This week, host Daniel Raimi talks with Robert Litterman, a founding partner at Kepos Capital, a board member at RFF, and chair of the Commodity Futures Trading Commission’s Climate-Related Market Risk Subcommittee. Raimi and Litterman explore the uncertain but potentially seismic impacts of climate change on coastal real estate, electric utilities, and entire financial markets. In their discussion about how policy instruments can reduce fossil fuel use, Litterman mentions a paper he recently coauthored, which presents the unexpected outcome of their carbon pricing model.
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The Full Transcript
Daniel Raimi: Hello and welcome to Resources Radio, a weekly podcast from Resources for the Future. I'm your host, Daniel Raimi. This week we talk with Dr. Robert Litterman, partner at Kepos Capital, and a board member here at RFF. Robert was recently named the chair of a new committee that will be advising US financial regulators on the economic risks of climate change, which makes a lot of sense given his extensive experience working on risk management in the financial sector and his deep interest in climate change. We'll talk about the scale of the risks to the US financial system from climate change. I'll also ask Robert about how and whether markets are currently pricing in the risks of climate change for assets like coastal property or energy companies. Finally, we'll talk about a new paper Robert has co-authored that takes an unconventional and novel approach to carbon pricing. Stay with us.
Okay, Robert Litterman, thank you so much for joining us today on Resources Radio. We really appreciate you being here.
Robert Litterman: My pleasure. Thank you, Dan.
Daniel Raim: So Robert, we're going to talk today about climate risk in the context of financial markets, but before we dive into the substance of our conversation, we always like to ask our guests how they got interested in environmental issues in the first place. So what brought you into this world?
Robert Litterman: Well, I tell you, I really have a bit of an eclectic background. My undergraduate major was Human Biology and I thought I was going to be a newspaper reporter. I had worked on newspapers quite a bit as an undergraduate. My first job was with the San Diego Union, but I decided early on in my journalistic career that I needed to get a specialty, and my background in Human Biology had kind of convinced me that if you want to understand human behavior, you have to understand incentives. And so I decided to go back and get a PhD in Economics, which I did from the University of Minnesota. I taught for a couple of years at MIT and then went back to Minnesota and worked for five years for the Federal Reserve Bank there as an economist in charge of economic forecasting.
And in 1986, I got a call from Goldman Sachs. They made me an offer I couldn't refuse, and I ended up going to Wall Street as one of the early quants, or financial engineers is I guess what they go by these days. And so, I started working on financial engineering. building models, pricing derivatives, and so on. I then moved into risk management. I spent four years as the head of firm-wide risk management at Goldman. And then I moved to the Asset Management Division and spent 11 years as head of the quantitative group in Asset Management, at which point I thought I was going to retire. And I left Goldman, but some of the folks that worked for me left about a year later and invited me to join them. And so I became a founding partner at Kepos Capital, which is where I am today.
But about the time I was leaving Goldman, one of my partners asked me to lunch and asked me, "Are you interested in environmental issues?" And at the time, like many people I suppose, I was kind of concerned about climate change, thought of it as a potentially a serious risk management issue, but didn't know a lot about it. And I thought, "Well as long as I'm moving on, maybe this would be something interesting." So I told him I could be interested, you know? And he introduced me to a couple of organizations, in particular the World Wildlife Fund, although also Resources for the Future, and I started getting involved. I joined the National Council of World Wildlife Fund, and later joined the boards of both RFF and WWF. And I really started digging into this.
And I remember early on thinking the essence of this problem is that we're not pricing the risk. And I mentioned this to my colleague, actually, Larry Linden, who had invited me to lunch and Larry said, "You know Robert, it's very typical of an economist to say you're not pricing the risk, but the problem is no one knows where to price it," and that really struck me as a challenge. I mean, here I am, an economist, an expert in risk management, and you're telling me no one knows where to price it. I can't believe that. So I started reading the economic literature.
And what I discovered is Larry was kind of right. This literature, at least back then ... this is probably more than 10 years ago ... it was not in great shape, I would say. And I don't mean to be negative about the literature, but at the time, that really sucked me into this literature, and I started doing work. And in fact, as a result of that, a couple of colleagues and I, Gernot Wagner and Kent Daniel and I, published a paper just last October in the proceedings of the National Academy of Sciences that focused on pricing risk. So that's what really kind of sucked me in. I would say it's more from my risk management and economist background than it is from an environmental or outdoorsy or whatever type of a background that often brings people into these issues.
Daniel Raimi: Right, that's great. And I want to ask you about that paper, and I will in a couple minutes, but it's great that you have that background that's a little different from many of the guests that come on our show who do start sometimes with a naturalist perspective, or experience in the outdoors. Before we talk about that paper, I want to ask you about a new subcommittee that you are chairing. It's a subcommittee under the Commodity Futures Trading Commission, the CFTC. And in turn it's part of the Climate-Related Market Risk Subcommittee of the CFTC's Market Risk Advisory Committee. So we're not going to spend too much time on acronyms today, although we could. But let's start with the basics. Can you tell us the purpose of this new subcommittee that you're chairing, who you'll be making your recommendations to, and how you personally became involved in it?
