The Economic Uncertainty of Climate Change

Caroline Grossman:
Hi, everyone. Thank you so much for joining us this morning, this afternoon, this evening, depending on where you're tuning in from. Welcome to the second session of the Future of Capitalism series, The Climate Challenge, hosted by the University of Chicago Booth School of Business and the Rustandy Center for Social Sector Innovation at Chicago Booth. I'm Caroline Grossman, executive director of Booth Rustandy Center and adjunct faculty here at Chicago Booth. If you're not familiar with the Rustandy Center, we're Booth Social Impact Hub. I'm so excited to be here today to continue the Future of Capitalism series. I've been chatting with the panelists in the green room the last few minutes, and you're certainly in for a treat. This series brings together economic experts from Booth University of Chicago and beyond to discuss the ways in which our economic systems are evolving as expectations about the role of business and society change. 

Caroline Grossman:
This series explores the evolution of capitalism from the perspective of investors, academics, entrepreneurs, healthcare professionals, and other thought leaders. At the Rustandy Center, we think a lot about the business of business. Some of our recent research initiatives are honing in on this topic. We've partnered with the HBS Impact Collaboratory and the Wharton Social Impact Initiative at University of Pennsylvania to build a database on impact investing funds, the goal being to learn more about the way impact investing funds are managed and governed and how their performance can spur research in evidence-based practices. And this summer, we published a report exploring the most commonly disclosed corporate social responsibility metrics from S&P 500 firms. The database provides a much needed window into CSR metrics and industry performance for those who rely on ESG scores, from investors to researchers. 

Caroline Grossman:
Today's question will seek to understand the question of what business owes society by focusing on one of the most urgent topics of our time, climate change. We've convened an impressive panel of speakers to examine the business and economic implications of this immense challenge. Our moderator is Randy Kroszner, deputy dean for executive programs, and Norman R Bobins professor of economics at Booth. Randy served as governor of the federal reserve system from 2006 until 2009, chaired the Committee on Supervision and Regulation of Banking Institutions and the Committee on Consumer and Community Affairs and took a leading role in developing responses to the financial crisis and understanding and undertaking initiatives to improve consumer protection and disclosure. Randy will facilitate today's conversation with a terrific group. Lars Peter Hansen is Nobel Laureate and is an internationally known leader in economic dynamics and indeed recipient of the 2013 Nobel prize in economic sciences. He currently serves as the David Rockefeller distinguished service professor in economics and statistics at Booth and at the college here at University of Chicago, is the research director of the Becker Friedman Institute for Economics and won the 2021 Michael J. Brennan Best Paper Award for joint research on pricing uncertainty induced by climate change. Look forward to diving into Professor Hanson's research in just a few moments. 

Caroline Grossman:
Sir Ronald Cohen is widely considered the father of impact investment and European venture capital and co-founded the global private equity firm, Apax Partners Worldwide and the impact finance and advisory nonprofit, Social Finance, in the United Kingdom, United States, and Israel. Sir Ronnie currently serves as chairman of the Global Steering Group for Impact Investment, the Impact-Weighted Accounts Initiative at Harvard Business School, and the Portland Trust. And his book, Impact Reshaping Capitalism to Drive Real Change, is not only on my bookshelf, but so a Wall Street Journal bestseller. And finally, Mili Fomicov is a Booth alumna like myself and our researcher at the Center for Climate Finance and Investment at the Imperial College. London is the academic director for the corporate renewable procurement program at the Grantham Institute at Imperial College and was previously director and portfolio manager of multi-asset strategies at BlackRock, also has been at J.P. Morgan, Barclays, AllianceBernstein, and is a member of the Spark Change Advisory board and a climate strategist as well. So welcome to all of you. And at this point, Randy, I'll hand it over to you so we can dive in. 

Randall Kroszner:
All right. Thank you so much, Caroline. This is very exciting for me because this is our second installment of the Future of Capitalism. I think a really interesting and exciting series to get at the most fundamental issues facing us today. And obviously, the climate challenge is one of those. And I think one of the key things that our approach at Booth is very helpful with is really how to think about problems, and so trying to come up with a very clear systematic framework for thinking through the most important issues of the day, social responsibility, ESG, climate, and then using that framework to try to clarify issues and also to try to specify what are the key and right questions that we need to address. And then that allows us to have a way of thinking about what are the data that we need in order to be able to answer those questions, whether it's private sector investment, whether it's government investment, whether it's policy. And I think today's panelists are just perfect for trying to get at that set of issues, really thinking about the right way to think about things, specifying questions, and then how to get the best data to try to actually answer those questions. 

Randall Kroszner:
And so what I'm going to do is first start off with a discussion with Lars, some of the incredible work that he has done on thinking about one of these most pressing issues, because of course there's an enormous amount of uncertainty when it comes to climate models. That's true of all types of modeling. Whenever we're thinking about the future, there's always a lot of uncertainty involved, and we always have to be a bit humble because we can never know the future with certainty. We can try to estimate it as well as we can, but in doing policy and making practical decisions on investment, we need to be aware of what we know and what we don't know. And so, Lars, if I could turn to you first and get your perspective on what are some of the key issues that you see in climate economics that pose these uncertainty challenges? Where are the key issues of uncertainty I climates economics? If you could unmute yourself please. 

