Are you prepared for a green bubble?

In the coming years, a huge “green” market bubble will emerge, driven by a pervasive fear of global warming, a panic away from oil, and U.S. government policies. Companies without a legitimate sustainability initiative will then face increasing difficulties as resources, including investments, begin to flow away from them and toward green businesses. As such, executives need to be achieving significant carbon reductions today to prepare for that upcoming shift.

In 2006, when I first published my book “The Green Bubble,” I was convinced that the global economy was headed toward a massive financial bubble fueled by a rush to invest in renewable energy sources. Today, in the aftermath of the financial crisis triggered by disastrous failures in the mortgage and credit markets, I am all the more certain. Unfortunately, some executives continue to believe that market bubbles are economic aberrations that can’t really be predicted or managed until after they’ve occurred. I disagree. Consider the last two major bubbles, resulting in collapses in the dotcom/telecom industry and the housing/credit markets. These two were, in fact, a consequence of national policy in the United States. And the next bubble will be “green” for exactly the same reason. It will be vastly bigger than the two earlier ones, driven by a pervasive fear of global warming and a panic away from oil that will spur investments in renewable energy technologies that are currently available. As such, executives who shrug off bubbles as anomalies that can’t be anticipated are leaving their companies vulnerable to unnecessary risks. Instead, they should be preparing their organizations now for the coming green bubble.

What Are Bubbles?

In the past, many experts insisted that market bubbles simply don’t exist. Their fundamentalist view of the market, based on something known as the efficient market hypothesis, argues that markets always reflect the sum total of all the information available to every participant and that the information spreads more or less instantly. Therefore, prices are always correct. And if prices always represent intrinsic value, where’s the bubble? But the collapses of the dotcom/telecom and housing bubbles have certainly led to a serious rethinking of that school of thought.

An alternative theory that has gained considerable acceptance is the behavioral finance, or standard psychological, view. Suppose that an asset such as stocks, real estate, or a commodity like oil experiences a sudden spike in value. That surge could be the result of any number of possibilities – say, unrealistic hype from so-called experts in the field – but if enough people buy into that story then prices will continue rising. Eventually, others jump into the market just to avoid missing out on a good thing – a phenomenon referred to as “momentum trading.” Each person figures he’ll get out in time by selling to someone known as “the greater fool.” As the enthusiasm continues, buyers far outnumber sellers and prices go way beyond what any rational analysis of the intrinsic value of that asset would suggest. Because everyone wants to get out before others do, even small events like lower-than-expected earnings can trigger panic selling. The inflated prices fall, sometimes dramatically as in a crash or other times less severely as in the long grinding slide of the NASDAQ in the early 2000s. According to behavioral finance theory, people frequently hold onto an investment longer than they should because losses have a bigger psychological hit than do gains. So with the initial and subsequent dips, investors are often reluctant to sell, but then they begin to feel trapped.

A third view, which I favor, builds on behavioral finance theory. So far this view, which I refer to as the managed market hypothesis, applies only to the last two bubbles — dotcom/telecom and housing — both of which originated in the United States and were stimulated (or pumped) by both the U.S. central bank (the Federal Reserve) and by presidential policies, provoking massive momentum trading. Let’s take a closer look at what happened.

Both the dotcom/telecom bubble, which ended in 2000, and the housing bubble that followed it originated during the tenure of Alan Greenspan, head of the Federal Reserve from August 1987 to January 2006. While in office, Greenspan served under four U.S. presidents: Ronald Reagan, George H. Bush, Bill Clinton, and George W. Bush. Recently, Greenspan has written about how stock markets do more than just reflect and forecast the underlying economic reality; they literally create that reality. So, when the stock markets rise, they pull the real economy up behind them.

