FTSE Russell Convenes | Episode 3, Season 1

Evolving market trends: The effect of global warming on our financial system

December 9, 2021


Chairman of the Risk Committee and Founding Partner, Kepos Capital Robert "Bob" Litterman explains the lack of appreciation in the diversity of incentives to reduce emissions across the globe. In this discussion, Litterman highlights what the importance of placing a price on climate risk on carbon emissions and how it would be a considerable move in the right direction for the US.

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Futti Russell is an index provider and research houseunder the Elsegg umbrella.They specialize in convening the best ideas on evolvingmarket trends and helping to develop strategies for global investors.In this series,we look at the evolution of the biggest of today's trends.No one needs reminding of the effect global warming is havingon the planet but is enough being done to predict what itwill do to our financial system.Prior to being founding partner at Keepos Capital,Bob Litman led a US sub committee that was commissionedto investigate this impact,and I talked to him about the repercussions of his findings.Bob, thank you so much for taking the time to, chat withus. And, we wanna talk specifically about the worldof, sustainable investing, just before we do that.Let's talk a little bit more about the, sub committee.We were just talking about it earlier.It sounds like it was the first of its kind, to be formed.And what specifically was the role? Yeah.It was kind of unusual because it was under the previous administration.And, the,one of the commissioners of the commodity futures tradingcommission, Russ Bantam his name,is a sponsor of a committee called the Market Risk Advisory Committee.They had some hearings on Climate Related Risk anddecided to create a subcommittee.Chairman, Benham asked me to chair that committee.I was very honored to do so.There were thirty five members of the committee,representing a vast diversity of,participants in the financial system, includingbanks, insurance companies, investors, asset owners,corporate, including oil companies, ad companies,data companies, and exchange. Also, a number of academics,a number of environmental NGOs So we really had a diversegroup. And,the commissioner said we'd like you to rate a high level reportHe hoped it would be fifty pages,come up with a number of specific recommendations andjustifications for those. And he raised kind of a high bar.He said, I'd like it to be unanimous.And,I thought, okay, didn't realize how high a bar that is.You realize you have thirty five people,and any one of them can say no. Okay. And in fact, it was evenworse than that because he said we want not just theindividuals represented here, but their organizations.So our draft report went to all the general councils,and they had to sign off on it.So this is a very much a cross industry type of report. Yes.So what I'm interested in is at that time,take the financial world, for example,banks and insurance companies, was,an aim of the report to try and highlight the fact that theywere not appreciating what kind of risk the climate change wasof was gonna happen to their industry. It was more about,you know, pricing into their product, selling to clients?Or or what was the approach of it? No.I don't I don't think it was, either of those.I think it was designed to say what do we have to do toprotect the financial system? I see.That that's what the financial regulators are supposed to do.Yeah. And the commissioner felt,and the commission itself felt that the other financialregulatory groups, the financial stability oversightcouncil, the FAD, the SCC, had not addressed climate related risk.For reasons that are understandable under theprevious administration, but it seemed to the, f t,to the commodity futures trading commission that someoneought to do this. It's interesting.The CFTC is responsible for regulating derivatives markets in the US.And so it has a very strong focus on risk management.Right. And, so I mean, that's yeah.I guess one of the main primary uses of derivatives is tomanage your Exactly.So they have a market risk advisory committee.And since no one else was focusing on climate relatedrisk, they decided to go ahead and do that. And, we were very,pleased in the end that we were able to write.Actually, we,we accomplished everything the commissioner asked for,we couldn't keep it to fifty pages.It was like a hundred and seventy pages.But you got all thirty five unanimous folks? We did.And, we got,fifty threespecific recommendations, including, I was very pleased.The first recommendation and the most important and urgentis that we have to put a price on climate risk on on carbon emissions.And, everyone agreed with that. Actually,that one wasn't hard to get through.The other thing that we got through that was very pleasedwith is that climate related risk, it needs to be disclosed. And,you know,at At the time we wrote this report,there was not adequate disclosure.Now,we're moving in that direction. There's a lot of work to do,but under the current,financial stability oversight council,which is chaired by treasury secretary yellen. The FAD,the SEC, the CFDC,and all the other financial regulators are now reallymoving forward with the agenda that we put into this report.And can you talk a little bit about other geographies hasthis become a more coordinated event,or is this still something that,is is more specific?Yeah.Something that I think most people don't realize is how farahead of the US, Europe is.Europe has strong incentives to reduce emissions.They have strong There's also markets for carbon trading.Is that right?Markets for carbon trading that have a very significant price. The the,diversity of incentives to reduce emissions across theglobe is not under appreciated. In Europe,there are incentives over a hundred dollars a ton.And so how far do you feel?America how do you think America is doing now?If you to give it a grade?It's doing terribly right now. We don't have a price oncarbon. We're not moving in the right direction.We're on the wrong path.I think the good news is the corporate community understandsthat. You know, everyone supports a price on carbon nowin in the business community and the finance community. Thatwas unanimous recommendation of ours. There was no pushback.At the first meeting of the sub committee, I said, you know,think we need to put a price on carbon. Does anyone disagree?No one no one said no. Even the oil company, so we get it.Yeah. You know, the American petroleum is too.Supports putting a price on carbon.The the chamber of commerce, the business roundtable.Our report was written primarily the financialregulators, but they can't put a price on carbon.The financial community can't put a price on carbon.It's gotta be governments. And it's not the White House, it's Congress.Am I thinking about this right in that, you know,let's hope we do get a price set for carbon,and then that increases the cost base for those companiesand then investors start directing their money away from those companies.And then then there's the financial incentives to stopinvesting in these companies. Does