How do we apply the principles of financial risk management to the challenge of climate change? In this episode, we connect the worlds of climate and finance with renowned economist Dr. Bob Litterman.
In this Episode
- A discussion with renowned economist & financial risk management expert Dr. Bob Litterman
- How climate change is a risk management problem.
- Pricing carbon
- Dr. Litterman’s Senate Testimony (April 2021): https://www.rff.org/publications/testimony-and-public-comments/testimony-to-the-us-senate-budget-committee-on-the-cost-of-inaction-on-climate-change/
Thank you so much for joining us again on Climatrends. Today we’re taking a different approach to our climate discussion. What can we learn from the principles of financial risk management? Well, a lot as it turns out. The reality is that risk management is essentially the same across industries–preparing for “worst-case” scenarios and quantifying such risk. In the world of finance, there can be a great deal of uncertainty. When the stakes are high, uncertainty often demands more action rather than less–to approach with more caution. Sound familiar?
Today we’re going to talk to a renowned financial risk management expert who has connected the dots between the world of finance and climate. It proved to be an intriguing discussion… have a listen.
Susie Martin: We’re excited about this next guest. Today we will be talking to Dr. Bob Litterman, an accomplished economist who has spent his career managing financial risk. He serves as the Chairman of the Risk Committee and is a founding partner of Kepos Capital, a New York City-based systematic global macro firm. He also enjoyed a 23-year career at Goldman Sachs working in research, risk management, and investments. He sits on several boards for groups that study and propose responses to climate risk and on April 15th, 2021, Dr. Litterman was invited to testify in front of the U.S. Senate Committee on the Budget about the costs of inaction on climate change. Dr. Litterman, thank you so much for taking the time to speak with us today.
Dr. Bob Litterman: My pleasure. Thank you.
Susie Martin: So I wanted to launch into your U.S. Senate testimony in April of 2021, you discuss some of the fundamental principles of financial risk management–this is your area of expertise–and how we can apply this knowledge to climate change. The first is to imagine and prepare, of course, for “worst case scenarios.”–that’s what risk management is about: to prevent disasters. The second is to price risk appropriately and to use prices to incentivize. And then the third is that time is a precious resource. You can practically solve anything if you had all the time in the world, but we don’t. So can you elaborate on the application of these principles to climate change and the existing challenges we face?
Dr. Bob Litterman: Sure. It’s my pleasure, and I always like to go over these principles from financial risk management, because they do apply to climate change. Although in financial risk management, I would say there are tens of thousands of risk managers, and they all know these principles, and they’re not hard to understand. In climate, we don’t have the same history of risk, and in fact, the central problem is that we’re not managing the risk appropriately in particular, we’re not pricing the risk. And so, let’s take the first principle, the fact that you have to think about worst-case scenarios. That’s not anything controversial in the financial markets with always thinking about financial crashes, the crash of ‘87, the great financial crisis. We’ve had many of these examples to learn from, but in the case of climate, you know, people have been saying, they’ve been denying that it exists.
You have scientists who start looking at worst-case scenarios and people say you’re an alarmist. The poor scientists have been pushed back in a corner to say, no, no, we’re absolutely sure this is real. Well, that’s not really the question. The question is what’s the full distribution of outcomes and what’s the worst case that’s what we have to be prepared for. And then the second thing is that we’re not pricing the risk. Well, of course, if you don’t price the risk in financial markets, that creates an opportunity. Either you take more risk because it’s cheap, or you sell it because it’s expensive. Well, in the case of climate risk, we’re not pricing it, and therefore people are taking much too much risk. They’re not paying for it, and as a society, we’re taking much too much risk, and that’s the fundamental thing that we have to change.
We have to create an incentive to reduce emissions by pricing it right now, we’re sending signals to people not to worry, and so they’re not worried and they make the wrong decision. And then finally, yes, you mentioned time. Well, if we have enough time, we can solve any problem. And I’ve had many situations in the financial markets where we’ve run out of time. We all have, I had a particular case during the great financial crisis where it spilled over into the quant sector, and we had positions in my business at Goldman Sachs where we thought we would be able to get out of those positions by carefully trading over a period of weeks or maybe even months. And all of a sudden as the market’s meltdown, we had to get out of our positions literally in hours, if not days. And so, we couldn’t get out of those positions and that’s when things can really get bad. So, it’s when you run out of time that risk can become a catastrophe. So, those are all good principles from financial risk management. That also makes sense as we think about the climate.