Lars Peter Hansen:
Thank you, Randy. Thank you for this opportunity to share ideas, and I look forward to learning from other panelists as well. So of course, I'm all in that climate change is a very important problem, one that's very challenging as we go forward. For the type of research that I do, it has to do with trying to figure out how to confront uncertainty in kind of sensible ways. And so a starting point is the fact that from policy standpoints, policy makers tend to want to project conclusions with great confidence, and scientific evidence doesn't always bear that. And how do we be true to the scientific evidence and still come up with sensible policies? And I believe there's ways to do that. I think economics has had a lot to say about that. There's literature on so-called decision theory that confront those type of questions. 

Lars Peter Hansen:
And so a concern, I think, of policy makers is kind of once you announce, "Well, we don't really fully understand things," then the next conclusion we jump to is therefore we don't do anything. But like in the case of climate change, that could be delaying can make it bigger and costly to make changes in the future. And it maybe lower costs to adjust now, even to make adjustments now in the presence of uncertainty, rather than to delay until we're fully confident that we understand the full and passive climate change. So that's the type of trade-offs, which I'm trying to wrestle with in terms of thinking about policy challenges. Now, the uncertainties? So let me start, that show up in our work is, one, we're interested in emissions and how they translate into environmental changes like temperature changes. 

Lars Peter Hansen:
So there's lots of climate science evidence that documents human imprint on the environment, but once you try to quantify that, there's where the uncertainty show up. Emissions, as you try to trace through its impact on temperature over 10, 20, and up to 100 years, there's substantial uncertainty as to what that impact's going to be. Now you factor on things, like so-called tipping points. So there's conjectures, although you cross certain thresholds of temperature or other environmental indicators, more dramatic things will happen. It'll spill over to even more dramatic consequences for the climate system. Those are possibilities. Those type of non-linearities or threshold effects are possibilities, but to quantify, and meaningfully, is challenging. And so how do we do that? The other piece is so-called damages, economic damages. So once we do damage to the environment, then we come back and start asking as economists what are the economic consequences of that? Because people will adapt. There will be modifications. How do we really measure those potential damages? 

Lars Peter Hansen:
And there frankly might be the biggest source of uncertainty in the sense of there's lots of speculation about that, but there's not any kind of really hard quantification. And the challenge for that is we love evidence, but we're really talking about moving world economies into places they haven't really experienced historically. So it's not as if we turn to evidence and it just magically addresses this question. We have to think about it kind of conceptually, economically and make smart guesses about the natures of the uncertainties here. And these components of uncertainties actually interact in very important ways. [inaudible 00:12:31] easily separable or [inaudible 00:12:33]. It's very important to think about them simultaneously rather than distinctly. 

Randall Kroszner:
And so how do you think about some of these trade-offs that you're talking about? Because obviously there's a strong desire to act, but we have a lot of uncertainty. And so how do you use the framework of decision-making uncertainty to think about these kinds of trade-offs? 

Lars Peter Hansen:
Yeah. So in some of our calculations which we've done, which are a bit illustrative to this point, and we're working on making it more ambitious, imagine you've got the following. You've got a world in which we're not sure about the damages, but once we start damaging the economy, in the future, then it might become kind of all the more evident. So it's a trade-off here. We could say well, we could wait until we learn about that damage curvature. It may be very, very steep consequences. There may be good news. Maybe they're not as dramatic as we feared. So our type of analysis, we want to go through and confront those type of trade-offs. And so we do the calculations, like so-called social cost of carbon. So what's the social cost of carbon? From people with an asset pricing perspective, a social cost of carbon is just like an asset which you value with the dividend stream. 

Lars Peter Hansen:
There's emissions that go into the atmosphere. It has social consequences, tomorrow, the next day, and kind of way off in the future. How do we then produce that into kind of meaningful measures of things like the social cost of carbon? And then to figure out what are sensible emissions policies that might progress from that? And so you get this trade-off whereby you're initially cautious. Then down the road, you learn more because of the so-called damages done to the economy. And then at that point in time, you will continue with a caution, or on a small number of circumstances you might actually decide to be more bold because oh, climate change damage wasn't quite as bad as I thought it was. But those are the type of trade-offs which we're trying to confront here. 

Lars Peter Hansen:
And what's really important in the work that we do is the fact that you think about these outside the usual risk framework that we're often taught in economics classes. What's risk? So when we think about risk and we do risk analysis, those are situations in which we know probabilities, but we don't know outcomes. Coin flips, roll of the dice, and the like. And if only uncertainties were that simple. If only they were that... But they're not. I mean, we live in a complex environment. So the first question has to do with what is the right conceptualization? What is the right model? What is the right view of the world going forward? There's uncertainties about that. And certainly work in statistics has been designed to address some of those, but for a decision-maker, those are not going to be fully resolved. And so how do you do the appropriate sensitivity analysis to kind of confront those? 

