“E” for Arbitrage

It has been hard to miss the fanfare and much ado of the COP 26, UN Climate Change Conference. It has caught the attention of investors and investment professionals alike as they ascertain what, if any, relevance, opportunity, or impairment COP conclusions might have, going forward.

Sustainable investment on paper sounds great and meaningful, and the numbers seem to tally with the importance with which it is being treated by investors, according to US SIF one third of all US domiciled investments fitted ESG or sustainability criteria.¹ The issue of course is that quantification and consensus around the metrics used to assess ESG and sustainability are, for want of a better word, varied.

The whole idea of a sustainable investment is somewhat arbitrary as each investor’s definition of sustainability will necessarily be determined by their specific investment timeframe. If one is assessing the implications of a climatic model illustrating the consequences in 2100 on the sustainability of an investment, inevitably this has diminishing relevance the shorter the investment timeframe.

In the current atmosphere where this environmental pricing is being monetized and deeply incentivized, a clamor to regularize and formalize ESG criteria on one hand combined with generalized confusion on the other, creates classic conditions for arbitrage opportunities.

Investment managers in many cases are now having to illustrate their ESGness to clients and this pressure is certainly helping pump both the notion and liquidity of the Green Economy. The lack of definition of as to what constitutes legitimate environmental criteria, for instance, has led to accusations of greenwashing investments, where the stamp of greenness is conferred using an ESG metric but is disputed by environmental campaigners. Consider French president, Emmanuel Macron’s recent announcement that in order to reach carbon neutrality by 2050, the country would begin constructing nuclear power plants again for the first time in decades. Ironic, given that nuclear power, the bête noire of generations of environmentalists, is to be used to save the environment.

Hence the dilemma, how does one classify investments related to nuclear power, are they low scoring “E” (traditional outlook, think Fukushima) or high scoring “E” (nouveau outlook, think low carbon energy à la Macron)?

This of course is a rather obvious example, useful for illustrative purposes to show how there can be two distinct opinions running in parallel, each with their own interpretation of the value of an investment when priced in environmental terms. In the current atmosphere where this environmental pricing is being monetized and deeply incentivized, a clamor to regularize and formalize ESG criteria on one hand combined with generalized confusion on the other, creates classic conditions for arbitrage opportunities. Furthermore, when one reflects even on the basic terms of reference of climate science; prediction, projection, and forecast and views their frequently confused interchange and misuse in the public debate on the environment via activism, and media, one sees how this could present a field day for a skilled arbitrageur.

The other interesting realization is that these opportunities born out of an apocalyptic umbra are very much in the immediate here and now. Investors will not have to wait until 2050 or 2100 to avail of the arbitrage opportunities. Far from being Boris Johnson’s “Last Chance Saloon” and the end being nigh, it very well could be just the beginning of a speculator’s dream and for proponents of the Green New Deal and the like, an unexpected and presumably unwelcome consequence. ■

Image Credit: Infinity3d at Can Stock Photo.

¹ US SIF – The Forum for Sustainable and Responsible Investment Report 2020.