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2 Bob Litterman May 2014 The Price of Climate Risk

3 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?

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

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

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

7 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

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

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 9 An equally risky portfolio long bonds and short equities earns -310 basis points

10 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

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

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 12 Estimates of the social cost of carbon from Anthoff, Tol, and Yohe (2009) emissions prices Increasing risk aversionWhy???

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 13 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 ) u t i l i t y u t i l i t y

The rigidity of standard utility functions explains why in most climate models increased risk aversion lowers the price of emissions 14

15 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

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

17 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

18 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:

19 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?

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

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 Doesnt impact underlying assets

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 atmospheres 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 22

23 Questions?

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