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Bob LittermanMay 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 AssetsGtCO2 Equivalent

Carbon budget 2000 - 2050

Carbon used 2000 - 2010

Rem

aining budget

Coal

Coal +Oil

Coal +Oil + Gas

Proven Reserves

Stranded assets 2230

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-diversifiableRisk

Diversifiable risk Expected damage

riskpremium

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 natureConsider 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 portfoliolong bonds and short equities earns

-310 basis points

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What does the Equity Risk Premium haveto 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 futuretemperatures 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

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Estimates of the social cost of carbon from Anthoff, Tol, and Yohe (2009)

emissionsprices

Increasing risk aversionWhy???

Higher curvature across states of nature is required to fit the very significant equity risk premiumsthat we observe in the market

While lower intertemporal curvature is required to fit the relatively low risk free ratesthat we observe in the market

Risk aversion Intertemporal substitution

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Epstein-Zin utility can be calibrated to bothhigh risk premia and low interest rates

consumption ( time, states of nature ) consumption ( time, states of nature )

utility utility

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 pricesAnother is increased risk of catastrophic outcomes

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Higher societal risk aversion shifts the appropriate emissions price path upward

forward prices willbe 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.

corporateforward expectationsfrom CDP survey

current forward curve?

Stranded Assets Total Return Swap

WWF DeutscheBank

¾ Coal index return

¼ Oil sands index return

S&P 500 index return

Stranded Assets Total Return SwapNegative correlation to S&P 500 -.36

Annualized net total return 21.7%

1/3/2011 through 1/17/2014Swap 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

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 emissions22

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Questions?

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