 Please welcome our guest speaker today, Dr. Mark Rosen. Mark is a research fellow at this Taylor Taylor Center for Energy Policy and Finance. His research focuses on climate risk and investment portfolio management, and he has 20 plus years of professional experience in the asset management industry. So I am very excited to hear his talk today, which is on the cost of the hedging climate risks. Without further ado, Mark, please take the stage. Great. Thanks, Soyoung. I'm very excited to be giving this talk. The title, how much does it cost to hedge climate risk? I guess what you should think about is this is basically a bait and switch, which for those of you who are thinking about going into the asset management business, you should get used to that. You need to learn this early that asset managers promise things that they don't deliver on. More seriously, when I first began to investigate sustainable investing, I was struck by the performance focus, and I was motivated. The motivation for what I'm working on is a question that came up to me was, should sustainable investing outperform? To a large degree, asset managers seek to convince asset owners that doing good means they will do better in their investment portfolios, but it's not completely clear that that's true. We would like investors and managers who do good to have greater success, and we'd like those who choose to continue to do harm, to do poorly. However, that's not really true, and it's probably wrong. We can hope it's true, but basically, if you start from the first premise and you say, okay, green buyers are going to bid up prices on green companies, and bidding up prices today reduces future returns. Similarly, if green investors choose to sell their dirty assets, they push down prices, and the result is that they raise prospective returns. That's reasonably easy to see, but in fact, it gets somewhat more complicated. Some of you may be familiar with the concept of integrated assessment models. What these models attempt to do is work out the core dynamics of decision-making, investment, and climate feedback loops in a fully developed economic system. We know these models aren't true, but we still try to produce them anyway, and the fact is, depending on how you lay out the dynamics of these models, you can end up with economies where more climate-friendly investments perform better or perform worse. It's just a construct of the model, and we can't really necessarily test these models particularly well. The other concern I had going into this research exercise is that traditional performance-driven sustainable, traditional performance to drive sustainable investing may actually fail, like most investment strategies have periods when they do well and when they do poorly, and it seems to me it's not particularly helpful if we encourage people to make sustainable investments simply as a, you know, don't worry, this is going to outperform exercise. So what I'm trying to do is refocus the story on the idea that sustainable investing should succeed as a risk management tool, even if it doesn't necessarily succeed in short-run performance. So let's turn back to our core question, how much does it cost to hedge climate risk? Well, we have to answer three questions to work our way to an answer to this question. The first one is what does climate risk mean in this context? I think we all have views as to what climate risk is, but I want to narrow this into some particular examples and we'll talk about that in a bit more detail. I want to understand, I want to make sure everyone understands what we mean by hedging when we're talking about hedging climate risk. And finally, we're going to walk through what to many of you who, you know, know a reasonable amount of finance might be just a little bit of an extension of how you think about portfolio construction, but this is going to help inform a discussion about how to think about the costs of what's going on in these attempts to hedge climate risk. So what do we mean by climate risk? Well, taking it very simply, greenhouse gas emissions raise temperatures increasing the risk to economy. Well, what risks increase? There are many different views here whether changes cause damages to agriculture rising sea levels lead to flooding. These are all sort of direct physical risks. There are transition risks around climate change that you may be aware of as the economy realigns in different ways. I think some of these transition risks are much more applicable to what we're talking about in investment and capital markets discussions. But in the simplest sense, economists will tell you, you know, taxing emissions solves everything. It's simple. It's straightforward. The story is about externalities. When we burn fossil fuels, we create greenhouse gases, and greenhouse gases get, you know, harm the aggregate economy and the aggregate world society, however you want to look at this. And there's no cost to the emitters. If we could tax, we could have solved that problem long ago. But basically, you know, the view today is either it's politically impossible or it's too late. It's really not going to matter. That's not a feasible way to solve these climate risks. In many regards, we're left with what people can refer to as the nth best solution. Basically, we're using policy and, you know, societal pressures of various sorts to raise the implicit price of greenhouse gases. The idea is if we