In an era where more means better, the speech delivered by Dr. Robert Litterman at the CFA Society Toronto Annual Pension Conference was a wake-up call on sustainability. Litterman, who is currently chairman of the board at Kepos Capital, is the co-developer of the renowned Black−Litterman Global Asset Allocation Model and the former chairman of the quantitative strategy group at Goldman Sachs. Addressing the importance of pricing for climate risk, he said that setting the appropriate price for carbon emissions is the essential first step towards planning for a sound risk management strategy. Litterman illustrated the importance of pricing climate risk with the catastrophic experience in the town of Johnstown, Pennsylvania, in May of 1889 when more than 2,000 people died when the earthen reservoir dam disintegrated in just a few minutes. Litterman used the Johnstown catastrophe as an analogy for climate change risk today, with its chain of risk, responsibility, and ultimately high social costs and disaster. To that end, Litterman outlined the following guiding principles for pricing climate change risk today:

“… if the current carbon price is not fully built into the current asset valuation process, then there is the risk of becoming overweighted in stranded assets.”

1. Clean energy policy should be determined by independent scientists rather than by a policy process that is tied only to the political process.
2. Since catastrophic outcomes happen decades after damages to the environment occur, the risk premium pricing should be estimated as the total social cost discounted against the forward curve.
3. The price of the risk should be set high enough to provide incentives for market participants to invest capital in technologies and strategies for reducing emissions. Only these actions can reduce the risk of a catastrophe and lower its damaging impact on the economy and society.
4. Any delay in doing this is unacceptable due to increasing risks of natural catastrophes. At the same time, the future emission price will rise higher as scarce resources continue to be used—and over-consumed—unpriced.

How carbon will be priced

According to Litterman, the utility function on carbon pricing should be constructed based on the optimization results from two basic factors.

First, although there is a low probability of a catastrophic outcome, the fact that the consequences are extreme and irreversible demands that the risk must be priced accordingly. Since there is high societal risk aversion to the potential for catastrophic climate changes to future generations, this being a non-diversifiable risk should be priced at a significant premium to a diversifiable risk pricing. The latter is determined based only on the distribution of outcome from expected damages.

Second, there must be trade-off decisions between consumption today and potential bad outcomes in the distant future. The discount rate to be applied should therefore include the societal risk premium rather than the government bond rate, as described in the 2006 Stern Review.

The degree of societal risk aversion can be observed to be quite high in global equity markets. However, while investments in equities increase risk and pay off primarily during good times, investments in emissions mitigation reduce risk and pay off primarily when there are natural disasters. Thus, the impact of risk aversion with respect to investment in emissions reduction is to reduce the discount rate on the future damages and to increase the appropriate price for creating emissions today.

What does this mean for investors?

With increasing societal awareness of the risks of climate change, we should expect more countries to adopt emission reduction targets through a combination of policy regulations, investment or production subsidies, and fines and levies. For a pension manager, this means that if the current carbon price is not fully built into the current asset valuation process, then there is the risk of becoming over-weighted in stranded assets. Plan sponsors and other investors may want to select investments in businesses that will benefit from a full implementation of carbon pricing in the market (e.g., intelligent buildings and efficient clean energy solutions).

Canada’s carbon measures

Carbon pricing is important to Canada, as our economy is the fifth largest world energy producer in 2011 and the 13th-largest in coal production worldwideⁱ. Energy exports in 2011 account for 22 percent of the total value of Canadian exports. In December 2009, Canada committed to reduce its greenhouse gas (GHG ) emissions by 2020 to 607 megatonnes, or 17 percent below the 2005 level under the Copenhagen Accordⁱⁱ. Furthermore, Environment Canada reported that in 2010 stationary combustion sources account for more than 80 percent of greenhouse gas emissions in Canadaⁱⁱⁱ. (Table 1 outlines energy use and emissions level by industry and household, and Table 2 outlines the per capita emissions summary statistics for various provinces.) Provinces such as Alberta and Saskatchewan have average per capita emissions that are higher than the national average due to their significant activities in resource extraction and due to their being highly reliant on fossil fuels for electricity generation.

Carbon capture projects in Alberta and Saskatchewan

In 2008, the Government of Alberta announced it would commit $2 billion for a Carbon Capture and Storage Fund to finance projects to capture carbon dioxide emissions. Their target is to capture underground 140 million tonnes of carbon dioxide emissions from its industrial plants by 2050. It was also reported in May 2013 that Saskatchewan invested in a $1.24 billion carbon capture project at a coal-fired power plant, potentially reducing one million tonnes of carbon dioxide per year, or 90 percent of the emissions at the plant.

Cap-and-trade system in Quebec

In 2011, the Government of Quebec approved a cap-and-trade system for GHG emissions allowance. Regulated businesses are required to meet their GHG emissions as of January 2013. Companies whose GHG emissions are higher than the number of units allocated will have to adopt new technology, otherwise they will need to buy emission allowances at government auctions or on the carbon market.

Global trends

In July 2012, the Government of Australia implemented a trading system on carbon units. The initial carbon price was fixed at AUD$23 per tonne of carbon dioxide emissions in 2012−2013, rising at a real rate of 4.5 percent per annum. A forward market has also been started for companies to hedge future price exposure ahead of the start of the floating carbon unit pricing on July 1, 2015. The European Union Emissions Trading System (EU ETS), as launched in 2005, is a platform where allowances or permits could be traded by businesses to meet their emissions limits. It was reported that currently EU ETS covers over 11,000 power stations, energy intensive industrial plants, and commercial airlines in 31 countries.

ENDNOTES
ⁱ CAPP on Climate’, Canadian Association of Petroleum Producer, Aug 2011, www.capp.ca
ⁱⁱ “Activities that produce one tonne (“t”) of emissions include – driving a mid size car for 5,000 kms or 20 cars idling 2 minutes each day for a year. 1 million tonnes = 1 megatonne”, Environment Canada On-line News magazine, www.ec.gc.ca
ⁱⁱⁱ ‘National Inventory Report: greenhouse gas sources and sinks 1990-2010’ Table S-2, Environment Canada, www.ec.gc.ca