Climate Risks: Lessons from the Financial Crisis

Among the many talking points that Wall Street emphasized in its successful efforts to de-regulate the financial industry over the past three decades was that it was more sophisticated now than it was back in the 1920s - it knew how to manage risk. The mantra that financial firms were doing a better job managing risk was no doubt a comforting thought for politicians from both major political parties who voted repeatedly to dismantle old regulations and permit new, unregulated financial firms to grow and dominate the industry.

Unfortunately for the rest of us, events have proved otherwise. The financial industry was not quite as sophisticated as it thought.

At the same time that the financial industry was building its risk management models, economists were constructing their own, ever more complicated models to assess the risks of climate change. Despite the emerging consensus from scientists that climate change posed significant and potentially catastrophic risks, these economic models purportedly demonstrated that the costs of emissions reduction in the present could not be justified by the future benefits of avoided damages from climate change. One reason these models reached conclusions so at odds with climate science was because they failed to recognize the implications of climatic black swans.

When analyzing risk in the financial industry and the risks of climate change, one must decide how to take into account events whose likelihood of occurring is extremely small. The usual answer is to ignore events with minimal probability of occurrence. This is reasonable, as long as the consequences associated with such highly improbable events are comparable in magnitude to the consequences of much more probable outcomes.

But what if the consequences of a highly improbable event are exceedingly large - bordering on the incalculable? Combine "incalculable" with "highly improbable" and you have two good reasons for analysts to avoid what is now popularly referred to as a black swan - an event that is highly improbable but whose consequences dwarf the consequences of more probable outcomes. Black swans are to finance and climate change what hanging chads were to Florida election officials - the nightmare everyone would like to ignore. But we ignore black swans at our peril - which is unfortunately what financial deregulation and failure to take precautionary measures to avoid climate change amount to.

The danger of black swans is becoming increasingly well recognized. Nassim Taleb popularized the notion of "black-swans" in his best-selling book of the same name. The book criticizes the Black-Sholes and Capital Assets models that revolutionized Wall Street for ignoring these types of risks. Taleb notices that hedge funds exploit a perceptual weakness on the part of their clients regarding black swans by placing bets that almost always generate small gains and only risk large losses once in a blue moon. By leveraging their bets heavily, hedge funds magnify the small gains that occur with a high probability into much larger percentage gains for their clients that predictably roll in year after year. The hedge fund then pockets a 2% management fee and 20% of client profits over some minimum rate of return each year. Year after year, the hedge funds pay their clients handsomely while paying themselves royally. This creates the illusion that blue moons don't rise over their particular hedge fund.

But sooner or later a blue moon will rise over every hedge fund placing these kinds of bets. By leveraging bets, hedge funds not only magnify gains on all the normal nights, they also multiply the magnitude of a loss when a blue moon does appear. Consequently, when the blue moon finally rises clients are wiped out, but the fees and profit shares of the hedge fund usually are not. Only when hedge fund managers are foolish enough to invest their gains alongside their clients' investments do the managers go down with the ship. That is, only when managers forget that they are exploiting the predictable tendency of clients, who they have carefully conditioned with an uninterrupted string of white swan sightings over their hedge fund to underestimate the likelihood that a black swan will appear, do they also fall victim to their own scheme.

Of course, since black swans do appear from time to time over the sky of all hedge funds, if clients take black swan sightings at other hedge funds seriously, presumably they would be less easy "marks" for their own hedge fund managers. And indeed, now that the global financial crisis has unleashed large flocks of black swans simultaneously over many hedge funds, the illusion that "no black swan could appear at my hedge fund because none has yet" may be shattered, in which case we may witness the end of an era defined by this particular kind of financial scam. But until recently, many hedge fund clients have apparently fixated only on the string of white swans their own fund manager can invariably show them and have falsely assumed that black swans only appear over poorly managed hedge funds where fools invest.

Protecting wealthy investors from hedge fund scams should be the least of our concerns. The shockwaves those swans have sent throughout the global financial system threaten all of us, because banks that were too big to fail were allowed to play Russian roulette with our funds by investing heavily in hedge funds. If we have learned one thing from the crisis it should be this: the interests of those who make short term profits with other people's money in the financial carrying trade do not coincide with the long-run interests of the public at large. If financial black swans appear, the public will suffer the full negative effects while those in the financial carrying trade will suffer only a tiny fraction of the negative effects. We need to regulate the behavior of those in finance to prevent them from undervaluing the consequences of black swans to our detriment.

But have we also learned to better manage risks? Climate scientists have warned that if we can't get on a trajectory to stabilize atmospheric carbon dioxide levels within the next ten years, there is a very high probability we'll experience moderate global warming and a smaller, but still real, possibility of passing critical thresholds that will result in cataclysmic climate changes. In light of this evidence, what is the appropriate response?

Economic models that claim that the costs of preventing climate change are not worth the benefits of avoided damages are ignoring the possibilities of black swans and maximizing the expected value of climate policy. If an action almost always produces small negative payoffs and only yields a large positive payoff once in a blue moon, maximizing expected value leads us to reject this course of action. Yet, if people behaved this way in the real world, no one would buy insurance. Profits in the insurance industry hinge on the willingness of buyers to pay more in annual premiums than the expected payout in the event of a blue moon. Insurance is profitable because almost all of us, fearful of incurring a black swan we cannot afford, buy insurance policies with a negative expected value for the buyer and only a positive expected value for the seller. Yet most of us do not think it is foolish to purchase life insurance or fire insurance for our homes. Why then, would we think it is foolish to insure the planet against catastrophic climate risks whose costs are literally incalculable?

Ironically, there is every reason to believe the benefits of avoiding even mild climate change would outweigh the costs of avoidance. A few unwarranted assumptions buried in mountains of technical details - such as ignoring whole categories of damages from even mild climate change and undervaluing benefits of avoidance by choosing a high rate of time discount - are responsible for giving the opposite impression. But even if avoiding mild climate change were not cost effective, and even if cataclysmic climate change was less probable than scientists warn, the appropriate risk model - paying reasonable premiums for insurance against black swans we cannot afford - would still recommend the precautionary policy of paying the necessary costs to avoid climate change.

The likelihood of cataclysmic climate change under business as usual emissions scenarios is far greater than the likelihood of a once in a hundred years financial crisis - to borrow the words of a chastened Alan Greenspan. Even Greenspan now admits that this small probability warrants precautionary regulations on the financial industry given the magnitude of the damages that such an event unleashes. Since both the probability of a climatic black swan and the magnitude of the damages are far greater, the rational choice is to pay our precautionary premiums to insure ourselves against climate change. Arguments that the expected value of our insurance policy may be negative are beside the point. There are times to maximize expected value and there are times to buy insurance. Now, as we are deciding how to respond to climate change, is surely a time to buy a life insurance policy for our planet. Haven't we learned our lesson yet?