Lars Peter Hansen:
And then the models we use, our view of the worlds are simplified. That's the only way we understand models through some form of conceptualization, simplification, but the world's complex. We need simplified lenses to look through them. How do we take those simple lenses and use them in sensible ways when you know there's simplifications at the end of the day? So our work is important. I think about uncertainty much broader than this kind of risk notion that shows up in our analysis of risk aversion and risk prices and the like. It's important to conceptualize the uncertainties in this more general framework. And for things like pandemics, for things like climate change, I think these type of issues have become very important. 

Randall Kroszner:
I think that's really important to separate that out. And there's a long tradition, of course, at University of Chicago because some of these ambiguities are sometimes put on the heading of Knightian uncertainty. So Frank Knight, who was a University of Chicago economist in the early part of the 20th century, really tried to differentiate between traditional risk where you can kind of easily calculate out the role of the dice, you know exactly what the probabilities are, and things where you're not really quite sure. There's a lot of uncertainty that goes beyond just simple risk measures. 

Lars Peter Hansen:
Yeah, Knight, in fact, book is very interesting in that regard. He's very good at identifying the problem, but when it comes to thinking through how to approach it, there the book kind of struggles. But we're talking about a book that was written like almost a century ago. And it's interesting at the same time Knight was wrestling with those questions, in some sense, Keynes was as well. It was not just Knight. It was Knight and Keynes in some sense, but, yeah, thinking about it in kind of different ways, this notion that we really need to confront uncertainty in broader terms. So yes, Knight's a great motivator there, for sure. Absolutely. So, thank you for bringing that up. 

Randall Kroszner:
Sure. And so what are some of the results? I mean, getting to exactly that, because we want to try to get to sort of practical implications. So how do you then think about that? What are some of your findings of how you deal with this uncertainty? 

Lars Peter Hansen:
Yeah. So there's this very interesting trade-off that comes up here. And I kind of saw this play out in real time over pandemics. Of course, the pandemic's modeling and implications played out in a much faster time scale than climate change, but you would see these model predictions that would come out. And model predictions sometimes give you best guesses. So here's my model. Here's what I think is going to happen. But models also can tell you adverse things that could happen. And sometimes of when people use models, they're not clear about how they're using them. Are they using them to give you the best guess about what's going to happen? Or are they using them to give you a warning about what adverse things could happen? And the key trade-off here is how you trade that off between your best guesses of the future versus your concerns about what bad might happen going forward. And so that's where, again, decision theory kind of offers nice conceptualizations for this. 

Lars Peter Hansen:
Now, as an economist, I can't tell policy makers how adverse they ought be to these bad outcomes [crosstalk 00:19:02] really help them understand that trade-off between best guesses and possible bad outcomes. But how adverse society should be to certain or how averse businesses should be to one certainly, of course, has to do with business making preferences or policy maker preferences. 

Randall Kroszner:
And so, let's say... Because I think that's exactly right. I mean, we have elected official in some sense to make these social choice trade-offs. How important are certain things? Where should resources be allocated? But let's say that the political process has given you those sorts of social choices. But then how do you help the policy maker to kind of think through these issues and dealing with that? So [inaudible 00:19:57] where we have a certain amount of risk aversion, but then what do we do about that and then turn that into policy choices? 

Lars Peter Hansen:
Yeah. So the way that type of calculations or approaches work... I would love to have some whiteboard and produce a lot of beautiful, elegant mathematics, but I will spare you of that for today. But there's ways to think about this into terms of when you're looking about these uncertainties, you use the models and the calculations to figure out what you're potentially guarding against. So we can tell you about how as you change certain aversions, here's really what's concerning you at the end of the day. Here's the thing which [inaudible 00:20:54] the outcome of the scenarios that are of biggest concern to you. And so those can reveal, and then you can kind of inspect those and say wow, should I be worried about this or not? And so you can start asking from these methods, kind of what leads to the biggest concern of the decision-maker. So imagine you've got uncertainties of a whole bunch of complexity, dimensions, and the like. Our aim is to reduce that down into something very, very small scale, but the ones here are the most troubling ones. And that's an issue, about how much do you want to be concerned about those? So the type of methods and calculations we do are all about that type of reduction. 

Randall Kroszner:
I see. And I think that's really, really valuable. Just some thoughts on what some of those dimensions are, whether it's the time scale issues, or whether it's sort of broader risk issues of interactions between climate and financial risk, do you have a thought on what you would focus on? What are the issues that you tell the policy makers to focus on? 

Lars Peter Hansen:
Yeah, So yeah, that's obviously a very important question. In my own research, we focus much more on the fundamental uncertainties that are out there, and this in terms of all the way for potential new technologies to help us out, to cross the environmental threshold and the like. There's other forms of uncertainty. And I think about this in the context of central bank policy too, since central banks are concerned about issues on climate change, which I'm happy to talk more about subsequently. But one of the things that firms have to face is unfortunately, policy uncertainty. So when it comes to climate change, yes, things like weather patterns are important, but for the private sector, unfortunately, they're having to speculate what policy changes will be coming down the road. And so sometimes I think central banks are stuck in this position, worried about the types of uncertainties that are potentially induced elsewhere by governmental activities, which is something I think they don't like to talk about, but to some extent, that's what some of their institutions that they're regulating are based on. And so both these transitional issues as well as policy uncertainty are things which are very important to both private sector and to central bank policy. 

