30 July 2010

Evolutionary fitness

...5% of movies pay for the other 95%, and success or failure is unpredictable. The best the studios can hope to do is find contractual mechanisms that back success after it happens and thus leverage their profits. This was what they had with distributors and cinemas, and it worked. They just didn’t realise it was these deals and almost nothing else that was paying for their Cohiba cigars. The movie industry was what Arthur [de Vany]] loves best: “a complex, adaptive, decentralised system”. Exactly like the human body. Evolutionary Fitness: the diet that really works, Brian Appleyard [UK] 'Sunday Times', 17 August 2008
And exactly like human society. The problem is that top-down planning cannot deal with such a system: it much prefers to impose the idea of equilibria, steady states, homeostasis and normal distributions about the mean on systems to which they don't apply.
Almost all dietary and fitness regimes are based on a homeostatic view of the body – meaning it is a self-regulating system that maintains itself in a continuous, stable condition. The average is the ideal. So we are told to eat regular meals consisting of a balance of the food groups and to take regular exercise, dominated by steady aerobic activity like cycling or jogging. This is all wrong.
We have seen where this line of thinking takes us in banking and finance too (see my post about Black Swans). And I suspect it fails in other policy areas, such as welfare, health and education. Our tendency is to ignore or discount the possibility and impact of catastrophe.

This is one area where Social Policy Bonds can function as a societal insurance policy against large-scale disasters that policymakers would otherwise neglect. The cause of the the disaster need not be specified: the bonds would function in a similar way to increasingly popular catastrophe bonds, except that they would have the purpose - and the backing- of making it worthwhile for investors to prevent disasters happening. A national government (or a consortium of corporations, non-governmental organizations and concerned philanthropists) could issue Social Policy Bonds that would reward investors if an event killing more than, say 10000 of a country's citizens in any one 48-hour period, does not occur before a specified date.

Such Disaster Prevention Bonds would encourage investors to investigate all sources of potential disaster, impartially. Unlike current attempts at disaster prevention, then, they wouldn't concentrate on those disasters that have a high media profile, for example.

The concept could be scaled up: a collection of governments under the auspices of the United Nations or non-governmental organizations could issue similar bonds, aimed at preventing even larger-scale disasters, such as a nuclear exchange. It's also conceivable that, again, the private sector could issue bonds that could, for example, aim to defuse regional conflicts (preventing war), or lessen the impact of malaria or crop failure in specified parts of the world.

26 July 2010

Heading for disaster: Kyoto, Copenhagen and climate change

This is an updated version of an article that first appeared in Economic Affairs, 22 (3), September 2002, published by the Institute of Economic Affairs, London. If you wish to publish it, please email me.

There is overwhelming, but not quite conclusive, evidence that the global climate is changing. That said, scientists are divided as to (a) how fast climate is changing, (b) what is causing it to change, (c) the likely effects of climate change, (d) how much we can do about it, and (e) how much we should do about it. Despite these uncertainties, climate change has the potential to inflict serious harm on large populations, so there is a strong argument for doing what we can to prevent it or minimise its adverse effects.

The December 1997 Kyoto treaty required developed countries to bind themselves internationally to numerical targets. Despite Kyoto’s flaws, between 1990 and 2007 emissions of greenhouse gases did fall by 4% in these countries. (Carbon dioxide, which is given off by fossil fuel combustion, is thought to be by far the most important of the man-made greenhouse gases that form an insulating blanket around Earth.) But evaluations by leading scientists indicate that Kyoto’s environmental effects, for all the bluster and bureaucracy, may be so small as to be almost unnoticeable.

Yet we are heading for more of the same. If any successor to Kyoto is ever agreed - or, more important, implemented - we can look forward to minimal reductions in emissions; undetectable effects on the climate; ingenious attempts to game the system; and the squandering of billions of dollars on wasteful, corrupt schemes all over the world. The big beneficiaries will be third-world dictators, Swiss bankers, and the burgeoning bureaucracies at national and supra-national level who will be charged with administering and ensuring compliance with whatever absurd regime is agreed. This is not cynicism, it’s realism: Canada has exceeded its Kyoto target by 29%,[1] but does anyone imagine it will be punished? And do we really want to see national democratic governments coerced by yet another supra-national governmental body into doing something to which their electorates object?

