A prediction market for climate outcomes?

From Shi-Ling Hsu:

This article proposes a way of introducing some organization and tractability in climate science, generating more widely credible evaluations of climate science, and imposing some discipline on the processing and interpretation of climate information. I propose a two-part policy instrument consisting of (1) a carbon tax that is indexed to a “basket” of climate outcomes, and (2) nested inside this carbon tax, a cap-and-trade system of emissions permits that can be redeemed in lieu of paying the carbon tax. The amount of the carbon tax in this proposal would be set each year on the basis of some objective, non-manipulable climate indices, such as temperature and mean sea level, and also on the number of certain climate events, such as hurricanes or droughts, that occurred in the previous year (or some moving average of previous years). In addition to setting a carbon tax rate each year, an auction would be held each year for tradeable permits to emit a ton of carbon dioxide in separate, specific, future years. That is, in the year 2012, a number of permits to emit in 2013 would be auctioned, as well as a number of permits to emit in 2014, in 2015, and so forth. In the year 2013, some more permits to emit in 2014 would be auctioned, as well as more permits to emit in 2015, 2016, and so forth.
The permits to emit in the future are essentially unitary exemptions from a future carbon tax: an emitter can either pay the carbon tax or surrender an emissions permit to emit in the specific vintage year. Because of this link between the carbon tax and the permit market, the trading price of the permits should reflect market expectations of what the carbon tax will be in the future, and concomitantly, expectations of future climate outcomes. The idea is to link the price of tradeable permits to future climate outcomes, so that a market is created in which accurate and credible information about future climate conditions are important inputs into the price of permits. The market for tradeable permits to emit in the future is essentially a prediction market for climate outcomes.

The rationale for this idea is clear, namely a desire to build consensus by getting agreement to a broader proposal ex ante.  Nonetheless I think of such fine-tuning as a misguided approach.  Is there such a good “basket” measure of climate outcomes with sufficiently low short-term volatility? (Or does the metric do econometrics on the higher-order polynomial?)  Should the tax be fine-tuned year-by-year when the lag times between energy inputs and climate outputs is thirty years or longer, possibly reaching up to one hundred years?  Still, I am happy to pass the idea along for consideration.

For the pointer I thank Chris Auld.


Fence sitting is generally the best play unless people see you as a fence sitter.

Aren't there already futures markets in Carbon credits and won't the price there already indicate the market expectation for the future? How is this idea novel?

PS. A naive question: What economic advantage does a carbon-tax have over cap-and-trade?

A quick answer -- carbon tax encourages different and better forms of fraud than cap-and-trade.

Markets work best when customers can tell whether they get value. Markets in tokens of social respectability encourage collusion -- people just want to get their work done and are not usually interested in chasing down "counterfeiters".

What economic advantage does a carbon-tax have over cap-and-trade?

Rahul, the principal economic advantage of a carbon tax over C&T is that it is thought to provide more price certainty for affected firms. They have a set price on emissions to figure into their cost functions, which is also applicable to their competitors and thus makes forecasting easier. Having said that, there are ways to reduce this price uncertainty in the case of C&T, such as a price collar... among the other economic advantages that tradable emissions permits enjoy over taxes (e.g. economic efficiency, distributionally neutral, etc).

At this point, I should say that proponents of carbon taxes do not typically argue along economic lines per se, but are more concerned with political factors. For instance, there are fears that, because C&T is less transparent than taxes, permit allocation could be gamed to suit big players and even provide windfall profits to financial trading houses and speculators. In my opinion, these fears are overblown and oft-misleading... Speculators, of course, provide liquidity to the market, while the practice of "grandfathering" -- giving away permits for free to chosen firms -- should simply be avoided in favour of conventional auctions. Still, I don't dispute that taxes appear to be simpler to administer and easier to understand on a general level; two factors that may give it a big advantage in today's fractured climate policy environment.

If you are interested in reading more, Rob Stavins has a number of excellent posts discussing the pros and cons of C&T versus carbon taxes (as well as other policy instruments to fight climate change). E.g.http://bit.ly/OkWPd and http://bit.ly/9v1h6G

"For instance, there are fears that, because C&T is less transparent than taxes, permit allocation could be gamed to suit big players"

This is exactly the issue. As of now there are over 200 exceptions to the 'mandatory' portions of the health care bill. Add to this that a tax would be easier to administrate. But building the bureaucracy is a goal too.

The proposal falls down at "objective, non-manipulable climate indices, such as temperature and mean sea level".

There is already a well-funded noise machine saying that global temperatures are not rising, nor are sea levels. How much more "objective and non-manipulable" do the indices need to be?

