Litterman: Putting a Price on Climate Risk

Earth's ability to absorb carbon emissions a rare resource.

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story_images_icebergAs a speaker at this summer’s Risk Management Conference in Muskoka (August 21 to 23) Robert Litterman, former Head of Risk Management at Goldman Sachs and currently senior partner, chairman of the risk committee and the academic advisory board at Kepos Capital, a New York based hedge fund, will talk about pricing climate risk. In advance of the conference, we asked Bob a few questions about risk management in general, why climate change poses  a risk and prospective ways to price it. To find out more about Bob’s presentation and the Risk Management Conference, click here.

What’s your approach to risk management?

The role of the risk manager is to measure and monitor risk, not to manage risk. The purpose of the risk management function is to get the right information to the right people at the right time. Interestingly, what a risk manager really has to do is figure out whether risk is being priced appropriately.

Presumably people react to those price signals.

Oh yes, people do react to price signals. The whole point of an organization that is taking risk is to get paid for the risk that it is taking — paid appropriately — and so as a risk manager, what you want to make sure is that the guy who’s taking the risk understands the risks he’s taking and is getting paid for it appropriately. If he doesn’t, then you’ve got to go over his head. You’ve got to have an independent pathway. If the trader is taking too much risk — where too much is defined by the organization, not by the risk manager — it’s important that that risk manager gets that information to whoever needs to know..

How does that apply to pricing climate risk?

Climate risk is not being priced appropriately by society. It’s a global problem; it requires a global solution.

Which risks are important? Which risks should we be focusing on right now?

We don’t know, do we? We’re doing an experiment. No one knows what’s going to happen. We don’t know when or how there might be a catastrophic outcome. Think of the earth’s atmosphere as a reservoir. We don’t know how big it is. We’re wastefully filling it up with greenhouse gases. Filling a reservoir is inherently a dangerous thing to do. We should be charging for filling it up at an appropriate price.

Should that charge fall on producers or consumers or both?

Both. When you price a scarce resource appropriately, the beauty of it is that no one needs to know what’s going on. They just respond to the price signal.

Should we be pricing this like gold?

The earth’s ability to absorb carbon emissions is a scarce resource. You could compare it to any commodity, but perhaps oil is more appropriate since gold does not get used up when it is consumed.  I would say the question is what’s the appropriate price. The answer is that the appropriate price is the expected damage plus a risk premium. There are two different kinds of risk. There’s diversifiable risk and there’s non-diversifiable risk. Climate risk is a non-diversifiable risk. Non-diversifiable risks require a risk premium. The premium depends on the amount of risk, which we have a lot of trouble quantifying. Then there’s societal risk aversion. The place where we observe societal risk aversion is in the equity market. What we know from the equity market is that society is very risk-averse. The equity risk premium is puzzlingly high.

Would pricing climate risk involve something like a stock exchange?

In terms of implementation there are lots of ways to do it. It could be a tax, it could be a cap-and-trade system. What is important is that you have a liquid forward curve. And the reason that’s important is because that indicates where society thinks the price will be in the future. You would like that forward curve to be actually downward sloping because that would indicate that society expects the problem to be solved. In other words, the current price should be high enough that the forward curve is downward sloping. Now it’s easier to get a forward curve, for example, in bond markets, where central banks set the short rate and the term structure of interest rates is observed in the market. I think that a similar approach would be the right mechanism, a sort of Open Market Committee for Climate Pricing.

To learn more about the Risk Management Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Garth Thomas to be considered, as limited space available.

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