Episode 08: Pricing Climate Risk with Bob Litterman

TRANSCRIPT

Dr. Bob Litterman:Once you build carbon into the prices of goods and services like everything else, you know, it gets allocated appropriately, and you don’t even have to think about it. Right now because it’s not being priced, all of us are making bad decisions about everything we do because we have no way to make the right decisions, and the beauty of the market system is, once we price it, no one has to think about it. You don’t have to worry about it because it’ll all be priced in. You know, do I fly, or do I take the train? Do I eat beef, or do I eat fish?

Michael Torrance: Welcome to “Sustainability Leaders.” I’m Michael Torrance, Chief Sustainability Officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.

Legal Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Manju Seal: I’m Manju Seal, Head of Sustainable Finance Advisory for BMO Capital Markets. Today, my guest is Dr. Bob Litterman. An economist, Bob is considered one of the leading authorities on risk management and quantitative trading on Wall Street. He’s also well known for codeveloping the Black-Litterman Global Asset Allocation Model in 1992 with Fischer Black. He spent 23 years at Goldman Sachs and at one point was Goldman’s Head of Firm-wide Risk, serving chairmen like Bob Rubin, Hank Paulson and Lloyd Blankfein. He has been studying climate change for a decade now and shares today not only his insights from managing firm-wide risk but how it applies to climate risk. As a board member of Climate Leadership Council, he breaks down for us the Baker-Shultz Carbon Dividend Plan, which is now supported by over 3,000 economists. He also explains why pricing carbon is imperative for informed decision-making. I sat down with Bob in New York City this summer, and as I expected from our GSAM days, his art of deconstructing complex topics kept me fully engaged.

Dr. Bob Litterman:My name is Bob Litterman, and I am the partner at Kepos Capital and chairman of our risk committee.

Manju Seal: I think it would be helpful for our listeners to become familiar of your personal journey and how you came to be in the finance world, what was the primary focus of your entire career and how that drives what you do today.

Dr. Bob Litterman:Okay. Sure. Well, I had a bit of a circuitous route to get to where I am. I started out as a scientist. As an undergraduate I studied human biology, and then I was a reporter for a year. I decided to go back to school and get a specialty, which was what led me to then go to graduate school in economics. I ended up getting a PhD at the University of Minnesota and started teaching at MIT, so I spent 2 years as an assistant professor there and decided the academic route wasn’t for me, and I went to the Minneapolis Fed where I was a research economist for 5 years. I also started a software firm while I was there. And while I was there, I got tapped by Goldman Sachs to come to Wall Street, and this was in 1986, so I started in fixed-income research at Goldman Sachs, and in 1994, Goldman asked me to leave the fixed-income research area and become Head of Risk Management, so that was an opportunity that I took. I became a partner, Head of Risk Management from 1994 to 1998, and I helped to develop the risk system that was deployed throughout the firm. In 1998, Goldman asked me to move over to Asset Management, and I took over the quantitative group within Asset Management, and I stayed there for about 11 years, retiring in 2008, and shortly thereafter, some of the folks at Goldman that I knew left and asked me to join them, so I did and became a partner, a founding partner, of this investment firm, Kepos Capital, where I now head the risk committee. But when I left Goldman, I got very interested in climate change from a risk-management perspective and then have joined a number of boards, including the Climate Leadership Council in particular, which is the sponsor of the Baker-Shultz Carbon Dividend Plan. I’m sure that’s something we can talk a little bit about, but it was really my interest in economics and risk management that led me to think about climate change and try to understand how significant of a risk it is and represents, and I’ve been working on that for the last 10 years.

Manju Seal: So, I think the next thing that would be really helpful is to understand … You’re very well known for the Black-Litterman Global Asset Allocation Model, so for our listeners who may not be aware, can you describe it, and who are the predominant users?

