The insanity of not assessing climate risk

One of the world’s leading risk managers has labeled the failure to factor in climate risk in the world’s leading equity portfolio as “insanity”.

Bob Litterman, the former global head of risk at Goldman Sachs, and now chairman of the risk committee for $2 billion hedge fund firm Kepos Capital, says risk managers need to assess the “worst case” scenarios for climate to properly protect shareholders, and says the best way to address the issue is to hit it hard, and early, with a high carbon price.

Litterman is currently in Australia at the invitation of the Asset Owners Disclosure Project, The Climate Institute, and the Investor Group for Climate Change, to speak on the subject of asset risk and the need for divestment of potentially stranded fossil fuel assets.

Litterman is considered one of the grandfathers of modern quant trading. With Fischer Black, he developed the so called “Black-Litterman asset allocation model,” which is still widely used by institutional investors to overcome certain problems in applying modern portfolio theory. He is now active in briefing north American pension funds on climate risk and how to assess it in their portfolios.

Litterman says part of the problem most economists who have been assessing the impact of  climate change have been looking at the wrong area – they have been focusing on “expected outcomes” such as impacts on agriculture or the effects of storms – which are difficult to predict.

But as a risk manager, he says in an interview with RenewEconomy, it’s best to focus on the worst case scenario. These are equally difficult to quantify, but ensures a safety first approach.

Isn’t that just being alarmist,we ask. Litterman says: “I say no, that is the job of the risk manager.”

The obvious result of that, he says, is to introduce a much higher carbon price, and much earlier.

“Many economists talk about a slow policy ramp, but when you take risk into account, you realize you have to be prepared for things to be much worse than expected. That means we have to be much more cautious. We have to price emissions high enough that we expect to get this problem under control.

“That’s a very different time path for emission prices, and it’s a time path where you don’t burn a lot more carbon.”

This leads to what is now commonly known as the “carbon budget”, a concept recognized by the International Energy Agency, and other institutions such as Australia’s Climate Change Authority.

But this, says Litterman, is not been priced into asset values.

“That means that it a good time to get out of stranded asset,” h says. “Coal in particu;ar, if I can sell coal at today’s prices, I think that’s a good deal.

Litterman’s visit coincides with the release of a letter to shareholders by global oil giant Shell, which dismissed the concept of “carbon bubbles” and said the concept of stranded assets was alarmist.

Shell Executive Vice President JJ Traynor said the ‘carbon bubble’ concept had some “fundamental flaws”  and had trivialised the issue. It claimed that none of its assets, or reserves, would be risk from any change in regulation.

Although most studies suggest that fossil fuel generation will have to reduce dramatically to meet climate target, Shell says that it still expects fossil fuel use to grow by up to 60 per cent by 2050, and it doubted the climate issue to be resolved before 2100. It did, however, factor in a theoretical price of carbon of $40/tonne in its calculations.

Carbon Tracker, which produced the “Carbon Bubble “analysis, said the assumption that oil demand would continue to rise was flawed. “Shell does not explain how it is solving the contradiction between the predictions of high oil demand and its acceptance of the need to address climate change,” it said in a statement.

Torbjørn Kjus, an oil analyst at DNB Markets told RTCC.org that the tone of the letter is a sign that Shell has been rattled by the Carbon Bubble campaign and the effect it has had on creating shareholder uncertainty.

“They are taking this seriously, and if you talk with big companies in Germany, and ask them 6-7 years ago did they have any anticipation what was going to happen six years ago, they did not. Now some of them have lost 90% in value, so the energy world can change quicker than 30-40 years. To have a view that goes further than five years is extremely difficult these days.”