Wednesday, February 21, 2007

Global warming critics

The world's political climate is getting greener.

The last legitimate skeptics of the science are coming to see the reality of a warming world, a Republican president is challenging America to curb its use of fossil fuels, and the world economic forum in Davos was abuzz with ideas on how to confront global warming.

Yet some economists, perhaps as a sort of contrarian reflex, are questioning the wisdom of going to extreme measures to combat global warming. There is certainly an economic cost for climate change, but the question is whether that cost is greater than the cost of slowing global growth to the point where the problem can be properly addressed. In October, a UK commission, the Stern review, was able to quantify these costs and determined that, yes, the future benefits of addressing global warming far outweigh the current costs.

But the report was obviously flawed. The biggest critic was William Nordhaus, the pointed out that the discount rate (the time value of money) used by the report was next to nothing:

The Stern Review proposes using a social discount rate that is essentially zero. Combined with other assumptions, this magnifies enormously impacts in the distant future and rationalizes deep cuts in emissions, and indeed in all consumption, today.

It is true that the discount rate used by the Stern review is ludicrous. It essentially implies that the value of a dollar today is exactly the same as the value of a dollar tomorrow - which, if true, would lead one to observe a massive glut of savings and an extreme shortage of consumption (a situation not too unlike the great depression). Nordhaus thus delivers a damning critique. It seems as though he is actually right: using a discount rate that is based in reality, a cost benefit analysis determines that immediate action to confront global warming is indeed not worth the costs.

And yet, Nordhaus is still wrong.

His reasoning would be correct in a world of certainty - but we do not live in such a world. In truth, no one can precisely predict how global warming will affect our climate, our ecosystems and indeed, our global economy. You can guess, and that guess can be reasonable - but no one knows for sure. In other words, there is a high variance of outcomes. Climate change could turn out to be no big deal, or perhaps the human race will be able to successfully adapt, or maybe it will be the biggest disaster the human race has encountered in millennia. But the bottom line is that we just plain don't know.

If you're an investor, it's your job to hedge against any kind of risk, no matter how unlikely. I remember reading an amusing story of a hedge fund manager that wanted to sell an iron condor (a derivatives strategy that is profitable if the security makes little or no movement) for U.S. government bonds. To hedge this kind of position, you buy the options on the extremes of the strangle. So this manager went out and one of the options he bought was one for an interest rate of zero percent - when he did this, the bank laughed at him, "why in the world would you ever buy an option for zero percent?" The manager responded, "I don't know, with my luck the world could go to hell and someone could blow up a nuke in Manhattan and that would be the day that all my options simultaneously expire." A few days later, 19 men hijacked four planes in what was one of the deadliest days in American history.

So you just don't know. And you have to plan for every outcome, not only the most likely one. Perhaps years from now our descendants will scoff at our unnecessary alarmism toward climate change, or maybe they will shake their heads amazed that we did nothing while we were systematically destroying our world.

We only get one planet. Do we really want to play Russian roulette for an extra measly few percentage points of growth?

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