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How the Climate Is Breeding More Black Swans

November 8, 2013


Here’s a definition that should send chills down the spines of investors: “An unpredictable or unforeseen event, typically one with extreme consequences.” This sums up a black swan event. Nassim Nicholas Taleb mainstreamed the concept through his writings. His points became particularly topical through his book, The Black Swan, around the time of the financial crisis — a major, destructive event that many people found unexpected and, beforehand, maybe even impossible.

There’s a similar risk brewing on the horizon. Climate change could be the next black swan event that causes an ugly ripple effect through our lives and economies. The majority of current investment strategy comes up short on modeling, even considering that this as a legitimate concern, at least for our lifetimes.

History’s lessons
Here’s a lesson in extreme irony: The term originated when people didn’t believe black swans existed at all. Because no one had ever seen one, it certainly looked as if none existed. The rare birds were first sighted upon the realization that Australia existed.

Taleb’s theory perfectly segued into the financial crisis as a black swan event. A few people isolated data pointing to a crash before the bust. Michael Lewis profiled several individuals who did suspect the approach of seismic financial disruption in his post-crisis book The Big Short. Taleb’s philosophical points included the fact that black swan events have become more serious in their impacts as the world has become more complex .

Climate change — and its effects on humans, ecosystems, and economies — fits within possibilities for unforeseen. Although the science of climate change is increasingly accepted, assigning urgency for actions and solutions still lags.

An excerpt from Taleb’s The Black Swan, published in The New York Times in 2007, gave examples that fit into this issue:

Consider the Pacific tsunami of December 2004. Had it been expected, it would not have caused the damage it did — the areas affected would have been less populated, an early warning system would have been put in place. What you know cannot really hurt you.

We may not know exactly what will happen when, but we are seeing the warnings of increased events in unprepared places, as well as causation — and can at least attempt to twist our brains around that, and devise solutions.

Shareholders should demand proper assessments of all future risks — even the ones considered remote. Corporate filings already disclose all kinds of possible material events as it is. Some companies warn if important parts of their operations are located in earthquake-prone areas, for example.

Climate change, and the disastrous consequences in geographical regions, are similar risks. Most corporation managements aren’t applying the same principle; earthquakes may not happen every day, humans don’t always plan for them because the possibility is remote, but they can hobble, or even destroy, businesses and economies.

Delayed reaction
More large entities, including corporations, should take action on issues like climate change, destructive weather in unexpected places causing unprecedented damages, resource scarcity due to disruptive environmental changes, and so forth. They can move the needle in a more positive direction.

Hurricane Sandy, and serious floods, fires, and droughts in 2012, have already shown us the kind of destruction, human costs, and economic disruptions that can result from extreme and unexpected weather incidents. Hurricane Sandy was an unprecedented hybrid storm with combined elements that stymied meteorologists, for example. It continues to affect people and communities. That’s frightening and haunting.

In 2012, adding up the costs of Hurricane Sandy and the Midwest drought came to $100 billion. These were the most expensive disasters ever – exceeding the costs of natural disaster incidents all over the world.

Recent data from sustainability advocacy group Ceres pointed out that investors and individuals should also assess near-term costs, like taxpayers picking up the tab. When private entities, corporations, and individuals get a free pass, it’s an example of another popular term popularized during the financial crisis: moral hazard.

In 2010, the SEC drew up guidelines for climate change disclosure and its material risks to business. Far too few companies have voluntarily evolved to deal with this mandate. That’s sad given the amount of time that has transpired.

Ignoring the weather
According to InsideClimate News, only a handful of companies mention the terms “climate change” or “global warming” in their annual SEC filings. An analysis released in September revealed chilling findings: of 3,895 companies, a mere 27% had taken the bull by the horns and put those risks into print, although many of those only skimmed the dull legalese often utilized in SEC filings.

Data-crunching was conducted by Lawrence Taylor, an entrepreneurial database developer, who had the know-how and the burning desire to closely examine the issue.

Taylor’s work on a searchable database took 1,100 hours, and five months of his life. That shows that, without disclosure, accessing information that many investors find important and meaningful to their stock research is an onerous task.

This is a sad state of affairs in a supposedly knowledge-based society with free and easy access to so much information.

Let’s not ask questions later
The deft skill of applying many disciplines and possibilities to risk analysis to look ahead instead of behind is a challenging talent. Such thoughtfulness should be the backbone of strong, robust corporate managements and boards. Shareholders should demand disclosures, policies, and specific goals before potential catastrophes.

BP‘s (NYSE: BP  ) Deepwater Horizon disaster is a solid historical example a failure of risk management. That tragic and damaging incident portrays a scenario that didn’t seem “possible” — and the company floundered trying to deal with an event they had considered too remote to plan for. Tracking the news at that time showed no contingency plan.

Liabilities and risks continue. On Monday, BP showed up in court wrangling over its settlement associated with the disaster. The company has paid out $3.7 billion, originally figured $7.8 billion figure of potential costs, and later concluded that it couldn’t even give solid estimates.

The situation remains important in the investing sense, even after all these years. Investors should think long and hard about what that means to investing.

Black swans are rare. Black swans do not always live in one place, swimming in a linear and predictable path. Once they reappear, though, they often make perfect — and horrible — sense. In many cases, asking why, after the fact, will be the sad and futile response to real, painful consequences, to investors and everyone else.

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