The successor to Kyoto will share the same, ludicrous assumption that afflicted its predecessor: that government knows the best way of achieving its goals. But with climate change the biological and physical relationships involved are many and complex. Even specialists in climatology disagree about the degree to which any of the myriad components of the world’s climate contribute or react to climate change. It would therefore appear to be poor policy to impose expensive, divisive, unpopular and upfront controls on certain activities on the basis that they might help bring about a slightly more stable climate some time in the future.

People who were serious about addressing climate change would not embody the assumption that they know exactly how the Earth’s climate is changing, what is causing it to change, and what is the best way of dealing with any change. They would not ignore a potentially catastrophic problem, but would try to be as cost-effective as possible, especially because of the colossal expenditures that will inevitably be incurred. An ideal policy would encourage innovative solutions, stimulating the investigation and adoption of promising new technologies, and be open to new information about the causes and effects of climate change. It would most probably seek to constrain the negative impacts of climate change, while doing little to discourage any positive effects.

An ideal solution would also use markets. Now markets are getting a bad press right now. Many blame them for the current financial crisis and for environmental depredations. And it’s true that unregulated markets are being abused to serve purely private interests at the expense of the wider public. So it is important to remind ourselves that a market economy is consistent with many different outcomes and that market forces can serve public, as well as private, goals. Markets are simply the most efficient means yet discovered of allocating society’s scarce resources. An ideal solution to the climate change problem would use market forces to channel people’s self-interest into the solution of the climate change problem.

If such a solution could be found, it would be bound to attract more support from world leaders, non-governmental organisations, and the public in general than Kyoto. Such buy-in is essential, because any solution is probably going to entail enormous costs and sacrifices.

Targeting outcomes, not activities: Climate Stability Bonds

Climate Stability Bonds would be a new globally backed, financial instrument, designed to achieve climate stability, rather than to regulate emissions, activities or institutions. These bonds would be issued on the open market and would become redeemable for a fixed sum only when the climate had achieved an agreed and sustained level of stability. In this way there is no need for the targeting mechanism to make assumptions as to how to stabilise the world climate - that is left to bondholders.

There are obvious difficulties involved in defining what a stable climate actually is, but the same difficulties apply when attempting to monitor the success or otherwise of Kyoto, neo-Copenhagen or any other regime. A Climate Stability Bond regime could target an array of objectively verifiable indicators such as temperature, change in temperature, rate of change of temperature, precipitation, frequency of extreme climatic events, ice sheet volume and many other variables, at a wide range of locations. It could also target for reduction the effects of a changing climate on human, animal and plant life. All indicators would have to fall into a satisfactory range for a sustained period before the bonds would be redeemed.

Normal bonds are redeemable at a fixed date, for a fixed sum, and so yield a fixed rate of interest. Climate Stability Bonds would not bear interest and their redemption date would be uncertain.

Bondholders would gain most by ensuring that climate stability is achieved quickly.

Internationally backed Climate Stability Bonds would be issued by open tender, as at an auction; those who bid the highest price for the limited number of bonds would be successful in buying them. A fixed number of bonds would be issued, redeemable for, say, $10 million each, only when climate stability, as certified by objective measure­ments made by independent scientific bodies, has been achieved and sustained. Once issued, the bonds will be freely tradeable on the free market.

What will determine the price of the bonds? Most obviously, the market’s assessment of how close climate stability is to being achieved. Interest rates on alternative investments will also be a factor. The bonds would sell for small fractions of their issue price if people thought there were virtually no chance of climate stability being achieved in their lifetime. People will differ in their valuation of the bonds, and their views will change as events occur that make achievement of a stable climate a more or less remote prospect. They would also change as new information about climate, and about the causes of climate change, is discovered. But the bonds, once issued, would be transferable at any time. Bondholders, having done their bit to achieve climate stability, could sell their bonds, realising the capital gain arising from the higher market price of their bonds. These market prices would be publicly quoted, just like those of ordinary bonds or shares.

Assume that Climate Stability Bonds, redeemable for $10 million each, have been issued, and that they each sell for $1 million. People, or institutions, now hold an asset that can give them a return of 900 percent once a stable climate has been achieved. It is this prospect of capital gain that gives bondholders a strong interest in bringing about a stable climate, as cost-effectively as possible.

Climate Stability Bonds could be issued by a world body, perhaps one supervised by the United Nations or World Bank. This body would undertake to redeem the bonds using funds that could perhaps be obtained from all countries, in proportion to their Gross National Product. It would be up to individual countries to decide how to raise funds, presumably from taxation revenue. Importantly though, no bonds will be redeemed until the objective of a more stable climate has been achieved and sustained.