can push up the explicit and implicit prices of greenhouse gases, we can shift in the direction of solving climate change. But you could easily see that this adds risk to the system. Because all of a sudden, we're dealing with policy risks, how investor sentiment can shift and impact the costs to different companies of, you know, working these costs through the system in this indirect way, rather than specifically through, you know, for example, carbon taxes. As a proxy for this risk, we have to come up with some measure of, you know, what's driving around this risk or what matters to different companies. You may have heard the term scope one and scope two emissions. Scope one emissions are the direct greenhouse gas emissions or carbon emissions from a company's operations. Scope two have to do with their purchase of energy inputs, of electricity inputs into their production. But basically, and parenthetically, there's also scope three, which is the carbon emissions in their supply chains. But for our purposes, we're going to focus on scope one and scope two emissions. And I guess I'm for convenience labeling this carbon intensity. This is carbon dioxide, tons of carbon dioxide per million dollars in sales for a company. This conveniently sort of normalizes to the idea, you know, we need something to normalize based on, you know, how big the company is, we can't necessarily use equity markets because it doesn't account for a capital structure correctly. Just think of this as just a simple and a reasonably simple and straightforward measure of what is the carbon involved in a particular risk facing a company for climate. So, you know, if I need to produce a lot of CO2 per million dollars of sales, then I have much higher risk to a implicit or explicit jump in the price of carbon than, you know, another company in another business that doesn't actually, you know, produce material greenhouse gases from their production processes. As I said, this is just one example of a proxy for risk. Later on, you know, we're going to walk through some reasonable detail using carbon intensity. But at the end, I'll make some comments about other types of risks that we could use instead of just carbon intensity. So the next question is what do we mean by hedging? Hedging in its sort of simplest form means offsetting some potential losses with opposite positions. So hedging often means giving up substantial potential gains to isolate some sort of risk. I also may amplify particular risks or uncertainties simply through my hedging exercise. So as an example, suppose I think Toyota will perform very well in the auto industry. I think the economy is strong, but I'm also concerned that the economy may turn. If I simply bought Toyota stock, I may be confident it will do well in a strong economy, and I may be confident that Toyota will outperform GM. So I could choose to say, well, I'm going to hedge my Toyota position by shorting GM. What I've done then is I've hedged my auto industry risk. I've probably hedged much of my sort of macroeconomic environment risk, and I've amplified my view that Toyota is going to outperform its peers because I've specifically said, you know, Toyota is going to outperform GM. But what I've also done is I've given up this tailwind of a strong economy where I just benefit, you know, when a rising tide lifts all boats. Hedging small risks and risks that are uncorrelated with bad states in the world are really cheap. So let me try to pick an example that should be near and dear to some of your hearts, at least. A Stanford student's renters insurance. That's simply you hedging your risk of loss. You're not hedging a bad state in the world except for possibly you and your family who think that's a really bad state in the world. You don't really have much stuff to lose. Your risk of a, you know, a break in isn't particularly correlated with the aggregate risk to the economy or the aggregate risks to an insurance company. So buying renters insurance when you're a college student is really cheap. Similarly, hedging the public equity exposure for small portfolios is not particularly expensive, even though that requires hedging a bad state of the world. Like hedging an equity portfolio means I want something that's going to pay off and in the event that the equity market drops significantly. It's a correlated hedge, but if you have a small portfolio, you can do that just fine. Things get different when we're dealing with large risks that are correlated with bad states. Hedging can become expensive and or prohibitive. Here, you know, imagine CalPERS, the largest pension plan in the in the United States, has about a $230 billion public equity portfolio. If CalPERS wanted to hedge their portfolio for, you know, I don't know, pick a number, 25, 30 percent, 50 percent drop in the equity market. That's just not going to happen. That's not a hedgeable risk. They can manage the risk on the margins, but they can't really do it. So to a large degree, what we're talking about with hedging and climate change is managing risk and manage and smoothing a transition. There's nothing we can really do with an investment portfolio in public markets that's going to solve climate change. But we'll talk a little bit more about that in some of the concluding remarks as well, because I think there are ways where we can we can sort of push in the right direction and help. So what does it cost? The answer is