Dr. Bob Litterman:Sure. Well, when I first came to Goldman Sachs, I was in the Fixed-Income Research area, and one of my early projects there was to build a global asset-allocation model. We had some clients that were building global portfolios and wanted to have a quantitative tool, so my boss, the Head of Fixed-Income Research, asked me to work on this. I started by talking to Fischer Black, who was another quant at Goldman Sachs at the time, and we built this model that has become quite standard now in use. What was, I think, unique about our model was that we incorporated a capital asset pricing model equilibrium into the optimization. That was a suggestion that Fischer had made, and being a young quant on Wall Street, I thought, “Well, that sounds kind of academic,” but when Fischer Black, you know, the father of option pricing, suggests something that sounds academic, you take it seriously, and so that’s what I did, and it turned out it was a great idea, and the … I don’t want to go too deeply into the Black-Litterman model, but let’s just say that a lot of people have found it very useful for optimizing portfolios, and portfolio optimization is a little bit related to climate in the following sense. What you’re trying to do in a portfolio is to get as much return per unit of risk as you can, and when we think about climate change, the real problem that we have is that we’re not pricing the risk, and so we’re making decisions that don’t make sense as a society, and that’s leading us to take too much risk in the end of the day.

Manju Seal: So, moving from theory to the practice of risk management, what are some fundamental insights you have gathered over the years as the Head of Firm-wide Risk for Goldman Sachs, which is a highly complex entity as most banks are as financial institutions?