To understand how that happens, consider the two immediate consequences of a bull market. First, it allows companies to borrow money more easily, either from a bank or by issuing bonds, thus encouraging business investments. In fact, we are currently seeing such an effect in the stock market run up from March 2009. Initially, companies that were issuing new debt were primarily U.S. blue-chip corporations but, now, even medium-sized European firms, such as Abengoa, a Spanish renewable-energy business, are issuing considerable amounts of high-yield (sometimes called “junk”) bonds. Second, the increase in stock values creates what is known as the “wealth effect” — people who see their stock portfolios increase in value will spend more, going out to dinner, buying new clothes, renovating their homes, and so on, thus further stimulating the economy.

So suppose a government wants to stoke that kind of growth because, well, a robust economy increases the general well-being of the public by, for one thing, keeping unemployment rates down, thus making it easier for politicians of the ruling party to be reelected. Governments typically have a variety of mechanisms for stimulating growth. In the U.S., one of the main ways is for the Federal Reserve to lower interest rates — or at least not to raise them too much even as the economy heats up. (Other mechanisms include making direct investments, for example, in a massive military build-up, and influencing regulatory bodies, such as President George W. Bush’s push for an “ownership society,” which encouraged the loosening of restrictions on home mortgages.)

Of course, a bull market that is propped up by various governmental inventions does not reflect the underlying economic reality. In fact, it is a certain kind of bubble. But if the government keeps pumping it, it will become an even bigger bubble, just like the dotcom/telecom or U.S. housing bubble. Viewed in this way, the U.S. Federal Reserve didn’t really “miss” those bubbles; by keeping interest rates low, it actually blew them. “The Fed, in effect, has become a serial bubble blower,” asserts Stephen Roach, now chairman of Morgan Stanley Asia. Moreover, the government might be proficient at pumping markets, but it’s far less skilled at managing them down, which is admittedly a tricky endeavor because of the risks of a recession or, worse, a depression.

And what about other stock markets worldwide? Well, they simply follow the U.S. If you doubt that, simply watch the French, German or British markets after the U.S. opening in New York City. When the European markets begin heading in one direction but the U.S. markets open by going the other way, the European markets will change course to follow the U.S. lead. Thus recent worldwide bubbles have been an unfortunate side effect of U.S. national policy, and the next one will be too.

The Emerging Green Bubble

Because of U.S. federal policies, I am certain that there will be a new bubble and this time it’ll be green, driven by a rush from an economy based on petroleum to one that relies on renewable energy sources. Consider that U.S. President Barack Obama, just over a year in office, has announced his firm intentions toward sustainable growth. This has produced, so far, a $70 billion stimulus for green initiatives.

The coming green bubble will, I believe, be the biggest in history because of two reasons. First, it will be truly global. Earlier bubbles in the stock market involved just the U.S., Europe, Japan, and Australia. This one will extend well beyond those regions to the BRIC (Brazil, Russia, India, and China) countries, much of the rest of Asia including Malaysia and the Philippines, the Middle East and the Maghreb countries, and South Africa because those areas are already all involved in renewable energy of one type or another. Second, the green bubble will expand around an enormous economic issue — the exit from fossil fuels for everything that is moved, heated, cooled, or built. The urgency of that issue can’t be overstated. According to the Intergovernmental Panel on Climate Change, which was established by the United Nations, we have maybe only 20 years to avoid the worst, irreversible consequences of global warming. This crisis will become all the more pressing as everyone starts to feel its pervasive impact, for example, through price increases and greater difficulties in obtaining casualty insurance policies as a direct consequence of the growing number of weather-related catastrophes such as Hurricane Katrina.

