Betting on climate change

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.

The Foresight Exchange market is an internet-based game which runs an ideas futures market, covering a wide range of claims including a number of environmental issues. The basic betting mechanism is based on the concept of a pair of coupons labelled “Yes, claim X is true” and “No, claim X is false” (where X is a proposition whose truth is not yet known). These coupons can be bought and sold individually on the open market, and a pair of them can always be bought or redeemed for $1 from the bank. When the claim’s truth is determined, the correct coupon is redeemed for $1 and the false coupon becomes worthless. The market price of the Y coupon is the market’s estimate of the probability of the claim being ultimately proved true. Here are a couple of examples – indicating how confidently (or otherwise) the market predicted the re-elections of Clinton and Bush in 1996 and 2004 respectively.

The Foresight Exchange is a small market with a limited number of players, and is certainly not perfect – I presented a simple analysis in a poster at the EGU in April, and I have also discussed a couple of claims in more detail here and here. (These are a slightly different type of claim, where the payout of the Y coupon depends continuously on the value of a variable at a specified future time – such as the global mean temperature in 2030. The N coupon pays $1-Y as before.) As Hanson’s theory predicts, by participating in the game, I have both improved the price on these claims (increasing market skill) and simultaneously increased my wealth (received a reward for my contribution). Although this small and non-serious market has noticeable inefficiency, a real money market could certainly hope to do better. So what are the drawbacks? It seems that there are are surprisingly few. Fears that rich vested interests could rig the market are generally misplaced: it would cost them a lot of money to do so, potentially much more than the price of influencing a few high-ranking experts. Robin Hanson’s pages have a great deal of discussion about the various criticisms of the idea that have been offered, and also how the basic idea could be extended to cover a wide range of applications.

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