Saturday, June 15, 2024

"Net zero arbitrage is large, but no one-way bet" (with a drive-by from Vaclav Smil)

From Reuters' BreakingViews, June 14:

If macro investing has one signature strategy, it is exploiting the arbitrage between unsustainable policy and irresistible reality. The biggest disconnect today is the gap between the ambition of governments in the rich world to eliminate net carbon emissions by 2050 and their ability to deliver on that goal. However, it is not a one-way bet.

The classic example of a macro arbitrage is betting against a fixed exchange rate, where a government has committed to keep its currency pegged to another. Investors who reckon the cost of defending the peg will be politically or economically intolerable sell the currency short. The country’s central bank is forced either to drain its reserves of foreign exchange or hike interest rates. Eventually, the peg breaks.
Investors who get it right – as George Soros did in 1992 when he bet that the pound would crash out of the European Exchange Rate Mechanism – can make a killing in an afternoon. Those who get it wrong can lose their shirts, as Marko Dimitrijevic of Everest Capital learned when the Swiss central bank unexpectedly lifted the cap on the country’s currency against the euro in January 2015.
Unfortunately for today’s would-be Masters of the Universe, currency pegs have gone out of fashion. However, the challenge of climate change is delivering a new arbitrage opportunity far bigger than anything they have ever seen before. The setup is the gap between governments’ policies of eliminating emissions of greenhouse gases and the economic, physical and geopolitical constraints on reaching that goal.
The rationale for the global drive to decarbonise is simple. The Intergovernmental Panel on Climate Change (IPCC) found in 2018 that, to limit global warming to 1.5 degrees Celsius above pre-industrial levels, global net emissions of carbon dioxide due to human activity must shrink to zero by the middle of the century.
The worldwide response has been impressive: 140 countries including the United States, Japan and all members of the European Union have committed to meet the target. Some have gone further. The United Kingdom has pledged to decarbonise its power sector by 2035, for example. The opposition Labour Party will bring that deadline forward to 2030 if it wins next month’s general election. Yet it is far from clear that the promised pace of transformation is remotely realistic.

The first challenge is economic. The International Energy Agency (IEA) estimates total investment in clean energy was $1.7 trillion in 2023. Yet the McKinsey Global Institute forecast in 2022 that capital spending on physical assets for energy and land-use systems needs to hit around $9.2 trillion per year to achieve net zero by 2050.

Other analysts reckon the needs are higher still. The Canadian scientist Vaclav Smil puts, opens new tab the cost of reducing global fossil fuel consumption even by a less demanding 60% from today’s levels in the region of $15 trillion to $17 trillion a year. Assuming rich countries shoulder the bulk of that burden it would equate to between 20% and 25% of their combined annual GDP....


Here's the Smil paper, "Halfway Between Kyoto and 2050, Zero Carbon Is a Highly Unlikely Outcome." (48 page PDF) I still haven't gotten to it despite  having started a post: 

I was just sent this monograph last week and have not yet read it. With that disclaimer, and noting that the good Professor has not led us too far astray in the past, here's his latest via Canada's Fraser Institute...

Regarding this post's headline, of course it isn't a "real" arbitrage. As long time readers know the number of real arbitrages is vanishingly small. From a 2013 post reprised in 2018's "Arbitrage: Historical Perspectives": People, people, people arbitrage opportunities have been disappearing for the past 150 years!

....I guessing the two commenters didn't have the definition: "The simultaneous purchase and sale of the same instrument in different markets at different prices" pounded into their head so often their ears bled.
I did.
How many arbitrages do they think present themselves each year?

Spotting and acting on an arb is pure alpha and here is a dirty little secret:
The entire amount of alpha available to the entire hedge fund industry is only $30 billion per year.
As reported by a hedge fund maven via Investment News back in 2006:

...PHILADELPHIA - Everyone in the crowd assembled for the CFA Institute's hedge fund conference took notice when David S. Hsieh said that the amount of alpha available in the hedge fund industry each year is $30 billion.

Mr. Hsieh, a professor of finance at the Fuqua School of Business at Duke University in Durham, N.C., presented a synopsis of his ongoing research, which focuses on the style, risk and performance evaluation of hedge funds, at the Feb. 16 conference here. As part of his work, Mr. Hsieh questioned whether flows into hedge funds are causing a decline in hedge fund returns and what might happen if the high rate of inflow continues.

Because of difficulties in obtaining reliable hedge fund data, Mr. Hsieh used fund-of-hedge-funds data and broke down returns into alpha and beta sources. He said the research led him to "feel comfortable" determining that there is a finite amount of alpha - conservatively, $30 billion - managed by the approximately $1 trillion hedge fund industry. And even if capital invested in hedge funds were to rise, the amount of alpha would remain the same.... 
Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06.
Here's CBS MoneyWatch in March 2013:
Hedge funds are too big to beat the market
This is probably just a definitional problem so let's say it plainly:

In so called risk (merger) arbitrage the emphasis is on the first word.
Cash-and-carry, buying physical and shorting a derivative is not arbitrage.
When people use the term "arbed away" when talking about market anomalies the are not talking about an arbitrage.
Shorting an ETF and buying the component equities is not an arb, it's just a hedged trade.
Same for Index Arbitrage.

The total pool of arb opportunities may be as small as $1 billion.
Even the old Royal Dutch and Shell Transport trade was not an arb, just a fairly good pair trade.....