Betting on climate change

Guest contribution by James Annan of FRCGC/JAMSTEC.

“The more unpredictable the world, the more we rely on predictions” (Steve Rivkin). The uncertainty of an unknown future imposes costs and risks on us in many areas of life. A cereal-growing farmer risks a big financial loss if the price of grain is low at harvest time, and a livestock farmer may not be able to afford to feed his herd if the price of grain goes up. One way to reduce the risk is to hedge against it in a futures market. The two farmers can enter a forward contract, for one to deliver a set quantity of grain to the other for a fixed price at a future date. And indeed farmers do routinely use futures contracts to reduce their risks.

Weather is a major uncertainty affecting our futures (it is one of the main sources of risk for those farmers), and weather futures markets can be used to hedge on the monthly/seasonal time scale. In the longer term, changes in climate will also bring a range of costs and benefits, and a market in climate futures would allow anyone who is vulnerable to hedge against these risks too. But how can we assign fair prices to the contracts? One obvious starting point would be to look at model predictions and historical data. This is essentially what the IPCC does, eg with its estimate of 0.3+-0.1C /decade for anthropogenically-forced warming over the next 20 years in the absence of substantial mitigation of emissions (at the “likely” level, ie 66%-90% probability). If we want to work out the probability of global mean temperature being warmer 20 years from now, we could take this 0.1C in uncertainty of anthropogenic forcing (which I will assume to be 1 standard deviation of a Gaussian deviate), and add another 0.15C of independent natural internal variability, which gives a combined estimate of 0.3+-0.18C warmer overall or about a 5% chance of cooling. To this, we can add perhaps another 5% due to the possibility of a large volcanic eruption at the right time, making 10% in total. Now before you all write in telling me my assumptions are wrong, the real answer should be 20%, or 4%…that’s precisely my point. Of course my simplistic assumptions can be questioned, and I could have performed a more accurate calculation, but however carefully it is approached, this sort of forecasting inevitably involves subjective judgement and assumptions. The IPCC estimate depended on expert judgement, so someone who believed that they markedly overstated the anthropogenic influence might deduce that the chances of cooling were closer to 50%, and an advocate of the more extreme solar forcing theories might even confidently predict significant global cooling. So ultimately it seems like we have no really firm, provably correct and objective basis for setting a market price.

Fortunately, there is a solution to this problem. Efficient market theory states that the price in a free market should accurately reflect the aggregated information that is available, and so in 1990 economist Robin Hanson noted that we can turn the problem around: use the market as an aggregation mechanism to tell us what the odds are on any particular event. This, he claims, could be much more effective than relying on panels of government- (or self-)appointed experts and media pundits to predict the future, since the financial penalty would keep the incompetent away from the marketplace, and the real experts would be automatically rewarded for correcting any errors in the market prices. There is now a growing body of evidence in support of these theories, including for example the analysis of existing markets and results from a market which was set up specifically to investigate the idea further. Of course the market price does not exist in a vacuum: in practice, traders would perform calculations as I did above (but rather more carefully), and the market price would reflect their consensus. The market is a highly inclusive mechanism: rather than having to debate to the death, anyone who has an opinion can invest as much as they want (which will relate to their confidence), and in the long run the winners will drive out the losers. If I offer (and accept) bets on global cooling at 10:1 based on my rough calculation, someone who does a better job of estimation will probably be able to take money off me, earning a reward for their skill and effort.

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