by Judith Curry
I am a strong believer that academic freedom is essential for scientific progress, and such freedom includes the right to be “wrong.” In fact, scientists can often learn much from failed experiments and failed predictions. However, for regulatory science and science for policy, should there be some premium on (and some reward for) actually being “right”? How can we know what is “right” in the short term? Shi-Ling Hsu has a provocative new essay that advocates an entirely different path for evaluating climate science that draws upon an institution that is truly independent: markets.
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A Prediction Market for Climate Outcomes
Shi-Ling Hsu
Abstract: This article proposes a way of introducing some organization and tractability in climate science, generating more widely credible evaluations of climate science, and imposing some discipline on the processing and interpretation of climate information. I propose a two-part policy instrument consisting of (1) a carbon tax that is indexed to a “basket” of climate outcomes, and (2) nested inside this carbon tax, a cap-and-trade system of emissions permits that can be redeemed in lieu of paying the carbon tax. The amount of the carbon tax in this proposal would be set each year on the basis of some objective, non-manipulable climate indices, such as temperature and mean sea level, and also on the number of certain climate events, such as hurricanes or droughts, that occurred in the previous year (or some moving average of previous years). In addition to setting a carbon tax rate each year, an auction would be held each year for tradeable permits to emit a ton of carbon dioxide in separate, specific, future years. That is, in the year 2012, a number of permits to emit in 2013 would be auctioned, as well as a number of permits to emit in 2014, in 2015, and so forth. In the year 2013, some more permits to emit in 2014 would be auctioned, as well as more permits to emit in 2015, 2016, and so forth. The permits to emit in the future are essentially unitary exemptions from a future carbon tax: an emitter can either pay the carbon tax or surrender an emissions permit to emit in the specific vintage year. Because of this link between the carbon tax and the permit market, the trading price of the permits should reflect market expectations of what the carbon tax will be in the future, and concomitantly, expectations of future climate outcomes. The idea is to link the price of tradeable permits to future climate outcomes, so that a market is created in which accurate and credible information about future climate conditions are important inputs into the price of permits. The market for tradeable permits to emit in the future is essentially a prediction market for climate outcomes.
Hsu, Shi-Ling, A Prediction Market for Climate Outcomes (February 26, 2011). Available at SSRN: http://ssrn.com/abstract=1770882 [link]
Some biographical information from Hsu’s web page: Hsu is Associate Professor of Law at the University of British Columbia. Professor Hsu has also been an Associate Professor at George Washington University where he taught courses in Environmental Law, Law and Economics and Property. Prior to his academic career, Professor Hsu was Senior Attorney and Economist for the Environmental Law Institute in Washington D.C; Deputy City Attorney in San Francisco; and practiced law with Fenwick & West in Palo Alto, California. Professor Hsu has a B.S. in Electrical Engineering from Columbia University, a J.D., from Columbia Law School, and a M.S. in Ecology and Ph.D. in Agricultural and Resource Economics, both from the University of California, Davis.
JC comment: Read the whole thing (all 74 pages), it is well worth it. Hsu nails the description and definition of the “problem” IMO, and points us in the direction of some new ideas for a solution. There are many small gems of wisdom in this paper, for which a blog post can’t do justice.
Introduction
Some excerpts from the Introduction provide the rationale for the prediction market for climate outcomes:
At the same time, the advantages of prediction markets are uniquely useful in processing climate science. First, the ability of prediction markets to aggregate and organize vast, disparate pieces of information is nowhere employed as productively as in the case of climate change. With climate science coming from so many quarters and drawing on information that is local in many ways, prediction markets are a singularly effective way to process the otherwise intractably numerous bodies of climate science. Secondly, prediction markets tap into pecuniary self-interest to process information in a way that is presumptively free of bias or preference for certain outcomes. This advantage is of crucial importance in the climate debate, as climate science is not only in need of aggregation and filtering, but also an institution that can scrub out some of the taint of ideology or political manipulation. In the current environment, beliefs about climate change are too intertwined with a variety of economic and professional interests, such that virtually no one can make an assertion about climate change without being accused of having some interest – economic, professional, or psychic – in convincing others. In prediction markets, it is simply too costly to sustain a disingenuous position. It is harder to put your money where your mouth is when you do not truly believe what you are saying, particularly when market prices are providing constant feedback. [ JC emphasis]
While this proposal could reduce greenhouse gas emissions, the primary purpose of this proposal is not to regulate or price emissions, but to create a market that harnesses, processes and even creates information about climate science in a way that is presumptively free of ideology and bias.
