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.
But he may have soon an opportunity to increase his stake if other shareholders want to sell theirs.
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 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.
The next disconnect is between the 2050 timescale and the physical constraints on the transition. The Energy Transitions Commission recently concluded that while there are no underlying shortages of required raw materials, the lack of existing extraction and refining infrastructure implies that “there could be significant supply gaps for six key energy transition materials: lithium, nickel, graphite, cobalt, neodymium and copper”.
Smil meanwhile offers two warnings regarding the realism of eliminating fossil fuels by 2050. One is that as of today there are still no industrial-scale processes to produce materials essential to modern life such as plastics, concrete, ammonia for fertilisers, and steel without generating carbon dioxide. The other is that the first global transition from traditional fuels such as firewood to today’s predominantly fossil fuel mix took more than 200 years – and is still not complete.
A third consideration is geopolitics. The vexed question of climate justice has complicated international action for decades. If the advanced economies grew rich by burning fossil fuels, can they prevent poor countries from doing the same? The growth of emerging markets over the past 20 years has only made that conundrum trickier. Research by Simon Evans of Carbon Brief suggests that by 2021 four of the five countries with the largest cumulative carbon emissions since 1850 were in the developing world.
Geostrategic conflict presents a new and even bigger problem. There is an obvious tension between Western countries seeking to reduce their dependence on China while continuing to decarbonise in a world where the People’s Republic controls 90% of the refining capacity for rare earth elements essential to electrification. Meanwhile, in a more contested world national security is likely to trump international cooperation on the energy transition. A single statistic summarises the challenge: China, Russia and Iran today produce nearly 40% of global carbon emissions from energy. On economic, physical and geopolitical grounds, in other words, betting against current deadlines for net zero policies seems like a certain winner.
There are two big caveats, however. The first is that financial markets may already have discounted governments falling short of their targets. The vote share of green parties collapsed in recent EU parliamentary elections , while countries from Scotland to New Zealand have chipped away at policy targets. The iShares Global Clean Energy exchange-traded fund is down nearly 20% in the last year while the S&P Oil and Gas Exploration and Production ETF has enjoyed a similar-sized gain.
The other is that arbitrages can close in either direction. Countries with currency pegs can defy speculators by attracting foreign exchange flows and sustaining penalty interest rates, as Hong Kong has shown time and time again. Reality can catch up with policy – rather than the other way round.
Investors seeking to exploit today’s net zero arbitrage should take note. Economic, technological and geopolitical conditions could change to render 2050 net zero targets feasible after all. The costs of generating electricity from solar power and onshore wind turbines have fallen so far they are becoming competitive with fossil fuels. Nuclear power could tip the scales if ambitions for so-called Small Modular Reactors are realised, let alone if companies succeed in harnessing nuclear fusion. Today’s geostrategic fragmentation may turn into tomorrow’s global truce.
For net zero, spotting the current arbitrage between policy and reality is easy. Predicting how the gap will close is not.
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