Jan. 11, 2023

Ep112: Bob Litterman 'Climate Risk, Financial Returns'

This week on Cleaning Up, Michael hosts Bob Litterman, founding partner at Kepos Capital and Chairman of the Kepos Capital Risk Committee. Litterman spent 23 years at Goldman Sachs, during which time he became a partner and established himself as an outstanding authority on financial risk. Since co-founding Kepos and joining the boards of the World Wildlife Fund, Ceres and the Climate Leadership Council, among others, he has become a leading voice on climate policy and risk as it relates to climate change and the transition.

From this unique vantage, Litterman is acutely aware of the time-sensitivity of climate risk:

“We have to create incentives globally to reduce emissions, and we have to do it very quickly. When you're managing risk, time is a scarce resource. If we have enough time, we can solve almost anything. When you're managing risk and you run out of time, a risk management problem becomes a catastrophe.”

Prior to founding Kepos Capital, Litterman had a 23-year career at Goldman, Sachs & Co., where he served in research, risk management, investments and thought leadership roles. Litterman became a partner at Goldman Sachs and head of the firm-wide risk function in 1994, and head of the Quantitative Resources Group in 1998. Litterman is the co-developer of the Black-Litterman Global Asset Allocation Model, a key tool in investment management.

Litterman serves on a number of boards, including the Niskanen Centre, Ceres, World Wildlife Fund, and the Climate Leadership Council, where he serves as co-chair of the Board. Litterman also chairs the CFTC Climate-Related Market Risk Subcommittee, which published its report, Managing Climate Risk in the U.S. Financial System in September 2020.

Litterman holds a Ph.D in Economics from the University of Minnesota, and a B.S. in Human Biology from Stanford University. Prior to Goldman Sachs, Litterman taught at MIT and worked at the Federal Reserve Bank of Minneapolis.

Read: Edited Highlights: CLICK HERE

View: Relevant Guest & Topic Links:

Read Managing Climate Risk in the US Financial System: CLICK HERE

Find out more about Kepos Capital: CLICK HERE

Watch: Related Episodes:

Cleaning Up Episode 49 with Johan Rockstrom: CLICK HERE

Cleaning Up Episode 48 with Nick Stern: CLICK HERE

Cleaning Up Episode 109 with Dipender Saluja and Ion Yadigaroglu: CLICK HERE


Michael Liebreich So, Bob, thank you so much for joining us here today on Cleaning Up.

Bob Litterman It's my pleasure, Michael.

ML What I'd like to do, just to get us all started, is for you to introduce yourself - but just give us the brief version. Because obviously, I've just done this intro which you haven't heard, but it's extremely fulsome in its praise of various aspects of your career. But just tell us in a nutshell, in your own words, for the audience.

BL Sure. Well, I'm an economist. I'm also a grandfather, I have four grandkids, two kids. I live in California. I've become very passionate about climate change. My career started out as an academic, I ended up as an economist working on Wall Street; at Goldman Sachs, I became a partner in charge of risk management. And when I retired a little over a decade ago, I started focusing on climate change, and worrying about it from a risk management perspective. And to be honest, the more I got interested in it and started learning about it, the more it kind of sucked me in, and indeed confirmed my concern that it was, in fact, a risk management nightmare; that we're totally screwing it up, and, you know, maybe I could help by bringing some of the principles of risk management to the conversation. So, that's what I've been doing for the last decade.

ML Very good. Now, what I'd like to do is kind of take that journey and just expand on it a little bit, because your background is as an academic, econometrician is it not? I mean, you were one of the first of the Wall Street quants.

BL Yeah, well, that's right. I enjoyed the statistical estimation part of economics, and spent my career as an economist kind of involved in forecasting economic outcomes using statistical methods. It was really, I think, those skills that attracted me to Wall Street in the mid 80s. There were a lot of quantitative things going on on Wall Street: new derivatives, bonds, and equities, and risk management, and new types of securities. So, there was a lot of interest in bringing quants to Wall Street, understanding how securities should be priced, how risks should be managed, and so on. And I just found that... boy, I was like a kid in a candy store; there were so many interesting problems and new tools to apply. So, it worked out well for me.

ML You've already use one of the key words we're going to be coming back to time and again during the course of this episode, which is risk, and the pricing of risk, and the construction of portfolios to manage risk. And there's one aspect of your background that I think highlights, at least for me when I was preparing, the extent to which you really are a risk professional, a quantitative risk professional through and through, and that was the model that you developed with Fischer Black - legendary name, right?

BL Yeah, absolutely. You know, I came to Goldman Sachs and I was trained as an economist, but not [in] finance. And I just arrived at Goldman; Fischer was there. He had actually been a colleague of mine at MIT a few years before, so we knew each other. He was Head of Equity Research, which included risk management; I was head of Fixed Income Research. And so, it was very natural that we would work together. He actually had developed a bond pricing model and option pricing model for fixed income securities that he and I started working on. And early on in that collaboration, one of the models that we were asked to work on was an asset allocation model. And it was kind of a funny story, because I went to Fischer and said, you know, any particular suggestions as to how to proceed? And he said, well, you know, I always believe in trying a simple model first, and if it doesn't work, then you can add some bells and whistles. And so, I programmed up a very simple Markowitz Mean-Variance Optimization, I tried to apply it to bonds and currencies and found that - these were highly correlated assets - and the results were very, very sensitive to the inputs. And so, I explained this to Fischer, I said, you know, this model doesn't work very well, it's too sensitive to these inputs, to which he said, well, Bob, that's well-known.