Randall Kroszner:
Great. And so in some sense, what would you say is sort of your bottom line? An audience question had come in in advance, and this may be a little bit unfair. If you want to defer, that's perfectly fine. But to kind bring this into sort of practice, one of the questions was, "if you were advising a policy maker on how to allocate, let's say a very large sum of money, let's say up to $1 billion a year related to the climate, where would you focus it?" 

Lars Peter Hansen:
Yeah. So I guess there's two places that would come to mind. And right now we're trying to figure out trade-offs between such alternative policies. One is how much social investment we want to make in developing new green technologies. And then of course, as you know, once the governments get involved, they can take resources allocated for this purpose and kind of start re-shifting in kind of an unproductive direction. So as we want to think about allocating resources towards R&D developing new green technologies, we also have to do this in a way in which we have sensible decision-makers making the call on what are the more productive type of investments to be made there. I'm always nervous when we make government officials the green social venture capitalists here. But then sometimes I think putting resources into green venture capitalism can be very valuable. 

Lars Peter Hansen:
And then I do think making policies that change people's incentives, like taxation policies connected to carbon emissions, can be important. Now, as we know, there's very, very big political issues that show up. We saw [inaudible 00:25:14] various different protests, once we started putting in various gasoline taxes and the like. At the same time, we want to think about things like carbon taxation. You have to think about what you're going to do with the revenues, and you have to think about what the distributional consequences are of things. It's not just like putting a carbon tax out there. It's important what you do with the revenues and how you make sure the burdens of the tax are shared appropriately. So those are the two type of activities that I find potentially most useful. 

Randall Kroszner:
Great. I think that's really helpful. Mili. I want to turn to you next because you've done a lot of work on thinking about the allocation of capital and what the implications of all of this uncertainty are for strategic capital allocation. And Lars had made reference to that. So maybe you could talk about a little bit of your work there, and if you're giving advice to people, thinking about how to best allocate capital. So in some sense, it's a variation on that question that came in from the audience of how you would allocate the $1 billion a year. What sort of answer would you give? What framework would you use? And how would you approach that? 

Mili Fomicov:
Well, Randy, and it was really good to hear from Lars how we can actually make uncertainty more discreet. And most models are currently not incorporating uncertainty, but there is a lot of uncertainty around the climate system, the emission system, and then the feedback from the emission system. And then there is uncertainty around the actions the different economic agents are willing to take when it comes to carbon pricing, climate policies, and different responses. And as an investor, you really need to think about certain implications on different macroeconomic variables, such as GDP, rate, inflation, but it will be path dependent. A two-degree scenario could lead to a radically different growth or decline rates. And some institutions are forecasting, for example, that [inaudible 00:27:24] beneficiary. And some are showing that we will see 3% to 4% GDP decline. And there's just so much variability. Also when it comes to carbon pricing, carbon pricing can have inflationary or deflationary effect, depending on different responses. 

Mili Fomicov:
So how should we really deal with this uncertainty as investors and asset allocators? Well, capital market assumptions that most investors really use when they think about their strategic allocation, they really rely on a single scenario. And you have to be very explicit about your assumptions and then take a very deterministic view. And a lot of practitioners are really not incorporating model and parameter uncertainty, which Lars just talked about, and at least not explicitly. They can think about it, but it's not currently really incorporated. And a lot of them are now trying to model the climate risks and opportunities by simply adjusting returns in volatility expectations by simply stressing certain macro variables. And we just mentioned how we can see such significant divergences, and that can go really wrong if you just approach it in a very linear way, as Lars was mentioning. 

Mili Fomicov:
So climate financial scenarios now really must provide an interface between transition scenarios and financial risk models. So we really need to think about expanding the [inaudible 00:28:53]. And this may sound daunting, but you can use built-in scenarios from their national energy agency, from NGFS, from SSP. There are quite a few, and they could be imported into different financial risk models to really be a lot more comprehensive. And then investors can choose between different scenarios and select pathways that can align with their own implementation capabilities if you're a long haul investor, long-short, or if you have different liquidity constraints. And what we would allocate is that you really think about combining both top down and bottom up approaches. And we just mentioned some top down scenarios. And also regarding bottom up techniques, we can expand our cashflow modeling to look at physical and transition risks and to also do sensitivity analysis, not just related to your cash flows, but also you can do that sensitivity for each line item below the operating line. 

Mili Fomicov:
And that is a lot more comprehensive. And then it can build your distributions and simulate different states of the world and incorporate that into your risk model. And we provide training to different investment managers. We actually frequently talk about Lars' work and to really formalize that uncertainty and to be a lot more comprehensive. And then finally, diversification becomes even more important. An investor can expand their toolkit and investing now new asset classes that are part of the solution so we can avoid large asset impairments. For example, carbon markets, and I'm talking about regulated carbon markets, not offsets. Given, there is a lot of uncertainty around carbon pricing, you can own carbon analysis and then potentially mitigate some of the losses that you could be incurring because your cause base will be increasing if [inaudible 00:30:45]. And this is also a great tool to achieve climate goals. You can also invest in adaptation and mitigation, nature-based solutions, renewable infrastructure in emerging markets and different assets classes really to really expand your toolkit and think more broadly out certain assets that were not considered asset classes before, they were not investible before. And that way, you're really investing in climate solutions and turning some risks into opportunities and diversifying in this really radically uncertain world. 

