Carbon Pricing, Protecting the Environment and Incentives

How do you solve the climate-change crisis? It’s all about incentives, according to Bob Litterman, founding partner of Kepos Capital, director of the World Wildlife Fund and former Head of Risk at Goldman Sachs.

“If you want to change the behaviour of seven billion people on this planet, you’ve got to change the incentives,” Litterman said in a podcast hosted by Jason Mitchell, co-head of responsible investment at Man Group. “The only way we are going to make progress is to create appropriate incentives. Incentives are like gravity, they’re like a force. We can’t just go up when gravity is pulling us down. Incentives have to go in the right direction. There are many things that can be an incentive, but for humans today in a free and open society, incentives are basically prices.”

This is why carbon pricing is at the center of addressing the climate-risk problem. “The reason we’re in trouble today is because we are not pricing the risk, we’re not creating the incentives to reduce the externality associated with greenhouse gases,” he said in the podcast. “Climate and carbon is just one dimension of a multi-dimensional problem. If we want to protect, for example, the diversity of life on this planet, then we have to think about the ecosystems that provide that diversity, and the value that they provide. Similarly with water resources: we are not pricing water, so we waste it. When we don’t price these things, so we don’t value them and so we don’t protect them. If you are concerned about the environment, you have to put a price on it. You have to value these resources.”

However, Litterman acknowledged that carbon pricing was not the only thing needed. “We also need regulation, research and development, government support for science and so on. However, at the heart of it is incentive structure, and at the heart of that is pricing greenhouse gas emissions.”

Still, formulating an effective carbon price is easier said than done: the price must simultaneously incentivise companies to be less carbon intensive, but without over-penalising firms to the point where economic growth is stunted. For Litterman, it is essential that current prices reflect economic reality. “One of the mistakes that carbon pricing proposals make is to think that today, we can set a trajectory for the next 20 years for the carbon price. We don’t know what the technologies are going to be for direct carbon capture 20 years from now, and that’s actually a very important determinant in where we should be pricing carbon emissions today. You’re not going to charge more for putting emissions in the atmosphere now than it will cost in the future to take them out!”

Comments may have been edited and condensed for editorial purposes.

To read more from Bob Litterman:

Applying Asset Pricing Theory to Calibrate the Price of Climate Risk

Robert Litterman interview: Climate change, the financial crisis, and other high-risk problems

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