TCS Daily


Hedging Climate Bets

By James V. DeLong - January 29, 2007 12:00 AM

The United Nations Intergovernmental Panel on Climate Change (IPCC) will release its Fourth Assessment Report Summary for Policymakers on February 2. While the report is embargoed, those involved say it will "increase the sense of urgency" that "time is running out," according to Greenwire.

As we put up the storm shutters for the forthcoming gale-force oratorical winds, it is interesting to suggest another way of looking at the issue, by borrowing some concepts from the world of finance.

Anyone who deals with financial operators such as hedge funds quickly learns the concept "mis-priced assets," and slides into a habit of examining the world within its framework. It is indeed a useful way to think.

Whereas most people live in a world of specific prediction, in which authorities assert firmly that X or Y will or will not happen, the hedgies admit that they don't know and can't know. Their world is probabilistic, full of uncertainties and contingencies. It is not probabilistic in the sense of a card game, where the odds of drawing a spade are precisely 25% -- that would make investment bets easy. It is uncertain, which means that you don't know the odds on drawing a spade, or perhaps even whether this particular deck has any spades in it, and the presence of spades may actually be contingent on whether another deck entirely turns out to have any hearts. The crucial judgments concern investment strategy in light of assessments of these complicated probabilities.

The nature of the business makes hedgies into odds players. Not in the sense of "I know there are no spades left in the deck, so my straight has a lock on his hand," but in the sense of "The market is pricing this hand as if there were 8 spades left in the deck whereas I know that there are only 3." Or, to shift to an investment context, the calculation is "the market is pricing Deck Industries as if it has a 30% chance of getting that contract, but my specialized knowledge of the particular processes involved leads me to believe that its chance is actually 50%," or perhaps, "this company looks like a dog, but my technical expert says there is 30%-50% chance that its patents will be crucial to some major tech players."

The bet is that Mr. Market is mis-pricing assets, in the sense that the value it puts on them does not reflect the true probabilities, and that the hedgie, for some reason, has superior insight into these true probabilities. This does not mean that the hedgie is always right - a 60% batting average is great - or that the favored horse always wins. A 10% chance is a long shot, but it wins 10% of the time. So the hedgie, like a Las Vegas casino, wants to keep making bets at favorable odds.

In this world, the worst sin is assuming something has a 100% probability when it may well have considerably less, or assuming it has zero probability when it actually has a real shot. "They forgot the tail of the risk," is a term of contempt, bringing to mind bygone firms gone bust, such as Long Term Capital Management.

As one capitalist recently noted at a conference (I don't think he would want to be identified): "I make money when idiots mis-price assets. Luckily, I am blessed with a large supply of idiots, many of them in government."

Governments are indeed reliable founts of asset mis-pricing. High in the running for all-time champion was the FCC's implementation of the 1996 Telecom Act, which led to extravagant valuations of new firms that had no assets and no customers - their business model was to buy access to facilities built by existing carriers and then attract these carriers' customers by offering cut rates. It did not work, and those who invested on the assumption that the government could make it work lost heavily.

Even as we speak, a combination of do-good greens, political manipulators, anti-industrial technophobes, venture socialists, and the reactionary rich (the categories are not mutually exclusive) are promoting a mis-pricing scheme of even greater magnitude. This one involves assets whose value is based on the theory that emissions of CO2 and other greenhouse gasses are responsible for what is going to be an unacceptable degree of global climate change.

It is possible that this theory is correct, but it much less certain than the drum beat of propaganda would have us believe. For example, a somewhat contradictory news account on the forthcoming report said, "And the cause is clear, say the authors: 'It is very likely that [man-made] greenhouse gas increases caused most of the average temperature increases since the mid-20th century,' says the report." I would have thought that "very likely" is not the same as "clear cause," but perhaps I suffer from excessive logic.

A competing explanation of the mild warming that has occurred during the past few decades is that the sun goes through regular cycles in the amount of energy it emits, which results in changes in the energy received by the earth and in its exposure to cosmic rays from elsewhere in the galaxy. It could well be that increased CO2 in the atmosphere is an effect of this sun-cycle-caused warming and not a cause. Some serious observers think so, and they have some interesting arguments (or see the recent controversial articles by Christopher Monckton (pp. 20-22)).

It is also of course possible that the sun cycle theory is not correct. The IPCC researchers dismiss it as a serious factor, according to the press leaks.

It is also possible that both theories are correct; that CO2 and sun cycles are jointly responsible. Or it could be that sun cycles are the primary cause of current warming, but that in the long run continuing CO2 emissions will have a warming effect, so there is a long-term CO2 problem to be dealt with, even if it not the immediate problem now assumed to exist.

