool story.
Cameron Passmore: I can vividly remember it was a snow storm delivering the Montreal Gazette in Lennoxville, and it's a very steep part of the hill. I can remember, wow. I can double my money in seven or eight years back then. I was just using interest rates. I used to go to the bank, a little kid by my Canada savings bond. Like I bet you've never even owned a Canada savings bond.
Ben Felix: I have not.
Cameron Passmore: But back in the day, yes, I sound incredibly old, used to go into the bank and buy your savings bond and you could get annual pay or compounding. And so I bought the compounding, because you just leave it there to show up whatever it was, eight years later or something. And your thousand dollars would be $2,000. Like this is a miracle. So, the lessons are vital at 10 years old, which gives you the freedom as a 65 year old. So, they're actually quite connected too. Okay, I'll let you answer this one. Would you spend money to make a friend happy, even if it meant not meeting a personal savings goal?
Ben Felix: Well, seeing as how I don't set goals. Yeah, I would probably tend to spend money to make a friend happy. I wouldn't put myself in harm's way. I wouldn't spend to make friends happy to the point where it put me in trouble. So, maybe that's kind of what the question's getting at. I would selfishly put my self in my family before making a friend happy with money. But practically speaking for myself because I don't really set savings goals, whether that's a good thing or not, we'll find out in 30 years. But yeah, in real life, if I was making a choice between saving some money away or paying for dinner, if I'm out with a friend or something like that. I would probably choose to make the friend happy. And there's a selfish motivation there too. Not that this is why I would do it, but doing stuff like that tends to make you the person giving the money also much happier.
Cameron Passmore: Yeah. I would do it responsibly. I agree with you. It's interesting your comment about not having savings goals and so many people we see that are financially independent later in life. So, many times to come some day in, day out habits that in many case did not have defined goals through the years. It's just, you saved, you live below your means.
Ben Felix: Yeah. We've talked to this before. I have habits, I just don't mandate like I'm going to save exactly this much, even if I make lifestyle sacrifices for doing so. I think I still save responsibly. I think I'm a reasonably good saver, but I also like doing stuff that costs money sometimes.
Cameron Passmore: Okay. That was good. Quickly. Bad advice of the week comes from Matthew. Sent it to me on Twitter. We shipped him off a hoodie. So, it was in the June 17th article in advisor perspectives called they can't decide between gold or Bitcoin. Why not both? Here we go. So, Paul Tudor Jones, who's a billionaire hedge fund manager and philanthropist is super bullish on Bitcoin right now and may give crypto the same 5% weight as a gold commodities and cash as portfolio. Two years ago, he said that gold was his favorite trade in the next 12 to 24 months. And of course the yellow metal has had, and I quote "everything going for it and asserts 55% since that statement."
So, this week he made a similar call I guess, and said, he'd go all in and not just gold, but also crypto and commodities. They called these and this hearkens back to our conversation with two weeks before with risk on inflation. These are inflation trades. So, put 5% into each of these four items, gold, crypto, commodities and cash. Then Ray Dalio is also quoted in the article is saying he prefers Bitcoin over government bonds, which are "stupid". Article goes on to say that many investors may not be able to afford to shun gold and Bitcoin. And of course, a simple 80/20 index of metals and cryptos has beaten the index, the NASDAQ 100 index, since August 2017. Did you know that?
Ben Felix: The old 80/20 portfolio.
Cameron Passmore: 80/20 portfolio of metals and crypto for the past four years, has beaten the NASDAQ 100. Volatility is relative in one combined with the gold Bitcoin has less risky than the S&P 500, which could sustain that quasi currency outperforms at 2021. It says a Bloomberg commodity strategist. Hmm. There we go. 5% in each of those for you.
Ben Felix: Yeah. I mean, it's probably bad advice. But I don't know. Gold's been kicking around, bouncing around, up and down in price for quite a while now. Bitcoin could do the same thing and maybe combine them together in a portfolio is good. Maybe you've got a little rebalancing alpha in there. I don't know. I wouldn't do it. I try to really understand the Bitcoin argument. I try to really understand it. I talked to someone who's very passionate about it and who I believe to be very intelligent. And I really tried to dig into the arguments. And I think it comes down to this view of economics where hard money is a requirement for a sound economy. And gold has a time has been used as hard currency or gold backed currency. And this view states that we need to get back there.