Robert Litterman: Sure. Well, to start with the question of, "What's our purpose?" Our purpose is to provide feedback to the financial regulators, in particular the CFTC, but we have a relatively broad mandate from the financial community, and actually the corporate community more generally about what are the implications of climate risk for the regulation of financial markets? And I say we have a rather broad mandate, I mean that we have been instructed to think about both the physical risks and also potential transition risks, and not only things like reporting and disclosure, also scenario analysis, maybe new instruments that might be useful for hedging climate risk, and both in the short term and in the long term.
Daniel Raimi: Yeah. And you'll be advising primarily the CFTC, I take it?
Robert Litterman: Well, we'll be writing a report. We've been asked by the CFTC to write a report with the deadline of June of next year, so a relatively short horizon. It's going to be a high-level report and hopefully we'll have some recommendations to the CFTC. But really, you can't separate climate risk management ... to one regulator, because really there's many different levels of financial regulation involved. And so in some sense, we'll be directing this report to all of those who regulate the financial community in the US.
Daniel Raimi: And so my understanding, and please correct me if I'm wrong, but my understanding is that the establishment of this committee is a new thing. We haven't had a high-level committee like this advising financial regulators in the past, at least in the US. And so, can you speak to whether that's accurate, my perception? And also from your perspective, does the establishment of this committee signal any kind of new degree of seriousness with which the US financial sector is trying to account for climate risk?
Robert Litterman: Yeah, I think you're right that it's probably the first time that something like this has been commissioned in the US. Of course there is plenty of work that's been done in Europe in particular, and frankly around the world. And so there is, for instance a NGFS. I guess we don't want to go into acronyms, but a Network for Greening the Financial System, which is really a group of central banks and other financial regulators from different countries around the world. And there's 40-some countries, including a number of European countries, China, Singapore ... now it does not include the US Fed, although I believe the DFS I think it's called, the New York State banking and insurance regulator, has joined as a member. And this is a topic that's being discussed. That is to say: what are the implications of climate risk for financial markets broadly around the world? And so, it's definitely something that banks, insurance companies, investors, asset owners are all focusing on. I would point to the Financial Stability Board, which a few years ago encouraged the development of the Task Force on Climate-Related Financial Disclosure. So there's a lot of conversations going on many different places, and I think the CFTC commissioners just felt like it was time to do something in the US.
Daniel Raimi: Great, that makes a lot of sense. And so let's transition now from talking about the context to actually talking about the substance of the work. And that is the confluence of climate risks and different types of markets. When I was first thinking about this topic, there were two major risks that came to mind, and I want to lay them out, and get your reaction to them, and see if I'm thinking about things the right way. So one of the major risks that we think about is the risks of climate change, so damage to coastal infrastructure, damage from wildfires, higher temperatures, and other physical or socioeconomic impacts. And then the second economic risk is the potential impacts of climate change policies, where ambitious policies could harm the performance of companies that, say, produce coal, or transport oil, or refine petroleum products. So are those the right two buckets to be thinking about? And how would you break up this challenge in broad strokes?
Robert Litterman: Yes, those are definitely the right two buckets, although some people would add liability risk as well, or litigation risk. And I guess that could fall into either of those buckets. But leaving that aside, yes. I think the long-term physical impacts of climate are really what I worry about the most, of course, and they're very uncertain, and they do tend to be long-term, but they can also have short-term impacts. You saw what happened to PG&E last year from the wildfires. So we've already seen a major bankruptcy associated with a climate-related event. And you could have significant depreciation of real estate along the coasts, or in other flood-prone areas. So these risks are already being realized, and they're expected to get worse in the decades ahead.
But then you bring up the transition risks as well, and they are very real. And in particular, if you think about ... and I don't want to oversimplify the policy response, but the heart of the policy response are the incentives that we as a society provide to reduce emissions, and right now those incentives go the wrong way. Governments around the world are subsidizing the production and consumption of fossil fuels. And so that can't last forever. And in fact, as a risk manager, one of the things that I focus on is the fact that we're not pricing the risk. This is the key mistake that we're making. And I don't think we're going to continue to make that forever. So to grossly oversimplify the point, when we decide that we're going to price this risk, I don't think that we will slowly increase the price from the wrong direction to the right direction.