Why is climate science so hard?
Some excerpts:
But it is ultimately self-defeating to focus on the role of climate skeptics in trying to explain why people have trouble understanding climate change. Even without an opposition campaign, the task of communicating and addressing climate change is bound to run into trouble. If there was ever a scientific problem that was tailor-made to create public doubt and confusion, it would be global climate change.
But how does anyone make sense of the barrage of information from these hundreds of entities? . . . Under these circumstances, it begins to appear rational to delegate some of the information processing to intermediaries, an interpretive vacuum into which interest groups of all types have been happy to fill in a self-serving manner.
A second major cause of the climate comprehension problem is the complexity of climate science, and the attendant uncertainties of modeling complex systems. . . Uncertainty and complexity are naturally going to be parts of this process, which makes for problematic communications to a lay public that may not relish the complexity or have the patience for uncertainty, and might just be looking for a reason to not think about such a depressing subject.
But given the high costs of trying to avoid climate change, this economic uncertainty, coupled with the scientific complexities and uncertainties, make a compelling case for rational denial.
Unsurprisingly, none of these measures have mollified critics or climate skeptics. . . It is hard to escape the conclusion that climate skeptics will simply never be convinced by institutional adjustments aimed at making climate science more credible, and would find fodder in efforts to increase transparency. This article thus advocates an entirely different path for evaluating climate science, and proposes to draw on an institution that is truly independent: markets.
Prediction markets
Talk is cheap. Predictions are very cheap. In the public world of climate science, talk and predictions are not only cheap, they are frequently valueless, issued as they are by individuals and organizations with self- serving agendas, and on the basis of questionable information. Quality climate science (and reasonable climate skepticism) is mixed with too much ideology to create an ill broth contains very little informational nutrition. [JC comment: wow, I wish I wrote that.]
The core value of markets can thus be boiled down to this: if well- designed, they are capable of collecting, filtering, and processing a huge amount of information of varying quality.
A prediction market is a constructed market in which trades are made on contracts that specify payouts based on specific outcomes. Participating in a prediction market is betting on outcomes. Depending on the type of prediction market, “shares” of an outcome are bought and sold, so that the trading prices reflect expectations about the likelihood of that specific outcome ultimately taking place.
In appreciating the vast information network embodied in market prices, it becomes apparent how markets can play a role in aggregating and weighting the disparate pieces of climate science.
Perhaps most importantly, a prediction market in future climate conditions would force market participants – in the first instance, emitters of greenhouse gases that face a future carbon tax liability – to be extremely discerning consumers of climate science, critically evaluating climate science and the critiques offered by climate skeptics. While some emitters may have an ideological axe to grind in terms of climate policy, it would probably turn out to be very expensive to allow an ideological filter to affect its evaluation of the value of different pieces of climate science.
In addition, prediction markets, like markets generally, weight the value of information by allowing market participants to vary the amount of money invested. This allows prediction market participants to place a premium on information that they believe to be especially important or credible, and likely to change the expectation of an outcome.
Perhaps most importantly, a prediction market in future climate conditions would force market participants – in the first instance, emitters of greenhouse gases that face a future carbon tax liability – to be extremely discerning consumers of climate science, critically evaluating climate science and the critiques offered by climate skeptics. While some emitters may have an ideological axe to grind in terms of climate policy, it would probably turn out to be very expensive to allow an ideological filter to affect its evaluation of the value of different pieces of climate science.