it's really complicated. What I'm going to do in the next several minutes is try to teach you everything you need to know about finance and try to apply to climate change. We're going to start with a crash course on modern portfolio theory to provide a foundation for investment decision making. We're going to extend modern portfolio theory to the way quantitative portfolio managers or investors evaluate managers and think about benchmarks and risk taking. And then we're going to try to extend this to some particular applications within climate that'll hopefully make some sense to you. So here goes all of modern portfolio theory. I'm trying to do this for an audience that has some basic understanding of economics and not a whole lot of understanding of finance. So for those experts in finance, I hope I don't screw this up so badly that you think I misled anyone. If we start with modern portfolio theory, looks at excess returns, I'm sorry, looks at expected returns and risks of assets. So if you just think of assets as being described as expected returns, expected risk, and the covariances of all the assets with all the other different assets. So you sort of plot here, any random number of assets. And in fact, this should be all of the assets in the world would fit on this plot. And we would have to calculate all of the correlations and covariate the covariances between all the different assets. And we can construct any number of portfolios using all of those different assets. If we could construct a particular set of portfolios, we get a thing that's called the mean variance frontier. The mean variance frontier is saying that for any given amount of risk, I am constructing the portfolio that has the highest expected return for that amount of risk. An important thing to understand about the mean variance frontier is that it doesn't depend on investor preferences. This curve plots out based entirely on the characteristics of the underlying assets. If you remember from your introductory economics classes, something called indifference curves, indifference curves describe how an individual makes economic decisions. So in your economics class, you probably looked at indifference curves between work and leisure or a classic example of guns and butter, two things over which investors have preferences. This is the exact same situation. Investors like expected return and they dislike risk. So for small amounts of risk, they don't need very much extra return. And that's why the curve is reasonably flat over here because at very small amounts of risk, they don't need to pick up a lot of return. As we get to more and more risk, investors demand more and more return. And so what an investor is doing is saying, well, I'd really like to maximize my utility, which means moving this direction with indifference curves. And they're basically saying, I want to maximize my utility when I'm hitting the mean variance frontier, which means you get to this point that's a tangent. Hopefully that made some sense. The next thing that happens in modern portfolio theories, you need a risk-free interest rate. We use a risk-free interest rate because we basically nice and conveniently assume everyone borrows and lends at the same rate. And it's nice that it lines up at zero. There are lots of more theoretical reasons why a risk-free interest rate applies here, but let's just make that simple assumption. Then what we do is we say, well, if we draw a tangent line from the risk-free interest rate to the mean variance frontier, we hit a single point. That single point is the optimal portfolio that everyone in the market should hold given where interest rates are. Why is that the optimal portfolio? Because if everyone can borrow and lend at the risk-free interest rate, then they can actually move themselves into higher utility space by a combination of the market portfolio and the risk-free rate. So if you'll notice my investor magically, the second indifference curve, which is a higher level of utility, is now tangent to the line that connects the risk-free rate and the market portfolio. And every single investor will hold a portfolio on this line. The investors up here will be borrowing money. The investors down here will be lending money at the risk-free rate. So this describes how all decisions are getting made in the framework of modern portfolio theory. You may have heard the term sharp ratio. The sharp ratio is really the slope of this line. It tells you what is the tradeoff that the market portfolio has between risk and return. On the next slide, we're going to switch gears a bit and talk about what quantitative portfolio managers do and how managers evaluate risk. A particular asset manager or portfolio manager has private information that differs from the market. This private information is generally about the characteristics of the assets. So they could have a private view about correlations. They get a private view about expected returns and expected risks. And what will happen is they will use this private information to construct a frontier of possible outcomes that are using that information that map to excess returns and tracking error. So if you think about what's going on in this picture, down here in the corner where you have zero excess return and zero tracking error, imagine this is just an index portfolio. So this is a benchmark portfolio like the S&P 500 where later we'll see I happen to use an