Discounting Discontinuty

Elizabeth Kolbert, author of Field Notes from a Catastrophe: Man, Nature, and Climate Change, has an article in the New Yorker's Talk of the Town section this week covering reaction to the recent Intergovernmental Panel on Climate Change report. Some new lines are being drawn in the sand. The I.P.C.C. is more adamant about climate change and mankind's contribution to said change. The newly emboldened Democrats are holding hearings on climate change. The newest line in the sand comes from industry:

Four days after [House Speaker] Pelosi labelled the science of global warming “unequivocal,” James Rogers, the chairman of Duke Energy, one of the nation’s largest electric-power companies, said much the same thing at the National Press Club. Duke Energy is part of a new coalition, the U.S. Climate Action Partnership, whose members include Alcoa, DuPont, G.E., and Lehman Brothers, along with groups like the Natural Resources Defense Council and the World Resources Institute. At the press club, the coalition called on the federal government to enact a mandatory “cap and trade” system that would first stabilize and then begin to reduce CO2 emissions. “We know enough to act now,” Rogers said. “We must act now.” The coalition urged Congress to set a goal of cutting emissions by at least sixty per cent by mid-century.

I got to talking to my friend Brad about why the free market was failing to price climate change effectively. The price of oil fluctuates much more with the latest news from Iraq and the middle-east than news from either of the poles or Greenland about melting ice. The price of real estate, even with the recent market adjustment for higher interest rates, fails to discount for rising sea levels. The highest U.S. housing prices are in sought-after locations in cities near the rising seas. Does it make sense to buy a house on an island, whether it's Fire Island or Manhattan?

Brad, a Wall Street whiz, asked the obvious questions: how do you know the market isn't pricing the risk of climate change properly, and does the market ever fail to price correctly?

It got me to thinking about another article Kolbert wrote recently (January 22, 2007) in the New Yorker about Amory Lovins and his Rocky Mountain Institute. Lovins designs all manner of energy saving solutions for buildings, transportation systems, and other large scale energy sinks. The problem implementing the solutions often stems from "split incentives," explained here:

Take, for example, the electrical system of an average office building. "If we were to dig into the ceiling of most offices where the wiring is for the lighting, we'd probably find that the wire size was speced by the low-bid electrician to meet the National Electrical Code," Lovins told me. "The code says you need wire so fat for so much current. Well, it turns out that wire-size code is meant to prevent fires. What would be economically optimal in terms of resistance losses would be wire twice as fat, which means four times as much copper. Now, the electrician isn't going to pay your electric bills, right? If you had such an altruistic electrician that they were willing to put in four times as many pounds of copper to get you a one-year payback on your electric bills, they wouldn't get the job, because they wouldn't be the low-bid electrician anymore."

I learned another lesson in perverse economic incentives early in my career when I was consulting on electrostatic charging problems. An electrostatic charging problem you may know of is the problem where corn silos blow up once in a blue moon. As the corn descends in the silo, corn particles rub against each other and charge electrically. If two nearby particles charge enough in opposite ways, these particles discharge their electric potential in a spark that causes the dust to ignite. Because dust is formed essentially from particles suspended in air with a high ratio of oxygen to surface area, the ignition creates an very rapid combustion, and an explosion results.

It turns out that the same thing happens from time to time in oil tankers. When you wash down the inside of a tanker, the water and oil cascading down the sides of the oil tank act just like the corn in the corn silo. The company I was working for first approached the oil tanker owners about finding a way to prevent tankers from exploding during cleaning. The owners said they were just as happy to pay their insurance premiums as invest in a solution who's payback was risky. Then my former company went to the insurance companies. The insurance companies were just as happy to raise the premiums a little bit each time a tanker blew up since none of their clients were canceling oil tanker policies. Even the union representing the workers who cleaned the tankers declined to invest in a solution. Union workers' lives fit the same profile as oil tankers: precious, but insurable.

Markets are great at allocating resources in the short term when there is no information asymmetry between transacting parties. With full disclosure, an investor can discount future cash flows reliably and calculate the net present value of an asset. In the short term, for transactions that take place frequently, transaction history is nearly enough information to make reasonable pricing and allocation decisions.

Split-incentives and other perverse incentives keep individuals and corporations from making economically sensible long-term decisions. Climate change may be the best example of technology change creating information asymmetry and uncertainty that cause improper pricing. While Lovins correctly blames the split incentives for incorrect microeconomic decision making, an emerging idea is that rapidly changing technology effectively shrinks economic time frames and increases information asymmetry and uncertainty.

For instance, housing markets that are comfortable with pricing based on 20- and 30-year cash flow estimates may not have climate change on their radar. Lovins points out the split incentive problems that keep home builders from building economically (and environmentally) efficient houses. But it is technology change and its resulting information asymmetry and uncertainty that mess up housing prices. Home buyers may discount climate change improperly because climate change appears relatively distant or looks like a garden variety technology change. Building and encouraging use of lots and lots of inefficient cars, for example, deploys technology with unknown or difficult to predict environmental consequences on a mass scale.

More and more rapidly changing technology creates unforeseen market discontinuities more and more rapidly. If these unforeseen market discontinuities follow some normal distribution, many will be imperceptible in the market while a few will cause catastrophes. Growing human population compounds the impact of catastrophic market discontinuities. Climate change looks like a catastrophe in the making, but it is being discounted as if it were a technology discontinuity of the variety that causes an imperceptible discontinuity rather than a catastrophic discontinuity. Maybe that's because investors and consumers are more familiar with the smaller discontinuities.

The hard question: do we wait until the discontinuity like climate change occurs to let the market correct itself, or do we regulate?

This is where I think we can use some help from the economists as well as the climatologists. Carbon markets are one idea for using market principles to solve energy allocation problems, and these markets result from regulation. Governments would have to require companies and citizens to meet carbon dioxide output quotas. Taxing energy consumption and investing in renewable energy and energy conservation is another regulatory option that is not based on market methods. It is less effective for short-term allocation, but it increases chances for the kind of breakthrough R&D that occurs when scientists can work outside market constraints.

Because climate change may be just one of a handful of problems caused by technology discontinuities, economists studying climate change options may help us understand how to anticipate and respond to other future technology discontinuities. Pure market forces may not be the answer, but economists may be able to determine which non-market solutions will work for the kinds of discontinuities we are more and more likely not to perceive.


Update: You can now bet on whether global warming will flood coastal cities, make polar bears extinct, or other catastrophes. If you own coastal property, here's your climate change hedge.