ML Let me pause you there just for one second, because our audience is extremely broad, right? You've got some real... there will be some, you know, quant jocks listening and going, oh, yeah, I know all this, this is great, and I know exactly [what you're talking about]. But there will also be some people maybe out of policy, or maybe out of civic society, you know, there'll be activists, there'll be all sorts listening. So, this was a model that was creating the perfect portfolio of international bonds? Were they government bonds, or all bonds?

BL International government bonds. In fact, we started very simply with all 10-year bonds. So, they were all the same 10-year government bonds. Of course, depending on where you were located, if you were a US domiciled investor, you're probably looking at your returns in dollars, if you are domiciled in Japan, you're probably thinking about your returns in yen. So, you know, currencies, you could almost think of it as 10 bond markets and nine separate currencies, and that's kind of how we thought about it. But these are all from the investor's point of view very highly correlated assets. And that's where we get into this problem of bad behaviour; they're good substitutes for each other. So, if you think of, what's an optimal portfolio, the optimizer will tell you a whole bunch of numbers. It turns out, if you don't put constraints on them -some of them are going to be positive, some are gonna be negative, some are gonna be way out here - you might find that it tells you you gotta be 40% in New Zealand bonds, and you go, wait a minute, that doesn't make any sense.

ML And this is answering questions like, maybe you've got your bond portfolio, and suddenly, you get bad inflation news out of Canada. Then you will find this model will say, well, in that case, put everything into New Zealand, you'd be like, whoa, where did that come from, right?

BL Yeah, exactly. It made no sense, and small changes in those assumptions... My first experiment was I said, alright, well, we have Goldman Sachs economists, they have views about all these different markets, let's just put them in and see what happens: you know, it goes crazy. And then you say, alright, well, we'll put on no shorting constraints, and then you get something else completely different. And then you try something else a little bit... change the forecast on a 10-year bond by five basis points over the next six months, which is well below anyone's ability to differentiate and all of a sudden, you get something else completely different.

ML That means dumping a trillion dollars, or hundreds of billions of dollars, of somebody's bonds. So, you then worked with Fischer Black, and stabilized it all and it kind of was then, variance on the equilibrium, variance on a market portfolio of bonds. So, that's the sort of stuff that you were doing, right?

BL Right. Well, I'll be honest with you, I went to Fischer and I said, what do people do, this can't be right? And he said to me, well, you know, people put constraints on, maximums and minimums, that's what they do. And, you know, obviously, you don't get any value added if you say put it right here, otherwise it would go way out there. You know, what's the optimizer doing for you? So, Fischer said to me, why don't we put an equilibrium into this optimizer? And I was like, an equilibrium? Knowing that was kind of an academic type suggestion, it wasn't something part of the standard options; I didn't even know, what equilibrium you're talking about? And he said, well, I've worked out this... I call it universal hedging equilibrium. And indeed, there was a paper that he had just written, maybe a month before, and I had seen it. It was talking about global equity markets and optimal currency hedging in equity portfolios. So, you can imagine it wasn't obvious to me that that had anything to do with a global fixed income portfolio. But that's what Fischer suggested and, you know, he was a very smart guy, so I thought, all right, well, let's see what this might possibly mean. It actually took me a couple of weeks playing around with the model trying to figure out okay, how do you use this? The first thing I thought is, well, let's just take the economists' forecasts and then let's take this equilibrium, expected returns for all assets, and we'll take a weighted average. It turned out that didn't work, you had to take correlations into account. So eventually, we came up with a better solution. In fact, this solution that worked incredibly well. And so, that became a very standard model, it's still being used today.

ML As they say, and the rest is history. And it is now one of the models that's taught to CFAs, to accountants, it's not, it's not... capital asset pricing model, or it's not Black-Scholes, but it's Black-Litterman. Now, the reason I thought it was worth going into that was to give an insight to the audience into the sort of work that you've been doing, and what does econometrics mean, and how is it applied, and so on. But you then have moved over; as you said, by the time you were retiring from Goldman Sachs, you were heavily involved in the area of climate and climate risk and managing that risk for the financial system. Was that a single epiphany? Was that because of your early academic background - your undergraduate, which I believe was in biology? How did you make that journey?