When the chorus who say "But global temperatures and sea levels are NOT rising" arrive, please provide independent measurements, with calibrations traceable to the national standards (e.g. www.nist.gov.au or www.bipm.org), that support your contention. This is not the same as criticising the measurements you don't like.

Is there a term like 'Godwin' for moving off-topic like this?

Predicting temperatures is like predicting next year's or next decades stock market. Economists wisely are staying away from those predictions. However climate scientists seemed entirely comfortable, in 2005, by the United Nations predictions that in 2010 there would be 50 million climate refugees. Haven't seen them, nor has the UN.

Nevertheless, here is the postglacial sealevel rise on Wikipedia. Sea level has been rising rapidly over the last twenty-thousand years, with a maximum increase around 12kya. Recently the rise has been slowing down as the effect of the last ice-age disappears and climate returns to 'norm'.

Yes, sealevel is changing, and it will keep changing in the future, as it has always been changing since the first seas appeared on Earth. But factoring out natural contributions to anthropogenic causes is really hard, and the mathematical and signal processing expertise of climate scientists has not been impressive, to say the most. A good term for their models would be Warming In - Warming Out.

Pathetic, but for the huge consequences.

When the chorus who say “But global temperatures and sea levels are NOT rising” arrive, please provide independent measurements, with calibrations traceable to the national standards (e.g. http://www.nist.gov.au or http://www.bipm.org), that support your contention. This is not the same as criticising the measurements you don’t like.

Adam, you ask too much.

When I have discussed this topic with global warming deniers, they have consistently said that there is no good data available. All the published data has been falsified by the fraudsters who try to get people to believe in global warming. If somebody had real data and tried to publish it, they would be censored and their funding would be cut off.

Sometimes, but not always, they generalize from "all the data is bad" to "data is bad" and give theoretical reasons to show that there cannot be any such thing as anthropogenic global warming no matter what, and therefore they do not need data.

It may be coincidence or sampling bias that most of the global warming deniers I have discussed this with also believe in Austrian-school economics and use similar reasoning about that.

There have been complaints by the Australian, Chinese, and one other government I cannot remember that the temps they have submitted we improperly shown. Australian temps actually went down at one point while the UN showed them to increase. This was due to a heat island effect that had been inversely adjusted for.

There have been a large number of discrepancies in the temp measurements. As this is the realm of, largely, statisticians, the UN really should take heed of the many criticisms of them not involving the statistical community. Most of the mistakes they make would not be made by any grad level student.

Tom, could you please provide links to better measurements?

See, there is a whole lot of disinformation floating around, so people just saying that the data is wrong is utterly inadequate. Any sock puppet can do that.

What we need is links to better evidence that can then be used to estimate temperature changes etc. And we need reason to suppose that the new information is better.

Sorry, not aware of any. That does not mean we should use the ones we know have been altered and ARE incorrect.

A more general problem with prediction markets having a 30+ year time horizon is that the time value of money exceeds the predictive value of the market for all but a few exceedingly important things.

I predict that a prediction market in climate change would reveal that it does not fall into the "exceedingly important things" category.

That's a good point. The indexed carbon tax is to be indexed to inflation as well, but that does not fully address the time value of money problem. That is true. I would not be quick to predict, however, that climate change would not fall into the category of "exceedingly important things."

A carbon tax tied to global temperatures was proposed by Ross M McKitrick a couple of years ago:


McKitrick's indexed carbon tax is a major foundation for this idea of mine. I have cited and praised McKitrick's idea in my article, acknowledging my debt to his work. His article is in Energy Economics, vol 33, p 111 (2010).

Once you index the carbon tax though, then all the price certainty arguments in favor of the tax become weak?

That's right - -but I am not arguing for an indexed carbon tax on the grounds that it would be more certain. That would be the argument for a vanilla, non-oindexed carbon tax, a point made earlier in this blog. What the resultant price uncertainty would do, though, is to induce people to think about what they would be willing to pay to buy some certainty -- the price they would bid for a permit to emit in the future, when they do not know what the indexed carbon tax would be.

A futures market for carbon credits performs a similar function?

What the resultant price uncertainty would do, though, is to induce people to think about what they would be willing to pay to buy some certainty — the price they would bid for a permit to emit in the future, when they do not know what the indexed carbon tax would be.

Perhaps we could apply that approach to other areas. Like, we could have a varying price for murder permits, and see how much people would pay for certainty. When you think you're likely to commit a murder in the future you look into buying the permit ahead of time instead of taking the chance of a very high price on the spot market.

This way we could regulate the number of murders.

Yes, I'm being ironical. I'm doubtful about the basis for this whole idea.