Randall Kroszner:
Great. I think that's very helpful in sort of translating this into a framework for practical investment. And Sir Ronnie, I wanted to bring you in now because you have done so much work on trying to get that data together and to think about how do we measure these issues of impact? Because of course, we can't translate the framework that Lars and and Mili were talking about into something practical without data. So how have you thought about that? What kind of filters have you used? How have you approached the issue of getting data about impact? 

Ronald Cohen:
So, first of all, let me say, Randy, this is a really great pleasure to exchange views with the you, with Lars, with Mili, with Caroline, and with everybody from the University of Chicago. And University of Chicago is the university I owe a great debt to, because most people don't realize that the existence of venture capital, where I made my career, really came from the measurement of risk. And the measurement of risk was of course in the 50s the area where Chicago brought this massive contribution, which brought the concept of risk adjusted returns, the concept of diversification, changed investment portfolios to include venture capital and private equity, and investment in emerging markets. So you could argue that the measurement of risk, which the University of Chicago brought to the world, funded the tech revolution and globalization. 

Ronald Cohen:
I see the same thing with regard to impact. The measurement of impact today is the tool which is going to shift our whole economies from risk return to risk return and impact. And there are three major forces that are driving us there. And I'm going to answer your question directly about climate and the work we've been doing in it. But I think it's important for us all to realize that there are three major forces acting in the world to improve it today. The first is a massive change of values, where young people, like many on this webinar, refuse to purchase the products of certain companies, refuse to work for them, and this has become perceived by a wider population and hasn't been lost on the investors who are now channeling $40 trillion plus of ESG investment to achieve impact as well as profit. So this is massive. This is half of all professionally managed assets in asset management firms. It's not the passing thing. 

Ronald Cohen:
The second massive change occurring to improve the world is leaps in technology. When you look at what artificial intelligence, machine learning, augmented reality, the genome and computing coming together, blockchain do, they effectively enable us to deliver impact globally in ways that humanity could never previously contemplate. And the third major force is that this technology enables us today to measure in a granular way, thanks to big computing power and the availability of big data, the impacts that companies create on the climate, on the planet, and on people. Now, it occurred to me a few years ago that if we don't have reliable data that businesses and investors can use in their decision-making, then we are not going to achieve the goal of shifting our economists to risk return impact. And so I hope to initiate an effort at Harvard Business School called the Impact-weighted Accounts Initiative. And it gives us a peep into the future. We published the climate impact of 3000 public companies across the world in monetary terms, using the metrics that have been around, that Lars has been looking at in all of his work, and that Millie has been working with, and we have applied monetization paths to these metrics. 

Ronald Cohen:
And here are the insights that you get. Out of these 3000 companies, 450 deliver more environmental damage in a year than they do profit. A thousand deliver environmental damage equivalent to a quarter or more of their profits. Together they deliver $4 trillion worth of environmental damage in a single year. And most interestingly, and this is a very deep insight, which explains why, as Caroline was saying in the green room, many people, including students at Booth, feel that impact accounting is a foregone conclusion. And the insight is this, within many sectors, you now see a correlation between higher pollution and lower stock market values. So the weight of ESG money is affecting the valuations of companies. And so regulators are, not surprisingly, focusing on impact transparency. IOSCO, which groups the world's regulators together, is pushing hard for climate transparency. IFRS, which is responsible for all accounting across the world, is hopefully going to announce the establishment of a sustainable accounting standards board, moving us in the direction of generally accepted impact principles and so on. 

Ronald Cohen:
So the crucial step that we need to take now is for governments to mandate impact transparency, which I believe is going to be similar to GAAP. It's going to be GAAP, generally except impact principles, and it's going to parallel what the Roosevelt administration did in 1933 and '34 when investors realized that they had no transparency on profit because there were no accepted accounting principles. There were no auditors. Companies could put a share of their profit into hidden reserves without telling shareholders. And today we are at similar crossroads. 40 trillion is going to achieve impact with no transparency on impact. 

Randall Kroszner:
That's very interesting. And I think in some sense, I mean, another way of thinking about what you're doing with risk return and impact is effectively trying to suss out what is the externality? And what is the external impact? So rather than something narrowly just looking at the traditional calculations of profit and loss, but we know that there could be externalities from activities. And so producing carbon, that can have impact on the environment and other sorts of impacts. And so actually, I want to first come back to Lars to think about that, because in some of your work on uncertainty, you've thought about this issue of trying to encompass the externalities. So how do you see what Ronnie just spoke about as being a way to be helpful in trying to address some of the issues that you have raised? And then Mili, I want to come back to you, because Ronnie also mentioned something very interesting about the market impacts. And I know that you've done some very interesting work on how the markets seem to be repricing based on these externalities, based on these impacts. But first Lars, let's think about kind of the theoretical framework, thinking about the externalities, and then, Mili, kind of the practical, how is this affecting asset prices?