And if that's true, I actually agree that Bitcoin is a very elegant solution rather than gold. But I don't agree at all that we need to go toward having a hard money, a constrained money supply. But that's my understanding at this point is that the Bitcoin evangelists hold that belief that the future requires hard money. And Bitcoin is an elegant solution if we go in that direction. But then it becomes a bet on whether or not the world is going to agree that we need to move in that direction. And there's a survey that University of Chicago does for their global markets initiative, where they survey, it's the top economists in the world, and this is on gold. But they asked if I can remember the exact question was, but it was related to would gold be a better system or gold backed currency be a better system.
And I believe it was every single one of them in the survey said no, with a high degree of confidence associated with their answer. I'll try and dig that survey up in the show notes, because it's very interesting. Anyway, so I really try to get it. And that's my current understanding of the evangelism. That we need hard money in Bitcoin is the answer. And even then there's a paper from a guy named Eric Budish at University of Chicago. He wrote a very compelling paper on the economic limits of Bitcoin due to the way that it functions. We can post that paper too. That's the people in our community that are Bitcoin evangelists, because there is a cohort in there. They might appreciate reading through that paper. Anyway, I didn't expect to go down this Bitcoin rabbit hole at the end of our discussion here, but I spent a bunch of time on it a couple of weeks ago and came up with some interesting nuggets.
Cameron Passmore: Anything else?
Ben Felix: No, I think that's good. Like we said, at the top of the show, if you enjoy the podcast, leave us a review, we will read it. We will read it out on the podcast for everybody else to hear, and it might help somebody else find the podcast.
Cameron Passmore: And if you're one of the number of people that listened to this first thing Thursday mornings, thanks for listening and happy Canada day. Should be a good day.
Ben Felix: That's right. Happy Canada Day. And I'm sorry for not wearing a red shirt. I am very proud to be Canadian.
Cameron Passmore: Indeed, all right. Thanks for listening.
Books From Today’s Episode:
How to Change — https://amzn.to/363m9pB
Factfulness — https://amzn.to/3y83B3y
The Coffeehouse Investor's Ground Rules - https://amzn.to/3hqJsyQ
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
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Benjamin on Twitter — https://twitter.com/benjaminwfelix
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'Wealthfront in its sixth pivot as a firm, reduces its robo-advisors role and puts decision-making power where it belongs with retail investors' — https://riabiz.com/a/2021/6/16/wealthfront-in-its-sixth-pivot-as-a-firm-reduces-its-robo-advisors-role-and-puts-decision-making-power-where-it-belongs-with-retail-investors
'Sustainable investing in equilibrium' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X20303512
'Market Expectations About Climate Change' — https://www.nber.org/papers/w25554
'An Inconvenient Cost to the Effects of Climate Change On Municipal Bonds' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3167379
'Disaster on the Horizon: The Price Effect of Sea Level Rise' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X19300807
'Science and the Stock Market - Investors’ Recognition of Unburnable Carbon' — https://www.sciencedirect.com/science/article/pii/S0140988315002546
'Environmental Externalities and Cost of Capital' — https://www.jstor.org/stable/24550583
'Carbon Tail Risk' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3204420
'Climate Regulatory Risks and Corporate Bonds' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3563271
'Greenhouse Gas Emissions and Expected Returns' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3714874
'Can't Decide Between Gold or Bitcoin. Why Not Both?' — https://www.usfunds.com/investor-library/frank-talk-a-ceo-blog-by-frank-holmes/cant-decide-between-gold-or-bitcoin-why-not-both/
'The Economic Limits of Bitcoin and the Blockchain' — https://faculty.chicagobooth.edu/eric.budish/research/Economic-Limits-Bitcoin-Blockchain.pdf
'Would gold be a better system, or gold-backed currency be a better system?' — https://www.igmchicago.org/surveys/gold-standard/
'Would a Gold Standard Brighten Economic Outcomes?' — https://research.stlouisfed.org/publications/page1-econ/2015/01/01/would-a-gold-standard-brighten-economic-outcomes/