Thursday, May 03, 2007

Could long-term weather markets help us understand the risks of climate change?

Markets are good at aggregating information. When individuals - each acting according to their own personal preferences, ideas and knowledge - interact in a market, the market price that is set for a commodity reflects society’s best guess about the commodity's value. For example, shares in Telstra can (probably) be bought and sold by Telstra employees, share market analysts, Telstra’s competitors and customers, telecom regulators (maybe), directors of overseas telco companies, etc etc. Each of these individuals has their own thoughts, based on their own expertise, of Telstra’s business and prospects. The resulting share price reflects a consensus on Telstra’s value.

To put it another way:

When individuals make economic decisions based on diverse sources of information, market aggregates – such as prices – will to a greater or lesser extent reflect the pieces of information received. By observing a market aggregate, each person may learn something about the information possessed by others. In some cases, enough information is reflected to induce everyone to agree on a consensus estimate of the relevant uncertainty. This theme has been extensively explored in the literature on rational expectations.
Another example: individual punters at a horse race may have particularly good knowledge of one or more of the horses in the race (how fit they are, what sort of conditions they like), the jockeys, the track, etc. When combined, they give odds which represent the betting community’s best estimate of the probabilities of each horse winning, distilled from this dispersed information.

The odds in these sorts of betting markets give a good indication of future events. For example, economists Andrew Leigh and Justin Wolfers have found that election betting markets are good at picking election results, and certainly better than polls on intended voting behaviour (papers here and here).

I don’t know much about the economics of betting markets but I was intrigued by this well-defined bet on future global temperature change between a climate change ‘believer’ and a ‘sceptic’:
We have three bet periods -10, 15, and 20 years - and two bets for each period - an even-odds bet and a 2:1 bet in David's favor. The even-odds bet centers around a temperature increase rate of 0.15C/decade with a 0.02 void margin on either side (bet voids if temps increase between .13 and .17C/decade). The 2:1 bet centers on 0.1C/decade with a .01 void margin. Even-odds bets are for $1,000 each, and the 2:1 bets increase over time, with me betting $1,000, $2,000 and $3,000, and David betting half that. My exposure is $9,000; his is $6,000.

So I was thinking: What if someone set up some decent markets in future global temperatures? Anyone would then be free to bet on how much climate change they expect in the future. There are already weather markets for short-term weather events, so it shouldn’t be too much of a stretch.

I can think of a number of benefits:

  • It would give an independent estimate of likely magnitude of climate change based on individual scientists, companies, individuals, etc all betting on how much they think temperatures would rise by based on their understanding of climate change science. This would be very valuable to guide government policy and private sector decisions.
  • Some people have criticised the scientific integrity of the Intergovernmental Panel on Climate Change (IPCC) estimates of climate change because they are based on consensus and therefore ‘political’ and biased. There could be no such criticism of this process – people would be acting independently and putting up their own money.
  • Climate change sceptics (and believers) could put their money where their mouth is: if they’re so convinced that we’re not at risk from climate change, they could make a motza. (And it would test the claims from some quarters that this is some sort of vast left-wing conspiracy).
  • There would be incentives to invest in climate change research, as people could make money from it: if you understand the likely future climate better than (or before) everyone else, you can make money on the markets.
  • People could use it to hedge or insure their exposure to climate change impacts. For example, say the market assesses the chance of very large temperature rises of 5 degrees in the next 50 years is 1 in 1000 and so I can make a bet on that level of change that pays 1000 to 1. Now, if I own a beachside house that will be ruined by sea level rises associated with a temperature increase in that range, I could bet say $1000 now that temperatures won’t rise by 5 degrees in the next 50 years. If they don’t rise that much, I’ve only lost $1,000. If they do rise that much, I can use my $1 million to buy a new house. Ski resorts could hedge some of the risk of declining snowfalls from higher temperatures. This could be helpful to all sorts of businesses, especially insurance companies, helping them to assess risks and cover them.

Wouldn’t a government or financial institution be providing an enormously helpful (and potentially profitable) service by setting up such a market?

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