MSCI index. When the manager uses this conditioning information they have, this private information, it allows them to say I'm going to generate excess return and generate some expected risk and I will plot where my portfolio is going to land. So here I just use an example of someone who's using some sort of conditioning information to say I can generate some excess return with some volatility or tracking error around a benchmark and that's going to give me a portfolio that someone wants to hold that my investor wants to hold with what's called an information ratio. That's this trade-off between excess return and tracking error. Now generally in the asset management world, a product strategy has a particular, a manager has a particular information ratio out of their proprietary information or they can have a product strategy. So for example, you could have three different products that an asset manager runs that sort of target tracking errors that they think investors might want to invest in. So for example, at one of my old firms we managed three different products in long only US equities and we happen to have similar but slightly different information ratios for three different tracking error portfolios much like you see here. How do we apply this to climate risks? So instead of having excess return on the vertical axis, I'm putting something that I'm calling a sustainability metric. This could be a lot of things but what we're going to put on this axis is this measure of carbon intensity and we're going to use carbon intensity as a percentage of a decreasing, sorry I don't want to confuse you or me, a decreasing percentage of the benchmark. So if you think about what I'm going to do is I'm going to say down here is the benchmark. This is the point where you have all of the carbon intensity of the benchmark and by going up the vertical axis I'm decreasing the carbon intensity of the benchmark by modifying the portfolio. So I'm reducing the carbon exposure by changing the allocation of the portfolio by adding more of some stocks less of some other stocks and that's causing tracking error in the portfolio to go up but it's also reducing the carbon intensity and this will play out this sustainability frontier much like a excess return and tracking error frontier and in a similar way you can investors will have indifference curves that will plot or describe how they would choose to trade off sustainability metrics so their desire to decrease their carbon intensity at the same time they are willing to take on tracking error risk. There's a couple of different ways to think about what's going on with these indifference curves for example investors could simply say I don't like carbon in my portfolio so it's just by saying I'm putting this sustainability measure into my utility function. Economists don't like this economists don't like putting weird things into utility functions because you can generate any outcome you'd like by simply modifying your utility function more generally they prefer to think about things that are risks so for example rather than saying I just don't want to own fossil fuel extractors economists would prefer things like coal companies will be regulated out of business or oil reserves will be stranded and companies aren't valuing them correctly because those assets are going to be stranded or you know climate change a more dramatic version of this is climate change will cause some tipping point and when that tipping point happens you know whole industries are going to disappear the economy is going to realign itself etc so what what we want to think about is what's the nature of a risk that is driving these decisions driving an investor's decision to say I want to reduce my carbon intensity in this setting what I want to distinguish because this is going to help us think about what's the cost to hedging in this scenario we're talking about trading off something that's pretty pretty well known we are definitively reducing the carbon intensity of the portfolio in exchange for tracking air versus the hiring an active investment manager who's saying I'm going to try to add excess return and I know I'm going to add tracking error and so when we're you know the difference here is information ratios in with with asset managers adding expected return is about trying to do something whereas with these sustainability measures we sort of we know it's going to happen so let's go to the real world I'm just jumping ahead to get to the real examples so let's play we're like we're quant portfolio managers what you're looking at here is a real actual curve generated so if as you see on the vertical axis as I mentioned before you're seeing decreasing carbon intensity so we start in this plot at about 70 percent of the carbon intensity of the benchmark this is using the msc i usa index at the year end 2015 the benchmark itself is generating 134 tons of carbon per million dollars in sales out of 621 positions what you'll notice is we can decrease carbon the carbon intensity very quickly with not very much tracking error we get to a 50 carbon intensity with about 17 basis points of tracking error you should understand that in the institutional world even in the institutional world 17 basis points of tracking error is not very much at all to give you some context like you know active typical active mutual funds could have you know three five seven percent sorts of tracking error and