We will have a change to where we start to price the risk, and the appropriate level is a high level. We have to create strong incentives now to reduce emissions. And so I view that very positively as a phase change in the economy, which has not yet happened. Now most people don't think that's going to happen anytime soon. I have no idea myself when it will happen. But I certainly hope it's soon, because again, coming at this from a risk management perspective, and we can talk more about this, the cost of delay is quite large and is growing larger every day that we delay. So my expectation is at some point soon we're going to price the risk, and that will be a big change. Now as you point out, when we price that risk, it's going to have potentially significant costs in terms of jobs lost in the fossil fuel industry, and potentially changes in asset valuations.
You never know, first of all, when this is going to happen, if it's going to happen, and whether those impacts will be significant or not. But I do think that many economists worry about that transition risk, and some even talk about the potential for a Minsky moment, which I think refers to the fact that perceptions can change very quickly. And so if all of a sudden everyone realizes, "Oh my God, we're going to have to price emissions and that's going to happen next year," you could have asset prices have a significant move over a short period of time. And so, that could lead to a systemic risk to the economy either here or more broadly around the world. So this is a scenario that we want to take seriously.
Daniel Raimi: Right. Yeah, and people certainly talk about that scenario and particularly with regard to government policies that address climate by pricing the risk as you describe. I guess one question that I was really interested in asking you, given your extensive experience with markets is, how well do you think markets are currently accounting for the risks that we're talking about, both the physical risks and the transition risks in different sectors of the economy? Are the financial markets doing a good job at pricing this risk? In your view, are they going to have a Minsky moment or something of the like, where things turn on a dime and then get very unstable? Or are asset managers already taking those things into account in a way that that might be effective? Or maybe it's impossible to know the answer to that question, but that's what I was wondering.
Robert Litterman: No, it's a great question. And let me just distinguish because first of all, if we talk about our financial markets, pricing climate risk per se, financial markets can't price the externality of emissions. That's up to government. So the answer to that question is no, governments are not pricing climate risk appropriately. And I'm very passionate about trying to get that done. But your question is really the second question, which is: are financial markets appropriately pricing in the probability of government action? And well, I would answer that this way. About six years ago the World Wildlife Fund started talking about, "What should we be doing in our portfolio to address climate risk?" And we talked about divestment, but it turned out that most of our risk was in illiquid assets, and by the way, we didn't have that much. But it would have cost us a lot to try to clean what we call their stranded assets, coal and tar sands, and oil exploration, and production out of the portfolio.
So we did something that was rather innovative. We created an overlay, and in effect sold those positions through the overlay. And we called it a “stranded asset total return swap.” And it was basically ... we got paid the total return on the market as represented by the S&P 500, and we paid a counterparty, Deutsche Bank, the total return on a basket of stranded assets. Now I often get asked the question, "Why would anyone ever take the other side of that?" And the answer there is, of course, they don't really take the other side. They just execute on your behalf, and the market takes the other side. Now I thought this was a good instrument, because it, first of all, insulated our portfolio from any potential decline in stranded assets. And I thought it's probably a good bet as well. It's basically a bet, if you want to think about it that way, that stranded assets are going to underperform the market.
What I had no anticipation of was how badly the stranded assets would perform over the next six years, which is to say to date those stranded assets ... and we rebalance every year, but those stranded assets have underperformed by over 100% relative to the market. So yes, it turned out to be a very good hedge to our portfolio. But to answer your question, coal and other stranded assets have dramatically underperformed the market. So there has been a repricing of assets.
Now the interpretation of that repricing is always somewhat unclear. People would talk about, "Well, it wasn't climate change. It was cheap natural gas due to fracking," and so on. So you can always come up with a story about why returns are what they are. But it's also true that those returns were very strong prior to the Paris agreement. They then hit several years of under-performance, and now in the last year and a half … the market has been outperforming stranded assets quite significantly. So my personal view, but it's just a view, this is not a proof or anything, but my view is that all of the repricing has not built into those stranded assets, and that they will continue to underperform.
Daniel Raimi: Yeah. Another side of the pricing risk in the markets question that I was wondering about is what your view is on how well the market is pricing the physical risk from, say, coastal infrastructure or coastal property. Have you looked closely at that or thought much about it?
Robert Litterman: Well, I've thought about it because that's a significant risk to the financial markets. I think there has been, again, as with the stranded assets with coastal real estate, there has been a significant repricing, particularly those that are in the most exposed areas, barrier islands and so on. And are they appropriately priced? Hard to say, but have the valuations of those exposed properties been affected by climate change? I think the answer is yes, very much so.
Daniel Raimi: Interesting. So last question, and we only have a couple minutes left. The last question before I ask you about what's on the top of your stack is, I want to briefly get your summary of this paper that you mentioned earlier, the paper called “Declining CO2 Price Paths,” which you published in PNAS with Gernot Wagner and Kent Daniel. So most existing climate economy models suggest that the economically efficient approach to pricing CO2 emissions is to start low and increase over time, but you guys find the opposite. So can you tell us again kind of briefly, but in terms that a general audience can understand, what are some of the principles that underlie that conclusion that you want to start high and then decrease over time?
