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Bob Litterman
May 2014
The Price of Climate Risk

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Climate Change: Some questions
Is climate change real?
Is uncertainty about climate change real?
Is a devastating natural disaster outside the realm of
possibility?
When, where, or how might a global catastrophe occur?
Does it matter how much carbon dioxide we put into the
atmosphere?
Should adding emissions to the atmosphere be priced
appropriately?
What is the appropriate price for emissions?

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Stranded Assets
GtCO2 Equivalent
Carbonbudget2000-2050
Carbonused2000-2010
Remainingbudget
Coal
Coal +
Oil
Coal +
Oil + Gas
Proven Reserves
Strandedassets2230
Source: Carbon Tracker Initiative

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Fossil fuel industry reaction:
A low carbon pathway would be too expensive,
thus none of our assets will become stranded

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Think about dynamic optimization
With Uncertainty, Tipping Points And Nonlinear Responses

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Where should climate risk be priced?
(economists call this: “the social cost of carbon)
There are 2 kinds of risk:
High risk aversion
Low risk aversion
Zero
The price of climate risk today
Non-diversifiable
Risk
Diversifiable risk Expected damage
risk
premium

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The Equity Risk Premium
US Historical Real Returns
Data are from http://www.econ.yale.edu/~shiller/data.htm
ERP = 4.75%
Stock real return = 6.4%
Bond real return = 1.6%
A consistent 475 basis points per year for the last 140 years

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Equities pay off primarily in good states of nature
Consider a portfolio that pays off in bad states of nature
Data are from http://www.econ.yale.edu/~shiller/data.htm
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An equally risky portfolio
long bonds and short equities earns
-310 basis points

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What does the Equity Risk Premium have
to do with Pricing Climate Risk?
Pricing carbon emissions is a risk management
problem involving trade-offs between consumption
today and potential bad outcomes in the distant
future
This trade-off depends crucially on the degree
of societal risk aversion
Societal risk aversion can be calibrated to the
equity risk premium

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Economic impacts depend on future
temperatures which are very uncertain
Science: 25 March 2012

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Climate modelers generally use a low curvature in
the context of a standard CRRA utility function
Counter to intuition, in the standard utility function increasing the
risk aversion makes curbing emissions less urgent
Higher curvature has two impacts:
1) it increases the risk premium, but
2) it also increases the risk free discount rate
The second impact dominates and causes the price to decrease
Lord Nicholas Stern, for example, set a
degree of curvature that implies an
equity risk premium of around 12 basis
points,
more than 30 times too low relative to
observed risk premia
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Estimates of the social cost of carbon
from Anthoff, Tol, and Yohe (2009)
emissions
prices
Increasing risk aversionWhy???

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Higher curvature across states of
nature is required to fit the very
significant equity risk premiums
that we observe in the market
While lower intertemporal curvature
is required to fit the relatively
low risk free rates
that we observe in the market
Risk aversion Intertemporal substitution
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Epstein-Zin utility can be calibrated to both
high risk premia and low interest rates
consumption ( time, states of nature ) consumption ( time, states of nature )
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The rigidity of standard utility functions explains
why in most climate models increased
risk aversion lowers the price of emissions
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The Appropriate Price for Carbon Emissions
Is Part of an Optimal Plan
The Appropriate Price
 Trades off current consumption against future damages
 Recognizes unknown impacts, and the potential for time compression and
catastrophic outcomes
 Builds in a margin of safety
 Anticipates risk reduction over time
Higher Risk Aversion
 Increases the risk premium
 Lowers the discount rate for future damages
 Raises the price today and potentially lowers the expected future price

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One cost of delay is higher future emissions prices
Another is increased risk of catastrophic outcomes

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Higher societal risk aversion shifts the
appropriate emissions price path upward
forward prices will
be driven by the rate
of technological change
in emissions mitigation

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Investors have exposure to emissions price risk
• Portfolio construction
• Tilt away from stranded assets e.g. coal and tar
sands
• Governance
• Appropriate, transparent business plan
assumptions about future emissions prices
• Markets
• Hedging requires a forward market in
emissions prices
This recognition has implications for:

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“Stranded assets”
(any asset whose value will be negatively impacted by higher emissions prices)
Are they a risk or an opportunity?
Stranded assets will re-price to reflect changing expectations of
forward prices, rather than changes in actual emissions prices.
corporate
forward expectations
from CDP survey
current forward curve?

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Stranded Assets Total Return Swap
WWF
Deutsche
Bank
¾ Coal index return
¼ Oil sands index return
S&P 500 index return

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Stranded Assets Total Return Swap
Negative correlation to S&P 500 -.36
Annualized net total return 21.7%
1/3/2011 through 1/17/2014
Swap 21.7%
S&P 500 15.9%
Tar sands 2.0%
Coal -10.1%
A hedge which reduces portfolio risk
And adds a potential source of return
Better aligns investments with mission
Doesn’t impact underlying assets

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Governance example: Aviation
• Aviation has promised:
– a “market-based measure” to reduce emissions
– but seems to have no intention to create appropriate incentives
• Aviation will need capacity to create emissions
– requires high energy content of liquid fuel for takeoff and ascent
– atmosphere’s capacity to safely absorb emissions is limited
– thus aviation has a special incentive to lead on this issue
• Owners of aviation shares have an important role to play
– management often focuses too much on short term profits
– long-term owners have longer term priorities, such as creating
appropriate global incentives to reduce emissions
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Questions?

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