BL Yeah, well, I would certainly say the undergraduate major in human biology planted a seed. And I came out of that, you know: four years of studying humans as biological organisms, but also as information processing organisms, and with a long history and lots of tools that they use. And so I guess early on, I became fascinated with economics, and what drives people and their behaviour, and so I ended up getting a PhD in economics. But that background in biology, certainly, I think gave me a good understanding of what humans are. These days, there's a lot of focus on behavioural economics and behavioural finance - the point being that people are not perfectly rational. And obviously, I get that, most economists understand that. It's also useful to say, what would humans do if they were rational? That's another observation that leads to interesting analysis. But in any case, I liked economics early on but as I got to my point in my career where I was retiring, I was concerned about climate change. It did seem like a risk management problem that wasn't being addressed appropriately. And so I got interested in it. One of my colleagues at Goldman, a partner, Larry Linden, really pulled me into this space; we had lunch one day, and he asked me if I was interested in the environment. And I said, well, you know, I could be, I haven't really studied it or focused on it previously. But he was, at that point, the chairman of the board of the World Wildlife Fund, and introduced me to the president, who's still president, Carter Roberts, terrific individual. And I got very interested in their program, especially their expertise on climate. And so I joined their National Council, started working with the staff. And, as I say, just got sucked in, more and more interesting questions. In particular, I guess, I should mention that Larry's... We were at lunch early on, I remember saying to him, Larry, it's obvious: I'm an economist, we're not pricing the risk. And Larry said to me, well, Bob, you know, brilliant observation for an economist, but here's the problem, no one has a clue where it should be priced. And I thought, wait a minute, you know, I can read the literature here, there's gotta be some academics who have studied this. And so, you know, I started reading that literature, and it was a literature that had a lot of problems, I would have to say, in particular, in the way that it treated risk. It's a complicated problem, and the future is highly uncertain. And so you'd think risk would be at the middle of it. But I would say, economists, like many scientists studying this, had a hard-enough time just knowing what to expect in terms of expected outcome, much less the full distribution of potential outcomes. That's one of the things about risk management: you don't worry about what's the expected outcome, you worry about what's the worst case, and that's what I have to be prepared for. Well, with climate risk going out 50 years or 100 years the question was, is it real? Is it measurable? Do we have any clue what's going to happen that far into the future? And, the answer, of course, was actually yes all along, but there was an awful lot of noise around that answer. And so, asking questions like, what's the worst case for sea level rise over the next 100 years, was not something that people had very good answers to, or focus on. We've come a long way, in the last 10 years in terms of public understanding of this, and the implications of it. Although the answers really haven't changed, Michael: the answer is, it's a serious problem, a very serious problem. What we have to do is we have to create incentives globally to reduce emissions, and we have to do it very quickly. Time is of the essence here with respect to this risk management problem. We've been wasting time. And the way I like to think about time, which is really at the centre of this... it's always an issue with risk management. One thing I like to tell people is when you're managing risk, time is a scarce resource. If we have enough time, we can solve almost anything. And it's when you're managing risk or trying to manage risk, and you run out of time, that a problem, or a risk management problem becomes a catastrophe, it's too late. And we don't know, we won't know, with respect to climate change, when it becomes too late. But I'll tell you what, it's a lot later today than it was 20 years ago; 20 years ago, if we had addressed it, it wouldn't be a problem. Today, it's a huge problem, no matter what we do. It's an existential risk. I say to people; we have to slam on the breaks; we just don't know how much time we have. And you know, we could cross a tipping point at any point in time. We may have already crossed a tipping point where it's basically just too late. Sad.

ML You're doing my work for me because you opened up... you used the word risk, you were the first to use it on this conversation which was spot on, and now you've moved to this question of time. And I'm fascinated by this because I think that a lot of people focus on the uncertainties: we don't know how much we will emit, we don't know quite what it'll do to the planet, we don't know what that will do to the mosquitoes, or to the to the Arctic ice and so on. So, there's uncertainties. But this question of time, I don't think is sufficiently understood in the debate. And we had a fantastic conversation on Cleaning Up with Johan Rockstrom. And Johan, he's now at the Potsdam Institute. And he's the developer of this kind of planetary boundaries model and thinking, because it's not just climate: there's a number of others around biodiversity, around phosphates and nitrogen and so on. But he draws this distinction in our conversation between the commitment time - which is basically decades, the decades that we have to act, because we're lighting the fuse on the impacts - and the impact time for these... Even if it's a tipping point, he talks about impact time, which is essentially in, and of the order of, centuries. And I love the conversation with him, because he's not doing what a lot of people do, which is pretend that the impact time and the commitment time are both decades. And that has conditioned the debate: a lot of people say oh, climate change is going to be catastrophic by 2030, by 2040, and that's just wrong. What we've actually got is decades to act to stop things hitting us, which could be existential in 2, 3, 4, 500, years, to use the words of Johan Rockstrom. How does that play into risk models? Really bad things that happen in a number of generations?

BL Yeah, well, it's good... I love the idea of thinking about timeframes that we're not usually thinking about. I mean, sea level rise to me is just a good example. First of all, let's not focus only on this dimension, right? You've got heat waves, you've got droughts, you've got stronger storms, etc, etc, etc. There's all kinds of dimensions. But sea level is one where we have a long history, we understand a lot about the science of the warming of the earth and what it does to ice sheets and so on. There's a lot we don't know. So, you can look at, for instance, Greenland, the Greenland ice sheet, which is huge: on average, a mile thick, 500 miles across and 800 miles north-south. And it's in the process of melting. And we don't really know how fast it's going to melt, but we do know that the oceans have been significantly warmed such that it's warming from underneath, and it's likely the whole thing is going to melt. Over hundreds of years, for sure, but it's starting now. And it's just starting very slowly, but it's accelerating, and Michael, it'll accelerate for your lifetime, and the lifetime of your kids, and most likely the lifetime of your grandkids. That's the kind of geologic change that we're putting in place, it's too late to change that. We're gonna hit maximum temperature if we do the right thing, maybe in 2050, or 2060.

ML Let me come in there, because what you've given us is a fantastic example of exactly what I'm saying. Because the fact is, although the Greenland ice sheet is melting - and the scientists, they go there, and they measure, and the water's flowing, and the sinkholes, and it's terrifying - but it is only melting to fractions of fractions of a percent of the ice mass that's there. The real problem with Greenland is not what it's going to do this decade, next decade, 2050. What it's actually going to do is inexorable, and existential, along with the Antarctic and others, but in centuries, because it's such a large piece of ice.