Paul Douglas: Dr. Litterman, thank you again for joining us this morning. I think I’m preaching to the choir when I mentioned that markets like certainty. You’ve lived that for decades now. Businesses operate under a myriad of laws and regulations until we find an effective way to price carbon and provide more, and I’d love to get your thoughts on a carbon tax. Is it time? Many companies today are in this state of limbo when it comes to taking climate action, some corporations taking the initiative to wean carbon from their supply chains. They’re transportation, they’re thinking long and hard about employees and facilities and customers when it comes to climate resilience. What, in your opinion, other than a possible carbon tax and getting a price on carbon, what is the number one thing that business leaders should be doing right now, right, this moment to prepare for more climate volatility, and weather disruption down line?
Dr. Bob Litterman: Yeah, well, we know what’s coming. I think that corporations the financial sector have woken up to the reality of climate change, and the fact that the climate is changing, temperatures are getting warmer, there’s more volatility in temperatures going forward. The sea level is rising, wildfires are becoming more common. This is the reality that we all face. Now, how businesses should react? Depends very much on what the business is. You mentioned that markets like certainty and corporations certainly would like to operate in a world of certainty, but the reality is we operate in a world of different potential scenarios of uncertainty. And so, we have to be prepared. You know, oil companies have been producing gasoline for decades without any certainty about what the price of oil is going to be.
So, businesses do know how to operate in a world that has potentially different scenarios going forward. And so, what businesses have to do today is recognize the potential scenarios that come forward, and a very important indicator of where we’re going to be is what the incentives are to reduce emissions today and then moving into the future. And so, it’s those potential future incentives to reduce emissions that should guide businesses as they make their investments. Today, if I’m building a new electric power plant today, that’s going to last for the next 40 or 50 years, I have to think carefully about what are the incentives going to be to reduce carbon emissions? Should I be building a coal-fired plant? I kind of doubt that. A natural gas plant, a nuclear plant, a solar or wind?
These are all going to have very different profit abilities in the future, depending on the price of carbon emissions. And so, it’s really expectations of those incentives that are going to drive investments that are sensitive to the price of emissions. And businesses are going to have to plan for that. I would say, if I were in business, I would expect that prices are going to go up very quickly globally, and therefore I have to be prepared for a rapid transition to a net-zero economy. And I want to build businesses that are going to be profitable in that context. And so, people who have been building have been investing in solar, in wind, in batteries, and electric vehicles. They’ve seen the valuations of those investments rise dramatically in the last couple of years. Whereas those who are in the business of exploring for oil, especially expensive sources of oil in refining and who are dependent on the fossil fuel-driven economy, coal producers, for example, have seen the valuations of their assets collapse over the last decade. And so, these are the things that businesses have to be thinking about. They have to be thinking about their path to net zero. Are they on that path or do they have to do things differently?
Paul Douglas: I’m going to just ask one quick follow-up question. Thank you, Dr. Litterman. Specifically, it seems to be an expert’s argument on of experts who are concerned about this. The clearest signal in the market today would be some sort of a price on carbon along with border adjustments, et cetera. Do you share that conviction? Is there another way to get more certainty into financial markets?
Dr. Bob Litterman: Yeah, the issue with isn’t a certainty, the issue is dealing with reality, and the reality is we have to reduce our emissions. We’re not pricing the risk. Let’s be very clear there’s an externality associated with creating carbon dioxide emissions, and that externality is the damages that are going to be created in the future. We’re seeing damages all the time. They’re only going to increase over the next you know, several decades, in fact, the maximum temperature, depending on when we slam on the brakes and that’s what we have to do. And when I say slam on the brakes, I mean, reduce our emissions dramatically. As soon as we get started on that, it’s going to take another 40 years before we reach the maximum temperature and the maximum damages. So, it’s really preparing for that. And when we think about where we should price emissions, the margin you have to think about is the fact that for every ton of carbon dioxide that we put into the atmosphere today, probably not for sure, but probably at some point in the future someone’s going to have to pull that out of the atmosphere, and that’s a very expensive process.
