Chad Slater, an Australian hedge fund trader, had actually been cutting his bets against oil companies in recent weeks, assuming the oil price could not fall any further.
Last week proved him wrong and the oil price dropped below zero for the first time in history. “I can safely say this wasn’t in my forecasts,” he says.
Nor was coronavirus but he is well placed to profit from the pandemic and broader crisis, as co-founder of Morphic Asset Management, which bets against polluters such as airlines and oil giants.
In Michael Lewis’s blistering account of the financial crisis – The Big Short – a handful of lone traders and hedge funds bet against the world’s most powerful banks, and won. Today Slater and a few others see a similar opportunity for a big short. This time, they say, it’s not mortgages but carbon risk that everyone has mispriced.
The fossil fuel industry thrived thanks to a decades-long campaign of disinformation. Banks and investors helped it along, compromised by years of exorbitant fees and lavish dividends. Plummeting demand from the coronavirus crisis has hammered the oil majors but, even once the market steadies, these traders say there is money to be made from shorting companies doing the most damage to the environment.
Dr Ulf Erlandsson, head of Diem Green Credit, clocked the opportunity in 2015. He was dabbling in ethical investing for the Swedish state pension fund and decided to take out a short position on bonds issued by a coal-burning utility, meaning he would make money if they dropped in price. Around the same time, investors started turning their backs on coal. The utility revalued its coal assets and its bonds dropped like a stone.
Erlandsson’s short position paid off handsomely. When bond prices fall, the indicative yield rises. Essentially, companies need to pay a higher rate of interest to entice investors to lend them money.
Erlandsson says: “They saw their cost of capital go up and decided they were not going to do coal anymore.”
He laughs at the brilliance of the trade. “It was like…this is fantastic; I can do the right thing and I can make money from it at the same time.”
A fresh faced Swede in a sharp suit, Erlandsson is not one of the “outsiders and weirdos” described by Lewis; nor is he a stereotypical, self-interested hedge fund trader.
Asked why he is so keen to pursue this trade, he cites the First World War poster where a man is sitting in his armchair as his children ask: ‘Daddy, what did YOU do in the Great War?’
“I am certain in 2050 my kids and grandkids will live with the effects of climate change and they will ask me, ‘What did you do?’ That gives me great comfort. Even if I fail utterly, I know that I will be able to respond that I actually tried to do something.”
All the traders shorting climate change risk have this unusual mix of ruthless capitalism and environmental zeal. Ben Dear, a 49-year-old serial entrepreneur, set up Osmosis in 2008 after selling his latest software company. He had seen the Al Gore film An Inconvenient Truth about global warming and decided to launch an asset manager “that society will benefit from as much as shareholders”.
It turns out asset management is not that straightforward. “I wish I’d never seen that movie,” he booms out a laugh. Osmosis now manages $1.3bn (£1bn) but Dear says: “It’s been a long 12 years.”
Osmosis employs 25 people who scour companies’ environmental reports to assess how efficient they are in water and energy use, and carbon emissions. One of its funds then buys shares in the most resource-efficient and shorts the least efficient.
This market neutral fund performed well in the recent turmoil, up 4pc between Feb 19 and March 23. Over the same period, its market neutral peers fell 6pc and the wider index dropped a staggering 34pc.
Trium, another London-based asset manager, has a similar strategy focused on companies in heavy emitting sectors, such as airlines and fossil fuels. These make up around one third of the MSCI Europe, but account for 90pc of emissions from the index. It too is taking long and short positions to iron out market risk.
So, if the whole market tumbles because of coronavirus, for example, the payout on the short positions will even out losses on the long positions.
A number of traders taking a long/short strategy failed spectacularly during the financial crisis. Howie Hubler famously shorted the lower, riskier tranches of collateralised debt obligations (CDOs), while buying up billions of dollars’ worth of the apparently risk-free, triple-A rated tranches. Ultimately, most CDOs were wiped out in their entirety and Hubler lost Morgan Stanley $9bn – more than any single trader has ever lost in the history of Wall Street.
It is the kind of comparison to make regulators blanch. Donald Pepper, managing director of Trium, is quick to point out this trade is very different. Forastart, Trium takes long and short positions of a similar size in a sector. So, if all fossil fuel companies are wiped out, they will not lose money.
The hope is, the company they have bought shares in and engaged with will be switching to renewables, so will not be wiped out. Even if it loses some value, that will be more than offset by gains from the company they have shorted, which they expect to fall in value. Trium will make money as long as the company they have bought shares in performs better than the company they are shorting.
The strategy has fared well, with the fund up 9pc in March, making positive returns both on days when the oil price crashed and when it rebounded. Ethical investors might flinch at an environmental fund buying shares in airlines and oil giants, but Pepper says that is the point. “We can make a meaningful impact because we’re talking to people who are causing 90pc of the problem.”
The environmental benefit of shorting climate change risk is arguably even greater in the debt markets. Erlandsson says: “Equity prices don’t really matter to the fundamental healthiness of a company. Whereas, if borrowing rates go up too much, then that becomes a killer, the grim reaper of the market.”
He is now raising capital for a strategy to short bonds with “fossil fuel risk”. He says the trade becomes even more attractive when you factor in the impact of quantitative easing. For years, central banks have been buying bonds to keep money pumping around the system. That has inflated prices and meant companies are paying lower and lower interest rates on their debt.
Sweden’s central bank has, however, said it will no longer invest in assets footprint. Christine Lagarde has mooted the possibility that the European Central Bank could do the same. It remains to be seen if she can carry this off. If she does, the price of polluters’ bonds will sink and the short sellers will see their bets pay off.
The traders say there has been a gear change in the response to climate change over the past 18 months, thanks in part to Greta Thunberg and Extinction Rebellion.
The global phenomenon | Greta Thunberg
Demographic change is also working in their favour. Dear says: “Millennials are running money, who get that this is an impact through their lifetime. As a consequence, there’s been a huge shift within the financial markets.”
First the Norwegian oil fund, the world’s biggest sovereign wealth fund, said it would ditch fossil fuel holdings. Then BlackRock, the world’s largest fund manager, said it would sell investments in thermal coal.
Tim Buckley, at the Institute for Energy Economics and Financial Analysis, said: “The BlackRock decision is profoundly significant. If one big player moves, people will watch but they won’t react. It’s when the second or third giant moves that the financial markets pay attention.
“Now [the Norwegian oil fund has] been joined by BlackRock there is a herd element. The lead players have started moving, now the pack has started to shuffle in the same direction. You will find it turns into a stampede.”
Erlandsson is confident governments will eventually legislate to curb climate change. “To paraphrase the old quote: ‘You can count on us doing the right thing, after every other option is exhausted’.” When they do act, he says companies may be shocked by the severity of the measures they impose.
The UN’s Principles for Responsible Investment (PRI) expects bans on coal and internal combustion engines, and a wider use of carbon pricing to be brought in before 2050. Notably, it says the policy response by 2025 will be “forceful, abrupt and disorderly”.
Erlandsson says the Australian bushfires were a wake-up call. “It’s something that is on a biblical scale. As these start piling up, it will get on a lot more people’s radars.”
At the end of The Big Short, Steve Eisman reflects on his short position against the US mortgage market and, by default, his bet against the global financial system. “It’s sort of like the flood’s about to happen and you’re Noah. Yeah, you’re OK. But you are not happy looking out at the flood. That’s not a happy moment for Noah.”
Slater fears the same if and when the literal floods arrive. “My vindication will be, ‘I was right, you should have priced carbon, and you needed to do it sooner’. My vindication will be the destruction of society and I don’t take any joy or pleasure in that destruction. It’s awful.”