Time is Key to Putting a Price on Climate Risk (Op-Ed)

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Time is Key to Putting a Price on Climate Risk (Op-Ed)
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Bob Litterman is a retired partner and former head of risk management at Goldman Sachs. He is now chairman of the risk committee at Kepos Capital LP, a New York-based hedge fund. He contributed this article to LiveScience's Expert Voices: Op-Ed & Insights.

Time compression is a simple concept fundamental to risk management. It refers to the fact that we can solve almost any problem given enough time — the problem only becomes troublesome when events unfold too quickly, leaving insufficient time to react and manage the consequences.

I first heard the term when my friend and former colleague, Jacob Rosengarten, spoke at a recent conference for hedge-fund investors, describing what went wrong during the financial crisis.

The concept can be applied broadly — in national security, for example, the concept applies to a country that must defend against an enemy missile launch or a cyberattack in minutes or seconds. Risk-management responses must come in a timely and accurate manner, for in such situations, there are rarely second chances.

History contains a number of risk-management lessons in which outcomes have gone awry due to the unanticipated emergence of time compression. Returning to the financial-meltdown example, it cascaded into market after market like falling dominoes, resulting in severe selling pressures, market losses, unexpected defaults and government bailouts of key companies. Things happened so rapidly that it was hard to keep score, all at great cost to society.

The consequences of time compression also describe the risk-management challenges created by climate change. Is it possible to avoid a global catastrophe caused by climate change coupled with time compression?

The answer almost certainly is yes. With foresight and planning, the planet can avoid the consequences of catastrophic time compression. It is important, however, that society not become overconfident about predicting or understanding all the implications of climate change.

Containing the unexpected risks associated with time compression requires immediate and urgent defensive action: It is time to price carbon-dioxide emissions.

This is an action that governments around the world can take simply by changing a few lines in the tax code, making industries that emit large quantities of carbon dioxide pay a price for doing so. The only interesting question that remains is how much to charge relative to a risk that is still unknown.

Let's examine the risk. Much like the financial crisis, we might expect a slow-moving increase in global temperatures resulting from climate change, as well as its related impacts, such as sea-level rise and ocean acidification. Yet the sheer complexity of the physical systems at work could lull the world into underestimating the risk, and increasing the chances of calamitous global damage.

Climate change, when tied to time compression, makes corrective actions more costly and less certain of efficacy. An invisible change in the tax system would create appropriate incentives for every economic agent in the world to change their behaviors. It would prompt businesses to develop alternative technologies that are safer for the environment, encourage consumers to make the right energy choices and coax investors to build capital stock suitable for the future.

Today, unfortunately, those invisible tax codes instead create incentives to increase carbon emissions.

Economists expect the emissions price required to successfully avoid catastrophic impacts from time compression to be relatively low if society were to act now. But there are two potential problems with such an expectation: First, it could be wrong, and second, until society prices carbon emissions fittingly, the risk itself is growing exponentially — as it has during the past half century.

Society must arrive at the correct response in the context of risk management.

The only effective brake on additional catastrophic risk is to price future uncertainties created by carbon emissions. The expected damages wrought by climate change are enough to justify pricing emissions today, but the latent risk produced by time compression and unexpected catastrophe requires an additional risk premium.

In economic terms, this means any carbon emissions pricing must take into account both the expected loss and the wide confidence interval (indicating the need to continue collecting data), as well as the cost to the planet of underestimating either. In reality, the appropriate price of carbon emissions will probably never be known. Like all pricing, it will adjust and fluctuate with changing circumstances and as more data become available.

Some may argue that it is premature to adopt such a risk-averse posture on carbon-emissions pricing. After all, if we don't know how climate change will unfold, is the cost of this conservatism really worth it in terms of what we will forgo today?

In fact, conservatism in pricing climate change is good public policy. The cost of being wrong — that is, not being conservative enough — potentially is unaffordable, not just for the plant and animal species that live on the planet, but also for humans. What if conflicts erupt as a result of changes prompted by climate change, such as access to freshwater?

People buy insurance on their homes, even though they can't predict when a natural disaster will strike — or if one will occur at all. But we all agree that the cost of such a disaster is unacceptably high should it happen. So we protect ourselves.

If people do this for their homes, why not do it for future generations and the planet ?

This is not the time to slowly ease onto the brake over multiple decades, as many policymakers have suggested. This is the time to brake hard. Such action, hopefully, over time, will prompt the price of carbon emissions to drop, along with the risk.

Society should not regard the act of filling the Earth's atmosphere with greenhouse gases lightly. Just as in the financial crisis, when the meltdown in value of the huge investments in risky mortgages unpredictably rippled into other markets, this global chemistry experiment also may spill over into uncontrollable environmental disasters, all compounded by time compression.

Whether the price of emissions today should be low or high compared with future prices depends on whether society considers the risk of potential, and as yet unknown, environmental disasters. If society does not consider that risk, then the price should be lower today. This approach assumes that future generations will be just fine, and that they will spend whatever it takes to offset the consequences of climate change.

Be forewarned, however: Starting with a low price does not take into account the possibility that today's actions will lead to unexpected impacts, which create time compression and additional consequences impossible to reverse.

Make no mistake — this already is happening. Arctic ice is slowly disappearing. What we don't know, however, is the long-term consequences of this. Will such changes lead to a world less hospitable to human life, and if so, how bad will it be? No one really knows.

The danger of time compression caused by climate change is real — thus, society must immediately price the risk.

World governments must address these risks urgently. They must work in a concerted manner — consistent with their responsibilities to protect their populations and futures — to price carbon emissions sufficient for creating a meaningful margin of safety. Pricing should be high enough for society to feel confident enough that it can control the risk and develop viable alternative technologies.

Hopefully, there is plenty of capacity for the atmosphere to safely absorb the emissions that will come over the next several decades while cheaper alternative energy sources take over. Of course, there are no guarantees, just as with homeowners insurance. The question is, how much risk is society willing to assume on behalf of future generations?

Yes, there are serious challenges to implementing a carbon-pricing policy. It must be fair to developing nations, and take into account that some countries, hoping for a free ride, will not want to participate. This will require true statesmanship by world leaders to resolve. But complexity should not be an excuse for inaction.

After all, we may have less time than we think.

The views expressed are those of the author and do not necessarily reflect the views of the publisher or Kepos Capital LP. This version of the article was originally published on LiveScience.

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