BL Well, yeah, but are you suggesting we don't have to worry about it? Because I've got I've got grandkids, Michael, who are going to be alive when the sea level is somewhere between two and ten feet higher. That's something that a lot of people worry about.

ML 100%. I think what I was looking for - don't get me wrong, I'm the last person, if you look at what I've done with my career, the last person to say, oh, it's all slow so we shouldn't be worrying, not at all - the question is, what's the analytical framework that enables us, in a sense, to worry properly? Worry with a framework, make trade-offs? Because one thing we could do, and it's kind of the way.... We also had, Lord Stern, also had one of these conversations with me on Cleaning Up. And if you go back to the Stern Review, it's kind of: well, what you do is you have these catastrophic things, and then you put a really, really low discount rate on, and then that wakes everybody up. But is that the methodology of choice?

BL I mean, look, the weather has already changed. Let's start with that. Okay, so, hurricanes, big hurricanes are much more likely, heat waves are much more likely, cold waves are much more likely, hail storms are much more likely. Very heavy downpours with rivers overflowing are more likely. All these things, floods are more likely. So, one of the things that we have to worry about is the fact that we're seeing 100-year events along all those different dimensions more frequently. We used to talk about 100-year events, which were kind of special because we weren't ready for them. You know, you've got your building codes, and infrastructure, and everything that's built for the events that you see regularly, every 10 years, or every 20 years, even every 50 years. But you get to the one in 100-year, or the one and one 500-year, whatever it is: you're not ready for that, that's going to wipe out everything. And we're seeing that more and more. It's no longer a statement about how frequent these major events are; this is a statement now about the magnitude of the event. The 100-year flood is just one that we're not ready for. And similar with the 100-year drought. Now in the west of the US, we have a 1200-year drought. I mean that drought is not going to end, it's just going to get worse. So, you've got things like forests, they're going to burn, you've got sea level that's going to rise and so people are gonna have to move away from the coasts. And we're not getting ready for that. We're not, for instance, setting insurance rates that would cause people to move from risky areas to hardened infrastructure in cities; we're not doing that. That's what we should be doing in order to prepare for the changes.

ML Let's move on to - again, you're doing my work for me because you brought the word insurance in, and then that comes to the financial system. And you know, all I'm doing... I'm not trying to in any way minimize the severity or even the urgency. I'm just exploring how it is that that we're going to get kind of analytical frameworks, econometrician-type frameworks, around some of these questions. Which brings me perfectly to the initiative that you chaired on behalf of the US Commodity Futures Trading Commission. They have a committee on market risk - an advisory committee - and then that had a subcommittee on climate risk, which you were invited to chair. How did that play out? And what were your recommendations?

BL Yeah, well, it worked out very well from my perspective, as chair. We had 35 people on that committee originally, and we tried to pick a diverse group representing all the different players in the financial markets. So, we had investors and asset owners; we also had corporations, a couple of oil companies, some Ag companies; everyone who works in the derivative markets. And we also had some academics and some environmental folks. So really, it was a very broad spectrum. And the commissioner, who was sponsoring this report, told us at the first committee meeting, he says, I want to have a unanimous report. And that's a pretty high bar: you get one member who doesn't like it... And he said, I don't just want unanimity from these committee members, I want it from your institutions. So, every corporation and every bank had to go back to their general counsel and get approval for this. I didn't know who I would have trouble with, or what would be the issues. It turned out we got unanimity, and we had an awful lot of very specific recommendations, there were 53 recommendations. The first recommendation, which I felt very passionate about, is that we need to put a price on carbon. So, we got unanimity from all of these corporates and everyone: yes, we should put a price on carbon. And yes, we should have disclosure of climate-related risks. And yes, we should do scenario analysis and stress tests. And yes, we need to move quickly to a net-zero economy. All these things that you would think perhaps would be obvious, but somehow have been controversial in the past. And this was under the previous administration... there was no controversy. The most controversial thing that we ran into was scope three emissions, sometimes called financed emissions in the context of banks. And so there are some folks that don't want banks financing fossil fuels, and so they want reporting on scope three emissions. The issue that I viewed as being determinative here was that, when you think of an oil company, its scope three emissions are basically all of the emissions coming out of the tailpipes of the automobiles that are using its gasoline or diesel. And, you know... whose responsibility is that? Is that the car owner? Or is it the manufacturer of the car? Or is it the oil company? Or is it the gas station, or the pipeline? There's 15 different companies that are involved in that legal activity. And the idea that oil company XYZ is going to have a risk because of the number of tonnes of CO2 that come from the gasoline that it produced... Well, it wasn't something that was number one, two, or three or four from that oil company's risk management concern. And so then the question is, should it be part of the disclosure of the bank that loaned that oil company some money? And my view was, no, that's ridiculous. And, well, not everyone agrees on that. We compromised on that one. Basically we came up with - if you read the report - it says the banks are working on this, and when they come up with a solution, it should be reported, that was kind of our compromise.

ML Where I am on the scope three is that, it should be disclosed... It's a brilliant way of looking at a value chain. Because it is important to know if somebody's using their car to do XYZ, and they've got no alternative, because whatever, then you need to kind of know that. But once you start to aggregate it up into portfolios, and then you start to use derivatives: so, if somebody buys futures in a company, do they take responsibility for those emissions? And if they do, does that mean if they sell that futures contract, does that mean they get a credit? It all becomes... and then they're trading in milliseconds... So, I kind of agree with you, but I'm sure you've got quite a bit of pushback on that.

