Building Institutions in
Financial Innovation
Remarks by Dr. Richard L. Sandor
February 9, 2011
Reproduction or quotation of this material is expressly forbidden without the consent of the Author.
CCX Members are Sector Leaders
A Selection of Members
0
2003 start
2009
2012
60
56
45
37
33
31
30
29
22
22
19
11
9
4
Belgium
New South Wales
Finland
Portugal
Austria
Denmark
Slovakia
Hungary
Sweden
Ireland
Estonia
Lithuania
Slovenia
Latvia
130
150
300
400
Luxemborg 3
71
86
The Netherlands
Greece
94
Czech Republic
California
France
170
171
Spain
US NE States (RGGI)
174
206
Australia
United Kingdom
232
100
Italy
200
237
300
Poland
Canada
Germany
540
600
CCX
Hundred Million Metric tons CO2
CCX Baseline Emissions Now Greater than
Largest EU National Allocation Plan
Size of Live, Emerging, Possible GHG Trading Markets
500
496
Live Market
Market in development
Under discussion
Environmental Results of CCX
Entity-wide emission reductions in excess of Program requirements, with no
hampering of Membership’s economic growth
469,554,700
500,000,000
450,000,000
404,358,500
400,000,000
metric tons CO2
350,000,000
300,000,000
250,000,000
200,000,000
150,000,000
100,000,000
53,359,000
50,000,000
11,837,200
0
Internal On-site
Emission Reductions at
Member Facilities
Project-based Offsets
Forest Management
Total
Cap-and-Trade with U.S. SO2 Pollution
1989-1991
6
Annual Mean Ambient SO2 Concentration
2004-2007
Pre-1992 SO2 Allowance Price
Forecasted vs. Actual
$2,500
Price per ton
$2,000
$2000 Fine Level
$1500 EPA Emergency Supply
$1,500
$1,000
$981 United Mine Workers
$785 Ohio Coal Office
$688 Electric Power Research Institute
$500
$0
$446 Sierra Club
$309 Resource Data
Intl.
$392 American Electric Power
$275 - average auction price, 1993-2008
$62
"Phase 1 Middle" prices,
1
11
Source: Hahn and May, The Electricity Journal, March 1994
Pricing Climate Risk
Remarks by Bob Litterman
February 9, 2011
Based on “Optimal Climate Policy” joint work with Kent Daniel
A view from Cancun
Mexico's President Felipe Calderon, comparing
global warming
to a passenger bus that is careening out of
control, warned:
“We need to brake as hard and fast as possible”
Is President Calderon correct?
Prices allocate resources
the brake is the price of carbon emissions
What is an appropriate price for emissions?
(in $ per metric ton of carbon dioxide equivalent)
current global
average price
(including global subsidies)
a reasonable range depends on
risk and risk aversion
Increasing risk
Increasing risk aversion
-$10
$0
current US price
$18
current price in Europe
$80
Think about dynamic optimization
…with uncertainty, tipping points and nonlinear responses
A risk averse rider, when recognizing
that he may be out of control, brakes
hard and expects to ease off in the
future as uncertainty is resolved
Slowly easing onto the brake
makes sense when the road
is well known and control is
certain
Four questions
1. What is the appropriate price of carbon emissions?
2. What should the emissions price forward curve look like?
In particular, should it be downward or upward sloping?
3. What is the cost of not pricing emissions appropriately?
4. How quickly should the price move to the appropriate
level?
The equity risk premium puzzle:
Investment behavior reflects extreme risk aversion
Data are from http://www.econ.yale.edu/~shiller/data.htm
Risky cash flows that pay off in bad states of nature
have an expected return below the risk free rate
Data are from http://www.econ.yale.edu/~shiller/data.htm
Why do typical economic analyses suggest that
higher risk aversion implies lower emissions prices?
