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FiveThirtyEight

Politics

Matt Yglesias is skeptical of an idea that I adulterated from Robin Hanson: a robust system of climate change predictions markets.

This idea has some merit, but let’s not get carried away with ourselves. The underlying intuition here is that talk about climate change is cheap, but if we made people put their money where their mouth is we’d force them to speak honestly. The problem is that when coal and oil interests or the Koch family pays people money to mislead people about climate science or clean energy policies they are putting their money where their mouth is. Big money is at stake in this issue, and it could be easily worthwhile for polluters to lose money on a prediction market if that helped undercut support for clean energy legislation.

The problem is that just about any metric you might like becomes contaminated once people know there are large political economy stakes.

I’m not sure that this criticism holds up. Suppose that Koch Industries, the fossil fuels giant, decides to make a $98 billion wager — roughly equal to one year of their annual revenues — on the proposition that global temperatures will not warm significantly over the next 15 years. And suppose that they make this wager not because they actually believe that the planet isn’t getting warmer, but in order to rally public opinion against climate change.

Now, suppose that Koch “succeeds” in manipulating the market — the price of the temperature futures contracts are artificially deflated, and governments are less inclined to take action on climate change as a result. So, the fossil fuels industry is not subject to stricter taxes or regulations. Koch is happy about this. But temperatures keep going up. They’re not so happy about this, because it means they’re out $98 billion dollars.

Of course, at least Koch is doing a decent job of hedging its risks this way, so perhaps this isn’t so bad for them. But in reality, the manipulation attempt is unlikely to succeed. Because that $98 billion is yours, mine, and everyone else’s for the taking. I’m going to buy up the “it’s gonna be hot!” contracts, expecting to realize a healthy return since the prices are artificially deflated. And so are a lot of other people — until the price gets back to equilibrium. $98 billion really isn’t very much; on a typical day, about $170 billion worth of the stocks represented in the S&P 500 index changes hands, and the S&P 500 captures only a portion of all stock trades worldwide.

So while a one-time hedge of $98 billion might be a reasonable investment for Koch Industries, if they wanted to continue manipulating the market, they would have to continue pouring more and more money in — all the while, giving the rest of us a nice little nestegg — until they’d eventually put so much money into the “climate will be cool” position that they’d start hosting their annual barbecues at the Sierra Club.

Now, it certainly is important that the markets are sufficiently liquid to be able to operate efficiently and punish stupid bets. As I inferred during the Presidential campaign, for example, political futures contracts on John McCain at Intrade did appear to be artificially depressed for some time, apparently as the result of one large institutional investor whose motivations are somewhat murky.

But Intrade, although it’s a product I greatly appreciate, has some problems when it comes to efficiently pricing futures. It’s hard to get money into the site. The exchange falls into a legal gray zone. Transaction fees are comparatively high. And Intrade is stingy about paying interest on deposits, which adds a cost to having your money tied up. Not that many people have heard of Intrade, moreover, which isn’t true for the stock market. And because of network effects, it’s likely that volume/liquidity is somewhat nonlinear with respect to the number of participants in the market. So if these encumberances reduce the number of participants by, say, a factor of 10, it’s likely that trading volumes are depressed by some multiple of that.

I don’t think you’d have any such problems with climate futures markets, provided that they were reasonably well designed, unambiguously legal, and open to essentially all investors. After all, people can already bet on the weather at places like the Chicago Mercantile Exchange and have been able to do so for about a decade; all that a “climate futures market” would be is a Merc-type setup that allowed you to bet on the weather years, rather than weeks or months, in advance.

I’m also not a big believer, in general, of efficient markets hypothesis. But to bastardize the point that Dr. Hanson raised with me at lunch last month: sure, markets can be inefficient, but compared to what? I’d certainly trust the markets to evaluate the contingencies of climate change more usefully than, say, the United States Congress.

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