Bob Litterman returns to judge Low-Carbon Portfolio Case Competition

November 12, 2015

Bob Litterman, former head of risk management for Goldman-Sachs, hopes that society will be as lucky as he has been in dodging fossil fuel-related tragedy. En route to a New York City show with his wife last December, the couple watched as a tanker in the oncoming lane of I-78 struck a car, jumped the median and exploded in front of them. Litterman swerved, and was the last car through as a major artery for New York closed for the next seven hours. For a man who has spent years trying to alert the financial community to the dangers of global warming, it was eerily reminiscent of a column he’d recently published that used the analogy of a driver traveling at a high rate of speed on a potentially dangerous road.

Litterman’s latest vehicle for addressing climate change is the second Low-Carbon Portfolio Case Competition, organized by Yale School of Management, for which he again serves as chief judge on Friday in New Haven. As happened last year in the inaugural event, business school teams from around the country will compete to present the best strategy for a hypothetical corporation redeploying investments in light of global warming. First prize in the competition is $10,000 and a bye to the finals of an event, modeled after the Yale competition, at the January World Economic Forum in Davos, Switzerland. 

Investors need cutting edge science to respond to climate change without sacrificing value. In anticipation of his first visit to Yale since the 2014 competition (won by a team from NYU’s Stern School of Business), Litterman renewed a dialogue with Yale scientists that began at last year’s event. With an increasingly climate-conscious investment community asking where to put its money, where does climate change dictate they put it? More succinctly, what are the grand challenges awaiting climate scientists and economists working together today? Litterman suggests three:

Improving the ability of models to predict worst-case scenarios. Yale atmospheric scientist Trude Storelvmo agrees, explaining that even the most recent generation of Integrated Assessment Models (IAMs), which describe climate change from an economist’s perspective, project future damages due to increasing CO2 based on little more than global average surface temperature. Meanwhile, General Circulation Models (GCMs), the principal tool of climate scientists, can predict precipitation, winds, and humidity at increasingly finer resolution, but rely on pre-calculated greenhouse gas emissions from IAMs. The two approaches could be hybridized, so that GCM outputs serve as IAM inputs and vice versa, producing a high-resolution picture of climate-related impacts at a scale more relevant for stakeholders.

Determining the discount rate endogenously based on appropriate asset pricing theory. Mitigating carbon emissions can be viewed as an investment yielding benefits far into the future, adds Yale economist Tony Smith.  “It is like investing in a stock yielding a risky stream of dividends. The benefits of mitigating carbon emissions are risky because there is imperfect knowledge about the likelihood of climate catastrophes (such as, for example, a reversal of the Gulf Stream).” The asset-pricing theory that Litterman endorses—the same one used to price stocks—provides a well-developed methodology for discounting uncertain benefits, such as future benefits from mitigation. The key point is that the appropriate discount rate depends, among other things, on the riskiness of an investment. There is, however, an ethical argument, advocated by Lord Nicholas Stern and others, that current generations should put very low, even zero, discount rates on the welfare of future generations, leaving the appropriate discount rate, a topic of some disagreement.

Establishing a tight upper bound on the social cost of carbon. The social cost of carbon is the discounted value of the stream of economic damages caused by an additional unit of carbon emissions today. There is a large literature on measuring this cost, though estimates nonetheless range rather widely, in part because there is disagreement about the appropriate discount rate. If the social cost of carbon turns out to be greater than or equal to the cost of capturing and sequestering carbon, then investment in the technology of carbon abatement makes economic sense in itself.

The student teams that Litterman will judge in the first round present their investment strategies for consideration at 10:30 a.m. Finalists present beginning at 2:15 p.m. First and second place teams, sharing a total of $12,500 in prize money, will be announced at a reception that begins at 5:45. Full details regarding panels and speakers are on the website at: http://www.yaleresponsibleinvesting.com/case-competition.

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