Risk management and other analytical strategies in the finance profession’s tool kit can make a positive difference in the battle against climate change. That was one of many insights at the Center for International Securities and Derivatives Markets’ (CISDM) Annual Research Conference on October 28. During the daylong event, four featured speakers explored the event’s signature theme, “Investment Strategies, Market Liquidity, and Climate Change.”
“Climate change has become an urgent risk management problem,” emphasized keynote speaker Robert Litterman. A founding partner and risk committee chairman of the global macro firm Kepos Capital, Litterman insisted that confronting the challenge calls for pricing risk through incentives that induce economic agents to reduce carbon emissions.
Overall pricing incentives for emissions are negative.Not a moment too soon, he continued, because we are working against a fast-ticking clock where climate risk is gaining momentum. “If we have enough time, we will solve this problem," he remarked. “But we don’t know how much time we have left, and we are wasting it.” Currently, in fact, our overall pricing incentives for emissions are negative, he said. That means global subsidies continue to encourage emissions.
We need to hit the brakes but not through divestment, which Litterman characterized as a blunt approach. Better to exercise more market-nuanced pricing strategies like hedging stranded assets (e.g., coal, tar sands, expensive sources of oil), whose current valuations fail to reflect the externalities of their emissions. Those assets, he added, are bound to fall in value.
Litterman illustrated that approach with performance data from the World Wildlife Federation’s Stranded Assets Total Return Swap with Deutsche Bank. The hedge, involving a coal index of 12 stocks and an oil sands index of 13, has paid off handsomely for the WWF, with the stranded assets underperforming the S&P by 18% annually since 2014.
Asset owners, Litterman continued, have growing governance responsibilities as well. Financial disclosure rules are in the works that will push asset owners toward climate-risk dialogs with the board members who represent them. Litterman also advocated engagement by asset owners in finalizing new regulations. MIT, he said, is leading an effort to insure that a new measure by the ICAO* to reduce emissions in aviation will reflect the economic externalities that that they impose. “Investors have an interest in getting this right,” he told the gathering.
In an earlier presentation, “A Fiduciary Approach to Carbon Investing,” Jess Gaspar of the Commonfund offered many similar insights. Targeting low-carbon portfolios, Gaspar, who is Commonfund’s head of Asset Allocation and Research, discussed reducing carbon risks like stranded assets and repriced emissions. He explored seizing new investment opportunities via transformative technologies and touched on managing portfolio risk itself.
In assessing a firm’s carbon footprint, look beyond a company’s apparent emission numbers to assess its value chain, Gaspar recommended. UPS, for example, has much higher emissions than Amazon. But Amazon outsources its deliveries to UPS and other carriers. You need, he said, to understand the bigger picture. At the same time, Amazon saves consumers trips to and from “the store.” So Amazon may be environmentally friendly after all.
In his remarks on portfolio risk management, Gaspar touched on issues involving volatility, tracking errors, and factor exposures. Portfolio risk management, he noted, entails benchmarking and assessment of carbon risks. It also calls for sensitivity to macro factors, including equity, commodities, and inflation.
Carbon risk, he concluded, is increasing, but alternative energy is becoming cost competitive. Governments and supranationals are ramping up taxation and regulations, and technology is improving efficiency of the entire energy value chain. All are indications that low-carbon investing is becoming mainstream. Reconciling fiduciary responsibilities with low carbon investment, then, is imperative.
More about the Conference and CISDM
Earlier in the day, Suhir Nanda, head of T. Rowe Price’s Quantitative Equity Group, surveyed quantitative investment strategies in a presentation with the same name. He was followed by Vanderbilt University’s Madison S. Wigginton Professor of Finance Craig Lewis, who presented “Regulation and Liquidity Concerns in the Asset Management Industry.”
Established two decades ago through the generous support of Michael Philipp ’82 MBA and Anshu Jain ’85 MBA, CISDM has consistently been at the forefront of research, education, and practical applications involving derivatives, alternative investments, and asset and risk management. The Center is home to The Journal of Alternative Investments and the Morningstar CISDM Hedge Fund Database, which tracks more than 7,000 hedge funds, commodity trading advisors, and funds of funds. As co-founder of the Chartered Alternative Investment Analyst Association (CAIA)—the leading professional accreditor of alternative investment professionals—CISDM supports standards and continuing education for practitioners in that increasingly impactful profession.