By Philippe Burke, Portfolio Manager, Apache Capital
We’ve all read alarming reports of collapsing fish populations, giant rotating ocean gyres filled with consumer plastic, ocean acidification, blanching coral reefs, and melting glaciers. Our disappearing marine life is a classic illustration of the Tragedy of Commons, and our inability to self-correct is sometimes explained as the natural outcome of an intractable Prisoner’s Dilemma. An illustration follows.
Dilemma
Suppose two rational neighbours live by a pond where a thriving population of 100 fish frolic, growing at a net rate of 10% per month. The two neighbors meet and agree to protect & maintain the pond’s stock of 100 fish, and share in the growth bounty equally, with each harvesting only 5 fish from the pond per month. The problem with the agreement is that it would in fact be rational for each neighbor to cheat. To see that, consider the possible actions of each neighbor: 1) if neighbor A decides to cheat (catches 6 fish instead of 5) and believes that B will not cheat (will catch only 5 fish), A gets 100% of the benefit of cheating, and the communal loss (i.e. diminished fish stock, that could be countered by harvesting a bit less next month) is born equally by A and B; similarly 2) if A thinks B will in fact cheat (catch 6 fish), then it is again in A’s interest to cheat (catch 6 fish), because not cheating would mean that A would bear ½ the cost of B cheating, with none of the upfront benefits in extra fish.
That cost/benefit assessment is of course the same from B’s perspective. So rather than both neighbours not cheating, which would in fact be in both A’s and B’s best long term interest (e.g. being able to harvest 5 fish per month for ever), it is short-term rational for both neighbors to cheat, and that of course is how we end up with fish populations in free-fall in oceans across the globe.
But the environmental problem is a bit more complex than this simple example suggests: in addition to rapidly falling fish populations, what fish stock remains is becoming increasingly toxic, from rising ocean pollution. Most ocean pollution comes from the land (e.g. fertilizers, pesticides, mine tailings, plastics); The table below summarizes statistics for the Pacific coastal regions, for illustration. In short, the Pacific accounts for roughly 50% of global ocean waters, and 99% of commercial fishing is done within 200 miles of coast lines, and within 500 meters of the surface.
In Table 1, we calculate the area of the “donut” of Pacific Ocean coastal waters where most of the fishing is done. This area also corresponds to where most of the ocean trash is dumped annually. This enables us to also compute the concentration of trash in coastal ocean waters. Assuming that toxins account for 2% of trash, and that fish have a concentration of trash-emitted toxins 50 times higher than ambient waters, we find that on average, large fish accumulate toxic concentration levels in their flesh in the range of the EPA’s maximum recommended threshold within two years of life in Pacific coastal waters.
How can this problem be addressed? Consider the parties that must reach a lasting agreement for this pollution and depletion problem to be reversed: it is no longer an agreement among fishermen to harvest responsibly, but also among nations to hold pollution in check. Our lake is now the Pacific Ocean, and our two neighbors are now China and the US. If one neighbor nation grows more rapidly, that nation will likely also increase its share of ocean pollution, impairing the resources and health of both neighbors, and both parties will have an incentive to harvest fish more quickly before the rapidly diminishing fish stock becomes even more toxic. So any agreement between neighbors must include both harvesting and pollution limitations, but as was the case in our simple lake example above, it may be short-term rational for both/either neighbor to cheat on any agreed quotas.
A closer look
To address this problem, let’s begin by modeling the dynamics between the human and fish populations. At its simplest, we have rising human population leading to an increase in GDP, an associated rise in industrial pollution, as well as greater harvesting of fish for food. Rising pollution and diminishing fish stock in turn causes higher concentration of pollution in fish populations, resulting in greater food-toxicity and deaths for humans. In sum, humans take fish out of the ocean while adding pollution. What outcome can we expect for human and fish populations over time? We have a number of modeling alternatives, including the Schaefer harvesting model and the Lotka-Voltera predator-prey model. In what follows, we will employ a modified set of Lotka-Voltera logistic equations and examine these dynamics over time.
