Robert Litterman
Dialogue: ​#23 [ All ]

Robert Litterman is a founding partner of Kepos Capital; a New York City based systematic global macro firm, and the Chairman of the Kepos Capital Risk Committee. Prior to joining Kepos Capital in 2010, Dr. Litterman enjoyed a 23-year career at Goldman Sachs & Co., where he served in research, risk management, investments and thought leadership roles. He oversaw the Quantitative Investment Strategies Group in the Asset Management division.

Dr. Litterman is currently on the board of the Niskanen Center, Robert Wood Johnson Foundation, Ceres, World Wildlife Fund, Woodwell Climate Research Center, and the Climate Leadership Council (CLC), where he serves as co-chair of the Board.  PCAST (President's Council of Advisors on Science and Technology), UCAR (University Corporation for Atmospheric Research), and the Climate-related Financial Risk Advisory Committee (CFRAC) of the Financial Stability Oversight Council.

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Position Statement

Motivation

Rapid decarbonization of the global economy is critical to protect nature and human well-being.  It will require an immediate, massive increase in investment in low-carbon energy production, manufacturing, and supporting infrastructure.  Such investments cannot be funded by government expenditures or philanthropic support alone.  The scale required, estimated to be trillions of dollars per year, is simply too large.  Because private sector investments are motivated by the expectations of future profits, the path forward is to increase expected returns to low-carbon investments.

Meanwhile, according to the latest IMF update, governments provided $7 trillion of subsidies to support the use of fossil fuels in 2022 alone.  These subsidies include both explicit government payments to reduce energy prices and the implicit subsidies that arise from not recognizing the damage from burning fossil fuels. The well-known negative impacts on human well-being include both particulate pollution and the increased risk of climate change created by greenhouse gas emissions.  These enormous subsidies reduce fossil fuel prices and lower the expected returns to low carbon investments.

Clearly, the key to decarbonizing the global economy is the rapid elimination of these fossil fuel subsidies and the institution of appropriate incentives to reduce pollution.  Decarbonization requires strong, globally harmonized, credible incentives to reduce carbon emissions.  

Charting a Global Path to Eliminating Fossil Fuel Subsidies 

The Kepos/Gro carbon barometer is a comprehensive measure of marginal incentives to reduce emissions, calculated across countries and over time.  For each country it creates an emissions-weighted average across all government policies that create marginal incentivizes to reduce emissions.  Today this metric reveals the sad reality that government policies to reduce emissions are neither strong, nor globally harmonized.

However, the carbon barometer measure of the average carbon price in a country also allows the creation of a carbon linked bond (CLB), a financial instrument which can chart the path toward elimination of fossil fuel subsidies and provide investors and entrepreneurs dramatically increased expectations that low-carbon investments will be profitable in the future.

How It Works

A carbon-linked bond would attract sustainable investments by:

1. allowing governments to signal carbon-pricing intentions,
2. supporting those future policies by providing cost savings from government action,
3. allowing investors to hedge climate policy risk, and
4. increasing credibility by allowing government policy to react to the revealed investor expectations of future carbon pricing.

In a CLB the payment at a future date is a nominal amount times a carbon price index.  Just as with a U.S. Treasury Inflation Protected Security (TIPS) in which the coupons and principal are indexed to the consumer price index, in the case of carbon-linked bonds the payments of both coupon and principal would be linked to the comprehensive carbon price.

How does this financial instrument help accomplish the above four goals?

1. (The CLB allows governments to show leadership in sustainability by signalling carbon-pricing intentions: 
   A key component of the carbon linked bond is the signal it sends at issuance about where the government intends to price carbon in the future.  The bond specifies a target path for future carbon prices at each coupon payment date and at maturity.  
   
2. The CLB provides additional motivation for future government action:   
   The coupon and principal payments are indexed to the comprehensive carbon price such that if the government fails to hit its target, it is required to make a larger payment.  Of course, a price on carbon already benefits the country with tax revenue and lower pollution, but with a CLB there is an additional incentive created because borrowing costs decline if the government hits or exceeds its targets.
   
3. The CLB allows investors to hedge climate-related policy risk:
   The future payments of the bond are structured to increase in a scenario in which the government fails to achieve its carbon-pricing targets.  For this reason, the bond’s price will increase if expectations of policy failure rise.  An investor can hedge this risk by entering into a financial contract tied to the bond price.
   
4. The CLB illuminates investor expectations of future carbon pricing:
   The market price of the bond reflects expectations of future policy initiatives to incentivize emissions reductions.  Thus, just as TIPS today reveal future expected inflation, the prices at which the carbon-linked bond cash flows trade relative to nominal cash flows will reveal market expectations of carbon pricing at future dates.  And just as a central bank can increase its credibility by tightening policy when expectations of  inflation rise, climate policy can be made credible by reacting to changes in revealed expectations of future carbon prices.
   

An Additional Benefit

Finally, the CLB addresses an inconvenient political reality, that voters have short time horizons.  This often makes the implementation of a carbon tax unpopular: the pain of increasing taxes is felt immediately by the public, whereas the benefits arise in the distant future.

The CLB turns this political equation around.  With a CLB the funds from the bond’s issuance become available for use immediately.  And credible policies designed to reduce future emissions, because they increase the expectations of the profitability of low-carbon capital, will also have a direct impact on the scale of private sector investments.  On the other hand, the pain of the carbon price starts low and only follows a slow, predictable, but steadily increasing path into the future. 

The first country to issue a CLB will thus be a true leader in our urgent, and inevitable, journey to strong, globally harmonized, credible incentives to reduce carbon emissions.