What would bondholders do?

How might bondholders aim to accelerate the achievement of a stable climate? They could:

· help finance countries’ or companies’ greenhouse gas emission control programmes;

· pay vacationers to stay at home rather than fly;

· supply solar heaters to villages and households in poor countries;

· carry out, or subsidise, research into schemes to remove greenhouse gases from the atmosphere.

Bondholders can also be expected to finance other climate stabilising initiatives, the precise nature of which we cannot, and need not, know in advance. Of course, governments, research institutes and others are already carrying out many of these activities. But there is a crucial difference. Under a Climate Stability Bond regime, the motivation arises from the self-interest of bondholders, who have the incentive to seek out those ways of achieving a stable climate that will give them the best return on their outlay. Their outlay, of course, is the taxpayers’ outlay. But note that it is only when the targeted degree of climate stability is achieved that governments end up paying for it. Until then, it is bondholders who have to finance the initiatives that they think will achieve climate stability. The issuing body will, in effect, be contracting out the achievement of climate stability to the private sector. But it will be stipulating the degree of climate stability that it wants, and undertaking to reward bondholders when that objective has been achieved.

Many will be skeptical that bondholders can actually do anything to combat climate change. It is true that too large a number of small bondholders would probably do little in isolation to bring about climate stability. If there were many such small holders, it is likely that the value of their bonds would fall until there were aggregation of holdings by people or institutions large enough to initiate effective problem-solving projects. As has happened with share privatisation issues, the bonds would mainly end up in the hands of large holders - probably institutions, brokers, governments or corporations.

Even then, each such body would probably not be big enough, on its own, to achieve much without the cooperation of other bondholders. They might also resist initiating projects until they were assured that other holders would not be ‘free riders’. But note that they will have a strong incentive to cooperate with each other, and to do so as cost-effectively as possible. If they did not, the market value of their bonds would fall. Their common interest in seeing climate stability achieved quickly means that they would share information, trade bonds with each other and collaborate on climate-stabilising projects. They would also set up payment systems to ensure that people, bondholders or not, would have an incentive to perform efficiently. Large bondholders, in cooperation with each other, would be able to set up such systems cost-effectively. Governments holding bonds would benefit by enacting legislation aimed at achieving climate stability, while large bondholders could lobby for such legislation, targeting their lobbying energies at those governments who will respond most readily.

Advantages of Climate Stability Bonds

There are two critical advantages that Climate Stability Bonds have over Kyoto and its likely successor. One is that the bonds do not rely on the robustness of our existing scientific knowledge. Kyoto aims to reduce emissions of a small range of gases. But there may be other causes of climate change that are far more important, of which we are currently unaware. And these need not be man-made: natural variability of climate has had severe impacts on human life in the past. Kyoto, responding to effects whose causes are uncertain, embodies a limited number of fixed ideas about the nature of the relationships involved. A bond regime, targeting climate change directly, may well lead to cuts in greenhouse gas emissions, but it would not assume that doing so is the best solution. Climate Stability Bonds improve on Kyoto because they encourage behaviour leading to the desired outcome, rather than seeking to control activities whose effects on the climate stability are not fully known.

The other major advantage of a Climate Stability Bond regime is that bondholders will support whichever climate stabilising projects will give them the best return for their outlay. These may involve controlling greenhouse gases, but they could also mean furthering research into such ideas as genetically engineered cyanobacteria that can soak up carbon dioxide from the atmosphere. The more efficient bondholders are in achieving climate stability the more they will gain from appreciation in the value of their Bonds. This efficiency maximises the degree of climate stability that can be achieved per dollar outlay. Because of the colossal sums involved, the benefits that Climate Stability Bonds offer in comparison to activity-based regimes, such as Kyoto, are likely to be huge.

Further advantages of a bond regime are:

· the bonds would have considerable informational advantages over such measures as Kyoto, which target activities rather than outcomes. Greenhouse gases are emitted from many sources. About half of carbon dioxide emissions, for instance, come from dispersed sources, such as cars and home heating systems. Immense quantities of information would be needed to establish and monitor a comprehensive system of control using taxes or tradeable emission permits. Costs of obtaining such information and resentment against the intrusiveness required to ensure compliance are going to be high. By contrast, Climate Stability Bonds would target and monitor a much smaller number of global indicators.