BL Yeah, not everyone agrees. We haven't figured this all out. But actually, what we need to know, and we need much better, is accounting for CO2 emissions into the atmosphere. When you add up all scope one emissions, you've got the total; we need to know that, we need to know who's responsible, and we need to create strong incentives globally to reduce those emissions. We haven't done that yet. So as far as I'm concerned, we haven't started to address the risk management problem here; it's getting worse every day. And what's important to understand about this risk management problem and time, is that it gets worse with the square of T, okay? Because the amount of CO2 in the atmosphere and other greenhouse gases, is basically going up over time. And the damage that's being done - per tonne - is also going up. Because the first time isn't that bad: the 20th time is worse than the first; and the 20 millionth is worse than the 20th. And so, you know, we're up into the gigatonnes now, and every tonne that goes in is a lot worse than it used to be 20 years ago. So, this problem is growing quadratically. And the way I like to think about it - and it's really frightening - is that the maximum temperature goes up by about a quarter of degree Celsius per decade. And so, wherever we are today, let's say if we immediately slammed on the brakes - by which I mean created globally strong incentives to reduce emissions - we're still not going to get to the maximum temperature for another, probably 40 or 50 years, and we're talking about a maximum temperature of somewhere between maybe 1.75 and two. And if we wait ten more years, then, it goes from 1.75 to two, to two to 2.25. And we just don't know where that first catastrophic tipping point is. I mean, in some sense, the results are already catastrophic, but... Not like killing all of the life in the ocean. You know, when does that happen? The IPCC report a few years ago said, you know, the difference between 1.75 and two is amazing. At 1.75, we're going to lose like 90% - I think it was 70%, 80%, of coral reefs - and at two, we lose like 99%. It's just crazy, absolutely insane. So we should be... And by the way, I would give Europe a lot of credit, because when I talk about strong incentives to reduce emissions, Europe is pretty much there. When you look at the EU ETS or the UK trading system, and then the taxes on diesel and gasoline: there are strong incentives in Europe to reduce emissions. If we did the same thing in the US and China, and then had some Border Carbon Adjustments, as Europe is proposing, that's when we would get to what we need. But we're not there yet.

ML Let's go back to that top recommendation - that first recommendation that you made - because that speaks to this question of the incentives. And what you wrote - in the report - it says, the report begins with a fundamental finding: financial markets will only be able to channel resources efficiently to activities that reduce greenhouse gas emissions if an economy-wide price on carbon is in place at a level that reflects the true social cost of those emissions. So, do I take it that that's the summary of the number one finding?

BL Number one, absolutely. And we do say, that's not something that the financial regulators can do. This is up to Congress in the United States, we need action.

ML But now, what the US has done, is gone off in a completely different direction with the Inflation Reduction Act. So, is the Inflation Reduction Act kind of nice, but noise? Or is it useful? Or does it replace the need for carbon pricing? Where are you on that?

BL Yeah. Well, on the positive side, the Inflation Reduction Act does create strong incentives. Strong, [but] not anywhere near what we need. I'll put it this way: McKinsey did a study few years ago, where they said we're going to have to spend something like three and a half trillion dollars a year between now and 2050 to get to the low carbon economy that we need. So, think about the magnitudes here - three and a half trillion, per year global spending on the low carbon economy. The Inflation Reduction Act is about... I think they say $260 billion over ten years. So, less than $30 billion a year. So, you're talking about $30 billion versus $3 trillion. It's just the wrong two orders of magnitude.

ML Can I push on that? Because the number I'd had is a bit higher than that, it was like $360 billion. But it doesn't really matter, it's still, you know, nothing compared to the trillions...

BL It wasn't all climate, that's the reason.

ML Ah, I see. Yes, that's a good point. But also, that's only the number that was assigned to it through the US budget reconciliation process, but it's only for the tax rebate. And, certainly since it's passed... My attitude at the beginning was exactly like yours. I said, oh, that's about the same size as the US food supplement industry, you know? Sort of $30, $40 billion a year. But, it is an open-ended check. And it's only the tax rebate piece, it's not the total of investment. So I mean, it could easily spark some trillions of investment during its - whatever it is - eight years no?

BL That would be great, if it would I don't know how that would happen.

ML Okay, so now I've got to bring in another player here.

BL Let me be a little bit more serious about that, Michael: what will channel the investment that we need, is the expectation that these investments will be profitable. So, if I'm an entrepreneur and I see a way to reduce carbon from some process, I'm going to invest in it if I think it's going to pay me for it; if I'm gonna get a profit back. That depends on expectations of future pricing of emissions. So, the key is really not so much what do we get paid today - although it's much too low - the key is, what do I expect as an entrepreneur to get paid when this investment is maturing 10 years from now? Is it going to be profitable or not? And I hope the answer is yes, I can see this coming, I can see the pricing of emissions. But I'll be honest with you, I would say most people in the United States do not expect to see pricing of emissions anytime soon, and that's very sad. That's what we need; we need the expectation that we're gonna get our act together and create the laws that will pay people who do the right thing, and will penalize those who are still polluting. You gotta expect to be penalized in order to motivate you to stop polluting! Anyone who thinks that people are going to voluntarily spend money to stop polluting because it's gonna make them feel good, have not been watching what's been happening for the last 20 years.