Dr. Bob Litterman:Sure. Well, there’s a number of, I would call them, lessons of risk management that I would focus on. First of all, you have to think about worst-case scenarios. You know, the thing about climate risk is that when people start talking about worst-case scenarios, people say, “Oh, you’re an alarmist,” you know, particularly scientists. They’re very conservative. But when you’re a risk manager, the whole point of your job is to think about worst-case scenarios. You know, senior management in financial institutions really wants to know, what’s the worst case? And the problem with being in a position of risk management is, you know there’s no answer to that, and, I mean, maybe in some cases you could lose everything, and that’s the worst case, but in most situations, you really don’t know what the downside might be. If we think about, how much could the stock market fall in a day, well, it’s not going to fall to zero, but, you know, who knows? At Goldman, we used to have a rule of thumb in the equities division that we wanted to make sure that if all the stock markets around the world fell 50 percent overnight, we would still be in business the next day, and so we managed our positions along those lines. Well, I would say, you know, you don’t know what the worst case is, but management wants to hear something about those kinds of situations, and so what we came up with in the financial world is the concept of value at risk, which was an amount that you could expect to lose with some regularity but only with a small probability so maybe once a year or once every 5 years, whatever it is, and it might depend on the context. You would ask, “What is the value at risk, the amount that I can lose? So, I better be prepared for that.” Another important lesson from risk management is that time is not on your side. You know, when you have a risk-management problem, it needs to be addressed. I can’t think about a situation in my years as Head of Risk Management at Goldman where I said, “We’ve got a risk-management problem,” and management didn’t take it seriously immediately. No one ever asked me to come back next week, and that’s because when you’ve got a risk-management problem, if you have enough time, you can solve almost anything. It’s when you run out of time that, you know, a problem can turn into a much worse problem or a catastrophe, and so time is a scarce resource when you’re managing risk, and that means it’s always an urgent issue. Another lesson from risk management is that the objective is not to minimize risk. People would assume, “Gee, if you’re a risk manager, you must … Your job is to minimize the risk.” That’s not at all the case. At Goldman Sachs, we’re very proud of making money from taking risk, and so we didn’t want to minimize the risk. What we wanted to do is make sure that we got paid for the risks that we were taking, so the job of the risk manager is much more about identifying risks and quantifying the amount of risk and then, you know, making sure that that’s all understood and that you’re getting paid for the risk that you take. The final message from risk management is, I think you have to be very cautious about trusting your models, you know? What we rely on in risk management are models to help us to quantify risk, and the problem with models is, they’re always an approximation, and there’s always events and things that haven’t happened before that might happen, and so sometimes economists make a distinction between risk and uncertainty, and the difference is, in that context, risk is something that you can quantify. It typically comes out of a model, might be value at risk or tracking error or standard deviation or different statistical measures. Uncertainty is when you don’t trust the model, and you don’t really think that you can put a quantification on something because you know the future is not going to be exactly like the past. And these risks are very relevant when we start thinking about climate change and the risks that are associated with climate change. First of all, the worst-case scenarios are very difficult to understand or know because we’ve never gone down this road before. Certainly, the Earth has warmed and cooled historically but not with seven billion people living on it and not in such a rapid fashion as is being caused by the buildup of greenhouse gases in the atmosphere, so we’re doing an experiment, and we really have tremendous uncertainty about what the future might bring. Scientists can quantify up to some extent what we can expect. They tell us, for example, that if the temperature increase is less than 2 degrees centigrade, that’s safe, and if we’re above 2 degrees, well, that’s risky. Well, of course, there’s risk that things might happen below 2 degrees, and we might not have something happen at 2 degrees. There’s a lot of uncertainty about what’s safe and what’s not and how safe. When we think about time, and, you know, we don’t know how much time we have. We’re doing an experiment that’s never been done. We’re creating this blanket of carbon dioxide and other greenhouse gases in the atmosphere. We’re probably going to have to suck them back out, but that’s going to take decades, and so in the meantime, again, we’re doing an experiment with highly uncertain consequences. The sooner we stop putting carbon dioxide into the atmosphere and start pulling it out, the better in terms of risk management. Also, when we talk about the purpose of risk management being to price it, well, with respect to climate risk, the fundamental mistake we’ve been making is that we’re not pricing the risk. It’s very important to recognize that incentives are what drive behavior. You know, incentive is a very profound word. Anything that changes behavior, that motivates behavior, is an incentive. With respect to humans, of course, it’s basically prices and wages that create the incentives that we face and determine how we allocate our time and our resources. Sometimes when I talk about the need to change the incentive structure, people say, “Well, Bob, you think people are rational. You’re an economist.” I don’t think people are rational. My dog, Bitsy, she responded to incentives. She didn’t know, you know, what incentives were. She doesn’t understand the word, but everything, all animals, respond to incentives, and people are, you know, going to respond to incentives as well. That’s just what incentives are. And so with respect to climate, the incentives go the wrong way. We haven’t stopped yet increasing the size of the problem. What we’ve got to do is, we’ve got to create appropriate incentives to reduce emissions, and so that really means putting a price on emissions, and the only issue is really, how strong should that incentive be? So pricing the risk is what it’s all about, and what that means with respect to climate change is it means putting a tax on carbon and carbon emissions, so that’s really the key issue that needs to be addressed. There’s other things that need to be done, but we will only solve this problem if we change the incentive structure. And then finally I would just say, “Look, the uncertainty about climate models and about the future is huge,” and so with respect to, where should we pricing emissions, that means there’s a lot of uncertainty there. If you ask me, “What’s the right price?” you know, let me answer it this way. The UN a couple of years ago published a report in which they talked about the limitations of economic models of climate risk, and what they said, they pointed out many limitations, but one of the things they ended up with is, they said, “Look, the right price could be anywhere from $2 a ton to $200 a ton,” and, you know, that’s not very helpful. Well, I think they exaggerate the amount of uncertainty, but certainly no one knows what the right price is. I would say it’s probably more between the range of $50 a ton and maybe $150 a ton, but there is tremendous uncertainty. We all have to recognize that. The models aren’t that great. We don’t know how people will react to pricing emissions. We don’t know what technology is going to develop over the next, you know, 50 years. This is a very long-term problem, tremendous uncertainties about what will play out, and with respect to that uncertainty, when it exists, you have to err on the side of caution, which means a higher price in this context not a lower price. People have for a long time now been focusing on the uncertainty and saying, “Therefore, you don’t want to react too fast.” Well, quite the contrary. The uncertainty itself creates risk, and that’s why it’s such an urgent problem.

Manju Seal: I asked Bob to explain carbon pricing for those who may be hearing about it for the first time and what it means for consumers. We then discussed the Climate Leadership Council and the carbon-pricing initiative called the Baker-Shultz Carbon Dividend Plan.

Dr. Bob Litterman:Well, there’s a lot of ways to create these incentives, and, you know, there’s some systems that are called cap and trade, some systems that are a carbon tax. I sit on the Climate Leadership Council, which has the Baker-Shultz Plan. We call that a carbon dividend plan. You know, we could dig into the weeds about how the incentive is created, but I would just say what pricing carbon really refers to is creating the incentives to reduce the production of this pollutant of carbon dioxide in the atmosphere.

