Volatility and the carbon bubble

Our world is volatile, but is this a good thing or not? It depends. The next wave of volatility may well come from the burst of the carbon bubble.

Change comes either too fast or too slow, depending on what's changing and whom you ask. If you ask Fridays for Future about reducing carbon dioxide emissions, you'll learn that it's not happening fast enough. If you ask commuters who drive Diesel cars and struggle to pay the rent, they'll probably hesitate to welcome a quick rise of energy prices.

Our world seems to change fast, but is it changing too fast or not fast enough? Depends on whom you ask.

It's now widely accepted that our world is shaped by volatility and its siblings uncertainty, complexity and ambiguity, or short: VUCA. Volatility is considered high, and this means rapid change, though not necessarily progress. It can also mean the pendulum swinging back and forth faster, or with greater amplitudes.

In the political sphere, volatility increased dramatically over the last years. The middle ground is shrinking, while the extremes on both the left and the right, as well as authoritarians, are gaining steam. Globalisation and tribalisation put pressure on our political systems.

Low volatility implies higher risk

At the same time, the financial markets have shown relatively low volatility. This is commonly measured by the VIX, the CBOE Volatility Index. In times of financial crisis, like in 2008/2009, the VIX peaks. But for most of the past decade, it has been surprisingly low. Or maybe not surprisingly, since we've seen a very long bull market now, with stock prices rising to new all-time highs.

Paradoxically, this low volatility implies higher risk ahead. At some point, the bulls will cave in, ending the rally.

Financial markets trade the future. Every investor expects returns on his investments. How quick these expectations change is a key factor for volatility.

In general, volatility isn't well understood. That's another paradox in a supposedly volatile world. It can mean two things: either we don't understand our world, or our world isn't as volatile as we think it is.

A third possible explanation is that we live in a bubbly world. Overblown expectations lead to bubbles, and at some point these bubbles burst, leading to sharp market corrections, like the bursts of the dotcom bubble in 2000/2001 or the housing bubble in 2007/2008.

Deflating the carbon bubble

These days, there is a growing notion of a carbon bubble, with the assumption that public companies based on fossil energies are still overvalued. Since the threat of climate change will enforce a quick decarbonisation of the industrial world, assets like oil and gas and the corresponding infrastructure will quickly lose their value.

If we look at the market capitalisation of Exxon Mobil for example, this has already started to happen. In the second quarter of 2013, Exxon Mobil was still the most valuable public company in the world. In 2018, Exxon Mobil left the Top Ten.

We can even attribute the fact that Saudi Aramco is now the most valuable public company to the foreshadows of decarbonisation. With the IPO of Saudi Aramco, Saudi Arabia started to unload some of its inherent risk and to build up new sources of wealth for the oil-rich country.

If there is a carbon bubble, a lot depends on whether it will deflate slowly and orderly, or quickly and chaotically. A quick and chaotic burst of the bubble will provide for another spike of volatility, and probably a big one, since our Western civilisation pretty much depends on fossil energy.

The world definitely can change too fast. But will it change fast enough?

Another hockey-stick

The financial markets are quite good at anticipating future changes. And they also drive these changes, since they allocate capital where expected profits are reasonably balanced with the associated risks.

The anticipated risks of climate change already lead to reassessments and disinvestments, like Saudi Arabia beginning to sell their big oil company, or US coal companies going through chapter 11. It was always clear that oil is a product with limited shelf life, think peak oil. The same is true for coal and gas.

In his latest book, Jeremy Rifkin cites studies showing that the carbon bubble is likely to burst by 2028, causing the collapse of the fossil fuel civilisation. This is a major sustainability problem. Rifkin advocates a Green New Deal, an idea that the new leader of the European Commission, Ursula von der Leyen, now also pursues.

We'll probably see another hockey-stick, or S-curve in the long run, on the way to a low-carbon future. For the last 50 years, change was slow. But at some point, it will tip. The carbon bubble will burst, either gradually or with a great shock and high volatility.

In either case, the digital revolution will look tiny in comparison.

Photo by Marc Sendra Martorell on Unsplash