The Climate Pricing Gap

Above illustration by artist, Nicole Kelner

Why the popularity of passive investing is making it harder for the market to price in climate risk/opportunity.

In the year 2000, 12 percent of the assets in US equity funds were passively managed. By 2021, over 50 percent of US equity fund assets were held in passively managed ETFs and mutual funds.

That is a massive jump in a short period of time. And it’s not the short-term investors who are the major adopters of passive investing, it’s the long-term investors.

This phenomenon of long-term investors shifting from active market participants to passive public market followers has created a pricing gap.

Historically, the stock market had both long- and short-term investors sending pricing signals, as more of those long-term investors have adopted passive investing strategies, movements in the market are increasingly being dictated by short-term investors. The near term noise is winning the day.

The deep currents are being ignored.

So, if you are a long-term investor like us, you are increasingly finding yourself with a “when?” problem when it comes to passive investing. Our clients’ time horizons are long, but the stock market’s pricing mechanisms increasingly can only account for near term trends.

And if you are a sustainable investor like us (and odds are that’s the case if you’re reading this), it might be time to start explaining this phenomenon to your clients more clearly. With so many long-term investors electing to follow, rather than lead, the stock market is not able to accurately price in the long-term risks and/or opportunities of climate change.

Electric cars present a pretty clear example:

• 50 percent of global oil today is used in cars and trucks on our roadways.
• In 2020, 1 of 20 cars sold in the world were electric
• In 2023, the IEA projects it will be one of 5 cars sold will be electric.

So, oil companies are having their single most important market (road transportation) being disrupted by a superior technology (electric cars) that is growing exponentially (33% CAGR).

Sounds like a reason for their stock to decline, right?

In 2021 and 2022, the opposite happened. Thanks to the short-term oil price increases driven by inflation and Putin’s invasion of Ukraine, oil stocks have had their best couple years in the past decade (although in 2023, we’ve seen a reversal).

From January 1st, 2020 – June 30th, 2023, The Morningstar US Energy Index is up 61 percent.

From March 20th, 2020, the bottom of the pandemic drop, this index is up a whopping 286 percent.

I won’t be retiring for decades. Does it make sense to not just hold oil stocks in my retirement account (given the rise of electric cars), but hold 61% more of them in my portfolio than I did on Jan 1, 2020?

No. It doesn’t.

Are we seeing the market en masse short REITs with major positions in Florida or parts of California given the exponential explosion in real estate insurance premiums? Nope. At least, not yet.

At some point, this game of musical chairs will end, and the market will correct itself. It always does. The question is, (you guessed it), when?

But until that, the abdication of pricing leadership from long term investors driven by the massive switch to passive strategies, has created a Climate Pricing Gap.

A “Green” Big Short moment is coming.

Fossil fuels have largely been underperforming over the last decade, as shown in this report, but most of the commentary has been that it was because of CEO incentives tied to oil production. This led to expensive fracking that wasn’t financially sound. But what will the performance drag be when investors open their eyes to the climate pricing gap and see that oil majors are being radically outcompeted?

It might not happen for a few years. It might not happen in a sudden collapse, but in a slow deflating. But it will come. And it’s not being accurately priced in today.