Estimates of the social cost of carbon from Anthoff, Tol, and Yohe (2009)
emissions
prices
Increasing risk aversion
Our analysis builds directly on a number of
previous works
1. Summers & Zeckhauser, ‘Policymaking for
posterity’ (2008)
–
A simple two-period model; the impact of increased uncertainty
on policy depends on parameters of technology and preferences
2. Weitzman, ‘GHG targets as insurance against
catastrophic climate damages’ (2010)
–
The essence of the emissions externality is the risk of
catastrophic damages
3. Ackerman, et al, ‘Limitations of integrated
assessment models…’ (2009)
–
Standard power utility used in climate models match neither market
interest rates nor the equity risk premium
4. Epstein & Zin, ‘Substitution, risk aversion…’ (1989)
–
A utility function that separates the elasticity of intertemporal
substitution from the degree of risk aversion
Economists model higher risk aversion as
increased curvature of the utility function
u
t
i
l
i
t
y
u
t
i
l
i
t
y
income
With lower curvature
increased uncertainty does
not significantly reduce
expected utility
income
While higher curvature
means increased uncertainty
will significantly reduce
expected utility
The degree of curvature is called the “income elasticity of marginal utility”
People react very differently to uncertain income
across states of nature versus over time
Risk aversion
High curvature across states of
nature is required to fit the very
significant equity risk premiums
that we observe in the market
Intertemporal substitution
While low intertemporal curvature
is required to fit the relatively
low risk free rates
that we observe in the market
The standard utility function has a well known rigidity
Risk aversion
Intertemporal substitution
The curvature of utility (as a function of income) is required to be the
same across states of nature and across time
That the same curvature cannot fit the high equity risk premium and low
market rates of interest is the essence of the equity risk premium puzzle.
Climate modelers generally use a low curvature in
the context of such a one-dimensional utility function
Lord Nicholas Stern, for example, set a degree of curvature that
implies an equity risk premium of around 12 basis points,
more than 30 times too low relative to observed risk premia
Something is very wrong here
Higher curvature has two impacts:
it increases the risk free discount rate faster
than it increases the risk premium
Counter to intuition, in the standard utility function increasing
the risk aversion makes curbing emissions less urgent
Epstein-Zin utility allows intertemporal
substitution to be separated from risk aversion
Risk aversion
High curvature across states of
nature can fit the very
significant equity risk premiums
that we observe in the market
Intertemporal substitution
While less intertemporal curvature
can fit the relatively low risk free rates
that we observe in the market
Epstein-Zin utility in a simple model
1. Following Weitzman, we add significant tails to the standard distributions
of climate damage – we admit the possibility of climate disasters
2. We calibrate emissions reductions costs to previous studies
3. We specify an Epstein-Zin utility function
•
we calibrate the elasticity of intertemporal substitution to market
interest rates
•
we investigate the impact of different risk aversion assumptions
4. In each case we solve for emissions reduction policies that maximize
welfare
Economic impacts depend on future
temperatures which are very uncertain
Projected increase
in temperature
in degrees C
The distributions above are expected under “business as usual” scenarios
Many climate models take into account only
known, or highly likely, damages
These calibrations, for example, which are designed to reflect the concensus
damage estimates from integrated assessment models, come from Robert
Pindyck’s 2009 paper, “Uncertain outcomes and climate change policy”
Many scientists, e.g. Sherwood and Huber (2010), feel “recent estimates
of the costs of unmitigated climate change are too low”
The probability of a significant reduction in
consumption at future dates is much higher
The rigidity of standard utility functions explains
why in most climate models increased
risk aversion lowers the price of emissions
Estimates of the social cost of
carbon from Anthoff, Tol, and Yohe
(2009)
Increasing risk aversion
Delay increases cost and increases risk
Alternative emissions policies
$60
$50
$40
$30
Market expectations
Low risk aversion policy
$20
High risk aversion policy
Delayed risk averse policy
$10
$0
2010
-$10
-$20
2020
2030
2040
2050
A simple cost-benefit view of optimal climate policy