we're talking small fractions of that when we reduce the carbon intensity to by 90 percent we're still only at about 1.1 tracking error and there are still 263 positions in this portfolio so one of the things you want to understand is what's happening when we reduce this carbon we are taking we're taking very small bets that are deviating from the benchmark so the way this this process works is it's in the footnote i'm sure you can't read it but it we're we're basically using a model called barra barra is a commercial risk model that does very sophisticated optimization of portfolios to try to minimize the tracking error around a benchmark so this is it's not like what we're doing is excluding fossil fuel extracting companies or excluding utility companies we are underweighting them in very particular ways to attempt to make this tracking error as non-systematic as we can this tracking error is actually highly idiosyncratic it's not driven by anything that you would you would sort of assume would drive this tracking error so it's not like we're just you know not holding utilities and we're dumping all the you know the money into you know tech stocks and healthcare stocks because they don't generate any co2 it's pretty carefully constructed to minimize those kinds of risks and so with that framework in mind understanding that we can take not particularly large risks and actually reduce the carbon dramatically we want to take our next step which is let's think like a risk manager or a hedge fund manager and let's construct a hedge portfolio what are we going to do we're going to buy the 30 carbon intensity portfolio so we're buying a portfolio that is very underweight carbon intensity relative to the benchmark and we're going to sell short I had to put it down here you know below the axis because my scale wasn't quite right but we want to we're going to sell short the benchmark so when we go along this 30 portfolio and we sell short the benchmark what we're really doing is we're constructing a very low volatility portfolio so it has no equity market exposure we've hedged out all of our equity market risk it's a pretty darn liquid portfolio because the thing we're shorting is just a very easy to short widely traded benchmark where long a whole lot of highly diversified positions and the performance of this long short portfolio will now reflect the risk of something that is very very short carbon intensity so what we can then think about is the performance of this long short trade will be that of the risk of of of uh to the economy of carbon intensity so that's a little bit hard to understand I'm sure I'm sure you all have some questions but the basic idea is imagine the price of carbon for political reasons or social reasons all of a sudden jumped and everything that was producing lots and lots of carbon emissions those stocks would be hurt more significantly than others and so under those situ in that situation this portfolio would likely perform quite well because it's heavily short the carbon intensive companies and it's long this portfolio that that hedges most of the equity market risk and leaves this residual risk that is just about carbons about about the carbon risk I make this note at the end here where I say this is an options replication strategy for for those of you who you know may know more about this depending on the underlying model that's driving around the carbon risk whether it's a continuous risk or a discontinuous risk you could think about this long short strategy as replicating an option on being short carbon intensity I'm hoping this made some sense for you but let me let's talk about some conclusions and implications for investors the first one that I think is worth thinking about is we can the traditional benchmarks we use like the S&P 500 or in my case in this case the MSCI USA index they're they're just convenient easy and cheap there's nothing magical about them and one of the things we we see here is we can take the carbon exposure down the carbon intensity exposures down extraordinarily without really putting that much risk into you know risk of deviating from these benchmarks so I think it's worth asking the question for institutions you know do you really need to use these traditional benchmarks or you know can you sort of eat the risk of these these slight deviations and there's something particularly relevant from you know you know sort of traditional economics here is when investors get more and more wealthy like big institutions you could think of as you know just extraordinarily wealthy investors they become closer and closer risk neutral and what that means is they don't even care about these tiny little uncorrelated non-systematic risks so I think it's worth thinking you know for big institutions to say well maybe I should just use a different set of benchmarks and I should forget about using these benchmarks that are so reliant on carbon intensity the second thought around institutional investors is how do you actually implement some of these ideas you know we used a very simple example of carbon intensity but in fact you could do this in a more sophisticated way and almost say well I want to trade off carbon I want to trade off coal versus natural gas because you know we know during a transition period that natural gas is less carbon intensive than coal for producing electricity so you could do a similar exercise that sort of trades off you