ML I said I want to bring in another player: there's somebody that you know very well, I know very well, Ion Yadigaroglu, who's one of the managing partners of Capricorn Investment Group, and that's the supporter of this show. And he and Dipender came on one of the episodes in the last season, season seven, just before the end of the year. And Ion who was a big fan, and supporter, and behind the scenes mover-and-shaker behind the Inflation Reduction Act, I think he agrees with you that the chances of getting a price on emissions in the US seems very low. And he's very enthusiastic about the Inflation Reduction Act, the amount of money it can move, not because you're making the emissions cost more, but you're effectively making the solutions cost less. And he certainly is enthusiastic about the amounts of investment that it will spur.

BL Yeah, well. Look, it's an incentive; I always use the word incentive, and incentives can go two ways: you can either subsidize the things you want, or you can put a price on the things that you don't want. The problem with using the approach of subsidies is that, number one, you have to decide what you're going to subsidize. And I would give credit in the Inflation Reduction Act, they more or less say anything that has clean energy gets subsidized. So, good, that's pretty good. And then, the second thing is you got to pay for it, and there's a limited amount of money. I mean, this was $300 billion, that's a good start, but, you know, we need trillions. And so, that's why you just have to put a price on it and say, look, if you emit greenhouse gases, you're gonna pay for it. And now we have to suck an incredible amount of co2 out of the atmosphere, and so that's also going to be costly. So, we have to pay for people to pull co2 and other greenhouse gases out of the atmosphere, and we have to charge people who are putting them in. That's the bottom line. It's the only way this is going to work.

ML Let me come to some of the criticisms, though, of carbon pricing. The first one we've kind of touched on, which is that politically, it has been enormously problematic. But I also am concerned that the model fundamentally is that you've got an externality, you've got people getting away with polluting, they're not paying for it. But a lot of people are enjoying their goods and services, and a lot of poor and vulnerable people both in the US or Europe or around the developed world, but also in the developing world. So, you've got energy that's too cheap, and now you want to make it more expensive, so it should price in a social cost of carbon, and I know you've done lots of work on what that social cost could be. So, you make it more expensive, and eventually, it gives a signal for investment, and the cycles, the good things happen, the innovation, the technologists work, and the price comes down. But in between the arrival of the carbon price or the carbon tax, and those new solutions appearing and being affordable, you've got this arc, which puts a lot of costs on especially poor and vulnerable people. How do you deal with that?

BL Well, you know, I co-chair the Climate Leadership Council in the United States with Kathryn Murdoch. And this is a group that formed about seven years ago to bring together a whole group of folks - primarily corporations - to focus on exactly this problem: how do you solve it? How do you square that circle? And the answer is surprisingly straightforward: what you do is, you take at least some of the revenues - in our proposal, all of the revenues - and you divide it up equally amongst members of society. So, the average family of four gets $2,000 a year, as a rebate; we call it a dividend, a carbon dividend. And their costs are much lower than that, on average, right? It's actually wealthy individuals who are flying all over the place - people like me who have a large carbon footprint - that end up much worse off when you price it that way and have a dividend. Because my costs are much greater than, you know, the $500 that I get for one person, but poor people are much better-off. So, that is just a very simple example of a carbon tax that is very progressive, and makes poor people better-off. It's not hard to see.

ML So the secret is in the distribution, the dividend, and that's pretty much... We had Catherine McKenna, who is the former Environment and then Infrastructure Minister in Canada. Canada has got a system, somewhat, that embodies those principles. How do you do that... you mentioned carbon border adjustments, so internationally? So, you do that all domestically, and let's assume that Father Christmas is generous this coming year, or this past year, and we get those in place. But then you have to have the carbon border adjustments to protect the jobs, and make sure you're not flooded with dirty imports. How do you do the equivalent of carbon fee and dividend, or tax and dividend, and price and distribution, however you want to call it? How do we do the equivalent of that internationally?

BL Well, certainly set up the incentives. So, let's say the Europeans and the US decide that we're going to have both have a carbon tax and a border carbon adjustment, and then you're sitting in China, you're saying to yourself, geez, you know, I need to do the same thing; I have an incentive, I can either pay that tariff to the Americans and the Europeans or I can put on my own - and by the way, they do have their own federal tax already, it's just much too low. But, I can raise that federal carbon tax to the level equivalent to Europe and United States, and then I'm better off. And so, as more and more countries create a border adjustment mechanism, then the ones that aren't part of it have every incentive to join in. That's how you get, you know, everyone to participate. And once you have China, the US and Europe, it's going to be in everyone's interest globally to become part of it.

ML And what about if it's energy imports? So, you look at a Saudi Arabia, obviously, the US now largely energy independent, or at least the flows kind of cancel out, of refined products versus crude and so on. But what about Japan, South Korea, Europe, India, China, who are importing large amounts of fossil energy still? How do you use carbon pricing to stop that? And what do you do with those countries that are exporters, who are being deprived then of their core revenue?

