Solar Flares and Risk Management for Investors
On 1 September 1859, the sun emitted a large solar flare releasing approximately 6 × 1025 joules of energy (i.e., a massive amount). Telegraph systems all over the world — which were connected by copper wires — failed, in some cases giving telegraph operators electric shocks; in other cases, cascades of sparks spontaneously erupted from telegraph lines. Amazingly, some telegraph equipment that wasn’t plugged in continued to receive messages. In the days that followed the solar storm, which came to be known as the Carrington Event, auroras were seen around the world — including as far south as the Caribbean and Ecuador. Fireballs were spotted in the sky. Equipment connected to this “Victorian internet” caught fire. What might happen to today’s internet if the sun were to emit another solar flare? What does this mean for risk management?
On 23 July 2012, there was a similar coronal mass ejection (CME) released by the sun, only this time the CME narrowly missed Earth. Had the CME occurred just seven days earlier, it would have directly hit planet Earth. According the the US Geological Survey, such an event has a 6%–7% chance of happening in the next 10 years. NASA scientist Daniel Baker calculates that there is a 12% chance that the earth will encounter another Carrington Event within the next 10 years.
CMEs are not our only worry. A similar phenomenon would happen if a nuclear device hundreds of miles above the earth were detonated, causing the release of an electromagnetic pulse (EMP). In government and military circles, this is old hat and has been addressed since the days of the Cold War. However, with the proliferation of nuclear technology, the risk of EMPs is growing. Although this phenomenon appears to be well understood and planned for in military circles, it is largely ignored in the private sector. Should such an event happen today, much (if not all) of our electric grid and communications infrastructure would fail. According to a recently declassified study by the US EMP Commission, an EMP event could cause a large-scale interruption of the power grid and communications systems, leading to the death of up to 90% of the population within 12 months.
Much of our critical infrastructure — water pumping stations, telephone wires, communication satellites, etc. — requires electricity or electronic components. In turn, our computer technology, smartphones, banks, ATMs, and a host of other services would be power challenged. Such an event could affect virtually every aspect of modern life. Consequently, military systems often operate within some sort of protective casing. Likewise, automobiles and consumer electronics are largely shielded from EMPs on the basis of existing design. However, they too are subject to power constraints.
Much of our private sector infrastructure, as well as communication satellites and the electric grid, is at risk. In fact, 70%–100% of the electric grid could be out for a period of years or even decades. A 2008 study by Metatech found that the time required to obtain a replacement for any one of the 370 or so largest transformers in the United States was three years. However long the electric grid is down, it appears that it would be long enough to cause some very big problems.
What Does This Say about Risk Management?
This phenomenon has caught the attention of not only astronomers and physicists but also one of the best fund managers of the past three decades: Paul Singer of Elliott Management. In a recent letter to shareholders, Singer highlighted the Carrington Event and suggested that the prospect of another Carrington Event is hugely important because almost no one is prepared for such an inevitability.
A CME or EMP would potentially have a profound impact on critical systems and infrastructure, leading to a severe economic shock. This prospect highlights the difference between forward-looking risk management and backward-looking attribution data or volatility analysis. The frequency of such an event falls outside the historical datasets of virtually all investors. Moreover, the present infrastructure was not in place when the Carrington Event hit Earth. So, the situation today is very different. Too often, investors mistake attribution or volatility analysis for risk management. Risk management is really more about risk identification and plans. And, to borrow some terms from the insurance industry, assessing risk properly involves estimating both the probability and the severity of each event.
Regarding probability, the sun naturally and routinely emits solar flares, ranging from several times a day, during active periods, to once a week. The flares also vary in magnitude and discharge in virtually every direction. However, the combination of Earth’s continuous orbit around the sun and natural solar activity means that a large solar flare hitting Earth is inevitable. The combined probability of EMP and CME events is even greater. So, this is clearly a nontrivial risk. It is only a question of when it occurs.
Solar Flare Severity
Just how severe would the consequences be? What might happen to the economy? How would financial markets react? What could the shock mean for highly levered institutions, such as banks, hedge funds, and major bond issuers? Would there be a permanent destruction of overall wealth?
The first-order effects might include a massive and semipermanent disruption of power and the destruction of communication satellites and infrastructure. In turn, supply chains of all types would be shut down. Health care would be challenged. Hospitals typically have backup generators on site, but how many of them are prepared for this? Even if they have generators, could they get the fuel and electricity they would need to get the gasoline? How long could a handful of power generators keep the system afloat? Moreover, much of the stored medicine would quickly go bad without proper refrigeration. The spread of disease alone would be rampant.
If, as the EMP Commission suggests, there would be large-scale loss of life, what might happen to our financial system? How rampant would inflation become as the central banks attempted to first nationalize and then monetize bad debts? What might happen to just-in-time inventories? What about software as a service? Would Salesforce.com survive? Would Coca-Cola?
Storing some portion of your wealth in the form of hard assets is perhaps the only prudent hedge against such an event. Presuming that such an event happened and presuming that the outcome was as bad as expected by experts in this field, then fiat currency would experience profound volatility and inflation as central banks scrambled to support the market with liquidity. Moreover, latent debt obligations that soured would create great deleveraging in the system, thereby destabilizing financial institutions and currency values. Such an event also highlights the importance of keeping some portion of financial assets in cash reserves to take advantage of the bargain-of-a-lifetime purchases for those businesses that furnish such necessities as water, clothing, communications, and medicine.
Responding to such a crisis would require serious leadership. Organizing and leading a country, or even the world, back to recovery would tax human and financial capital in the extreme. This is a prospect that should catalyze every living soul to action, at least in part because the payoff tree is so attractive. The United States, for instance, can spend a small sum of money ($2 billion) to neutralize the problem. If we don’t prepare and it does happen, we would pay a cost so enormous that it is, perhaps, too great to imagine. However, if $2 billion is spent in preparation but it does not happen, then the costs are about $6.41 per capita. Maybe we could each forgo a couple of our skinny double-shot mocha lattes and save the world.
It’s very rare that you come across such a profound problem that is so poorly publicized. There is, of course, time to deal with it . . . until there isn’t. Will your portfolio be prepared? Will you?
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: NASA/GSFC/SDO