How to Put a Price on Climate Risk

Coverage of the 2012 Risk Management Conference.

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hurricane trailerAccording to Robert Litterman, humans are conducting the largest “chemical experiment” in history as unfettered production of greenhouse gas emissions continues to take its toll on the environment. In his keynote address, Litterman, the former Head of Risk Management and Goldman Sachs and co-developer of the Black-Litterman asset allocation model, provided a wide-ranging perspective on how climate change risk could and should be priced.

A key insight: the role of the risk manager is to measure and monitor risk, not to manage risk. Instead, the risk management function should be about getting the right information to the right people at the right time. A big part of this process is determining whether risk is being priced appropriately.

From the standpoint of climate change, this concept is crucial: right now, climate change risk is not being priced at all, nor is it being measured or monitored from an investment standpoint. If this continues, the costs will be passed on to future generations who will end up paying an even steeper price for unregulated and unpriced carbon emissions today. “The earth’s ability to absorb carbon emissions is a scarce resource,” Litterman said and companies that use it should pay a price that is equal to the expected damage done to the atmosphere plus a risk premium. Those cost should fall on producers and consumers.

The big question for delegates, however, was what kind of system should be put in place to create this pricing mechanism? From taxes to cap-and-trade systems, Litterman proposed a number of options, not all of which seemed ideal from the perspective of delegates, some of whom questioned his assertion that pricing climate risk could stop further damage to the earth’s atmosphere.

Despite lingering questions, Litterman was able to reframe the climate change debate in terms that resonated with this pension-focused audience – climate change is a risk that does need to be measured and monitored. Whether pricing it will help is another matter.

Read our pre-conference interview with Robert Litterman to find out more.

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