As a measure of revealed market-forecasts for net economic harm you could compare the relative evolution of prices of waterfront real property with that of those parcels which are "one house back" from the water. At some point in the dissemination of global warming theory (and especially in the presence of very low discount rates), people should have come to a conclusion of the probability of a previously unexpected acceleration is sea levels. That should have created something of a trend-discontinuity, a drop in the price of waterfront properties and a rise in the soon-to-be waterfront properties. This relative shift should be more obvious in waterfront locations where polls indicate that more homeowners believe more strongly in this consequence of global warming.

Hypothesis: A rigorous analysis of waterfront and neat-waterfront prices will reveal that people aren't pricing in predictions of rapid sea-level rise *at all*. Whether that is due to behavioral economics or just revealed-actual-beliefs and politico-moral-exhibitionism and tribal-loyalty-signalling, is a matter of some debate.

Let me say it again (thanks to MR's reader Peter for translated it):
"As stated by the Spanish coach Juan Manuel Lillo, football intelligence lies in living with the certainty of uncertainty and not on building certainties that make us believe that there is no uncertainty “

This applies also to policy making and Professor Hsu's proposal is not exception. Certainty cannot be built by voice (some political process) or by markets (Hsu is wrong when says that "a market is created in which accurate and credible information about future climate conditions are important inputs into the price of permits" because market aggregation of information about benefits and costs is never accurate since it cannot eliminate the uncertainty of future conditions). If one day there is political support for internalizing fully the costs of relying on fossil fuels, I hope that Congress chooses a simple carbon tax and never delegates on EPA or any other agency its power to adjust the rate (yes, Congress is a terrible political institution but it's better than all others; those that don't like it should attempt to reform the Constitution rather than bypassing it).

BTW, I strongly recommend this post by Professor Hsu in his blog The Dismal Environment

Howabout instead of a carbon tax, carbon emitters must purchase a 100-year bond whose coupon is indexed inversely to certain verifiable data -- rise in sea level, increase in temperature, etc. Like a TIP, but not using the CPI, but a CCI (Climate Change Index). So when the CCI rises, the coupon reduces, and the yield increases. Too crazy?

Sorry, switch that, reverse it. ;)

The prediction market for climate change already exists in the property insurers and they have spoken rather clearly:
- the seas are going to rise, so the won't insure beach front property from flooding
- the weather is going to be more violent, so they won't insure for hurricane or the flooding that comes with storm surges.
- the rain extremes are going to increase so they won't insure for floods in any low lands near rivers because 100 year floods are going to occur more frequently
- the extremes of weather and storms are too unpredictable and profits seeking make preventing harm from extremes of environment unlikely, so insurers won't cover nuclear power plant accidents

Insurers are predicting much higher than expected climate related destruction and are refusing to share the risk, or they are charging much higher premiums.

And insurers support much stricter building codes, zoning, and other regulation as a means of reducing losses.

Obviously, the widespread refusal to respond to the market signals from the property insurers indicates individuals and businesses won't respond rationally to market signals. Even insurers know they need government to impose regulations and act to make the insurance markets work rationally.

Think we buy the deniers some beach front property to store all their worldly possessions.

Nah, it wouldn't work.

They would just ask for a federal disaster relief handout after the first storm. Sort of like Louisiana extolling the benefits and safety of offshore oil drilling in very deep waters, (reaping the benefits, by the way, of a slice of what had been federal OCS lease revenue which became "theirs" after the last "Energy" bill) and then asking for federal disaster relief when the oil runs up on their shore.

Go ahead and do it! I won't ask for any kind of protection. What's good for Al Gore and his beachfront property is good enough for me.

Mulp, sounds like the insurance companies are taking GE's lead. Let's milk this fear mongering for everything it's worth. Can't believe I need to explain to you how the business world could take advantage of a situation.

Mulp, sounds like the insurance companies are taking GE’s lead. Let’s milk this fear mongering for everything it’s worth.

What? You don't trust supply-and-demand to work?

Don't you believe in free markets? Are you one of those socialists? I thought everybody knew by now that socialism is wrong and does not work.

If you can't get free markets to work for insurance, what will it work for?

I trust supply and demand. I don't trust companies like GE (and insurance companies) not to use their influence with gov't officials to gain unfair advantage. The market place at this point is not picking the winner, but socialist intervention of the government is.

Source? That insurers won't insure or charge hugely higher premiums for beach properties and areas prone to floods and hurricanes is all news to me.

Agree with DK re sourcing, even though I agree with Mulps comment.

A co2 tax could be coupled with a payout for removing co2 from the air. There are various schemes for removing co2 from the air. You could also use the tax money to cool the plant through GEO engineering.

