A Conversation with Robert Litterman (Kepos) and Riccardo Rebonato (EDHEC): Fighting Climate Change Through Financial Innovation

Why do you believe fighting climate change is inherently a “money game”?

Litterman: The urgency of combating climate change cannot be overstated. Rapid decarbonization is essential, necessitating massive investments in low-carbon technologies and infrastructure. The scale of this investment is beyond what governments or philanthropy can provide. For now, the GDP equivalent of low carbon investments is 3.8% in China, 1.2% in the USA and around 2.4% in Europe (1). It’s here that the private sector must step in, driven by the potential for future profits. Private investment is critical to achieving the scale and speed required for effective climate change mitigation. And with $1.3 trillion in yearly direct fossil fuel subsidies, money is definitely at the center of it all (2).

Rebonato: Absolutely, and alongside decarbonization, we must not overlook the importance of negative-emission technologies such as afforestation and carbon capture (3). These technologies, currently underfunded and undervalued, are vital to staying within the targeted temperature limits. Their role complements efforts in reducing emissions, but they also require significant financial investment and support. The problem is that these initiatives do not offer the attraction of future profits for the private sector, and therefore require substantial subsidies. This is why we need to rethink our subsidy policies – we must continue our efforts in renewables, but focusing only on this aspect of the decarbonization process at the expense of everything else will not ‘get us there’ (4). Moreover, learning from the history of renewable energy, we should anticipate and foster a similar reduction in the cost of these technologies through strategic investment and 'learning by doing'.

Litterman: The current total subsidy to fossil fuels, 7 trillion dollars, when we add to direct subsidies the 5.7 trillion dollars of indirect subsidies, is an enormous barrier (2). And unfortunately, the international situation, with the war in Ukraine, comes with a huge increase in primary fossil fuel subsidies.

What is the influence of financial markets on climate strategies?

Litterman: Financial markets play a pivotal role in shaping climate strategies. The trillion-dollar issue of fossil fuel subsidies is a good example. By eliminating these subsidies and establishing strong, globally harmonized incentives to reduce carbon emissions, we can significantly increase expected returns on low-carbon investments. If it is enticed with the right levers, the private sector will invest. Tools like the carbon barometer (5) and carbon-linked bonds (6) can be instrumental in this process, demonstrating the power of financial markets in supporting decarbonization.

Rebonato: Financial markets are indeed crucial. But their role today is far from optimal for the goals we’re collectively trying to achieve. The consideration of climate risk premiums in investment decisions is key (7). We need to reassess both green and brown assets in relation to their potential climate damages. This reevaluation can profoundly impact investment trends and decisions. The concept of carbon-linked bonds proposed by Mr. Litterman, for instance, raises important questions about the alignment of financial instruments with long-term climate goals.

How do your proposals, like carbon-linked bonds, make climate scenarios more relevant for investors and entrepreneurs?

Litterman: Carbon-linked bonds are designed to closely align government and investor interests in carbon reduction goals. And it is based on a key indicator for investors, firms, entrepreneurs, governments – basically everyone: a carbon price. The bonds would allow governments to signal their future carbon pricing intentions and provide an incentive for government action by tying coupon and principal payments to a comprehensive and harmonized carbon price index. By turning carbon pricing into a financial instrument, the bonds help mitigate the short-term political challenges of implementing a carbon tax and provide immediate funds for credible governments, smoothing the ecological transition for society and economies. They would also enable investors to hedge against climate policy risks, driving investments and innovation in low-carbon technology, benefiting the whole sector and society at large.

Rebonato: To make these scenarios truly useful for investors and entrepreneurs, it's also essential to incorporate better probabilistic assessments (8). This approach provides a clearer picture of the likelihood of different climate outcomes, offering vital insights for financial decision-making. By enriching climate scenarios with this level of detail, we make them more practical and informative for those directing investments in climate-related projects and technologies.

References

(1) See International Energy Agency 2022 and Bloomberg New Energy Outlook 2024

(2) Fossil Fuel Subsidies Surged to Record $7 Trillion - IMF Blog (2024) - https://www.imf.org/en/Blogs/Articles/2023/08/24/fossil-fuel-subsidies-surged-to-record-7-trillion

(3) Optimal Climate Policy with Negative Emissions. Riccardo Rebonat et al. (2023). EDHEC-Risk Climate report - https://climateimpact.edhec.edu/sites/ercii/files/ercii_wp_optimal_climate_policy_0323.pdf

See also To halt global warming, forget net-zero: aim for net-negative, Riccardo Rebonato. EDHEC Vox / The Conversation (2022) - https://www.edhec.edu/en/research-and-faculty/edhec-vox/halt-global-warming-forget-net-zero-aim-net-negative

(4) How To Think About Climate Change. Insights from Economics for the Perplexed but Open-minded Citizen. Cambridge University Press (2024). Riccardo Rebonato.

(5) Tracking Global Carbon Pricing Policies: Carbon Barometer Price (CBP). GRO Intelligence, in partnership with Kepos Capital - https://www.gro-intelligence.com/carbon-barometer

(6) A Renowned Economist’s New Idea for Stopping Climate Change. The New-York Times, June 2023 - https://www.nytimes.com/2023/06/26/opinion/climate-change-carbon-linked-bonds.html

(7) Where is the Climate Risk Premium? Watch R. Rebonato's webinar (Sept. 2023) or read the associated academic article Value versus Values: What Is the Sign of the Climate Risk Premium? in Journal of Portfolio Management (April 2024)

(8) How to enhance climate scenarios for investors? Watch R. Rebonato's webinar (March 2024) or read the associated publication Climate Scenario Analysis and Stress Testing for Investors: A Probabilistic Approach. Riccardo Rebonato, EDHEC-Risk Climate publication (January 2024) - https://climateimpact.edhec.edu/publications/climate-scenario-analysis-and-stress-testing