Risky Business: Leading Wall Street Risk Manager Says Failure to Price Carbon Will Lead to Disaster

Financial expert Dr. Robert Litterman has built a career on evaluating risk while working in the financial sector. An inductee into Risk Magazine's Risk Hall of Fame, Litterman is skillful at identifying and evaluating risk.

Below are excerpts from a recent piece by Litterman, explaining why the Senate’s inaction on climate and clean energy legislation is putting America and the global community at risk. He describes how the growing risk of climate change can be addressed by harnessing America’s capitalistic prowess and following current examples of risk valuation.

To read the entire piece and view Litterman's bio and short video, click here.

The gulf oil spill. The tragic loss of the Space Shuttle Columbia. The collapse of the global financial system. Even Tiger Woods’ fall from grace.

What do each of these events have in common?  

They are all examples of risk not being appropriately valued – or “priced” – and a disaster subsequently occurring.  Individuals involved in these, and most disasters, understood that there were significant risks in their actions, but they failed to adequately account for those risks and their actions led to catastrophe.

We are now facing a far greater risk of a far greater disaster in the form of catastrophic climate change.  With the exception of a few hardened deniers, there is broad recognition that our climate is changing and that the risk of those changes is significant. Yet, when faced with these growing risks, our government has largely chosen to ignore them.  Most notably, the Senate has failed to act on the clear risk posed by climate change.  The right way to fully account for the risk of a given action is to put a price on it.  In this case, that means putting a price on the carbon pollution that is altering the composition of our atmosphere.  But what does it really mean to “put a price” on a risky behavior?  Let’s take a common example, where we consciously “price” risk in our lives today—insurance.

Why do we buy insurance for our homes, our cars – even our lives? Because the risk of a bad outcome – whether it’s a home lost in a fire or a breadwinner tragically dying – is simply too great to ignore.  In the case of insurance, society has quantified reasonable “prices” (i.e. insurance premiums) that consumers pay to protect themselves against a disaster.

We need to apply the same concept to climate change, which poses great risks to all of us on this planet and especially to those who will follow.  These great climate risks are created by unlimited releases of carbon pollution into our atmosphere.  As in the case of insurance, those that engage in the riskiest behavior should have to pay the highest premiums for their insurance.  By creating a system like this, where we price actions that produce dangerous carbon pollution, we will allow the market to shift investments and consumption to clean, efficient technologies, goods, and services that produce less risk. There is no private sector only solution.  The way to price this risk is to recognize the negative impact of emissions and to price it. It is what is called a Pigouvian tax.  Economists love them because they raise revenue and penalize activities that are harmful.  It is a proper role of government, acting on our behalf.

...Not pricing risk leads to disasters. History is littered with such examples.  Yet, the Senate has decided to say to the entire world, on behalf of the American public: “We are going to ignore the risks of a climate disaster.”

No scientist can say with certainty what the future of our planet will look like if our climate changes unabated… But scientists agree that there is a real and meaningful risk of climate change ending in catastrophe.

The future is always an experiment and there are always risks.  As a risk manager on Wall Street, I’ve been dealing with these tradeoffs my entire career.  The key to avoiding bad outcomes is to price the risks appropriately. The question, therefore, is not whether we should price risk – i.e. pass legislation that puts a price on carbon – but rather, “What is the right level at which to price the emissions risk?”

...the Senate has failed our country by failing to pass a bill.  So where does that leave us?  We could individually try to take voluntary measures in our own lives to reduce emissions but that approach will only get us so far.  As consumers, we need a price on carbon to help guide our behavior...“voluntary” behavior is incredibly inefficient because none of us have any idea how much carbon we create in our daily activities…Sadly, we know such voluntary behavior alone will not have a meaningful impact.

The only way to effectively deal with the growing threat from climate change is to price the risk embedded in carbon pollution.  It’s not a radical new idea.  It’s a basic concept that has guided risk management for everyone from homeowners, to major corporations, to professional investors.

…In the four and half months it has left in this Congressional session, the Senate must find a way to deal with the reality of this situation and pass a strong climate bill.