Our first Conversation of 2017 featured Bob Litterman, former head of risk assessment at Goldman Sachs and a founder of Kepos Capital. Litterman brought his expertise in risk pricing and management to the topic of climate change. An important solution to the unsafe levels of carbon in our atmosphere, he said, lies in creating “appropriate incentives for economic agents to reduce carbon emissions.” His presentation was based on an understanding that climate change poses a growing risk to society, which can and must be curtailed when we include this risk in our pricing schemes.
Litterman related the uncertainty of the future outcome of climate change to financial risk: when a company becomes aware of the potential for future losses or damages, i.e. risk, its risk managers respond immediately by assigning an appropriate price to these losses. In the culture of financial risk assessment, managers consider “any problem an urgent problem.” As Litterman pointed out, our climate’s capacity to safely absorb carbon is a resource that we are wasting.
In outlining a pragmatic solution to pricing emissions, Litterman spoke simply: “What is an incentive? It’s something we respond to.” Pricing things, he continued, leads people to make better decisions. When we hold fossil fuel industry actors accountable to externalities, namely the future damages posed by their ongoing emissions, we give them the opportunity to make better financial, social, and environmental decisions. Government subsidies on fossil fuel production create the opposite effect, enhancing the risk of climate change.
Pricing should be based on the “social cost of carbon,” or the present value of expected future damages. This price, over time, will be driven by the revealed fragility of the environment and the rate of technological change, i.e. our means of reducing the impact of and adapting to climactic conditions as they inevitably arise.
Then Litterman spoke of the straightforward reality of what needs to happen to attain this solution. “We’re talking about changes in the tax code,” he said, indicating the fiscally conservative nature of pricing emissions.
What is required from government and industry is to urgently curtail the risk by representing the price of emissions far past where it currently stands, which is lower than zero. It stands so low because subsidies to the fossil fuel industry are six to ten times greater than incentives not to produce emissions. With the risk so great it is crucial that we take the foot off the accelerator. It is too late to ease on the brakes, Litterman declared; we must now find an effective and immediate way to hit the brakes. If we stop now, we avoid putting more carbon into the atmosphere and thereby increasing the risk and consequently the price that we will eventually be required to pay.
This talk provided its audience with a sense of realistic possibility for change. The first question posed after the talk revealed the deeply felt desire to get things moving: “What can concerned citizens do?”
Litterman had an answer: we can demand that our government price emissions, and frame this demand as a risk management problem. Whatever sacrifice we make by adopting these prices now is necessary to curb the costs to security, health, and economy that we know to degrees of scientific certainty will result from the excess carbon in our atmosphere. Investors, companies, and concerned citizens all have an interest in getting this right.
Thank you to co-sponsors Princeton Environmental Institute for help with marketing, Princeton University’s Bendheim Center for Finance for providing a bright, welcoming space for the presentation, and to Climate Central for helping C-Change Conversations bring Bob Litterman to the Princeton community.