18-05-2021 · Interview

‘We must prepare for the worst-case scenarios’

Bob Litterman is chairman of the Risk Committee and a founding partner of Kepos Capital in New York. Before that, he spent 23 years at Goldman Sachs, where he was head of the Quantitative Resources Group in Goldman Sachs Asset Management for 11 years. His recent research has focused on carbon pricing. We talked with him about climate risk and how investors should address it.


How did you come to single out climate risk as the key risk for financial investors?

“It started during the last financial crisis. I was then thinking about retiring from Goldman Sachs and one of my future partners asked me: Bob, what will you do when you retire? I said: I don't know. And he asked: are you interested in the environment? I said: I could be. At the time, climate change was still in the background for me. But I soon started to wonder: how dangerous this really is?”

“Then, I got introduced to many people from the environmental community and it sort of sucked me in. And I remember once talking to my friend and saying: you know, the key thing here is that we're not pricing the risk. He said: the problem, Bob, is that no one knows how to price the risk. So, I took it as a challenge, and I started reading the literature.”

“One of the top experts was someone called Bill Nordhaus, a Nobel Prize winner now. Bill had tried to estimate future damages and discounted them to the present. But that gave a very low figure, so it didn’t look very serious. I came into this debate and said: this is not how we price risk on Wall Street. We don't just choose a rate to discount cash flows. We take many things into account.”

“That makes climate risk a little bit more complicated and a little bit more interesting. And I ended up working with other economists, Kent Daniel and Gernot Wagner, with whom I co-wrote a paper, ‘Declining CO2 price paths’. We worked on it for about five years and it published a little over a year ago in the Proceedings of the National Academy of Sciences.”1

What was your main takeway?

“We found that it's time to have a very high carbon price because we’re starting to see the impact and we’re running out of time to reverse things. So, we must prepare for the worst-case scenarios. Admittedly, if we had started twenty years ago, putting a high price on carbon, and creating incentives to reduce emissions, we wouldn't have an existential crisis.

“This is the key. We must slam on the brakes, which means that we must create significant, globally harmonized incentives to reduce emissions. And we must do it now.”

There's going to be a rapid transition and it's going to have impact throughout the economy

What does that mean for investors?

“Investors around the world are all asking the same question - how do I align my portfolio with a rapid transition to a low carbon economy? – which is great. That's absolutely the right thing to do. But it's not easy. It basically means recognizing that there's going to be a rapid transition and it's going to have impact throughout the economy and on the valuations of securities.”

“Until now, investors haven’t been expecting a rapid transition. They’ve been expecting a smooth one. I mean, the average price of carbon emissions is USD 2 a ton. But what my colleagues and I discovered is that the right price is probably over USD 100 a ton. That's what it's going to take to make sure we avoid the worst-case scenarios.”

If, as you suggest, climate change will radically transform the economy, aren’t quant models – which tends to rely on past statistical data – at risk of becoming obsolete?

“If you ask me, whether addressing climate change has more to do with fundamental investing than quant investing as we know them today, the answer is yes. It will have more to do with fundamental. That said, as quants, we can also think about the impact of the rapid transition, and try to take advantage of it.”

“Think about the consequences for oil or the automotive industry, for example. Think about stranded assets. Think about the consequences for valuations. Investors are going to have to monitor all these things, and they will need metrics and statistical tools for that. And if that's how you think about quant investing, then it can remain relevant.”

“Imagine, for instance, a factor – and we can talk about how to create such a factor – that would reflect expectations of future carbon pricing. Well, then you could screen every asset and assess its loading on that factor. And that could help you to identify investment opportunities. Quants, you know, always try to be forward looking, even if the data they use is always historical data.”

As quants, we can think about the impact of the rapid transition, and try to take advantage of it

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