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Bringing economic leadership to climate change

An Interview with Robert Litterman
December 2, 2020

Photo of Robert Litterman

Photo of Robert Litterman
Robert Litterman, PhD '80, recipient of the Outstanding Achievement Award. Photo courtesy of Jake Armour for Minneapolis Fed.
Climate change is the driving force behind all manner of calamities – wildfires, hurricanes, floods and droughts. They may be just the beginning. An era of environmental extremes threatens to batter financial markets, adding trillion-dollar shocks and stresses to commodities, banking and insurance markets.

In a first-of-its-kind call to action, a subcommittee of the U.S. Commodity Futures Trading Commission recently issued a call for “carbon pricing” and scores of other measures to meet climate change. Delay could mean calamity from farm to factory, destabilizing financial markets in the U.S. and around the world, the study warns. 

Robert Litterman, chairman of the subcommittee that authored the report, is a founding partner of Kepos Capital, an investment firm based in New York, and a board member of the Heller-Hurwicz Economics Institute. He is also an alumnus of the University of Minnesota (PhD '80, economics).

The interview has been edited for space and clarity.

People have come to associate forest fires and hurricanes with climate change. But your report argues that financial markets could face buffeting of a different kind.

There are financial risks that are going to be emerging over the coming decades and we have no idea how systemic they’re going to become. 

We’re not saying there’s going to be a market meltdown that’s going to hit everybody. But the risks could be particularly bad if we don’t address climate. We have to price emissions. We have to reduce emissions and we have to do it immediately.

If we do that, presumably we’ll avoid those systemic [financial] impacts.

The panel makes dozens of recommendations. What are the key findings?

The key finding is that we’re not pricing climate risk right now. It’s got to be fixed. It should have been fixed 30 years ago. We need a carbon tax. We’ve got to create appropriate incentives to reduce emissions. That’s number one.

The other findings are very diverse and apply to a wide range of organizations. We’re including a great deal of expertise from banks, insurance companies, financial regulators. We focus on risk management. Risk management requires data and analytics.

Climate risk is very different from traditional financial risks…We don’t have a long history of climate impacts to look at. It’s a relatively new problem and it’s going to be increasing over time. Not only do we have long experience with it, but it’s going to develop, to emerge over decades.

We have to look at a time horizon that’s much longer than a traditional financial risk. How much capital will financial institutions have to hold to be safe relative to sudden financial shocks? Those have traditional answers. But they just don’t apply to climate risks that develop over decades. You can’t look at today’s balance sheets and have them tell you that you’re safe from the emerging risks.

The report talks about facts regulators don’t know. Among them: How stressed are corporate balance sheets? What will the strains be on government budgets? How hard will household wealth be hit by disruptions in financial markets?

Do we have the tools and the will to sort through all these complexities?

Do we have the tools and the data today? The answer is absolutely no. Not only do we not have them, we’re not sure what they’re going to be. Will there be interactions and stresses that we haven’t even thought about yet? 

We need to focus on these questions. Some companies are well ahead of others in this type of analysis. We need to take a comprehensive approach, with leadership from financial regulators, with considerable effort by individual companies to develop the data and the analytics that we need.

We have the private sector that’s trying to develop these data to make a profit. So there are providers who are very active in this space. But we need an open-source approach where everybody has access to the data and analytics. It’s in everyone’s benefit that we can have a common understanding.

When climate scientists talk time horizons that span decades and centuries. Do financial market instabilities tied to climate change arrive sooner? In other words, can we see financial markets rattle years before the disaster arrives?

Absolutely. Clearly, there are climate impacts.

Many people talk about a “Minsky moment” when expectations change suddenly. [The late Washington University economist Hyman Minsky modeled circumstances in which the sudden decline in market sentiment inevitably leads to a market crash.]

You could have a change in expectations…There are lots of companies and countries with “stranded assets.” Buggy whip factories, which became unnecessary with the advent of the automobile.

I’ve got a coal mine I’d like to sell you.

Exactly, a coal mine is a perfect example of an asset stranded by climate change. There’s a concern that market participants are not recognizing that the value of those assets have gone down because we won’t burn all the coal or oil or natural gas that’s sitting on the balance sheets of fossil fuel producers.

There’s a feeling that these fossil fuel producers are overvalued and investors are going to realize that all of a sudden. That could lead to a dramatic drop. They’ve already had a significant decline in valuations compared to 10 years ago.

The futures commission is a creature of the Trump White House. How has the report of the subcommittee on climate risks been received by the full panel, by the Trump administration and by Congress?

We’ve had positive reaction to the report. There’ve been hundreds of articles about it. Most have been very positive. Millions of folks who’ve read those. I’ve heard from the private sector, from government and, especially from academia and the non-profit sector. It’s been almost universally positive.

Many people were very surprised that a report under the Trump administration would even address climate change, much less focus on what’s to be done. It’s a road map for the financial system. It’s something that was absolutely needed. Now we’ve got to educate on that. There are a lot of recommendations for different institutions, both government and private. A carbon tax is key.

After our report came out, the Business Roundtable, representing CEOs of the largest corporations in the U.S. came out and said we need a market price that reduces our dependence on fossil fuels.

It’s a fundamental problem, a flaw in the economic system. We don’t have proper incentives to reduce emissions. That’s the source of the risk. If you’re going to have risk management, you’ve got to price the risk.

We know we have to have incentives to change behavior, to protect the behavior of future generations.

It’s like a bug in a computer program. Once you find it, you fix it. Instead, we’ve now been waiting 20, 30 years. It’s now urgent.

Will the participation of Morgan Stanley, S&P Global and Vanguard, BP and ConocoPhillips and ag trading giant, Cargill, make the findings hard to ignore?

Absolutely. This is a consensus report. When a group that ranges from oil companies to environmentalists agree on something, I would hope that’s pretty powerful. The agreement is now. We’ve got to price emissions.

Everybody gets it, except maybe the Republicans in the Senate.

How do you balance the costs of action against the price of doing nothing?

Everybody agrees we need to price the risk. I didn’t hear any pushback on that. On the question of where to price in and when, everybody agrees it should be done as soon as possible. When you’re managing risk, time is not on your side. Given enough time we can solve any problem. It’s when we run out of time that a risk can become a catastrophe.

Personally, I think we have to be prepared for extremely bad, but plausible scenarios. A [tax on carbon] has to be high enough to change behavior now, to protect future generations. We’ve got to get emissions down to “net zero” by 2050. 

If you add a buck to the price of gas, the screaming will be heard from here to the moon.

I’m not sure there will be screaming. First of all, two third of Americans understand we have to have incentives to reduce emissions. It’s very popular.

When you put a price on carbon, you increase [tax] revenues. One of the things you can do is distribute those revenues on a per capita basis. You can make 70 or 80 percent of people better off, as long as you distribute the money.

It could be very popular. It certainly could be very progressive, right? 

We’re buying insurance against the worst possible outcomes in the future that might happen if we don’t do this.

What’s next? How will the authors of the report ensure their work does more than gather dust on a library shelf?

After the election, we’ll have a plan in place to price carbon. Once the U.S. acts, other countries have the opportunity to create harmonized prices on carbon. All of a sudden, that force – like gravity – will direct every economic decision in the right direction.

Dealing with climate change creates opportunities. Already far more jobs are being created in solar energy than are being lost in the coal industry.

I think pricing carbon will stimulate the economy by unleashing investment in new technologies and industries.