Barry Ritholtz was commentating over at Bloomberg View on climate change, with the initial stimulus being Hank Paulson’s article in The New York Times about “The Coming Climate Crash”. I have actually been thinking about climate volatility for some time now because it is one of the fundamental factors that drives not just our politics, but also our economy.
The History of Climate Volatility
Back in early 2011, at the dawn of the Arab Spring, one of the grievances was the intense inflation in food: whether you refer to the UBS Bloomberg Index, S&P GSCI, or Rogers Index, in the span of September to February, food prices had more or less risen 30%. In the developed world, where food is a relatively low portion of our budget, it causes a minor inconvenience. But in the developing world, where food consumes a larger portion of the household budget, it can be a principal cause of revolution.
I saw parallels with the Arab Spring and the historical revolutions across Europe in 1848, starting in Paris and rapidly spreading throughout the Germany and the Hapsburg Empire. One of the chief grievances in those instances was food pricing as well. The most ancient of supply shocks—famine—can be severe enough to cause whole societies to migrate. Two relatively modern instances are the Irish migration to the United States in wake of the 19th century potato famine and the Oklahoman migration to California during the 20th century dust bowl.
Indeed, there were unique forces in 2011 that were causing 30% food inflation in a span of only several months. Central Banks across the world had been cutting rates and experimenting with quantitative easing. An attempt to jumpstart biofuels also created a bit of a run on grains. But there were also supply constaints caused by some remarkable weather events.
In 2010, drought and fires had destroyed a quarter of Russia’s grain area and floods had affected half a million tons of wheat in Pakistan. The fires in Russia were so bad that you could see them from space. Australia had floods of Biblical proportion, with most of the province of Queensland being submerged and rainfall records being set, exceeding one metre at some weather stations. Perhaps an apt metaphor for 2010–2011 was that a “perfect storm” created an agricultural supply shock that contributed to the catalysis of simmering populist outrage.
Thinking of it as a Straddle
How have agricultural prices performed since that time? Over the long term, prices haven’t consistently gone up-and-to-the-right. In fact, according to International Grains Council, we have been able to keep ramping up production to meet demand. If you pull up the DJ-UBS Commodity Subindices on your Bloomberg or Thomson, there was a doubling of grain prices in the ’07–’08 time period, most of which receded. The rise in 2010 and the spike in 2011 were merely transitory. The magnitude of grain price rises haven’t been on the scale of, say, precious metals. And livestock is, surprisingly, priced less in 2014 than in 2004. Therefore, a good way to think about a climate-based investment thesis as expressed through commodities is that it behaves mainly like a volatile asset.
This is also what the payoff ratio of something like flood insurance essentially looks like as well. If a tail event like a hurricane occurs and damages your property, you receive a payout based off your insurance premium, with the premium equivalent in function to an option price.
In the Spring 2010 issue of Intelligent Life, an article called “What’s happened to the seasons?” profiles the impact of climate volatility on societies extremely reliant on agricultural yields. In Balaka, Malawi, unpredictable rains result in wilted maize. In Vietnam, cold snaps and floods destroy entire harvests. And in Kashmir, a traditional season called the tsonth has not happened for ten years.
How can these people come with greater unpredictability? Modern futures markets are actually descended from efforts by farmers to hedge harvest risk. It may be time to bring things full circle. While the most basic forms of financial services have been brought to the developing world in the form of microlending, more sophisticated financial products such as insurance and futures do not seem to have achieved the same level of success. Or at least, not visible success; I am not aware of large scale microinsurance ventures on the scale of Grameen or Kiva.
While the introduction of savings accounts would help smooth the volatility of incomes in non-agricultural sectors, farmers and ranchers will need financial products tailored to their needs. If the administrative costs can be brought down to a micro level, the farmers in Malawi would pay a small premium and receive a payout if rains destroy their maize. It’s the same principle behind the strategies used by a Cargill—the difference is that the opportunity is brought to those far more vulnerable.
The greatest irony, however, can be found in societies like Greenland. While climate volatility brings an end to traditional ways of life, it can open new vocations in certain countries.
Prior to assuming office, Aleqa Hammond the Prime Minister of Greenland, noted the following irony:
“If we are standing there, feeling sorry for ourselves, we can’t gain anything. So, we have to think: what does [climate change] bring? Some places will lose everything, and I feel very bad for them, but we are not in that position. The retreating of the ice gives Greenlanders a greater survey of what the country contains—the riches. We know that there is oil in Greenland. You can touch it, you can feel it…Now there are companies around the world showing interest in it.”
The melting of the ice in Greenland actually makes it easier for oil exploration and production. But Greenland would not be the only beneficiary of the increase in climate volatility. Vladimir Putin was once quoted, “For a northern country like Russia, it won’t be that bad if it gets two or three degrees warmer,” since “we would spend less on fur coats” and “our grain production would increase.” This comes from the leader whose graduate school thesis was Mineral And Raw Materials Resources And The Development Strategy For The Russian Economy.
Although Paulson’s editorial was about a coming climate crash, there are indications that changes—whether you or not you believe it is anthropogenic—have already been well underway. The decrease in Arctic ice has finally made it a viable shipping route. Scott G. Borgerson has been sounding the bell for some time now, presciently in the March/April 2008 issue of Foreign Affairs in an essay called “Arctic Meltdown”. More recently, Borgerson published “The Coming Arctic Boom” in the July/August 2013 issue of Foreign Affairs.
The main theme of those pieces is the following: as the Arctic opens up, it provides both dangers and opportunities. Dangers in terms of a potential for a 21st century scramble for maritime territory. And opportunities in terms of cutting the shipping times between northern cities. While Prime Minister Hammond’s commentary was about turning Greenland into an Emirati-like petro state, energy is just one industry that can be empowered by these changes. Arctic nations can also use the receding of the ice to become a shipping and trading hubs, much in the same vein as Suez or Panama.
There are other risk factors unmentioned thus far. Intertwined with climate volatility is water: Lake Mead’s bathtub ring, water wars between American states, or the receding of the Aral Sea. These have other dimensions to them as well in terms of increased irrigation needs, population growth, and migration.
Whatever your political position, climate volatility is a real issue that will be consequential in human affairs. And whether or not it gets to the point where we intentionally cross the controversial geoengineering threshold, we are going to need to adapt to the uncertainties that lie upon the road ahead.