Lars Peter Hansen:
Yeah, so the work that I've been doing has been focused more on the so-called social cost of carbon. It used to be that the pre-Trump, the EPA, would post these numbers about the social cost of carbon on their website, which was supposed to be used in policy making purposes. During the Trump administration, they got pulled down. Now they're being put back up again. It's pretty frustrating to open the hood of how those numbers are produced. Yes, it looks impressive superficially, but once you open the hood on it, you can start seeing a fair bit of skepticism there in terms of their construction. And in many cases, they were kind of rushed to put numbers out there for regulatory purposes that I think are almost counterproductive. At one point in time, when I was thinking about writing a paper about will you tell me what the social cost of carbon number is? And I can manufacture the way to get it. So we're still figuring out good ways to do this reliably for uncertainty. And most of those measurements really treated uncertainty in very, very casual and pretty much sloppy ways.

Lars Peter Hansen:
So I do think this kind of going from data to useful quantifications is an important task. I think we've got a ways to go. I think there's much stuff that we can do to improve it. And I get nervous when I see numbers posted on EPA webpages that are just not well thought out. So I hope going forward, we can put a lot more effort into thinking through how to do this in open and very actually appealing ways. And certainly, data richness is obviously very, very important going forward, and I'm a full believer in that data richness. I also think we have conceptualization issues, which are absolutely first order as well. And putting these things together to get meaningful notions of social cost, I think, are really important. In terms of private sector responses, so I'm all in favor of kind of getting better and richer data. And I think it's also important that we open the hood on how these social metrics are actually constructed.

Lars Peter Hansen:
The other thing I found really interested here is related to some of Mili's comments. She was talking about the naive use of scenarios, which I'm completely on board with. And this has been all the way over into central bank policy. They're putting out these deterministic climate, statically specified climate scenarios over 30 years and asking financial institutions to do something with them. The type of scenarios, as Mili indicated, it's really important to take those static notion scenarios and make them dynamic and in some sense probabilistic. And this shows up in social cost of carbon measurements. People use scenarios quite a bit there as well. And they'll put on mission scenarios. And the example I like to think of is think about in a mission scenario going forward. Suppose we're uncertain about the damages going forward. The plausibility of that scenario is going to depend on the amount of damages which we incur in the future, because [inaudible 00:43:50] policy responses. So we have to think about this dynamically. I think about plausible scenarios without simultaneously thinking about how information's going to be revealed about them in the future and at least thinking about them in kind of probabilistic terms. So thinking about it dynamically and probabilistically, I think, is really important and is critical, not only for private sector decision-making, but also for social decision-making to go beyond the deterministic scenarios.

Randall Kroszner:
Yeah. I think that's super important. And it's super important to have the best data possible. And that's why I think Sir Ronnie's approach of trying to sort of do it from the bottom up of company by company seems to be something that is valuable. And I know that the Rustandy Center is working with Harvard and also working with Wharton on trying to get these kinds of measures together. And we can't make good decisions unless we have good data. But, Mili, and I want to come to you, again, building off of what Sir Ronnie was talking about, the markets' pricing in the different climate scenarios, how are they taking into account these externalities, if they are?

Mili Fomicov:
Of course, and the market already started to reprice quite substantially. And the National Energy Agency and I are now working on four reports, looking at the power sector and really how that is repricing based on certain climate variables and macroeconomic variables. And the market really started repricing something that is a little bit more obvious. Renewables have significantly outperformed fossil fuels in the last five years, in the last 10 years, even during certain periods when their fundamental metrics were not really favorable. So when we looked at different credit conditions and different factors that influenced their performance, very frequently we were quite surprised by their response function. And also they have showed a striking degree of resilience during the pandemic, despite the fact they're lower market cap, high leverage, low profitability. And everyone who worked on this report was really surprised by this response because their standard attributes simply would not warrant the kind of behavior. So there is this significant repricing based on some forward looking expectations that they will have to grow three to four times in line with some recommendations.

Mili Fomicov:
And I really like how Sir Ronnie mentioned this third dimension of returns, which is impact. Some of that could be explained. This out-performance that is not linked to standard asset pricing attributes that we know, that we understand, risk returns and all, factor decomposition, that our performance could be driven by this impact factor and this need for them to grow substantially. That is when it comes to the power sector. And also, the market is not just repricing fossil fuels and renewables, but it's also now starting to price certain externalities. And certain companies within, let's say utilities or chemicals, they're already seeing really significant dispersion between companies within different sectors that are not your obvious beneficiaries from the energy transition. You're seeing that dispersion that is also linked to certain externalities. And also within certain sectors, such as utilities. NextEra used utility. Now is about four times the [inaudible 00:47:25] just a year or so ago. So you're seeing also within sectors that really huge dispersion in terms of the role they play and also certain externalities that are associated with their operations. And the market is also telling us that decarbonizing doesn't have to be a negative [inaudible 00:47:43]. And this impact dimension that, I fully agree with Sir Ronnie, that is becoming even more critical, and it seems that the market is repricing based on that dimension as well.