BL Yeah. First of all, I think you're absolutely right, to start focusing geopolitically on whether a country is an exporter or an importer of fossil fuels. That's going to be a very important dimension going forward. And so, what you're going to see is that the critical issue today is how quickly do we move to net zero; we've got to do it incredibly fast, it's way too late. And the countries that are importers of fossil fuel obviously have a strong incentive to move quickly. If you're going to have to import that fossil fuel, you want to reduce the amount that you're importing, versus, if you're well-endowed with coal and fossil fuels, you want to slow down this transition - that's your country's wealth. And so, that's really a dynamic that you're seeing countries aligned on now. You've got Russia, the Middle East, Venezuela, these are fossil fuel exporters; and you've got Europe, China, India, these are fossil fuel importers. And so, they have a lot in common now, in terms of trying to move quickly. The US is kind of in the middle. We're, as you point out, kind of energy independent; we've got a fair amount of fossil fuels. Even within the US, you find some states like Alaska, West Virginia, Texas, that are fossil fuel-rich, and others, like New York, California, that are fossil fuel-poor. So, these do drive the politics, and we have to move quickly. So I would say, look for a coalition of those who are fossil fuel importers to drive this forward more quickly. And don't be surprised when you see countries like Russia, and the Middle East, slowing it down.

ML A question for you: could you envisage the fossil fuel-exporting countries, essentially, imposing the carbon tax on their exports in exchange for that then not being taxed on the incoming side? On the importers side?

BL Well, I would say if you're a fossil fuel exporter, you're in trouble, right? Because the demand for your product is going to zero, quickly. There's not a lot you can do; what you want to do is slow it down, but there's not a lot you can do.

ML And earn revenue, and build sovereign wealth funds, and diversify your economy. You have no choice. That's the only way it's gonna go, right?

BL Yeah. And hopefully, it's going to go very quickly. We're going to stop using your exports more quickly. And that's what you're seeing going on right now, between Europe and Russia. Russia thought, well, we'll just squeeze Europe and Europe's like, well, screw you, we're gonna get off of this stuff.

ML It's a very interesting question, the extent to which the fact that we have scalable alternatives for the first time; in however many, a couple of centuries, we can actually do something different that is not just trying to secure fossil fuels at all costs. So, the extent to which that was important. I wonder if I might come on to Kepos Capital, because you have embodied some of this thinking in an investment vehicle. Do you want to just talk us through what that is, in your own words?

BL Well, first of all, the history of Kepos Capital is we were a bunch of quantitative investors, and we were using computer models and all kinds of economics and statistics to try and forecast price movements. And as I got more and more involved in the climate space, one of the issues that investors came to me [with] and said, you know, how can we hedge our climate risk? In fact, it I was chairing the Investment Committee at the World Wildlife Fund when we addressed this, and we thought about divestment, but divestment has certain issues associated with it that we didn't like. And we came up with something that we thought was very simple, and I liked it because of the simplicity, which was something we called a stranded asset total return swap. And it was basically just a simple way of eliminating what we called stranded assets - coal, tar sands, oil exploration companies - from our portfolio, not by selling them because they were owned by intermediaries, by a fund that we were invested in, for instance, or an external manager, but rather just buy a derivative instrument where we entered into a contract with a counterparty and we said, here, you get the returns on the stuff we don't like, and we'll take the returns on the market instead. And what I liked about it, Michael, was it was so simple; it was okay, here's a bet that these - we call them stranded assets, these fossil fuel assets - are going to underperform the market. And it removed them from our portfolio from an economic perspective, so it reduced the risk. And if you expect the market to outperform stranded assets, it was a positive expected return. I thought, yeah, that makes sense. I had no idea by the way - this was about 10 years ago - and over the next seven years, we had this instrument in our portfolio: it had the best performing outcome of anything else in our portfolio. The market outperformed the fossil fuel sector by mid-teens on average, every year for seven years. Which basically meant that, while the fossil fuel assets stayed essentially the same value, the rest of the market doubled in value. So while that was going on, my firm, the partners in my firm were watching this, and saying, wait a minute.

ML I just want to make sure that people have understood what you did, right? Because for those that are not capital markets, sort of, aficionados... What you've essentially got is, you own, through the endowments that you've got at World Wildlife Fund, you own lots of funds, and embedded in them is a little bit of Exxon, and a little bit of this, and a little bit of coal, and so on. So, what you've done is rather than force every fund manager to either sell those, or to exit that fund, what you've done is you've essentially shorted the equivalent amount of those fossil fuel equities so that you are not benefiting if they go up. Well, you are, because if they go up, then they're in your portfolio, but you benefit much more if they go down. And so it nets out, and that was where you earnt your money, because they did in fact have a catastrophic performance for seven or eight years.

BL Yes, absolutely, that's exactly right. Although, one issue that we addressed - I raised it - is, how big to make this bet? We could offset what we own, which is what we ended up doing, or we could have made it bigger, and we would have made a lot of money! We weren't thinking of it as a return opportunity, we were thinking of it as a risk management [strategy]. But I would say that my partners at Kepos did not go unrecognized as an opportunity. It's like, whoa, we could do that; but we can do better, is what we thought at Kepos. It was so such a one-dimensional bet. You watch for seven years, and you do say to yourself, wait a minute, what's the basic idea here? And the basic idea is that we are witnessing a rapid transformation to a net-zero economy. And so now if you think about that, more generally, as an investor, you might think there's other opportunities other than just focusing on fossil fuels and their negative returns. Why not focus on clean energy and the positive returns there, or batteries and electric vehicles? And in particular, one of the things that we decided to bet on was carbon credits, carbon offsets that are delivered in the EU, or now the UK, and California and the RGGI states. So, that is something that we put into our portfolio. And frankly, what we found is that a lot of investors had already decided how they were going to bet on clean energy, for instance. But they hadn't really figured out carbon allowances, and that's what they were interested in. So, we started with a diversified fund, a rapid transition to net zero idea, but then we also found that a lot of investors are just focused on the carbon allowances. Our timing was pretty good, by the way; when we started this fund in August of 2020, I think the carbon allowances were in single digits, or very, very close. And now they're I think around $80 a tonne or maybe even higher. So, they've been on a on a strong run. And actually, what we see now as a big opportunity are the credits in the voluntary carbon market. Nature-based solutions is something that is really the cheapest way - scalable way - to reduce co2 in the atmosphere, to pull it out and put it into landscapes. And that's exploding right now, globally; there are countries around the world that are competing to do this, a lot of developers trying to do this, a lot of markets expanding. It's an area that's had a lot of trouble historically, because of what are called integrity issues. You know, is it real? You've planted those trees, but are they going to be permanent? Would you have planted them otherwise? So there's all these issues of additionality, leakage, double-counting...

