August 23, 2018 | by Steve Kihm CFA, Principal and Chief Economist, Seventhwave
On the path to a cleaner, more sustainable energy future, we will have to make decisions that have uncertain outcomes. In other words, they involve risk. Newer technologies might not work well—or they might work better than expected. Customers might not embrace home automation—or they might use it in ways we haven’t even imagined.
We often think of “risky” as a synonym for “bad outcome,” when in fact all it really means is that there is a range of possible outcomes. Unfortunately, in policy discussions we often find the view that risk taking is necessarily undesirable. For example, de-risking sustainable energy assets is almost always seen as a good step to take on the path to a cleaner energy future. In some cases that might be true, but we must ask what we give up by reducing risk.
We can observe our own actions to cast doubt on that notion that de-risking is always desirable.1 We don’t seek to eliminate risk at every turn in day-to-day activities. For example, most of us invest a portion of our retirement funds in stocks rather than safer investment alternatives (e.g., Treasury bills). If taking on risk is bad, why don’t we de-risk our retirement portfolios by moving out of stocks completely?
We know the answer intuitively—it is the potential for reward, in this case the chance of having more money at retirement. The same notion applies in policy making. If we carefully choose certain riskier alternatives over safer ones, we may be able to increase the potential for greater societal outcomes.
The emotional aspect of risk assessment—the role of regret
In evaluating risk there is an important emotional factor at play—the desire to avoid regret. Risk is an abstract characteristic associated with a decision, not an emotion. Regret manifests after the fact when we compare the result we obtain having made one choice to the result that we would have obtained if we made a different choice, and we find that the other choice would have made us better off.
To illustrate this concept, consider an employee who invested $5,000 per year in Treasury bills over the past 40 years. That person’s retirement balance today be $430,000. It is difficult to know whether that’s a good outcome without a reference point, which is precisely the notion upon which the concept of regret rests. If the same employee had instead invested the same amount in stocks, at the end of the period he or she would have a retirement fund balance of $3 million. Now we can determine the potential to feel regret.
Who took on more risk? The equity investor, who experienced widely swinging annual returns. Historic annual stock returns have ranged from a low of -44% to a high of +53%. U.S. Treasury bills never produced a loss over that period. The highest annual return was +14%.
Who, though, experienced more regret? The Treasury bill investor who sees the equity-investing colleague living quite well in retirement while the Treasury bill investor pinches pennies to get by. Note that the Treasury bill investor doesn’t regret taking on too much risk, he or she regrets taking on too little.
To be sure, sometimes taking on risk can lead to regret. There are no guarantees that equities will outperform Treasury bills in the future, but we must consider the fact that, on average, markets reward those who take on reasonable, calculated risks. Markets never compensate anyone for experiencing regret.
The risk-regret tradeoff is not a new frame. Consider Tennyson’s classic line from his 19th century poem “In Memorium”:
‘Tis better to have loved and lost than to never have loved at all.
Relationships have potential downsides, but they also have upsides, which is the very essence of risk. Tennyson tells us something we already knew intuitively. To avoid regret, take some risks.
Human beings are, and always have been, calculated risk takers. By taking reasonable risks we often simultaneously increase the potential to earn greater rewards and decrease the potential to feel regret.2 That perspective on risk taking is common practice in the non-regulated world. When asked in a Harvard Business Review interview how she managed risk, a highly-regarded CFO of a major pharmaceutical company responded that she put more, not less, money at risk. Similarly, in public policy settings we should be true to our essential selves, looking for opportunities to manage risk in a similar fashion, which in some cases means increasing exposure to it.
If we ask utilities to take on risks that increase the cost of capital,3 we should be willing to compensate them with the possibility of earning higher corporate returns, on average. A higher utility return in this context is not necessarily a fatal flaw or undesirable in a public policy sense. Even with higher returns there still could be net gains to society that dwarf any potential financing cost differences.
The future is always uncertain. Moving toward a more-sustainable energy future will undoubtedly involve taking on certain risks. But rather than avoiding those risks we should consider embracing them when the circumstances are right. If we don’t, we’ll likely regret it.
Steve Kihm is Principal and Chief Economist at Seventhwave and Senior Fellow in Finance at Michigan State University’s Institute of Public Utilities. He is a Chartered Financial Analyst. He co-authored the book Risk Principles for Public Utility Regulators (Michigan State University Press) with Janice Beecher.
1This is not to say that de-risking is always a bad idea. It is to say that de-risking isn’t always a good idea.
2Damodaran. 2007. Strategic Risk Taking: A Framework for Risk Management. Upper Saddle River, NJ: Financial Times/Prentice-Hall.
3Most risks that investor-owned corporations face do not affect their costs of capital as the investors who provide capital can diversify those risks away in a portfolio. See Koller, Goedhardt, & Wessels. (2015). Valuation: Measuring and Managing the Value of Companies. Hoboken, NJ: John Wiley & Sons.