Randall Kroszner:
Well, that's very interesting because the usual concern, and the standard issue with externalities is the market typically doesn't price them and that you need to have intervention in order to get the pricing right, because the markets will ignore those externalities. It's very interesting the research that you're doing that suggests that, at least to some extent... I don't want to say by any means perfectly because, as we were just discussing, there's a lot of uncertainty about the extent of these externalities... some of that does seem to be coming into market pricing. There's an interesting question that came... I mean, we've got a lot of interesting questions to come in about potential tension between Sir Ronnie's approach and Lars' approach. And so I'll read parts of the question. When one prepares the traditional GAAP accounting statements, isn't there a lot of uncertainty about labor costs, capital expenditures, and traditional issues of depreciation. And so do you see greater uncertainties or similar uncertainties of trying to think about the broader impact issues? Because of course, there's a lot of imprecision in traditional accounting also. So I don't know, Sir Ronnie, Lars. Sir, Ronnie, maybe you start.

Ronald Cohen:
Yeah. No, I'd love to jump in there, and you're absolutely right. We make judgments all the time on the sorts of issues that you've mentioned. The revenue recognition for software companies is another major area, recognition of the value of leases. And an accounting system is a living organism, and there are changes to accounting rules on a monthly basis. And the same is going to be true of impact accounting principles. Now, we've tried to make some assumptions about costs. The cost of carbon that we've used last, for example, in the calculations that I mentioned is $300 [inaudible 00:50:08]. We're not saying this is the right price. We're simply saying look, based on what we've read, we think this is a defensible price. We need to get an intelligent group of people around the table, as we did when we defined the initial GAAP principles, and agree what the price should be.

Ronald Cohen:
And so the process of establishing GAAP is one of beginning to agree what are the right metrics? What are the right parts to monetization? And it's not going to be 100% perfect, and we shouldn't expect more of impact accounting than we do financial accounting, where people are asking, "Can we measure every single type of impact?" And the answer is no. We can measure, though, the crucial ones. Certainly where climate and diversity are concerned, gender equality, differences in pay, and so on, we can do that. So we have a robust approach, in my view, but we need consistency of data. We need consistency of data, and only governments can mandate that.

Randall Kroszner:
Lars, what are your thoughts?

Lars Peter Hansen:
Sure. So I'm certainly all in about the data part of this. I think that's absolutely critical. It's vital going forward. The thing I want to emphasize, again, is this, translating data into social values, I think, is a very important thing to be doing. And when I'm talking about the difficulties in doing that, I don't mean to say we therefore shouldn't it. But to my taste, there's not been a whole lot of transparency in the conceptualizations and modeling aspects of it, which I know from my own calculations can be very highly sensitive to how you want to conceptualize this stuff. So the openness has to be more than just on the data side, but how we map that data in the meaningful measures in terms of social valuations. So I think that's a very important task. I'm all in that we should be having important conversations about that. I just want to make it clear that that's hardly something that's a settled issue now within the context of climate change. And so I look forward to having further conversations about this very important topic. But the transparency that I think is also important is how we map from data into social values.

Randall Kroszner:
One of the questions that had come in earlier was thinking about the incentives. How do we get the right incentives for getting the right disclosure and then using that in a systematic way to get to good policy outcomes? Who wants to jump in on that?

Ronald Cohen:
Well, perhaps I can jump in, Randy. It seems to me when you get this sort of transparency on impacts, you shift to a fair attack system. We're already beginning to talk of the carbon tax, as Lars has been saying, based on cost of carbon, but we will be able to do that for other social issues like diversity and so on if governments choose to do that. So one incentive can be taxation, but I actually think that transparency provides a massive incentive if indeed there's a correlation between impact performance and company valuation, as Mili was illustrating. So the transparency itself will create a race to the top.

Randall Kroszner:
Mili or Lars, do you want to hop in?

Mili Fomicov:
[crosstalk 00:54:01]. I'm sorry.

Lars Peter Hansen:
Go ahead. Go ahead, Mili.

Mili Fomicov:
Thank you. Transparency, and actually we wrote a paper about this, that transparency would provide proper benchmarking, and not just more data, but very consistent data. And no firm wants to be the dirtiest on the block. And when you have very consistent metrics across sectors and then create a proper benchmarking, that competition, the role competition can be extremely powerful. And one of the things that we are advising is actually every company needs to show their breakdown of capital expenditures, and all matches are relevant for each specific sector. And then the market will price you accordingly. And I think the role of transparency competition can be extremely powerful.

Randall Kroszner:
Lars?

Lars Peter Hansen:
Yeah, I'm not sure I have a whole lot more to add. I certainly agree that transparency can open the door to better tax systems, for sure. And we're still struggling with how to make carbon taxes implemented in ways that could be politically feasible, and it's quite possible that transparency can help us to achieve that aim. So on that I would be all in.

Randall Kroszner:
We had some questions that came in about cap and trade. Do you think that's the most effective way to try to deal with these issues? Anyone want to jump in on that?