ML There's a question I have to ask. I had Mark Carney also on Cleaning Up, and I asked him the same question. The credits that you will invest in through Kepos; you talked about the ones that pull carbon out of the atmosphere, and in a sense, those are non-controversial, as long as you solve the integrity issues, as you call them; if they're real, if the forest doesn't burn, if it doesn't get chopped down and sold for wood in 30 years, whatever. Will you also be investing in avoided deforestation?

BL Well, that's a good question, and it requires a governance structure that I would say is not there yet. If and when the UN figures out Article Six, and how governments can take jurisdictional responsibility for their forests, and if they then have a baseline that's agreed to. So that, then, let's say, Indonesia pulls out, or has a baseline and protects more of its forests than it thought or was in that baseline, and so the UN says, yes, we're gonna give credit - you know, maybe Norway, or someone, pays Indonesia for that additionality. Those are the kinds of agreements that have to be in place in order to say, okay, that was additional. And not just additional, but not double counted: you can't have the government taking credit for it, and then a private developer taking credit for it as well. So, there are definitely rules of the road that have to be agreed to, in an international context, in order to have these baselines. You can't just have, alright, I'm going to agree with you that you would have cut down this forest, and now I'm going to pay you not to. That's not going to work.

ML It's probably to do with the framework, but it also feels to me really problematic if those credits are then use - the avoided deforestation - are then used to offset other emissions. I mean, we should avoid deforestation, we should put a stop to that no question, and there will need to be money changing hands, and there may be credit-based approaches to do that. But as soon as somebody says, well, I certifiably stopped that forest from being chopped-down, therefore, I can continue to drive around in my gas-guzzler, or I can fly or I can continue this industrial process... We won't get to net zero by not chopping things down, but continuing to emit.

BL Yeah, no, I totally agree. What we really need - and actually, the good news is we're getting close to it - is the ability to, basically cover the earth, in terms of measuring carbon in the soils, in landscapes, and the flux going into and out of the atmosphere. And at that point, when we have that kind of data coverage, then we can say, okay, yeah, this is additional, this is where we're at, and this is where we're going, and this is the amount in the atmosphere. That's what we need, ultimately. That's going to depend on governments, frankly. So, my attitude is we've got to get governments involved in the measurement and standardization of these markets. And then also in setting baselines, so that we can say, alright... It's a little bit artificial, what the baseline is, right? It's a counterfactual. But at least once we get started, and we say, okay, here's the baseline for this country - for instance, or this landscape - then we can start talking about, okay, now we're making progress in the right direction.

ML So on Kepos, just to round out on that, you've got a number of funds, you've got some others that you're planning. Where is that going to be going in the next few years?

BL Well, I think that this voluntary market is going to be moving very quickly, and so we're certainly looking at that and trying to make sure that we're involved in it, and take advantage of the opportunities that come. More generally, we continue to have a good quantitative business at Kepos and, and we're looking for more opportunities to put the two together; which is to say, to incorporate some of the opportunities that we see in the climate space, as well as with our quantitative investing as well.

ML The reason I said earlier that you know Ion Yadigaroglu well, and so do I; Capricorn, not Ion specifically, is the supporter of this show, but is also one of the backers of Kepos, correct?

BL Yep. Yeah, absolutely.

ML And I hope you work closely with them, they seem to be doing great work across lots of fronts.

BL No, they have, and they've been really helpful in terms of developing our carbon business and focusing us on that, and going forward. This seems to be a real opportunity, not just for Kepos, but for the investment management world. You see a lot of folks moving in different directions and different niches. Ours happens to be a quantitative approach, and so we think in terms of risk and return, but now we're just thinking more broadly in terms of risk and return in the carbon spaces as well as the traditional asset classes. Again, I think of carbon flux as a new asset, and probably the biggest commodity that there's going to be, you know, in a couple of decades. It's just gonna be a huge opportunity.

ML Very good. Well, we'd love to get you back as that evolves. Particularly, there's one that I'm sort of smiling here, because I do a lot of work on hydrogen, and there are those out there that say the biggest commodity won't be carbon, it'll be hydrogen. But that's a conversation I'm not sure that we have time for here today.

BL No, I wouldn't be... I mean that would be great. If hydrogen becomes more than carbon, I'm very happy.

ML Okay. Bob, it's a great pleasure talking to you. A truly impressive career, and what you're doing is just so, so interesting, and thank you for your service on these various, chairing the various organizations and being on the various boards on which you sit.

BL Thank you, it's been my pleasure. Nice talking to you, Michael.

ML Thank you. Bye, bye.