Talk is cheap; but prediction markets force participants to back their stated beliefs with money. . . In the world of climate change, climate scientists and climate skeptics alike, can, instead of lobbing rhetorical grenades at the other, profit by trading on what they believe is superior information. Complaints that the market price reflects too much optimism or too much pessimism about future climate outcomes could be met with the advice to go and buy or sell some emissions permits.
The Tax-and-Cap-and-Trade Proposal
For details on how this would work, see the original article. Some overarching points are excerpted here:
The motivation for this part of the proposal is to tie market activity in tradable permits to future climate outcomes and thereby create a market for information about future climate outcomes. If emitters with future carbon tax liability are rational and risk-neutral, they should be willing to pay for tradable permits a price just slightly less than their anticipated liability under the indexed carbon tax.
This second part of the proposal forces emitters to forecast their own future carbon tax liabilities, and reveal their forecasts through the exchange of tradable permits. But the level of private concern over future climate conditions, as expressed through market prices for permits, is at least an unbiased opinion derived from self-interest. The price bid by emitters for say, permits to emit in 2020, would speak volumes about private expectations of the consequences of climate change, free from, as climate skeptics claim, conspiracies by climate scientists to shore up their research grant fiefdoms, or desires by radical environmentalists who really wish to use climate change as an excuse for imposing environmental restrictions. The market price is a far stronger and clearer signal of future expectations than what would probably be mostly anecdotal information about which firms are worried about and planning for rising temperature taxes.
There is one final benefit of this tax-and-cap-and-trade proposal that is worth emphasizing, as it achieves something unprecedented in both enhancing climate science, and accomplishing something far more effectively than any previous prediction market has accomplished. This proposal would create a private market for information and information processing about climate outcomes. Clearly, emitters with future carbon tax liabilities do not have and would unlikely develop the internal capacity to do their own climate outcome projections. At the same time, a carbon tax liability that is tied to future climate outcomes would compel most emitters to invest some money to investigate the likely extent of their liabilities. This could constitute a major source of funding for a new climate information market.
Which Climate Outcomes?
A key element of the proposal is the development of an index of climate outcomes, that is more complex than the oft used global average temperature anomaly.
A broader “basket” of climate outcomes, not unlike a consumer price index, might be devised to be a better indicator of the state of the Earth’s climate.
Hsu suggests an index with the following elements:
(i) global mean temperature
(ii) days of unusually high or low temperatures
(iii) extreme rainfall and drought events
(iv) sea level rise
(v) ocean acidity
(vi) hurricanes above a certain intensity level
JC comment: This concept of a broader climate index (beyond global mean surface temperature anomaly) is a key contribution, IMO.
Conclusion
We are probably better off not giving in to cynicism when considering the arguments of those with whom we disagree about climate science, however tempting it is to think that the “other side” is just nuts or corrupt. However, the vast uncertainties, the enormous political stakes involved, and the very core personal values implicated by the problem of climate change, not to mention the large investments that both climate advocates and climate skeptics have in their particular substantive positions, give rise to a situation in which anybody can accuse anybody of taking a subjective interpretation of climate science. It is truly challenging under these circumstances to take a benign view of those with whom we disagree. This proposal, more than even addressing the problem of reducing greenhouse gases, addresses the question of whom we truly believe, and how sure we are of our beliefs. Markets are inherently imperfect, so the information generated by this proposal will be imperfect. It is not as if this cap-and-trade market will reveal the true climate science. Rather, what this proposal does is provide objective information about what everyone else thinks. This information network aspect, similar to the information network embedded in market prices, is feedback more than it is information, and serves as a challenge to our beliefs.
JC summary: there is much food for thought in this article, even if you don’t buy the idea of a prediction market for climate. But I think this is an idea worth exploring, even if I don’t quite understand the actual market aspect of it.