There are many possibilities, but the crux is that the probability that the current strong form of the CO2 theory of climate change is correct is nowhere near the 100% assigned to it by the hype, and the probability that the sun cycle theory (or any other theory or group of theories) is correct is nowhere near the 0% that is assigned to it. So, by definition, any assets that are now priced on the basis of these complementary assumptions are mis-priced. As climate change research proceeds over the next decade, better insight into the true probabilities will be achieved, so the potential for repricing assets to better accord with the underlying realities offers opportunities for favorable investment bets.

So, of what use is this information?

One could use it to start the Sun Cycle Investment Fund. This would be a beneficent enterprise, in the same way that the bets on Tradesports are useful. There is nothing like the opportunity to place a bet at favorable odds to trigger curiosity and investigation. In fact, maybe those known contemptuously as "the deniers" should establish an on-line betting market, a la Tradesports. Surely, all the scientists, politicians and journalists who assert that CO2 theory is indisputable would be eager to bet their own 401(k) money on the proposition. (Figuring out how to resolve the bets would be a problem, though. Tradesports deals with discrete events.)

For those interested in keeping national policy from going off the rails on climate change, with all the economic and social destruction this threatens, the question is how to leverage this hedge fund mode of thinking to influence the debate.

Several thoughts come to mind.

The first is to ask whether such a mis-match really exists. Another tenet of hedge fund thinking is that market prices not only react to information, they also provide information about what people really think. Mr. Market is made up not just of New Yorkers and Londoners, who get their environmental expertise from the New York Times and the Economist, it encompasses Russian oligarchs and Asian billionaires, who can buy excellent advice from scientists not dependent on toeing the proper foundation or Western government political line to keep their grant money flowing. If these see deluded Westerners willing to place bad bets, they will be on the other side of the trades until over-all prices better reflect the underlying probabilities.

So one logical approach is to ask exactly what the prices of various assets are telling us about disinterested opinion concerning CO2 theory. Granted, the market is very noisy, and prices reflect possible government mandates and subsidies, the U.S. interest in energy independence for security and foreign policy reasons, and the peak oil issue. But buried somewhere in the haystack is valuable information about what some of the world's smartest investors really think about CO2, and it would behoove those in the "skeptic" community to find it and feed it back into the political debate. Who ya gonna believe -- Al Gore or an Indonesian billionaire with real money on the line and access to some of the best expertise in the world?

A second use for the question about the relationship of asset prices to the probabilities of CO2 theory is domestic. At present, much of the U.S. financial class seems seriously misinformed about the climate change issue; unrelenting propaganda has had its impact, and this is about to be accentuated by the impact of the new report.

But this mis-education occurred when nothing of personal importance was at stake and ignorance was rational. With the Democrats back in power on Capitol Hill, there is a real possibility of serious governmental initiatives, and ignorance is no longer rational. The financial markets bustle with smart people, all seeking an edge over Mr. Market's assessment of probabilities. Once they are alerted to the possibility of mis-pricing, their smart move will be to seek out the work of the reputable skeptics and judge it by honest yardsticks of scientific inquiry rather than by the hype of self-interested propagandists. Of course, the prospect that Asian billionaires may be selling or buying mis-priced assets from New York counterparties is a powerful incentive.

If over the next five to 10 years, as more information becomes available, there is a significant probability that the credibility of the CO2 explanation will be undermined, then the implications for the proper allocation of investments are enormous. Those who get a good grip on the real probabilities will profit at the expense of those who do not.

A third possible use of these concepts of probabilities and mis-priced assets lies in dealing with those who now seek to profit from the hype, which is increasingly supported by important economic interests that hope to ride the issue to profits (See Kim Strassel's recent article in the Wall Street Journal for more on this). Indeed, one can regard the rising intensity of CO2 theory propaganda, the increasing pressure for government subsidies and mandates, and the efforts to silence "deniers," all as contrarian indicators that the crisis mongers are aware that reality is not necessarily on their side, and as a symptom that they are determined to cash in quickly before more sober analysis prevails. Venture socialists investing in subsidized ethanol or windpower are examples, as are companies that would like to collect CO2 tax credits for phasing out obsolete facilities.

These punters need to understand that there is a downside to such bets. If the strong form of the anthropogenic CO2-induced climate change theory turns out to be wrong, there will be a significant push to abolish misbegotten policies of favoritism that would then be crippling developed world economies in international competition, and a lot of assets might be written down to zero. The venture socialists will not be given a pass. If their bets turn out wrong, it will be pointed out that they knew the risks, and that any bailouts will be loudly mocked.

So in the end, those who doubt the hype may need to do little except make sure that skeptical information remains available. If it is out there, the financial community will come to it in the end, as long as it understands that the stakes involve possible trading profits. Greed does indeed have its uses.


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