that sound about right?That is about right.I mean incentives are so important. Yeah. That's,that's fundamental. People respond to incentives.You wanna change behavior.You change incentives. And in a modern capitalist economy,that's wages and prices. Right now, we have no price oncarbon. There's no incentive to reduce emissions.And so, you know, pollution is free. People are gonna pollute.Now, it's it's the same in the financial community.If risks aren't priced correctly, then, you know,capital flows in the wrong direction.And this is absolutely the case. The only caveat, I wouldsay, and it's an important caveat,is that investors are forward looking.And so if I'm sitting here today thinking about a capitalinvestment over the next twenty years,It's not just the price of carbon today. It's my expectationsof the incentives to reduce emissions over the lifetime of the investment.That's gonna drive the capital.And what you are seeing these days is a rapid change in expectationsof those incentives.And so capital is starting to flow in the right direction,especially long term capital. But, you know,it's not fast enough.And we have to move. And if they're disappointed,because we don't get those incentives, well,then it's a step in the wrong direction.And we don't have any time to wait. Right.We should have done this twenty years ago.We wouldn't have a problem. Instead,we have an existential threat to the well-being of future generations.And that risk is growing, you know,very it's quick growing faster now than it was twenty yearsago. Twenty years ago, we had time. Yeah. Today,we have no time.In fact, It's too late.We are seeing catastrophic impacts of climate changealready. We can't turn back the clock.The best we can do is preserve the well-being of futuregeneration and every day that we delay is a step in the wrong direction.So speaking of future generations, are you somewhat,hope given, and I hate to generalize and call millennials.But let's say people under the age of thirty five are just somuch more environmentally aware than the older generation.Does that give you a glimmer of hope that this can change faster,or is it still too late by the time they're making decisions?Well, it gives me a lot of hope,and I think we're on the cusp of you know, globallyharmonized pricing.At which point,the whole capital markets will move in the right direction.Technology will be developed.People will have the right incentives.And I think we'll make a lot faster progress than people expect.So that gives me hope that every day that goes by,that we haven't done it. Is a problem.I was watching an interview recently with a man called Robert Freeland.I don't know if you know who he is from from Ivan.And he was really saying that we are just gonna have totransform the world, you know,away from hydrocarbons and to electric,but we just don't have that,the electric grid infrastructure right now,actually his point was that China was slightly ahead of theUS. A lot of the US electrical grids are still quite dated.And, so we need this big infrastructure spent to go intoknow, the sort of,to to having the capability to to have enough electricitybecause we all take for granted that you know,when we switch on the lights, the lights comes on,but if everyone's driving a Tesla,is it gonna be ready for that?No. You're right.There's a lot of money that has to go into the grid,making it a available for intermittent sources of,electricity like solar, like wind. We need backup storage.We need a base load. Mhmm. That doesn't create pollution.Maybe that's nuclear, maybe that's batteries or hydrogen.The technology has to be developed.But I'm sure it will be developed.It's just what's the most efficient technology is the only issue,but it won't be developed fast enough unless we have thoseincentives in place. Even with Biden's infrastructure plan?Yeah. No. We, you, you,you have to start with a price on carbon. Yeah.That if you don't get that, Right.Infrastructure won't do the trick. Right.And we don't have a price on carbon yet. Bob,so final question I wanted to ask you is we're asking a lotof people about their outlook.So in five years time, call it twenty twenty six,do you think we'll have a price of carbon by then?Are you do you feel that we'll be taking the right steps by then.How do you sort of see the world of sustainable investingby then? Absolutely.We will have a price on carbon,and we will be on the road to net zero.Corporations will make their pledges.They'll have their targets. They'll be, making progress.I'm sure we all will.There's a lot of uncertainty about what the technology willbe, how these will develop, but I have no doubt that by then infive years, you know,either we're on the road to net zero at that point or it's toolate. Right. Okay.But, conferences like COP twenty six, are they helpful,or is it too much just lip service?Well, so far, the UN process has not delivered.Let's be honest about that. However, they are now,moving to develop the mechanisms, the government,the governance to allow for globally harmonized pricing.And, so that's a key step.I think the next step that's,being developed right now is the ability to create a market,a global market for carbon credits. Yeah.Credits that are real, that are reliable,that can be used in the compliance markets. And, when that happens,that opens up the gates for investors to start investing inthese technologies, investing in, reducing emissions, and,and we're off to the races.So I'm excited about all that.There's a lot of opportunities as well as a lot of risk.Now if most of the world is committed to to net zero withina pretty short time frame,how do you feel about China and and I know India just saidthey'd commit to it, but only by twenty seventy, I think?It seemed a long way out.Does does that give cause for concern? Well,the the relationship between China and the US is key.And right now, it's a bit fraught. Right.But you have to understand China's way ahead of the US interms of having a federal, electricity,clean electricity standard in terms of the number ofvehicles, the number of electric buses, the,amount of solar and wind, they're just, racing forward.And, you know, we're behind. In terms of the infrastructure.In terms of the infrastructure, in terms of pricing,in terms of,many different things.It's really kind of sad. The US should be providing leadership.We haven't been. Where are we? That's the problem. Well,let's hope that all changes, but Bob,it's been really great chatting with you today.Thank you so much for your time.Sustainable investing and the role of ESG in corporateculture was something that was certainly talked about for ten years.But it didn't really translate into investment opportunities.Now due to the rise of indices,allowing more direct investment in ESG in sustainable themes,capital allocations are accelerating these trends,creating opportunities that are only going to get bigger andmore diverse in the future.If you'd like to read more on this topic,please go to footsie russell dot com forward research whereyou'll find much more information.

Video recorded on June 3, 2021 at FTSE World Investment Forum

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