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The Actuary The magazine of the Institute & Faculty of Actuaries

Global meltdown

As a profession, we claim to make financial sense of the future. This may be true in certain technical areas, but what about wider social issues? Should we have been more proactive when it was strikingly clear that an economy built on cheap credit and a pyramid housing market scheme was going to end in tears? We believe it is the Profession’s role to highlight issues currently under the radar but which will become key challenges for society in the future. Here is our attempt to predict the future by answering five topical questions armed just with our actuarial skills and a dusty crystal ball.

Why has the price of oil dropped, and what can we expect for the future?
After the historic record peak in July 2008 of $147/barrel, oil prices decreased sharply reaching $38/barrel in December 2008. So, what happened? The first and most obvious reason was demand destruction caused by the global recession. The sub-prime mortgage and banking crisis, spiralling inflation, the withdrawal of cheap credit and increasing unemployment all contributed by reducing the world’s spending power and demand for oil. Since December 2008, however, despite the gloomy economic news, prices have increased by over 50%. We believe that, as the world economy recovers and developing countries continue a course of industrialisation, demand — and prices — will only then increase.

On the supply side, too, all evidence suggests that prices are heading high again. With less money to seek new oilfields and the higher opportunity cost of exploration, short-term oil supply will decrease. ‘Peak oil’ — the point where the rate of production peaks — is close, meaning inevitable increases in oil prices in the long term. It is estimated that around 95% of currently extractable oil has already been found; finite resources and increasing demand point to increasing oil prices. We believe the fundamentals point to prices as high as we saw last July in the next few years.

The collapse of the equities market, interest rate cuts and corporate bond spreads are all to be attributed, at least in part, to the spike in oil prices. The role of oil prices in the volatility of price inflation and the impact on companies’ profits whose costs depend on oil prices (utilities, rubber/ plastics, food) are some examples of how pension funds have been directly impacted. Clients will increasingly require advice in dealing with the consequences and risks of the end of cheap energy and developing solutions to address what is likely to be one of society’s biggest challenges.

Last winter was cold! Does this mean global warming is not happening?
No. Although it was the coldest winter in the UK since 1995/96, it was on average just 0.8 degrees below the 1971 to 2000 average. Perhaps it felt cold since it was a whopping two degrees cooler than the 2007/08 winter. However, last winter was considered normal 30 years ago. In fact, global temperatures have risen by 0.7°C over the last 100 years and have increased by some 0.15ºC per decade since the 1970s. We may see a slight temporary slowdown in the rate of warming, due to La NiÑa, but the trend will continue. In addition, there is significant warming ‘in the pipeline’ from emissions we have already put into the atmosphere. According to the Intergovernmental Panel on Climate Change, if strong action is not taken to cut greenhouse gas emissions, a multi-degree temperature rise is very likely by the end of the century; their current best estimate is for a 3ºC increase by 2100.

As actuaries, we have a number of roles to play; predicting what the impacts may be for our clients and society as a whole, what measures can be taken now to reduce global warming and offering advice on adapting to the new conditions in 20, 30 and 50 years’ time. Some practical examples are the proposed zero carbon bonds for pension fund investment and climate change insurance.

Does the UK face an energy shortage?
Probably. In 2006, 92% of primary energy consumed in the UK was derived from fossil fuels. In the same year, the UK became a net oil importer, oil (and natural gas) production having peaked in 2000. As consumption increases, replacement energy sources are not looking too plentiful. Nuclear has been touted as the obvious replacement but is very expensive from conception to decommissioning, slow to get up and running and will only ever play a minor, though not unimportant, role. The UK has a lot of coal but currently is a net importer due to comparatively cheaper low-cost imports. In any case, increasing extraction of coal from UK mines would be catastrophic for global warming and would make it impossible to meet Kyoto Protocol requirements. The recent announcement to build carbon capture coal plants is perhaps a step in the right direction. Renewables need to play a bigger role, but the plans are hardly ambitious — Portugal produces 21% of its energy needs from renewable resources, compared to 1.3% from the UK.

The UK can, of course, import energy, but this will become increasingly expensive and availability is not guaranteed. We will be competing with other countries with stronger currencies just as peak energy hits the world. The UK is heading for an energy crunch and the current Government does not seem to be planning seriously for it. Witness the plans for a third runway at Heathrow and subsidies for buying cars and car manufacturers.

As actuaries, we can model this new, lower-growth state and therefore estimate the impact on pension funds and insurers. We can also raise the energy shortage issue and advise on practical policy solutions to move away from a carbon-dependent economy.

What would be the implications of a 5°C rise in global temperatures?
In short: disaster. Increased insurance and infrastructure costs, rises in sea level, and mass migration. Irreversible damage to the ecosystem, human health and agricultural systems would cause a total breakdown in the global economy.

Although global temperatures would not increase overnight, storm/hurricane damage, eroding shorelines, fresh water contamination, coastal flooding and an increase in the salinity of estuaries would make the world a far less hospitable place to live. Competition for scarce resources such as food, fresh water and land will increase refugee flows and cause political unrest. Hans-Joachim Schellnhuber, at the Climate Change summit in Copenhagen this year, estimated that a world that is 5ºC warmer would be able to support only a fraction of the current world population.

As actuaries, we know very well how to analyse trends and assess best and worst-case scenarios. If warming is not limited to less than 2¢ªC, it is possible that feedback processes (for example, methane release) could take control out of our hands and drive temperatures higher, up to 5¢ªC or more above today’s levels. By learning about the danger and understanding the urgency, actuaries can help others understand the risk we are taking with the climate. Apart from the impact on the global economy, life, pensions and healthcare actuaries will need to consider the impact of global warming on life expectancy and human health. Actuaries will need to incorporate these new environmental issues, making assumption-setting an increasingly challenging task.

What solutions exist to reduce carbon emissions and what is their impact on corporate profits and behaviour?
CO2 emissions have reached 27 billion tonnes per year globally. As developing countries continue down the path of industrialisation and economic expansion, emissions will continue to rise. Two main alternatives have been proposed to combat increasing levels of carbon emissions: carbon taxes and a carbon allowance trading system. The aim of the first would be to increase the cost of polluting. Trading systems instead limit the amount of emissions to a government-set target level. Clearly, both systems are linked to fiscal policy and can only be successful if they have the support of current and future policymakers.

Companies investing in sustainable energy sources may see a short-term worsening of their profits and balance sheet due to the high initial cost of these investments. However, the energy payback period for some of these projects is surprisingly short and, with the low cost and renewable nature of these energy sources, the benefits will soon emerge.

Investment actuaries are already considering carbon trading as an investment vehicle and advising clients on ethical investment funds. Non-life actuaries can design and price new policies associated with new technologies, and all actuaries should consider the global economic benefits of reduced carbon emissions.

Simon Brimblecombe leads SJRB Consulting, based in Geneva, and Valentina Rocchi works at Watson Wyatt in London. They sit on the Institute of Actuaries’ Resource and Environment Group