know different parts of the energy complex the third point which I think is is particularly useful is because this strategy is highly scalable and not particularly risky relative to equity markets you can use this long short hedging strategy to hedge away from your public equity portfolio so for example you know I did a bunch of work for a very large insurance company several years ago that has an enormous incumbent portfolio private equity portfolio in extraction industries and someone in that position could say well I can't really get out of the risk of my private equity portfolio but I could in fact use a larger hedging tool out of my public equity portfolio to hedge the carbon risk and transition risk of my private equity portfolio for just in a couple of concluding thoughts for individuals I think it's worth thinking about your own preferences and the trade off you make in your own decision making like I will admit traditionally or traditionally in the past I've sort of been call it semi opposed to investing this way you know I generally used to take the view that better to invest and generate the best returns I could and then choose to say I'm going to take the extra money I make and use it to do good things but but frankly looking closely and examining these ideas has convinced me that first of all it's not particularly costly to think about directing a portfolio in a more sustainable way and second of all if I sort of embrace this idea that I'm actually managing risk by shifting the portfolio and I think I feel much more comfortable saying all right there's a good reason that is good for my portfolio in the long run even if it means I possibly give up a little bit of return in the short run but most importantly I think this you know drives people in the in the direction of saying I want to invest in a sustainable way that will manage my risk rather than simply doing this to try to generate you know greater returns because some asset manager is convincing me that if I you know follow their recipe for sustainable investing I'm going to definitively generate you know better returns I hope I hope people could follow that reasonably well so young I will open it up to questions and hopefully I don't have to start over to re-explain everything because I made no sense well thanks mark I mean it's really insightful and I have a couple of questions and also we got a question from the audience too so I think we are kind of heading there together so and then please you know raise hands anyone if you have any questions so my one question is more about the clarification question so if we go back to that sustainability ratio graph how can you actually implement this long short portfolio like for example you know like how can you create those portfolio that has 70% of carbon intensity reductions versus you know like 0% or I mean 0% but you know how can you make those a portfolio sure yeah so so the the the simple answer is you need an optimizer and a risk model so what what is going on in that portfolio construction is you know in a normal portfolio optimization exercise you're saying I want to maximize my expected return subject to a bunch of different constraints of any sort using the the the benchmark and the risk model and so what I've what I did in that plot I'm not sure how quickly I can go and share the picture again and try to re-explain it let's see all we're really doing is saying I want to I want to make a minimum tracking error portfolio that is constraining the carbon intensity of the portfolio and so every you know in the in the in the in the optimization software I have carbon intensity for every single company that's in the in the index and you know I know that the index the cap weighted index has a carbon intensity of about 134 tons per million dollars in sales and I basically you know I I sort of pick a number and I say okay give me a portfolio that has a 10 carbon intensity so give me a 13 ton portfolio and construct the lowest tracking error 13 ton portfolio I can that'll give me a you know that gives me a you know that that'll give me a portfolio that I need to trade and I would you know call up my local I'd say call my local broker but really no this would be I'd call my local you know swaps market dealer and I'd say I want to you know I want to swap that's you know long this basket of stocks and it's short this index and you know I want X number of dollars of notional exposure you know this is not something that you know I can do personally or you know many of you can do personally but these are portfolio this is you know these are strategies that big institutional investors can do all the time does that does that help you understand does that make sense for you know how someone actually goes about doing this so basically all I'm doing is saying well I've I want to you know I want to sell these 600 stocks at these you know in these quantities and I want to buy these 300 stocks in these other quantities and it's going to be a portfolio that doesn't have any net equity exposure and so that what amount the exposure that remains is this thing that we can just describe as the risk of carbon it's it's a little it's a little abstract but that's that's sort of the idea of what's going on so if I say all right fine I you know if I have a hundred billion dollar that's probably too big to worry about if I have a several billion dollar equity portfolio and I say well I'd really