Economist Robert Litterman: "Price Climate Risk Immediately" through a Price on Carbon Emissions

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"The logic is very simple," says economist Robert Litterman.  "Not pricing risk leads to too much risk being taken; and too much risk being taken leads to disasters."

Litterman, an alumnus of the University of Minnesota Department of Economics, made the remarks on 9 February 2011 at the university's Heller-Hurwicz Economics Institute’s (HHEI) premier event, “Addressing Climate Change: Economic Perspectives on Pricing Environmental Risk.”   Also speaking was fellow alumnus, Richard Sandor, CEO of Environmental Financial Products LLC. A video of the event is available.  A higher resolution video of Litterman's presentation is separately available, providing a more legible display of his slides.

“Climate change is perhaps the seminal issue that will confront the world in the 21st century,” said V. V. Chari, University of Minnesota economics professor and HHEI founding director in a press release announcing the event. “Solving this problem effectively and efficiently will require us to harness the power of markets in channeling private incentives towards socially beneficial ends. Litterman and Sandor bring knowledge and experience in helping us think through these issues.”

In his presentation, Litterman said "we should price climate risk immediately at the appropriate level."  He explained: "Carbon emissions should be priced...They increase the risk of a climate disaster.  The logic is very simple.  Not pricing risk leads to too much risk being taken; and too much risk being taken leads to disasters.  The only question, really, is where should emissions be priced? What is the appropriate level? And that is an interesting story.  It is a story of economics." 

Litterman co-developed the Black-Litterman Global Asset Allocation Model with the late Fischer Black. He has a Ph.D in economics from the University of Minnesota, and taught at MIT and worked at the Federal Reserve Bank in Minneapolis before moving to Goldman Sachs in 1986. Bob retired at the end of 2009 after heading the firm’s risk department and heading the quantitative group in the asset management division. He currently serves on the boards of the World Wildlife Fund.

Litterman comments further on the economics of climate change in the video interview below.

In his presentation, Richard Sandor said: "Unless we deal with the environment in a serious way that makes business sense, and produces financial incentives to achieve social objectives, we will not be in a happy situation in a decade or two."  Sandor, chairman and founder of the Chicago Climate Exchange, warned that as the U.S. delays or avoids such action, "we will be third-railed, and China and India will beat us to the use of market-based solutions." 

In a Minnesota Public Radio interview with the economists (Can economic measures affect climate change?,  7 February 2011), Sandor said the potential impacts of climate change are "so disastrous that we should do something from an economic point of view."  He continued:

"It's like buying insurance, or what economists call `gambler's ruin': You're never supposed to make a bet -- no matter how good the odds are -- if its ruinous.  And my particular attitude is that there is enough evidence that it would be disastrous, that it at a very small cost could be hedged by dealing with the issue."

Online Resources: 

U of M Heller-Hurwicz Economics Institute convenes premier event, "Addressing Climate Change: Economic Perspectives on Pricing Environmental Risk."  Press release (24 January 2011) from Heller-Hurwicz Economics Institute.

The following are available from the HHEI Web site:

  • Video of the event. Litterman's presentation starts at 34:57.
  • Presentation slides (MS Powerpoint file).  Includes Building Institutions in Financial Innovation (Slides 2-9) by Richard Sandor; and Pricing Carbon Risk (Slides 10-30) by Robert Litterman.

Risky Business: Leading Wall Street Risk Manager Says Failure to Price Carbon Will Lead to Disaster (WWF Climate Change Blog, 27 Aug 2011.

Dr. Robert Litterman discusses the need for action on climate change.  Video, November 2009.

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