Michael Liebreich Bob, by the time you were retiring from Goldman Sachs, you were heavily involved in the area of climate risk and managing that risk for the financial system. How did you make that journey?
Bob Litterman One of my colleagues at Goldman, Larry Linden, really pulled me into this space. We were at lunch and 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, here's the problem, no one has a clue where it should be priced. With risk management, you don't worry about what's the expected outcome, you worry about what's the worst case. 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 yes all along. The answers really haven't changed, Michael. We have to create incentives globally to reduce emissions, and we have to do it very quickly. One thing I like to tell people is when you're managing risk is: time is a scarce resource. If we have enough time, we can solve almost anything. And it's when you're managing risk and you run out of time that a risk management problem becomes a catastrophe.
ML We had a fantastic conversation on Cleaning Up with Johan Rockstrom. He draws this distinction in our conversation between the commitment time and the impact time for these risks. How does that play into risk models? Really bad things that happen in a number of generations?
BL Well, I love the idea of thinking about timeframes that we're not usually thinking about. So, you can look at 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. Over hundreds of years, for sure, but it's starting now. And it'll accelerate for your lifetime, and the lifetime of your kids, and most likely the lifetime of your grandkids. One of the things that we have to worry about is the fact that we're seeing 100-year events along all sorts of different dimensions more frequently. 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.
MLThe US Commodity Futures Trading Commission have a committee on market risk that had a subcommittee on climate risk, which you were invited to chair. How did that play out?
BL Yeah, well, it worked out very well from my perspective, as chair. We got unanimity, and we had an awful lot of very specific recommendations. The first recommendation is that we need to put a price on carbon. We should put a price on carbon, and yes, we should have disclosure of climate-related risks. The most controversial thing that we ran into was scope three emissions, or financed emissions. We haven't figured this all out. But really, what we need is proper 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? Every tonne that goes in to the atmosphere is a lot worse than it used to be 20 years ago. So, this problem is growing quadratically. When you look at the EUETS or the UK trading system, 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.
ML The US has gone off in a completely different direction with the Inflation Reduction Act. Does the IRA replace the need for carbon pricing?
BL On the positive side, the Inflation Reduction Act does create strong incentives, but not anywhere near what we need. 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. The Inflation Reduction Act is about $260 billion over ten years. It's just the wrong two orders of magnitude.
ML But, it is an open-ended check. It could easily spark some trillions of investment, no?
BL 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. That depends on expectations of future pricing of emissions. I would say most people in the United States do not expect to see pricing of emissions anytime soon. 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.
ML In between the arrival of the carbon tax, and 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 The answer is surprisingly straightforward: you take at least some 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. It’s wealthy individuals who are flying all over the place that end up much worse off when you price it that way and have a dividend. So, that is just a very simple example of a carbon tax that is very progressive, and makes poor people better-off.
ML How do you do the equivalent of that carbon fee and dividend 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, I need to do the same thing. As more and more countries create a border adjustment mechanism, the ones that aren't part of it have every incentive to join in. 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 I wonder if I might come on to Kepos Capital, because you have embodied some of your thinking in an investment vehicle.
BL As I got more and more involved in the climate space, investors came to me and said how can we hedge our climate risk? And we came up with something we called a stranded asset total return swap. It was a simple way of eliminating stranded assets from our portfolio, not by selling them, but by buying 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. Over the next seven years, we had this instrument in our portfolio: it had the best performing outcome of anything else in our portfolio. Another thing that we decided to bet on was carbon credits. 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. I think of carbon flux as a new asset, and probably the biggest commodity that there's going to be in a couple of decades. It's just gonna be a huge opportunity.