So, you can think of many different potential scenarios most of those scenarios have a lot of carbon dioxide being pulled out of the atmosphere. If we want to get back down to 350 or much less 280, which was the historical amount of CO2 in the atmosphere, 280 parts per million. If we want to get back down to that, you’ve got to suck an awful lot of carbon dioxide out of the atmosphere. You’d be doing that for decades and decades, and you can’t do that easily. It’s expensive to do that. And so basically you can think of every time you put a ton into the atmosphere, you ought to be putting some money in the bank for those people who are going to have to pull it out of the atmosphere. It’s a liability that we’re leaving to our kids and our grandchildren, and frankly, it’s an expensive liability.
So, that to you where we ought to be pricing today, and it’s a high price probably well over a hundred dollars now we won’t get there immediately. But the reality is that those incentives are already there in Europe, and they’ve already reduced the carbon intensity of their economies dramatically. So, the US is behind China is behind China’s biggest emitter today. And the developing world is going to want to have a clean source of energy, and so we’ve all got to work on that. There’s a tremendous amount to be done and we’ve got to get started immediately.
Susie Martin: So switching over to more market discussion. It’s clear that we’re starting to see detectable changes in prices due to anticipated climate risk, such as flooding. So just recently the NY Times published an article discussing how new federal flood insurance rates will take into account climate change and that premiums will rise sharply for some… we’ve been talking about this for years–essentially Americans will be paying the “real cost” of their flood risk. What other markets are noticeably responding to perceived climate risk?
Dr. Bob Litterman: Yeah, well, the flood market, you mentioned wildfire, the market for homeowners’ insurance in California, if you live in an area that’s potentially hit by a wildfire and that’s most of California. Well, then you’ve got to pay all of a sudden, much higher rates for insurance, and it’s not clear what’s going to be done about that. Both flood insurance, wildfire insurance, and other potential hazards. These are things that are going to be more expensive in the future. Just reflecting the reality of the danger what’s going to actually have to happen is that over time, people are going to have to move into areas where they can be protected from the increasing hazards from climate change, whether it’s the sea-level rise, the wildfires, the heat, et cetera these are…. we’re going to have to live in a hardened infrastructure, and humans can do that, it’s going to be expensive, but we can do it.
Nature can’t do that. So, nature’s going to have to fend off these increasing hazards on its own, and it’s not going to do well. It’s really kind of sad, but we have created a very significant risk for the natural environment, and that’s something that we have to address absolutely as quickly as we can because there are just dangers there that we don’t understand. What really is scary is what scientists call tipping points. The idea is there may be a point where let’s say the melting of Greenland gets so far it can’t be stopped. And if that happens sea level rises several meters, well, that’s going to be a disaster for much of Florida for the east coast especially for big cities in Asia, and that’s one potential tipping point.
There are others. The circulation of the ocean, the Atlantic Ocean is slowing down if that slows down too much that means that Northern Europe and Great Britain are going to have much colder winters, and environments and there are others that we just don’t know about the methane, and it’s coming out of the Arctic Ocean, as it warms up the CO2 that’s coming out of the Arctic as that melt, these are all things that can create positive feedback. The Arctic ice has already melted, which means that instead of having a very reflective surface, there’s a very dark surface in the Arctic Ocean, and so that’s creating positive feedback, which makes the waters warm even more the drying out of the Amazon is causing trees to die, which then causes more carbon dioxide to go into the atmosphere, which warms it, and again, it’s positive feedback.
So, what we worry about is really crossing a point where things start to speed up and they get out of control, and this may happen three, four decades into the future, but in order to prevent it, we have to take action today. And I guess it’s a good thing that science gives us the capability of forecasting, what the impacts of our actions are going to be in the future, the actions that we take today, unfortunately, we haven’t taken that to heart, and we haven’t created the incentive to reduce emissions. These globally harmonized incentives really, we have to get started immediately it’s, we should have started 20 years ago. If we had started 20 years ago, we wouldn’t have the existential problem that we have today, and if we don’t get started today, it may be too late. So, this is really a, it’s truly a climate emergency.
