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."

Wednesday, December 2, 2009

KEEP IT SIMPLE: From Cap-and-Trade to Tax-and-Cut

The California Air Resources Board (CARB) released last week the “Preliminary Draft Regulation for a California Cap-And-Trade Program. Sandwiched right between “ClimateGate” and the Australian rejection of a similar system, the timing of the release could scarcely have been worse… But it’s a very important document nonetheless.

The regulation seeks to drive a reduction in greenhouse gas emissions (GHG) on the order of 2%-3% every year, potentially exceeding the targets which are being mentioned for Copenhagen. But how are going to realize them? A review of the summary text provides a quick reminder of some the challenges which are inherent to any cap-and-trade (or emission trading) scheme:

  • Complexity: As most people know, the determination of carbon footprint is far from obvious, and relies on approximations and assumptions (see for example this). These pale in comparison to the additional elements built into a cap-and-trade system. Such complexity virtually guarantees that the impact on incentives will—at best—take a LONG time to materialize.

  • Costs: The system entails significant costs to administer, monitor, track, and report, as well as the need to create and fund secondary trading platforms for the allowances/credits.

  • Inequity: The system is potentially arbitrary, due to the likely need to allocate allowances and to adjust the allocation over time.

  • Rigidity: A system which is not designed to be responsive to on-going changes in the conditions of Californians

  • Adverse economic impact on growth: An effective levying of a significant tax on corporations, small businesses, and individuals (the draft suggests that some of the government revenues might be redistributed to Californians—to be further discussed).

These challenges should come as no big surprise to anyone even vaguely familiar with such systems. So why should California follow the wrong approach to tackle the GHG targets? I strongly believe that California—true to its track record in many fields—should innovate, rather than replicate, in this area.

So what should we do? Well, let’s go back to basics: If we seek to reduce the amount of carbon which we add to the atmosphere (beyond what is part of the normal carbon cycle), we have three primarily levers:

  1. Shift the mix of energy sources away from fossil fuels (crude, gas, and coal) and to sources which have a no (or low) contribution to the carbon total
  2. Increase the efficiency with which we use energy in our daily life (as long as some of this energy relies on fossil fuels)
  3. Keep incremental CO2 out of the atmosphere, either by limiting deforestation, or via novel technologies for carbon sequestration and storage

It so happens that the first two levers can be addressed by a fairly straightforward economic mechanism: A carbon tax shift or what I’ll call “Tax-and-Cut.” Al Gore described a variant of this approach in his book, "Earth in the Balance;" my suggestion for California is:

  • Tax fossil fuels (crude, gas, and coal) and their products, based on their carbon content. This would raise the costs of using energy and thus would provide a “price umbrella” for introduction of lower/zero-carbon content alternatives (dealing with issue #1 above) and also encourage consumers to adopt higher-efficiency solutions (dealing with issue #2 above).

  • Redistribute the entire carbon tax revenues (ideally on a quarterly basis) to individuals and corporations, in proportion to their income tax payments to California during the preceding 12 months. Some proportion of the revenue should initially be used to increase payments to recipients of unemployment benefits and other State transfer payments.

  • Set the tax level against a benchmark of the modeled societal cost of GHG (e.g., $30 per metric ton of CO2 equivalent), and the price can be set up on a sliding scale over time: for example, 25% of target cost in year 1, 35% in year 2, etc. California will still have the flexibility to adjust carbon tax level based on changes in environmental and economic conditions.

For further discussion of this topic please read Elaine Kamarck (who was Al Gore ‘s domestic policy advisor) or the Carbon Tax Center.

Having addressed items #1 and #2 with a “Tax-and-Cut” scheme, what can we do about #3 (carbon sequestration)? In part, it could be folded into Tax-&-Cut, via a carbon tax on wood products (calculated based on the net lost in sequestration capacity, in a way similar to the method for fossil fuels) and a tax credits for buyers of carbon-sequestration solutions (including RE-forestation). However, it is less obvious how California could use a tax solution as a disincentive for deforestation, given than the majority of it occurs in other nations… Something to think about—but not enough to question the superior simplicity of the Tax-&-Cut approach.

In summary: Setting up a California system for “Tax-and-Cut” which will use pricing and incentives to drive GHG emission reduction will be much simpler and cheaper than the draft “Can-and-Trade” approach, which is based on onerous limits on quantities and complex tracking and reporting.