like to you know take all the I'd like to take all the carbon out of my equity portfolio I could do this by not holding any fossil you know utilities or fossil fuel extractors or I could do it this way which is a much more you know precisely tuned approach and doesn't necessarily have the big sector bets and sector risks but on the other hand it it's also not like it's not divesting my portfolio of fossil fuels or I as I was alluding to if I have a you know a several billion dollar public equity portfolio and let's suppose I also have another billion dollars of private equity and a whole lot of my private equity just because of for historical reasons happens to be tied up in reasonably carbon intensive industries I can just size up I could just size up this this long short trade to say okay you know take the take the carbon out of my public equity portfolio and take the carbon out of my private equity portfolio because I can or maybe you know maybe an institutional engages in this sort of activity because you know I it you know we so young as you know we we've had discussions within our research team you know do should the pension plan assets of a company count in some regard into their you know scope three emissions or you know when Stanford is going through an exercise of calculating Stanford's you know carbon footprint well does does the endowment count you know these are these are all interesting questions that you know the different investors will have different views about you know which which of these exposures should count and you know how we should deal with them yeah in that way I mean I have a question about the proxies too but let me ask you questions on behalf of our audience I think you've answered some of the questions already but my question also about questions that have you tracked this in returns of those changing long shot portfolio and then you know how's market is pricing this already or not yet and then how stable this optimal long shot portfolio is okay so the the performance of this portfolio so let me let me talk about performance a bit there are lots of people who are looking at the question of how does you know how does sustainable investing perform and you know that was one of the my my I'll call it initial frustrations because it depends it depends on a lot of things it depends on exactly how you implement it it depends on the data you use to measure sustainability it depends on the time period and that's what brought me to the question of well wait a second instead of asking the question you know has it has it worked I wanted to ask the question should it work and you know and I and my my tendency is to say I'm not really sure why it should work in the long term I can understand you know if we if we're bidding up the prices of green assets that's almost like a sort of a moment to me kind of trade but it's not clear to me that that means anything for the long term and then if you this might get a little bit complicated if I haven't already done that but if you think about this long short trade as a as a replication of an option on a jump in the price of carbon which mathematically speaking like in a in a theoretical sense of how you reproduce how you hedge option price options for option pricing purposes this is legitimately an option strategy you could you then can infer that the movement of the expectation of the carbon price is actually changing the option price so if you you know know anything about options pricing we understand an options price has to do with you know what's the price of the underlying what's the strike price of the option how long is it until the option expires and what's the volatility on on the underlying and I think we could probably in some sense figure out what's been going on in the performance of sustainable investing if we sort of knew the true underlying model of the carbon price and the implicit option so it's like if the option strike price is moving around because of how you've constructed the portfolio and the time to expiration on the option is really it's actually an uncertain thing in this context because we don't know when the policy proposal might come through or we don't know when the tipping point hits that causes some you know massive shift in the economy it's very hard to predict how what the you know the profit and loss on this strategy ought to be because it's it's constructing a P and L that reflects this very odd option structure and so that's where I I just find it more satisfying to say well I'm thinking about this risk and I know I'm reproducing this risk in a portfolio and it you know maybe it's a little blind faithy but I think it needs to be another way I just I guess another way to approach this is like the World Wildlife Fund you know sort of went through this reasonably complicated transaction to say we just want to basically sell all of our fossil fuel assets they divested they did it through a swap and it worked really well it's very straightforward but it it it's it's not necessarily like hedging the risk going forward to what happens to the total economy or to all of capital markets there are some people who have developed way more complicated strategies to try to hedge this risk like using natural language processing of news stories to construct synthetic portfolios that respond to news stories and I I'm trying to view this as like okay World Wildlife Fund really simple over here