370. Managing Climate Risk feat. Bob Litterman

Jan 3, 2024

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The financial world has to grapple with the complexities of climate change just like everyone else.

Bob Litterman is an esteemed figure in risk management and investment and the author of the book Modern Investment Management: An Equilibrium Approach.

Bob and Greg discuss the dawn of quantitative finance and the integration of academic theory into the bustling trading desks of Wall Street. Bob sheds light on the intricate dance between market intuition and the precision of quantitative models, with the pivotal Black-Litterman model's influence on investment decisions. Bob helps peel back the layers of asset allocation conundrums, correlated assets, and financial forecasts. The conversation takes a deep look at the potential of carbon pricing, the inertia in climate policy, and the financial sector's crucial role in a sustainable future, highlighting the nuances of navigating investment strategies amidst these global challenges.

*unSILOed Podcast is produced by University FM.*

Episode Quotes:

Why everybody hates taxes, but love subsidies

52:12: Incentives come in all different forms, and the IRA is a bunch of subsidies. People do love, and it is creating a lot of movement and a lot of investment. But, we just can't afford it. Like the subsidy to fossil fuel in the U.S. is an order of magnitude bigger than our piddling subsidies to low-carbon investments. And then you say, "Well, why don't we do more?" It's because who's going to pay for it? Ultimately, it's the taxpayers. And so that's why people don't like taxes. And that's why we can't subsidize our way out of this. We've just got to create the incentives. If you ask people, "Should polluters pay?" You know, it gets an 80% or 90% approval rating. So, I'm sure we're going to get there. But, it's a tough political hurdle to get over; that's the problem.

Risk is covariance with marginal utility

21:57: Most people think about risk as volatility…We think of risk as covariance with marginal utility. I've probably lost half the people out there, but it means that money in good times is not as valuable as money in bad times.

How can we get the price of carbon tax right?

26:41: We don't have good models, and those models have a lot of uncertainty as to what the right parameters are and so on. I think we just have to buy into that and recognize that we aren't going to have the right answer. There is no right answer. And so the uncertainty means you have to err on the side of caution. We have to have a price that's high enough today that we react very strongly, and then we have to respond to new information. We shall see if things are worse than we expect and have to raise that price. The price should be high enough, though, right today, that we expect to solve the problem. And we expect the price to come down as the uncertainty is resolved over time. That's how high it should be, that we expect it to come down over time.

Are economists helpful on climate risk?

26:28: I remember reading an IPCC report, probably ten years ago, that said economists aren't very helpful on climate. They tell us that the damage from another ton could be anywhere from $2 to $200 a ton. What good is that? The answer is risk management. That's risk. Yes, it could be all over the place. So the right question to ask is, "What does your model say it will be? $100 a ton." The right question is, at what price are you highly confident that we're not going to go off the cliff, run into those tipping points? And that's a different question.

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