Bob Litterman knows a thing or two about risk. After all, the Black-Litterman model, which was designed to measure and manage financial risk, is named after him.
These days, the risk he's most concerned about is climate change. Since his retirement from Wall Street in 2009, following a 23-year career during which he led Goldman Sachs' risk function, Litterman has specifically focused on pricing climate risk. Climate risk is a non-diversifiable risk most investors have not fully grasped and policy makers have not priced.
It is crucial, Litterman believes, that risk be priced. Non-diversifiable risks, such as exposure to the equity market, cannot be avoided or insured against in the aggregate, so they require a risk premium.
Pricing Climate Risk: When, Not If
As policy, pricing risk -- such as applying a carbon tax on emissions -- will harness the power of the market. Without a carbon tax society both assumes an unnecessarily large risk of climate change, and pays its costs. Economists call the externality created by emissions the social cost of carbon. Not pricing this risk skews the market, undermining economic forces that would otherwise place a premium on carbon risk. Instead of a carbon tax in the United States, production is often subsidized, further confounding the market.
Once companies that produce carbon pay a tax, prices would rise. Consumers would respond to the higher prices, resulting in lower greenhouse gas emissions as consumers shift their buying preferences. That's why economists believe a carbon tax is the most efficient way to reduce greenhouse gas.
"Some folks don't trust market-based solutions. They say people are not rational -- and they are correct about that -- but even though we may not be perfectly rational, we still respond to economic incentives," remarks Litterman. "My dog didn't understand incentives, but she responded to them. What many people don't appreciate is the informational efficiency of incentives. Incentives are like hidden forces. Once we have appropriate economic incentives in place, without their even being aware of it we'll have seven billion people acting in concert; consumers, businesses, and investors all over the world trying only to act in their own self-interest, but in doing so appropriately helping to reduce emissions."
Litterman feels strongly that a carbon tax is a given, even if the timing is uncertain. He does not claim to know the "correct" tax, but perceives $50/ton as a reasonable starting point. According to Litterman and others' calculations, this amount would have minimal impact on the overall economy. While hurting fossil fuels, it would certainly boost growth in renewable energy, for example. (ExxonMobil, in its 2015 report claiming none of its assets were at risk, implied that the cost of a carbon tax on the economy would eventually be much higher. Litterman claimed this report was deeply flawed, probably deliberately so. If a carbon tax is perceived as too costly, it is less likely to be enacted. More recently, ExxonMobil appears to have accepted the eventual reality of a carbon tax.)
Investors Will Demand a Premium for Higher Risk
Once climate risk has been priced, investors will demand an appropriate return for assuming this risk. This is Litterman's forte. Helping investors identify and manage risk is his job as Chairman of Risk Committee at Kepos Capital, a New York-based hedge fund, and as a board member of several prominent environmental groups. This can be challenging, as climate risk is not currently priced.
Despite the political impasse that makes a carbon tax in the US this year unlikely, Litterman believes the market is sending signals that oil prices will remain low and a carbon tax will eventually be enacted. Given this scenario, investors should focus on the risk of stranded assets. "Who really has exposure?" asks Litterman. "It's fossil fuel companies -- their reserves could be stranded."
What, Exactly, Are Stranded Assets?
All companies, big and small, have assets. Simply put, assets are what a firm owns. Their value is often subjective, based on what a company's management believe they are worth. Seems simple enough. But financial executives and analysts often debate what assets are, in fact, worth. This is especially true for oil and gas companies, whose assets include reserves of oil and gas they own, but have not yet produced. Large oil and gas companies have billions of dollars of such reserves on their balance sheets.
According to Carbon Tracker Initiative, major oil companies have at least some assets that are significantly overvalued. For example, the Oil Majors (the six largest private oil companies) have billions of oil assets that will cost more to produce than current market prices. For example, oil in tar sands or in the Arctic likely costs far more to produce than $45-50/barrel.
In extreme cases, many of these assets are at risk of being stranded if oil prices remain at current levels. It makes no economic sense to produce oil above selling prices. In such cases, these oil reserves will be stranded. Their value must be written off. Think of a factory filled with pallets of Betamax. Or a utility with an aging coal-fired power plant.
Is Oil the Next Coal?
Companies are often slow to write down these assets, hoping, perhaps, that prices will rise. Financial executives are often lifetime industry insiders, and simply can't imagine a scenario where their product has lost its luster.
Markets, however, often move swiftly, often faster than companies -- and investors -- can react. Think of 2008, when stock prices plunged, seemingly overnight.
Consider the coal companies that refused to write-down their aging mines, even as coal prices plunged. When natural gas and renewables flooded the market with lower cost alternative fuel, they hoped -- overly optimistically with the benefit of hindsight -- that these price pressures on coal were temporary. The rash of bankruptcies throughout the coal industry proved them wrong.
Stranded assets affected the coal industry, as company after company was forced to write down the value of its coal, as demand and prices dropped. Investors in coal companies have been wiped out through multiple bankruptcies.
Litterman fears investors in oil and gas companies could face similar risks.
"The stranded asset risk makes Exxon an inappropriate investment for anyone, of any age group," notes Litterman. "The valuation of Exxon's shares could collapse tomorrow if perceptions of the timing and strength of incentives to reduce emissions change."
Climate Risk Management 101: World Wildlife Fund Example
When Litterman joined the board of the World Wildlife Fund (WWF) in 2007, he was tasked with reviewing the organization's endowment investments. The WWF endowment had a small, almost insignificant, exposure to stranded assets. Nonetheless, WWF's leadership believed this investment was both risky and not in alignment with the WWF's mission. However, many of WWF's investments were with hedge funds or private equity funds that would be nearly impossible to unwind.
WWF, and its consultant, Cambridge Associates, relied on Wall Street expertise to get creative. They created a synthetic financial instrument that would short (sell) fossil fuel assets that mirrored their actual portfolio holdings. Their short position combined index returns from coal and tar sands. Simultaneously, they bought an index fund that tracked the Standard & Poor's 500. If the fossil fuels declined in value compared to the S&P 500, the WWF would benefit -- and offset losses in their underlying endowment. As the chart below illustrates, WWF has hedged any losses in its underlying portfolio that includes these stranded assets by the gains in this swap.
Sense of Urgency is MIA
In particular, Litterman is concerned that, like the public at large, investors have no sense of urgency. They are not acting quickly enough, given the monumental risks posed by climate change.
"It is time to slam on the brakes with respect to climate risk, and perceptions can change quickly," concludes Litterman. "Pricing emissions is the only effective brake society has which can prevent a future catastrophe."
Investors may be wise to heed his warning.