Lars Peter Hansen:
So, Randy, yeah, part of, I think, where cap and trade becomes interesting as an alternative straight tax is once we start looking across countries and the like, putting a uniform tax across countries without some type of reallocation on so-called property rights becomes very problematic. And so maybe we start thinking about more like cap and trade systems as we start looking across various different regions of the world, I think it's a tremendously challenging problem how we coordinate policies across countries. And there I think cap and trade becomes interesting to add to the conversation.

Randall Kroszner:
Mili or Sir Ronnie, do you want to chime in?

Ronald Cohen:
I don't have anything to add, I'm afraid, Randy.

Randall Kroszner:
[crosstalk 00:56:18]. And related to that... Oh, I'm sorry. Mili.

Mili Fomicov:
No, no, I fully agree with Lars.

Randall Kroszner:
And related to this issue, we had a number of questions come in about emerging markets versus developed countries. And how do you get the incentives right across the globe? Because Sir Ronnie, I assume most of your focus is probably on developed country companies. And so how do we expand this? How do we get the issues that Lars was talking about right to sort of get something that encompasses the whole globe? Because there are many emerging market countries, so a country like China, which is an enormous emitter of CO2, and without getting a country like China on board, a lot of the other work that's done may not have that much of an impact. But getting a country like China and many emerging markets on board would be really important. Sir Ronnie-

Ronald Cohen:
[crosstalk 00:57:18]. So it's really amazing to see how financial markets are allied in bringing these changes about. I don't know how many people on this webinar are aware that there's now one half trillion dollars of green social and sustainable bonds in the world. But within that pool of one half trillion, 10% are sustainability linked bonds where your rate of interest as a corporate borrower falls if you achieve certain social or environmental objectives. So Novartis, for example... And this begins to answer your question directly on emerging markets... issued a 1.8 billion euro sustainability link bond where its rate of interest falls if a certain percentage of its sales reach vulnerable populations. That could be in emerging markets or in developed countries. Similarly, Enel, the Italian utility, has issued 7 billion euros worth of sustainability linked bonds where its rate of interest falls if it achieves certain environmental targets. So I think these pay for success bonds are ways of actually using impact to guide capital to emerging markets. And when you begin to have the transparency we're talking about, investors can reward companies whose sales and investments are growing in emerging markets versus those that are only serving well-off populations in developed countries, for example.

Randall Kroszner:
Mili or Lars?

Mili Fomicov:
Sure. I think this is such an important topic, really. And if you look at all, not just government, but also corporate flows, and all corporate really flows are extremely concentrated in develop markets. Even if you look at some sectors that are part of the solutions, such as renewable energy, we have built our portfolios that include emerging and frontier markets. And then when we looked at actually capital flows that are going, they're just really concentrated and invested into 20 to 30 companies, and none of them are in emerging markets. And I really do think that investors now need to think about how they're channeling their flows more holistically. And I totally understand that you're dealing with some FX risk that are not used to, that is difficult to hedge, but that investment is required. And I think the investors need to have a slightly different mindset and be more open-minded about different kind of risk forms and managing them and to still channel capital towards certain areas that really need it desperately and that are going to be a part of the solution.

Mili Fomicov:
And actually, the National Energy Agency and I are just now working on our renewable infrastructure reporting in emerging markets. And we are really struggling to find enough projects to study, much less capital flows going in that direction. And that is going to be a topic of our next report. How do we really think about this universe and some capital flow constraints that both regulators and investors need to address?

Randall Kroszner:
Lars, did you want to chime in?

Lars Peter Hansen:
Only a little bit. Certainly, impact on capital flows can be important here, for sure. But I do think that China, India, and elsewhere, issues about climate change are very, very important ones. I mean, certainly, the developed economies have had their day in terms of [inaudible 01:01:11] and leading to environmental degradation. And so it doesn't put us in a great position with some of these developing countries in terms of getting them to initiate important policies to address climate change. So I think it's an important challenge going forward as to how we as a world help to provide good incentives for developing countries.

Randall Kroszner:
Excellent. I think that's a great way to end. We're just a few minutes past the top of the hour. I think it's been a super great discussion. I mean, it got at, I think, the key issues of how do we think conceptually about this very important issue that has a lot of uncertainty around it? What does that mean for policy? What does that mean for practical investment choices? What does that mean for data collection? So I think it's very interesting to see how we seem to have a change from the tradition of the way people think about markets, is not pricing externalities, and some of the work that Mili has done to suggest that they are, and consistent with what Sir Ronnie is saying, that these are important issues where people are going to be disclosing around them, and it is going to have an impact on the returns for investors, on the cost of capital.

Randall Kroszner:
And so it's a very, very interesting set of both conceptual and empirical issues. And I think we've made a lot of progress. And I really, really appreciate the contributions from Lars, Mili, Sir Ronnie, on both the research work you've done, the practical work that you are doing. And obviously there's a lot more to be done. And hopefully, we will have some of these ideas that you're talking about be integrated into the [inaudible 01:03:02] 26 that is coming up next week. So thank you very much. And thank you all for the amazing questions that you sent in in advance and during the session. I could only get to a small fraction of them, but it shows the high level of engagement on these super important issues. Thanks so much. Bye-bye.

Ronald Cohen:
Thank you, Randy.

Mili Fomicov:
Thank you.

Ronald Cohen:
Bye, everyone.