Because we don’t have enough time to count on technological breakthroughs, we must rely on what currently works. This includes wind turbines, photovoltaic power, geothermal energy, hybrid vehicles, and conservation. As just one example of conservation, current “passive house” technology can reduce energy consumption for heating and cooling in buildings by some 90%, with just a small price premium that pays for itself over time in reduced energy costs. The point here is that the technology to deal with most of the problem exists today; there is no need for an initiative like the Manhattan Project, which developed the atomic bomb during World War II. Instead, a massive industrial build-up is required. According to the 2009 World Energy Outlook of the International Energy Agency, we need to spend about $11 trillion above what would normally be invested in energy over the next 20 years (or about $540 billion annually) to get out of fossil fuels. An example of the type of projects required is Desertec, a vast network of concentrating solar power in the Sahara desert and offshore wind turbines on the North African Atlantic coast. The total price tag for that initiative will top $400 billion over 30 years, with Munich Re, a major insurance company, playing a big role.

So, to put everything into perspective, we would need the equivalent of one Desertec project each year for 20 years to make the transition to renewable energy. Is that vast investment likely? Is it even possible? Sure, if people are scared enough. Consider that the U.S. Department of Defense requested budget for fiscal 2010 is about $664 billion. So the figures to combat and stop global warming are not impossible to achieve. In fact, in a world of government stimulated (managed) economies, these figures may look like real opportunities.

I predict that such investments will lead to an enormous bull market in renewable energy stocks. That exuberance will then morph into a bubble. But how to tell when one transforms into the other? There are various indicators, one of which is the price-to-earnings ratio of stocks. Historically, the P/E ratios of stocks have averaged between roughly 10 and 17, depending on how they’re calculated. During the dotcom market bubble, P/E ratios for many companies soared well above that range.

What to Do?

Companies do not want to be caught on the wrong side of the coming green bubble. If, for example, a corporation lacks any legitimate sustainability initiative, it could face increasing difficulties in raising money through the issuing of bonds because investments will be flowing toward greener companies. If a governmental agency develops a “sustainability index” as a guide for investors, that would only accelerate the flow of money away from traditional businesses. Already a number of green mutual funds and exchange traded funds are providing such guidance, and Standard & Poor’s has developed two carbon indexes, one for U.S. corporations and the other for companies in emerging markets.

Not only money, but other resources could begin flowing more toward green businesses, leaving other companies at a disadvantage. For example, corporations with strong sustainability initiatives could become increasingly attractive places to work. As talented employees begin to flock to such places, the movement could lead to a self-reinforcing cycle. For instance, as more people work for companies with strong sustainability mandates, that will strengthen the numbers of people lobbying for environmentally friendly causes, thus accelerating the move away from fossil fuels.

What should executives be doing today to prepare for the coming green bubble? At the very least, top management should have a strategic plan in place with respect to carbon reductions. Cap-and-trade legislation and carbon taxes or tariffs could result in severe penalties for companies that are caught unprepared. To exacerbate matters, insurance companies may make some financial protections against carbon-related risks prohibitively expensive. Consequently, executives need to be making progress today (if not yesterday) in achieving significant carbon reductions. All new office buildings, manufacturing plants, and renovations, for instance, should be designed to achieve substantial reductions in energy consumption. The transportation of products over long distances should be exploiting existing technologies to reduce carbon emissions by orders of magnitude. And so on.

Furthermore, executives should not make the mistake of assuming that the financial innovations that exist today will be available in the future to help hedge against sustainability-related risks. Whether such risks can be distributed through securitization remains to be seen. Indeed, companies would be wise not to count on that because, really, the financial industry has yet to recover fully from the fiasco of their collateralized debt obligations and credit default swaps.

Of course, I expect that many companies will be skeptical that a green bubble will emerge in the coming years. And even after that bubble begins to form, some might still be in denial for a while. But those businesses will be in for a rude awakening as the world begins to shift dramatically around them. Novelist William Gibson famously said: “The future is already here. It’s just not evenly distributed yet.” From my vantage point, the future is quite clear, and it definitely consists of a huge green bubble, larger than anything we’ve experienced before. Those companies that are prepared for it will be more likely to prosper, while those that have yet to see the future may well struggle for their very existence.

http://www.paristechreview.com/2010/04/14/are-you-prepared-for-a-green-bubble/