Dynamics
What are the dynamics of the system around these non-zero critical pairs of Human and Fish populations? We begin by setting equations (i) and (ii) equal to zero:
and analyze the local dynamics (local linearization) of the H & F populations around the non-zero critical values Hc and Fc computed in (v) above: for the Human population, we take its partial derivative with respect to Humans and Fish populations around their critical values Hc & Fc; and we then repeat for the Fish population.
This gives is the Jacobian matrix:
To get a sense of the actual dynamics between the two evolving and co-dependent populations, we need to select parameter values for our model. An illustration follows, assuming unconstrained growth rates of 1% and 2% for Human and Fish populations, environmental limitations of 0.8% and 1.9% respectively, and cross-specie encroachment (i.e negative impact from fishing and pollution) of 1% and 1.5% respectively.
With these parameter values, we are now able to specify our model, and calculate the eigenvalues of our system:
Result
Eigenvalues of opposite sign are characteristics of a saddle path, indicating unstable dynamics between Humans and Fish populations in our model, as specified. Different input parameters result in different (non-saddle path) dynamics, so confidence in the dynamics of our system would require solid empirical support to estimate the input parameters. That said to the extent the parameters used above are realistic, our model would suggest that the environmental dynamics at play today { growing human population -> increasing pollution spilling into primary fishing zones -> combined with rising fishing hauls to feed more humans -> resulting in more toxicity entering the human food chain} are likely to be unstable for both human and fish populations over time, and endogenous corrective forces in the system may not be sufficient to result in a stable long term equilibrium in which both populations survive. At the very least, counting on the current system to self-correct without exogenous intervention would seem reckless, considering the extinction risks of both populations.
Potential solutions
To have staying power, solutions must address the perverse incentive of pollution and over-fishing highlighted in our Prisoner’s Dilemma example: pollution and over-fishing currently benefit the perpetrators up front, while costs are shared inter-temporally by the entire human and fish populations. Correcting that externality is likely to be an essential element of any stable, long term solution.
Public Solution: One relatively direct solution would be for the World Trade Organization to appoint an honest, trusted independent third party (Sweden?) with the task of measuring ocean pollution off of the coasts of both Pacific neighbors (e.g. using 10,000 monitoring bouys), reporting the results daily with full transparency and monitoring, and whenever pollution exceeded a certain preset sustainable threshold levels for a period of time (e.g. 10 days?), the offending party would find the price of its export goods taxed in foreign markets, with tax proceeds used by a competent NGO (Cousteau?) to clean up ocean pollution and help revitalize marine life. The economic incentive to pollute would be lowered by the tax on the offending nation’s export profits, and if pollution did not fall below the sustainable threshold, funding would now exist to counter its negative environmental impact. As importantly, there would now be market incentives for businesses on both sides of the Pacific to find ways to grow sales (and contribute to GDP) in more sustainable, environmentally sustainable ways.
Private Solution: Large asset managers could demand a change in behaviour from publically traded polluters, by (1) using their voting rights, (2) divesting their holdings, and (3) shorting the stock of polluters. Jana Partners, a large hedge fund, recently announced plans to launch an ESG activist fund this year. To get a sense of effectiveness, consider that a concerted plan by the largest asset managers to divest from the equity of the 20 largest publically traded polluters would likely result in a drop in the stock prices of these polluters, all else equal. As illustrated in Table 2, gains from a market-neutral short position (properly sized and disclosed) could be used by an impact fund to finance pro-environmental activities.
Table 2: Environmental Activism
Step 1: start with 30,000 public equities
Step 2: use negative environmental filters (e.g. energy use per $US of sales, CO2 emissions, environmental files) to identify the worst polluters
Step 3: use negative financial filters (e.g. low revenue growth, high leverage, high price-to-book, high P/E) to select, among the worst polluters, those that have a poor financial profile
Step 4: short their stock (against a market-long)
Step 5: use gains (extracted from the shareholders of weak polluters) to finance environmental clean-up work.
Sources:
* Ocean Fish Census:
https://www.worldatlas.com/articles/how-many-fish-are-there-in-the-ocean.html
* Hedge Fund ESG Activism
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