Climate Catalysts: The Pairs Trade Of The Century

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Climate Solutions with Erik · Climate Catalysts: The Pairs Trade of the Century (2/9/2021)

This article is the first installment of my column’s new feature, Climate Catalysts. Climate Catalyst articles highlight cutting edge research into climate science and its implication on economics and investing.

This month, we look at what I’m calling The Pairs Trade of the Century: Long flour tortillas / Short corn tortillas.

Executive Summary

• Academics at Northern Arizona University and the Woodwell Climate Research Center released sobering research detailing their findings about the effects of increasing CO2 levels and heat on plants.
• The team’s findings have implications in the world of AgTech, the new industry of carbon sequestration and reuse, and in the market for carbon credits.
• The punchline is that you should go long wheat while shorting corn – it’s at least as plausible of a trading idea as anything the Robinhood crowd is doing.
• In this article, I mention Carbon Engineering, 1PointFive, Pale Blue Dot Energy, and Storegga.

The Research

One argument I sometimes hear from people not well-versed in climate science is that increasing atmospheric carbon dioxide will spur plant growth, creating more food for the expanding global population.

The process of photosynthesis is one in which plants take in CO2, convert it into energy, and give off oxygen. So, in a simple world, more CO2 is better for plants.

However, the world is not so simple. There is another process involved in plant growth, called respiration, which gives off CO2. The balance between photosynthesis and respiration is presently about 2:1 – two units of CO2 are taken in during the process of photosynthesis for every one released during respiration. This imbalance means that the world’s plants serve as an important “carbon sink,” pulling in around 30% of the CO2 we produce by burning fossil fuels.

This sink effect is so powerful that it has prompted the idea of the Trillion Tree Project, which advocates a policy of planting a lot more trees. The Trillion Tree Project got a big boost in the media last year, when it was mentioned by former president Trump in his State of the Union address.

However, recent research from Northern Arizona University, the Woodwell Climate Research Center (formerly known as the Woods Hole Research Center), and colleagues from New Zealand shows that there are biological limits on how much we can count on trees to pull down atmospheric CO2 levels.

Photosynthesis is spurred by increases in CO2 levels, but the process is sensitive to increasing temperatures (the kinds of increases that go hand in hand with rising CO2 levels). A few degrees of additional warming causes photosynthetic activity to decline (i.e., plants stop growing as quickly), even when more CO2 is available.

Respiration, on the other hand, simply increases as temperatures go up.

As temperatures rise, plants’ ability to take in CO2 via photosynthesis decreases, while respiration’s capacity to give of CO2 increases. The research team measured the actual levels of CO2 gives and takes around the world and found that this effect was already measurably occurring.

More frightening, the researchers found that on our current trajectory, the relative balance of photosynthesis and respiration will flip within about 20 years, thus turning all the world’s plants (the “terrestrial carbon sink”) into a net source of carbon dioxide.

Keep in mind, at the rate we are going, the likely timeframe for this flip to occur is within 20 years – that’s a future that is as close to us today as we are to the 911 attacks.

Were our present terrestrial carbon sink to flip into a terrestrial carbon source, our ecosystem would reach an extremely critical tipping point. The hotter our atmosphere would get, the more CO2 plants would give off; the more CO2 plants would give off, the hotter our atmosphere would get – the classic definition of a vicious cycle.

(You can see the original paper in Science Advances and Scientific American also has a good article explaining the research.)

Why This Research Matters

About eighty-five percent of plants – including major staple crops such as wheat and rice – use a form of photosynthesis known as C3 carbon fixation. C3 photosynthesis is extremely sensitive to temperature increases, and plants using this pathway are already facing temperature increases over the C3 photosynthetic limit in certain regions – especially South America, Africa, and Asia.

As temperatures rise for more months of the planting season, farmers growing C3 food crops will find their fields less productive all over the world. Add to this natural, metabolic drop of plant productivity, the negative effects of drier soils and / or damagingly severe rainstorms and it is not hard to see that agricultural production will start to suffer.

The social impact of food scarcity driven by the financial impact of higher prices is a very powerful force in economics and politics. As a reminder, think back to the Rice Riots of 2008.

This dynamic – physical shortages of basic necessities due to inescapable biological processes – is the reason I am so interested in the field of Agricultural Technology (AgTech) and why this is one of my three main areas of focus. I am less bullish on genetic engineering solutions to this problem, but good old-fashioned breeding programs may allow some crops to be a bit less sensitive to rising temperatures in the time scales that matter to us.

The other reason the NAU / Woodwell research is meaningful is its implications on the future of carbon sequestration technologies. Many Greenies are dead set against Direct Air Capture technologies like those pioneered by Carbon Engineering; instead, they believe we can simply plant more trees to pull down atmospheric CO2 levels.

This research suggests that natural based sequestration solutions (i.e., setting aside forest land as carbon sinks) face a real metabolic limit to effectiveness, and will work less well as temperatures continue rising.

In my mind, the building out of a new carbon sequestration industry a-la the strategy being implemented by 1PointFive in the US and Pale Blue Dot Energy and Storegga in the UK is absolutely essential to the continued thriving and surviving of our civilization.

An ancillary potential effect of the dynamics highlighted by the NAU / Woodwell research is the impact it is likely to have on carbon credit markets. One major source of carbon offsets now traded on carbon markets are large-scale forestry projects. The assumption giving rise to these credits is that a forested area will sequester a certain amount of atmospheric CO2 for at least a half-century. Based on the research we’re highlighting today, it seems like some of those assumptions are too optimistic.

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So, where does the Pairs Trade of the Century come in? Sorry – this is an ex-futures trader’s idea of a joke…

C3 photosynthesis is more sensitive to temperature increases than the respiration of plants using another type of photosynthesis known as C4 carbon fixation.

Food crops using the C4 pathway include corn and sorghum.

Flour made of C3 wheat will start to be scarcer sooner due to the effects shown in the research. As it becomes scarcer, it will become dearer. Corn will continue to be able to be produced at a much higher average temperature, so its prices should remain less dear relative to wheat.

So, a tongue-in-cheek trading strategy would be to go long flour tortillas and pair the trade with a short position in corn tortillas. Just plan to roll your tortilla contracts for the next 20 years and be prepared for the breakdown of social order sometime before your final expiration.

Clearly, the better trade is to find and fund well-run companies that have smart ideas about reducing emissions and sequestering CO2 and those that are working to improve the resiliency and capacity of our food production system. We have about 10 years to ramp these new economy ventures up.

Intelligent investors take note.