Monday, December 21, 2009

We Got What We Asked For in Copenhagen!

Recently Fareed Zakaria discussed (on CNN's GPS program) an interesting idea: Let's think about acting on global warming as a form of insurance, whereby we attempt to protect ourselves (or our descendents) from a very undesirable outcome.

A new way to frame the discussion is more than welcome. We've been locked into a few typical "mental models" in dealing with this question, and they have been hampering our creative thought process. In general, three "archetypes" have dominated our approach to climate change action:

1. Advocacy (or, depending on one's opinion, "religion," or even "cult"): Key objective is to educate individual, organizations, and decision-makers about global warming (status, causes, and outcomes) and drive them to desired action (or inaction).
2. Public Policy (or, depending on one's perspective, "regulation," or "bureaucracy"): Key objective is to drive, set, and enforce public policy (like carbon cap or tax) aimed at certain environmental outcome.
3. Business (or, depending on one's bias, "capitalism," or "profiteering"): Key objective is to enable and direct market-based solutions (like credit trading platforms) aimed at desired environmental outcomes.

But these are certainly not the only potential frameworks for this issue. Let's consider Fareed's idea: What are the prerequisites for a viable "insurance" market? At the very least, insurance requires two parties which have a different perspectives about a potential risk. The two parties may have different evaluations of the likelihood of the potential risk (the risk may seem more likely to the insured than to the insurer); they may have different views on the impact of the potential event (see for example the market for Credit Default Swaps); or they may have different levels of aversion to the potential risk (which is why many people buy some type of life insurance).

Does that sound applicable to the global warming space? Of course! We have two camps with wildly differing views about the likelihood, severity, and relevance of global warming. This creates a golden opportunity for "arbitrage" through some "insurance" products. For example, let's say a policy would pay the insured $1 million for every 1 degree rise in a particular temperature benchmark by a given date. Some people think such an event is imminent, likely, and horrible—and therefore would like to buy the policy; some think that such an event is highly unlikely and of little consequence—and would therefore be delighted to issue such a policy (for a fee). With willing sellers and buyers and significant stakes, a market can emerge and flourish.

One can imagine, for example, small island states like the Maldives (which are very concerned about sea level rising) buying such a policy from Canada (winner of the "fossil of the year" award in Copenhagen). And how about these potential transactions:

In general, matching two parties with wildly differing world views need not just result in name-calling and hot air (as enjoyable as that may seem for a while)—if properly managed, it could also result in a win-win solution (and nice profits, most likely). Those who worry about global warming put their money where their mouth is—by paying upfront for protection; those who don't care collect the money—but take on a major potential liability to mitigate the risks, should they materialize.

[Note: Insurance markets pose some additional interesting issues, like the questions of reinsurance, moral hazard, and self-selection; we may get back to them in a later post.]

Now the alert reader might notice something odd in the (admittedly tongue-in-cheek) illustrative transactions above. "How come," asks the reader, "you're showing the Maldives paying Canada? The Copenhagen climate talks were about precisely the opposite transaction—with developed nations paying developing nations. What's wrong with that picture?"

Well, the alert reader is correct: The climate talks used a mental model which is diametrically opposed to the idea of insurance. While insurance focuses on protection against future unknowns, the Copenhagen climate talks bogged down is discussing past behaviors. Even though only one developed nation (the U.S.) is among the five nations contributing the most to greenhouse gases (the others are China, Indonesia, Brazil, and India), developing nations are expecting payments—"penalties," "accommodation," or even "reparations"—from developed nations, on account of the history of CO2 emissions (primarily from the developed world).

This mindset is rooted in a fundamental sentiment, in developed and developing nations alike, that the history of global economic development has been unfair in some important respects and resulted in major inequality and injustice; global warming is simply a symptom of our historical excess—and taking action on climate change is a way to atone for sins of excessive development, progress, and wealth. While many talk of the "sacrifice" necessary to drive an equitable solution, Hugo Chavez has taken this mindset to its logical extreme, pointing out in his Copenhagen speech: "Capitalism is a destructive development model that … threatens to put a definitive end to the human species."

But our approach to global warming need not be one of constant self-flagellation. For example, "Energy Efficiency" (or "Resource Efficiency") could represent a terrific framework to align environmental and economic considerations.

As some readers may recall, decades ago the "quality movement" redefined the factory floor; that school of thought moved well beyond a focus on product reliability, and instilled an unrelenting commitment to eliminating all operational errors (a famous Japanese metaphor was "Pursuing the last grain of rice in the lunchbox"). "Quality" was really a pretext for world-class productivity.

Fast forward to today: By focusing on the lifetime environmental impact of their activities, businesses can drive an unrelenting focus on eliminating waste of economic and environmental resources; just like Total Quality Management became synonymous with overall productivity, Resource Efficiency can become synonymous with "lean business" and superior business performance.

Understanding the varying mental models for tackling global warming is not just a nice intellectual exercise: Each of them would lead to materially different negotiations and outcomes. For example, if we ask (as we did in Copenhagen) how to best compensate the developing world for the sins of past development, of course we end up with Hugo Chavez spitting in our face to a standing ovation. The Copenhagen climate talks embodied a subset of mental models--Advocacy and Public Policy built on a foundation of Guilt/ Penalties/ Reparations--which were evidently ineffective. The disappointing results of the conference --despite the heroic efforts of its staff and participants--reflect the fundamental flaws in these mental models.

But challenging and adjusting our mental models can help us correct our course. Much as the "reparations" mindset of Copenhagen may be a pretext to far-reaching social and political change, an "efficiency" mindset can be a pretext to overall gains in business productivity--a lot less controversial goal. Let's take advantage of that, and work to frame the global warming question in terms of Business solutions encompassing concepts like insurance and resource efficiency.

Otherwise we'll keep getting what we ask for: Just like Copenhagen turned out to be "Kyoto Light," Mexico (Climate Change conference 2010) will become--at best--"Copenhagen Light."

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