Manju Seal: You just mentioned Climate Leadership Council, and you’re a board member of that council. So what are some of the goals of this council?

Dr. Bob Litterman:Well, the goal of the council is to create an incentive structure to reduce emissions into the atmosphere.

Manju Seal: And I believe there are various corporations who are part of this council.

Dr. Bob Litterman:We have what we call founding members, and it has tremendous support from the business community. Let’s start with the fact that we have many energy companies, and we specifically went out to try and develop a big coalition, so that coalition includes names that you clearly recognize as leaders in their industry. ExxonMobil, Shell, BP, ConocoPhillips, Total are all, you know, oil companies that belong to the coalition. Xcel Energy is a big utility. Johnson & Johnson, the health-care company, Microsoft, the software company, Unilever, a consumer, you know, company, Ford, GM are both members and many others, so we have … Really the entire leadership of the business community has joined and said, “Look, the right way to address this issue is through the incentives provided by this carbon dividend plan.” And in addition, we’ve gotten support, almost unanimous support, from the economics community. We have more than 3,000 economists who have said, “This is the right approach, pricing carbon,” and that includes almost all of the Nobel Prize winners in economics. It includes the former heads of the Federal Reserve Bank. It includes the heads of the National Economics Council and the White House so really leadership from, by the way, both sides of the political spectrum. There is no disagreement within the economics community that this is the right thing to do. And finally I would mention the environmental community. We have support from The Nature Conservancy, from World Wildlife Fund and from a number of other environmental organizations, so what I like to say is, we have support from everyone from ExxonMobil to the World Wildlife Fund. It’s a coalition. There aren’t too many people who aren’t, you know, somewhere on that spectrum.

Manju Seal: It really sounds like a dream team and has the potential of doing some amazing work. What I would love for our listeners to learn is if you could share more about what the Baker-Shultz Carbon Dividend Plan is all about, and why is Climate Leadership Council sponsoring it?

Dr. Bob Litterman:It started a few years ago, and the basic idea was, we need to have a bipartisan solution. You know, the problem has been a difficult one from a political perspective to get legislation, and so this country has not yet created appropriate incentives. There are a few states that have created some incentive schemes, but it’s very difficult, and we could talk about why at a state level. It really needs to be addressed at a national level, and a few years ago, some of the elder statesmen of the Republic Party, Jim Baker and George Shultz, came together and said, “What are some of the basic principles that might lead to an approach that could generate a bipartisan support?” And so they got together and wrote down a plan. It has four basic components to it. The first one is a price on carbon, and so that’s the basic idea that would drive the reductions in emissions. Now if you’re going to put a price on carbon, you get quite a bit of revenue, and the question is, what are you going to do with that revenue? Well, in the Baker-Shultz plan, the idea is distribute it back on a per capita basis, so everyone in the country will get a dividend, and that’s why we call it a carbon dividend plan. The dividend the first year would be something like $500 per person, so an average family of four would get about a $2,000 check each year. And now energy prices would go up, but when you look net, something like 70 percent of the people in the country would be better off. They would get more money through the dividend than they would pay in terms of increased energy cost, and it’s not a random selection of people that are better off. Of course it’s the people who don’t consume as much fossil fuel, which is to say typically people who are in the, you know, have less money to spend, so it’s a very progressive plan. The people who would be better off are people who use less energy, and the people who’ll be worse off are people like me who are flying around all the time. So I think it’s a very fair plan, and it should be a very popular plan. Another component of the plan is that when you put a carbon tax on, you would disadvantage carbon-intensive industries in your country if right next door you had, or down the block you have, countries that don’t price emissions, so what you have to do is, you have to make sure that there’s a border adjustment so that carbon-intensive goods are not imported into the country from countries that are not pricing carbon. Now hopefully all countries will agree to price carbon, and one of the things that this border adjustment does is it creates an incentive for another country to price carbon as well. If Country A has a tax and it has a border adjustment against Country B, Country B then has a choice of either putting on a tax and then having parity so that there’s no cost and it’s equally economic to produce goods in both countries, or if they don’t put on a tax, then Country A will tax the imports at the border and thereby get the revenues, so obviously it creates an incentive for Country B to do it itself and collect the revenues rather than let Country A collect the revenues, so that’s a third component of the plan. And the final component is what we call regulatory rationalization. There are a lot of regulations now that are intended to reduce emissions and do so in a very inefficient way, and so those kind of regulations should be rolled back. Now we haven’t determined exactly what those are, but that’s kind of the basic principle, and in fact with respect to all of the details, they continue to be worked out amongst our founding members, so that’s what being a founding member means is, you have a seat at the table and can express your preferences as to exactly what the components of the plan are, and still it’s just a plan, you know? We don’t write legislation, so our hope is to get enough consensus amongst a large group of businesses in particular that we can then get consensus within Congress along something along these lines. Obviously, Congress is going to write their own legislation at the end of the day.