Robert Litterman: Sure. Well it is a mathematically complicated paper, so I will grossly oversimplify. But the basic idea is, I describe it as a slam on the brakes scenario. And the idea is that we all agree we should price the externality. The question is: what is the externality? And what we said is, "You can't leave risk out of this picture. You have to think about the full distribution of potential outcomes, and you've got to worry about the worst case scenarios." And then we apply what you might call the methods of modern asset pricing, which basically say that in bad scenarios, your additional dollars are worth more. And so you want to put more weight on those bad scenarios, and what we end up with is recognizing that you have to be prepared today for a bad outcome in the future.
We have a random variable which represents the fragility of the environment, and we basically therefore have a model in which the environment may be very robust, or it may be very fragile, and today we just don't know. And so in order to prepare for that, we have to start with a relatively high price that means that we're prepared, in case it is a fragile environment, and importantly then, we should respond to new information. The existing models typically say, "Let's pick a policy and stick with it." And the policy is what I call an “ease-on-the-brakes” policy, because it starts low, and then slowly goes up over time. Our policy is, it tries to be more realistic and say, "No, we have uncertainty about the future. You've got to slam on the brakes and then respond to new information. If things are better than the worst case over time, you can ease up a little bit. If they're worse, you have to raise the price in response to that new information." So it turns out the expected price path declines because you're being cautious today, and worrying about the worst case, but it may go up over time if you get bad news.
Daniel Raimi: Yeah. It's so fascinating. It definitely reminds me of the conversation I had a few months back with Gernot about Martin Weitzman's work and the uncertainty that he identified, and the implications of that for carbon pricing policies.
Robert Litterman: Right. I think Marty was way ahead of his time in basically pointing out that you have to worry about the tails, and I'll tell you, our paper really grew out of a paper that Larry Summers and Richard Zeckhauser wrote years ago, and in which they wrote down a very simple model. And one of their conclusions was it's unclear whether increased risk causes today's price to be higher or lower. And I thought, "Wait, that doesn't make any sense." And so part of what our paper is, is really taking their suggestions seriously and saying, "Well, wait a minute." I mean, they were right. They basically said it depends on parameters. And so we basically said, "Well, okay, let's see what those parameters are, and build a model and see what the implications are." And it turned out to be a very rich set of issues, and that's what we were investigating in that paper.
Daniel Raimi: It's so interesting. Well, Robert Litterman, thank you again so much for talking about both of these really fascinating topics today. I know we're just scratching the surface, but hopefully this is wetting people's appetites to learn more. And we'll close by asking you the same question that we ask all of our guests, which is what have you been reading, or watching, or listening to recently related to the environment, or any of the issues we've talked about today that you think is really interesting, and that you would recommend to our listeners?
Robert Litterman: Yeah, well, I'll tell you, the IPCC “1.5 Degrees” Report, a little bit scary, but to me, from a risk management perspective it says, "Look, this is an urgent, urgent problem. We’re at one degree C above historical average. We've already put enough CO2 into the atmosphere that it's going to be very hard to keep the warming to one and a half." And the difference between one and a half and two is just very, very frightening. I think that historically scientists had a view that you really get into a danger zone well above two. And now I think they realize that two degrees C is very much a danger zone. And, and frankly, if we don't price emissions in the next few years ... here's a scary thing, every three years the maximum temperature is going up by about a 10th of a degree, it just becomes too late. That's the cost of delay. And so if we're today shooting for something like 1.7 or 1.8, we're less than 10 years away from crossing two. And again, that report was pretty scary about two degrees. Just as a simple closing soundbite, the IPCC thinks that at two degrees C we're going to lose over 99% of the world's coral reefs. To me, that is a catastrophe. And so I'm working as hard as I can to get emissions priced as soon as possible.
Daniel Raimi: Yeah, yeah. It's a sober note to end on, but an appropriate one given our conversation today and the work that you're doing. So, we'll end it there, and thank you once again, Robert Litterman, for joining us today on Resources Radio. We really appreciate it.
Robert Litterman: My pleasure, thank you.
Daniel Raimi: You've been listening to Resources Radio. If you have a minute, we'd really appreciate you leaving us a rating or a comment on your podcast platform of choice. Also, feel free to send us your suggestions for future episodes.
Resources Radio is a podcast from Resources for the Future. RFF is an independent nonprofit research institution in Washington DC. Our mission is to improve environmental energy and natural resource decisions to impartial economic research and policy engagement.
Learn more about us at rff.org. The views expressed on this podcast are solely those of the participants. They do not necessarily represent the views of Resources for the Future, which does not take institutional positions on public policies. Resources Radio is produced by Elizabeth Wason, with music by me, Daniel Raimi. Join us next week for another episode.