straightforward everyone understands how it works but it's not ideal you know you've got some of this very theoretical not intuitive at all of what's going on and I was trying to sort of split the baby and say I'm gonna you know sit in the middle here and say well I can construct you know a long portfolio that people understand I can construct a short portfolio that people understand match them together and come up with a way to manage the risk. Interesting thanks let's talk a little bit about the proxy so do you think that I mean you know in this you know simulation you use carbon intensity yeah do you think that is there any other proxies that actually measure better of the sustainability or you know well I that's a good question I think that's probably a pretty good generalized one but the kinds of ideas I have for other things to look at is people worry a lot about or I've you know talk a lot about actual physical risks and how physical climate risks impact sustainable investing and one of the challenges I think there are that most of the physical risks don't actually matter on the time scale of you know sort of stock investing so for example you know there's some some people who have done some interesting work on on very specifically quantifying well this company has exposure to things that can flood or you know this this company has too much going on in coastal Florida versus you know California wildfires and things like that but in in many ways all of those physical risks at least in the near term for the foreseeable future are insurable and they are insured and so when we when we're talking about like highly highly disruptive climate related risks in this like tipping point or or catastrophic change framework what we're talking about is something happening where all of a sudden the insurance markets break down right so like you know Disney World sure you know we all know Disney World could flood you know eventually you know we're going to be in a situation where you know we maybe the answers we all can agree Disney World will flood but for the foreseeable future there really isn't much direct risk because Disney insures at all they probably have business interruption insurance on all the flooding anyway so as a stock investor you're not really subject to physical risks until something goes very wrong like a discontinuous jump in that risk and you know all of it so this is you know possibly happening in parts of California right now it's really happening in large parts of Florida where in Florida it's a little bit different but you know we're we're reaching the point where if something doesn't change then all of a sudden there's going to be a whole lot of stuff that's not insurable and so that's what I mean by looking at different kinds of risks that are climate related but could have different implications for an investment portfolio that's interesting or we are about the time but I also had some questions about you know like why you exclude this scope three and also Jeff's question about you know like who is implementing the principles in the market actually but you know if you can kind of concluding or answering those you know like two questions out there would be great or you know anything to you know like yeah I guess I don't know that that there are that there are people trying to do strategies like this there are a couple of people who are still on the in the zoom who I will ask because they may know but as far as I know I don't know if anyone doing transactions like this to try to hedge climate risk you know there's there's a lot more detail that goes into actual product design than you know the simple approaches I've taken but the goal here was to to to help inform some thinking about well what can we do in public markets because I think one of the greatest frustrations people have is public markets aren't particularly good for or or haven't been historically particularly successful paths for you know uh activists and impact investing to a degree that's changing um and you know hopefully for the better um but I think using tools like this at least people can start to think about you know what different approaches could I take um yeah so that that was very uh I mean yeah I know that we are touching a lot of you know like very hot you know like hardcore financial like finance concepts today and also you know this is very new concept you know as you mentioned um mark you know it's there are not many players in the market who are actually doing this but uh I mean but you know your your talk was very clear and thanks thanks for sharing your thoughts today and thanks again for accepting our invitation this is great yeah so um thank you and I'm being mindful of everyone's time so yeah stay tuned for the next seminar so next seminar will be on March 11th Professor Shelly Walton from University of South Carolina will be joining us and she's going to talk about improving electricity markets through improving electricity governance so she is actually on her mini virtual visit to Stanford this quarter so um and then SFI team is actively looking for um to collaborate with her um in terms of in you know like in kind of like aligning this you know energy law and governance and market and and finance and policy so it'll really great to hear about her research next month so um yeah looking forward to see you all next month and thanks mark now I will let everyone go thank you for coming