Manju Seal: So, is there a timeline or a plan as to when this might all happen?

Dr. Bob Litterman:Well, the time … We don’t have much time to spare here, and I could talk about why it’s so urgent, but I would say we would hope to get our legislation introduced this year. We don’t think it’s likely to be passed this year but maybe next year or the year after, but that remains to be seen, and it remains to be seen, you know, who’s going to be sponsoring the legislation and all that. We have set up a C4, which is to say a lobbying organization, and it’s been funded by a number of our founding members, so we are moving forward with the process of trying to get this through Congress and signed by the President, whoever the President is at the time, and we’re making really good progress. The Democrats of course have been publicly calling for climate action for a long time, not necessarily for our plan, which hasn’t really been introduced yet, but for things along these lines, and there’s many other plans that have very similar components to the particular components in our plan. But this is something that should’ve been done decades ago to be honest, and we’re kind of running out of time in a sense because the risk is exploding right now. You know, if we had addressed climate action 20 years ago, it’s very likely that the maximum temperature that we would reach would be something like where we are today, which is to say about 1 degree C of change, but given the lags in the system and the fact that we’re producing more emissions today than we ever have historically, it’s inevitable that the temperature is going to continue to rise. The problem is going to continue to get bigger for decades, and the maximum temperature right now is headed toward somewhere between 1 1/2 and 2 degrees C. Best case is probably closer to 2 degrees than 1 1/2, and here is the scary thing. Every 3 years that we wait, the parts per million of CO2 in the atmosphere today goes up by about 10 parts per million. So we’re sitting at 415 parts per million right now, which the historical level was about 280, so here we are, whatever it is, 135 parts per million above the historical average, and it’s growing at the rate of 10 parts per million for every 3 years, and for every 10 parts per million, the maximum temperature goes up by about 1/10th degree C, so if we’re heading toward 1.8 and we wait another 3 years, then we’re going to be heading toward 1.9. That is a huge difference and a huge problem. Just to give you an example, the UN just published a report where they compared the outcomes with a 1.5-degree maximum versus a 2-degree maximum. At 1.5, the world is going to lose somewhere between 70 and 90 percent of its coral reefs. If we get to 2 degrees C, we’re going to lose, they said, greater than 99 percent of the coral reefs, so, you know, where we’re at today, that could be … A 6-year delay could put us over that 2-degree mark, so it’s really urgent that we address this issue as soon as possible. The way to address it is to create appropriate incentives to reduce emissions.

Manju Seal: The support for Task Force for Climate-related Financial Disclosures, or TCFD, has grown exponentially over the last few years and aims to provide transparency to investors, lenders, insurers and other stakeholders. The work and recommendations of TCFD will help companies understand what financial markets want from disclosure in order to measure and respond to climate-change risks. BMO, for one, is a supporter of TCFD. I asked Bob for his view on this rapid development in the industry.