Tyler Cowen's original critique is important -- that it is difficult to come up with a representative "basket" of outcomes. That is, in fact, my most vexing problem in carrying this proposal further. Climatologists Andrew Dessler (http://atmo.tamu.edu/profile/ADessler) and Judith Curry (http://curry.eas.gatech.edu/) seem to think my 8 indices are ok, although Dessler has some reservations about hurricane intensity and thinks that sea level extent might be a better index. But they would not say that this basket of outcomes is a perfect proxy for climate disruption. At the end of the day, however, the more modest and possibly more important contribution is not coming up with a perfectly representative climate outcome index, but creating an institutional alternative to the IPCC and the climate science community. As I make clear in my article, this proposal is not a slap at the IPCC or the climate scientist community, but an acknowledgment that for a variety of reasons, a large portion of the population have doubts about climate science. Whatever people will say about markets, it would be implausible to say that a prediction market would be biased, in either direction. John's 100-year coupon idea is very interesting, I need to think about that more.

One thing that confuses me about the proposal is whether it is a way to get better predictions or is it a way to get better control (of emissions). And if both then can a single instrument really be used to achieve both purposes?

What about Intrade markets on Climate Changes? Are those any good?

Intrade is truly excellent. If you are good at predicting how Intrade customer opinion will change, you can make small bets and double your money in weeks. It is far better than online poker, though of course much much slower.

Some people have some sort of idea that Intrade is good for predicting the particular events that it reflects marginal Intrade-customer opinion about. For all I know that might have some validity, so long as nobody important cares what Intrade says. As soon as Intrade predictions are worth money, somebody will be willing to lose Intrade bets to distort the predictions and Intrade will then become worthless for that purpose, assuming it had value before.

I agree here. We already have (and could expand) a market-based approach to future climate changes with Intrade. There is no need to create a complicated scheme to tie in prediction markets to carbon taxes. The single biggest problem is simply finding a way to impose a carbon tax in the first place. This is one of those times when the details do not matter. Any tax or cap and trade with binding force would be fine. All else being equal, it might as well be simple.

Nate, let me suggest my carbon tax.

1. Tax oil and gas and coal at the source, when they are mined or enter the country. Make it a high enough tax to bring gasoline to somewhere around the $10-$12/gallon range.

2. Take the tax money and distribute it all equally to voters. Give every voter a government-issued debit card, and every week just split the tax income equally and put it in the debit accounts. Our current welfare system has a prototype for this. The Federal government would have to allocate a rather small amount of funds to collect the tax and run the debit card system. If that money comes out of the actual taxes collected it's an invitation for fraud and inefficiency.

So, consumers pay around $12/gallon for gasoline, because of the tax that was collected from a few sources. But on average they get $8/gallon back to do whatever they want with. If they want to buy gasoline with it, they come out even on average. but every individual voter who finds a way to reduce his use of gasoline gets to keep the money he saves, to spend on whatever he wants.

Meanwhile, businesses also pay $12/gallon for gas, and they pass the costs on to their customers. Every business that figures out a way to use less fossil fuel can cut prices and pass the savings to their customers, or else keep the profits. They also have a great big incentive to find ways to cut fuel use. Customers who buy fuel-intensive products have less money left over.

Exports will tend to be expensive because foreigner competitors don't pay $12/gallon. But we aren't exporting real well when we pay $4/gallon and they pay $8. We don't have any business trying to export fuel-intensive products. That is not our comparative advantage, and we are wrong to subsidise it.

Some people just plain need to use a lot of fuel. Texans, for example, and Alaskans. OK, if they are doing something important they will get paid enough to buy lots of fuel. Otherwise they don't belong in Texas or Alaska and they should move somewhere that they can afford to live.

This is a transfer tax. It transfers funds from people who use a lot of fossil fuel to people who use less. It is appropriate when we want people to use less fossil fuel. When the time comes that we stop using fossil fuel the tax will disappear.

The "non-manipulable" assumption might lead to some interesting side effects. Maybe someone with a big tax-position will try and modify a nascent hurricane center. Or cause a drought here or prevent a cyclone there.

I did read of some futuristic sattelite mounted mega-laser proposals to destroy hurricane centers........

Rahul, if you can manipulate public opinion you can find ways to buy in to positions cheap. For a 2-value prediction, once you have bets on both sides that cost less than half the payoff, you're doing pretty well.

On the other hand, if people pay attention to the Intrade odds, then while an Intrade bet is not heavily traded you can buy enough to change the odds, in the belief that the public announcement of the odds you changed are worth more to you for their effect on public opinion than they might cost you in bets at bad odds.

What I don't get out of this is, what's it all about, Alfie? Sure, it's fine for people to have fun betting about climate change along with anything else they feel like betting about. And it's fine for the people who have a good sense of public opinion to make money off people who are too certain of their own idiosyncratic opinions. But what does it really have to do with anything?

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