Disequilibrium in the market for Carbon Emissions: Implications for Portfolio Benchmarks


Robert Litterman, Kepos Capital


The appropriate price for carbon emissions today is far from the current actual price, which throughout the world is very close to zero. This discrepancy between the actual and the appropriate price is a disequilibrium situation.
Although the timing of the resolution of this disequilibrium is itself uncertain, and the forward curve is not observable, current market prices seem to embed an expectation that emissions prices will rise slowly over the next several decades. Many recent economic analyses have suggested that because emissions prices reflect discounted damages which are expected to occur in the far distant future, such expectations are rational. In fact, because the forward curve for carbon emissions reflects the pricing of a systematic risk, it should decline with maturity as uncertainty is expected to be resolved and risk is expected to decline.

Current emissions prices are far below a level that reflects the externalities associated with carbon emissions. Thus, assuming that government policy will evolve toward a price of carbon that is consistent with the level of these externalities, long-term investors currently have an opportunity to profit from tilting toward equities and other assets that will benefit from carbon being priced more quickly than is currently priced in, and away from those that will be hurt.


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