Dr. Bob Litterman:Well, the TCFD is a good … It’s a good effort to try and standardize reporting of climate-related risks as you say. It was motivated by something called the Financial Stability Board that was headed by Mark Carney, the Head of the Bank of England, and it was a gathering of the financial regulators together with the energy companies, with investors, with data providers and a large group of folks who have done a lot of work to try and create a standardized approach, basically scenario analysis. What’s going to be the impact on each company of a, you know, a set of scenarios moving toward the low-carbon economy? And so I think it’s an excellent way to disclose information and start a dialogue between asset owners and management of these companies and allow a comparison of the risks and the actions being taken by various companies in all the different industries to address this issue. So I think it’s a complex process, and it’s been moving forward slowly, and I applaud it.

Manju Seal: In the end, Bob and I talked about why developing countries need to take a lead on this issue and how countries will be impacted by climate change. He also makes a final case for carbon pricing and why action is required urgently.

Dr. Bob Litterman:Well, of course, one of the things that is needed is to address the issue of what some people call environmental justice, the fact that it’s typically, as you say, poor people that can’t adapt as easily to some of the effects of climate change, the impacts on the coast of sea-level rise or more generally flooding, bigger storms, wildfires or just the heat. Now I would say that’s true within the United States, but it’s even more true when you start thinking about the impacts on developing countries around the world, so it’s just imperative that rich countries like the United States lead in the reduction of emissions, and to be fair, the US has been a leader in reducing emissions. Today, we’re only 15 percent of global emissions, but the right way to approach this problem is as a global problem, and what we need is to create a globally harmonized set of incentives to reduce emissions, and so the US should be leading this effort. You mentioned the impact on biodiversity. That’s just one of many dimensions in which this is an urgent risk-management nightmare, you know, to put so many of the species at risk. The worst-case scenario, of course, is a collapse of ecosystems around the world to the detriment of people globally, and that’s why I’m very confident we are going to address this issue because it is so urgent, and we have to address it quickly and especially in the United States.

Manju Seal: So, Bob, you’ve been studying climate change for over 10 years now, and as you look forward to the next 20 years of being involved in different ways, what do you think you would like your legacy to be?

Dr. Bob Litterman:Well, I hope I have another 20 years.

Manju Seal: I’m sure you will.

Dr. Bob Litterman:You know, to me, this is very personal. I have three grandchildren now and a fourth grandchild on the way, and I think about those grandchildren who are, you know, most likely going to live through the rest of this century into the next one, and they will experience this legacy that we have created of a bubble of carbon dioxide that is warming the planet and destroying ecosystems, and, you know, if I can be part of creating the solution by pricing carbon, you know, that’ll be terrific.

Manju Seal: And my last question is, since we both spent a lot of time in asset-management industry, if you were to think of a future in 10 years, what sorts of products or financial structures you can imagine that could be in place to have more sustainable finance, investors looking at it, both at retail and institutional? So if you had to dream about it, what would you want to see?

Dr. Bob Litterman:Well, let me say I would start with carbon pricing because it’s such an urgent problem, and it’s an example though where we can use the, you know, incentives in the market to drive the solution. We’ve done that before with things like acid rain, but climate is certainly the big one that’s in front of us right now. Pricing the externality is an example of what happens when you don’t get incentives right and then, you know, what will happen when we do get incentives right, and right now we’re misallocating resources in so many different ways just because we don’t have the right incentives. I think when you think more broadly about natural capital and, you know, protecting nature, it’s the same thing. We have to recognize the services provided by nature, and when we recognize them, we will value them appropriately, and so that’s … We will protect nature, and we will protect biodiversity and all those good things that nature provides, and so to me, certainly with respect to sustainable finance, what you’re really talking about is recognizing the externalities associated with diminishing nature and not weighing the future well-being the way we should. When we put enough weight on the well-being of our grandchildren, we will certainly be pricing emissions appropriately.

Manju Seal: On behalf of BMO, I want to thank Bob very much for making time to be with us today and speaking with me on this important subject. Until next time, I’m Manju Seal.

Michael Torrance: Thanks for listening to “Sustainability Leaders.” This podcast is presented by BMO Financial Group. To access all the resources, we discussed in today’s episode and to see our other podcasts, visit us at bmo.com/sustainability leaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider, and we’ll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO’s marketing team and Puddle Creative. Until next time, I’m Michael Torrance. Have a great week.

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