Paul Douglas: Yeah, we should listen to the scientists, and we should have listened 20, 30 years ago, and I think Susie and I both agree with your premise that we don’t know what we don’t know when it comes to these tipping points. Dr. Litterman, last question. When companies do a cost-benefit analysis of taking action now, what should be top of mind? I don’t have to tell you timing is everything; being too early can be as bad as being too late. But in your experience, and in your opinion, is there a tangible economic benefit to taking action sooner rather than later, even if we don’t know what all the regulatory landscapes will look like in 2, 5, 20 years. Would you counsel caution in patience or does it make sense dollars and cents to be engaged on climate planning, and taking climate action today versus sort of biting your time and seeing what comes down the road from a regulatory standpoint from the feds at a state level, et cetera, how would you address people who say, well, I’m just going to wait and see how things shake at out?
Dr. Bob Litterman: Yeah, Paul, that’s a great question. And you’re right. Timing is everything in the financial markets, and it’s very hard to get the timing right. But as we look at climate, I think we’re at a very key point right now. You’ve had this buildup for decades; people were talking about climate change a hundred years ago. They didn’t have much data, and it was way off into the future. 30 or 40 years ago, scientists started getting particularly nervous about it, and so on. Where we are today is that we don’t have the appropriate incentives that we need, but there’s no longer any uncertainty about the science. We know…. well, let me be careful what I say. There’s no uncertainty about the reality of climate change. Now there’s a lot of uncertainty about where we’re going to be 30 years from now, and what is going to be the impact.
So, there’s a lot of uncertainty about the future, but we know that climate change is real, and we know that we’re not pricing it appropriately. We’re not taking that risk into account, that externality is not being priced, so people are making the wrong decisions. Investment decisions are being made consistent with the old high fossil fuel economy, not the new net, zero economies, but that’s all changing very, very quickly right now. And I would say it changing because people’s expectations about pricing emissions are much higher in the future. And so, investors now, as we had discussed just a few minutes ago are making investments based on expectations of future pricing of climate. And so, when you ask about timing, those who moved earlier are getting the benefit of that, whether it’s Tesla now, which has a market valuation of over 800 billion, look at Ford as like, I don’t know, 40 billion, and GM 60 billion, or something.
So, it’s 10 times as valuable as what people think of the old auto companies in this country. And similarly, you’ve seen the fossil fuel companies, valuations collapse, Peabody coal, one of the biggest coal producers in the world went bankrupt several years ago, got recapitalized. It nearly went bankrupt again during COVID. So, you’ve just seen a lot of change in valuations because markets are forward-looking. Now, I don’t think it’s all over at all there’s the change in valuations really hit the fossil fuel areas, what we sometimes refer to as stranded assets, but where we are today is that it’s moving through the entire economy, the auto companies, the utilities, the cement and steel manufacturers, the other commodities that are used in the net, zero economies, these things are all the valuations are changing as we speak.
And so, companies that are affected by climate, either in terms of their supply chains or the things that they manufacture they are really seeing this very much right now, and when they take these actions, their valuations are reflecting either actions to get ahead of it in which case the valuations are positively impacted or they’re falling behind, in which case they’re negatively impacted. And there are other valuations, for instance, I would say in terms of the physical impacts of climate change, like sea-level rise, I don’t think that’s built into the real estate along the Eastern Coast of the US, or Florida, and it will be built in over the next couple of decades. When you go to get a mortgage, a 30-year mortgage on a house that’s on a barrier island, you can probably do that today, but good luck, 10, 20 years from now. So, what that’s going to do to the valuation of that property is probably not a good thing.
Paul Douglas: Wow. A lot to unpack Susie
Susie Martin: Yeah, I know. There’s so much. And you know it’s interesting getting your take as an expert in financial risk. Usually, we talk to climate scientists and this was a very interesting angle to take. Certainly learned a lot in this discussion. Thank you for taking the time to speak with us, Dr. Litterman.
Paul Douglas: Yeah, thank you so much.
Dr. Bob Litterman: My pleasure, thank you.
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