What price is right for a low carbon future

Australia’s lower house of Parliament passed a carbon tax yesterday. It prices carbon at $23 a ton. India’s carbon tax is 80 rupees (about $1) a ton. So what is the appropriate price of carbon? According to Robert Litterman in his Financial Analysts Journal editorial, it is a complex equation that should reflect fundamental uncertainty about catastrophic risks and a high level of societal risk aversion.

Most governments that have taken early action, relative to their global peers, have been met with much criticism, partly I believe because the US is not pricing carbon at all. For this those countries, such as Australia, should be applauded. I for one like governments, and any leaders, to lead.

But it is not just governments that can act to educate the public. As Litterman points out, investors are experienced in pricing unknown risks, and so are a natural constituency to educate the public on the benefits of pricing emissions.

He says in the case of carbon emissions that the risk premium for increased exposure to unknown risks is clearly not being set appropriately. And with regard to climate change, society cannot afford to wait and see whether truly catastrophic outcomes will result.

“Because the known and unknown risks of catastrophic consequences are significant, the risk premium for increased emissions today should reflect those risks,” he says.

The price of carbon, Litterman contends, can be related to the equity risk premium puzzle.

Sponsored Content

“The appropriate price for carbon emissions depends critically on how risk-averse a society is,” he says.

Until recently, economists assumed that society had a very high tolerance for risk.

The typical “reasonable” risk-aversion assumption used by economists would imply an equity risk premium in the range of 13-19 basis points, not the 600-800 basis points that has been seen in equity markets historically, he says.

“In recent years, the combination of the recognition of uncertainty in worst-case outcomes and the need to incorporate risk aversion realistically has had a powerful impact – namely, to raise the appropriate price of emissions significantly,” he says.

What this means, he says, is the appropriate price for carbon emissions is much higher than the values in earlier studies that assumed higher risk tolerance.

He explains that the reason economists typically assumed very high levels of risk tolerance has to do with the use of the constant relative risk aversion (CRRA) utility, which captures two aggregate economic behaviours. The first is inter-temporal substitution (try convincing a six-year-old to forgo eating chocolate now for more chocolate in the future!), and the second is risk aversion.

“The rigidity of CRRA utility is also a serious problem in climate economics because inter-temporal substitution and risk aversion are key determinants of the appropriate price for carbon emissions, which when emitted today create increased risk in the distant future,” he says.

While Litterman does not suggest an appropriate price for carbon, he does say “we do know that it is significant”, citing a recent US Government study (US Interagency Working Group on Social Cost of Carbon) that suggested a range of values centred on $21 per metric ton of carbon dioxide.

As with all matters of politics, it is up to governments to explain to an uninterested public the rationale for their price. And while it is complex, there is an opportunity for investors, with their experience of pricing unknown risks, to play a part in that education.

 

Leave a Comment

Sort content by

Rotman ICPM research

The Rotman International Centre for Pension Management (ICPM) has approved five research projects for funding this year, including a behavioural-finance project by Swedish academics, to investigate plan members’ views of the “extended” fiduciary duty of pension funds. This project, to be conducted by Joakim Sandberg, Anders Biel and Magnus Jansson from the University of Gothenburg

MSCI: the data toolmaker

With hundreds of indexes, portfolio and risk analytics, and a growing emerging-markets and environmental, social and governance (ESG) focus, MSCI is a business in constant evolution, but chief executive and chairman, Henry Fernandez, says institutional investors are demanding further development, such as private-equity indexes. Fernandez has been chief executive of MSCI since 1996, when the

Illinois pension reform

At least one state in the US is acting on the need for epic reform of its pension system, but the political difficulty associated with such reform – something all states are wary of – was demonstrated in the violent outburst by Illinois representative, Mike Bost, last week (see video) and the inability of representatives

Ang angles for more dynamism at CPPIB

The Ann F Kaplan professor of business at Columbia Business School, Andrew Ang will teach a case study on the Canadian Pension Plan Investment Board’s (CPPIB) reference portfolio in the fall. While for the most part complimentary of the approach and process, he challenges the Canadian fund to consider a more dynamic reference portfolio. The

Governance disclosure needs nutrition label

Pension funds should disclose their governance arrangements using a methodology similar to a nutrition label, with members easily able to compare the transparency and accountability of fund standards, a leading corporate-governance expert from Yale says. Dr Stephen Davis, the executive director of Yale School of Management’s Millstein Centre for Corporate Governance and Performance, has called

Mercer lists priorities for Norway’s GPFG

A report finding Norway’s $582.7-billion sovereign wealth fund could face significant losses in a range of climate-change scenarios is unlikely to result in changes to the fund’s investment strategy, Norway’s state secretary Hilde Singsaas says. Norway’s Ministry of Finance released the report into the Government Pension Fund Global’s (GPFG) that it commissioned from Mercer and

Previous