· governments would pay up only when a stable climate has been achieved - any risk of failure or of undershooting the climate stability target is borne by bondholders, rather than taxpayers;

· funds for global climate stability could bypass corrupt or inefficient governments or, by appealing to their financial self-interest (if they were bondholders, or bribed by bondholders) could effectively modify their behaviour in favour of achieving climate stability; and

· formulating the redemption terms for Climate Stability Bonds will entail clarifying of what is actually wanted. Framing the debate in terms of outcomes, rather than institutions or activities, will bring about greater public participation and buy-in to the entire process: essential of the challenge is to be met.

Achieving a stable climate will unquestionably require a wide range of diverse, responsive projects. Reducing greenhouse gas emissions or sequestering carbon may be helpful ways, but they are not necessarily going to be the most cost-effective. Other ways yet to be discovered may be far cheaper. Kyoto is, in my view, deficient, in that it offers no incentives to find out how to achieve a stable climate most cost-effectively. Climate Stability Bonds would encourage the most efficient solutions given the knowledge available at any time, and they would stimulate research into finding ever more cost-effective solutions. This occurs because of the nature of the bond mechanism, and requires no presupposition as to the optimal set of solutions. Scientists and governments would need to decide only on the objective - climate stability - not on the ways of achieving it.

Of course, the Climate Stability Bond concept involves surrendering of policy instruments to the private sector, and this may be difficult for politicians to swallow, even though, under a bond regime, they would continue to set, and be the ultimate source of finance for, the targeted objective. The potential benefits of a bond regime are colossal. In economic theory, and on the evidence of recent history, market forces are the most efficient means yet discovered of allocating society’s limited resources. Under a bond regime, government would do what it's good at doing: articulating society’s wishes and raising the revenue for achieving them. Where government often fails is in actually achieving these goals efficiently and that is where investors in the bonds would do what they are best at; exploring, investigating and implementing an array of approaches, while responding to events and our rapidly expanding scientific knowledge; all in the service of the overall goal of climate stability. Investors’ rewards would be inextricably linked to their success in bringing about society's climate stability goal, as articulated by national governments. Rather than punish countries, upfront, for dubious long-run benefits, the bonds would reward and motivate people for achieving demonstrable gains in climate stability.

Climate Stability Bonds are intended to channel the market’s incentives and efficiencies into the achievement of society’s overriding environmental objective. By appealing to people’s self-interest, Climate Stability Bonds could be far more effective at achieving climate stability than Kyoto or whatever deal is struck in Copenhagen. And, by targeting a desired outcome but leaving it for the market to achieve, the principles underlying the bond concept could show the way to solving other seemingly intractable global problems, including other environmental problems, war, civil war, disease and malnutrition.

© Ronnie Horesh, November 2009


Injecting incentives into the solution of social problems: Social Policy Bonds (September 2000), Ronnie Horesh, Economic Affairs, 20 (3), Institute of Economic Affairs, London, UK.

Injecting incentives into the solution of social and environmental problems: Social Policy Bonds (January 2001), Ronnie Horesh, iUniversity Press, USA. ISBN: 0-595-15374-7

‘Investing for the Future’, UK CEED Bulletin No 35 (September-October 1991), Centre for Economic and Environmental Development, Cambridge, UK.

[1] Avoiding a crash at Copenhagen, ‘The Economist’, 24 September 2009

20 July 2010

Doing what the corporates want

One of the virtues of Social Policy Bonds is that people, as distinct from government agencies and corporations, would decide on policy goals. As human beings, we probably would not want to divert funds from taxpayers and consumers to, for example, big agriculture, wealthy landowners, or big energy. The sums involved are staggering:
...more than US$ 550 billion was spent in 2008 on subsidies to oil, natural gas and coal by 37 of the world's developing and emerging economies ...their removal would result in significant energy savings. G-20 Summit sees little mention of pledge to reform fossil-fuel subsidies, by Fernando Cabrera Diaz, Global Subsidies Initiative, June/July
It's only because of the way in which government and big business make policy that they can get away with such a waste of resources. The current way of deciding on policy priorities is too obscure and protracted to engage ordinary people. Big corporations and government bodies fill the vacuum.

Social Policy Bonds would be different. The focus would be on outcomes right from the start. Organizations would be entirely subordinate to chosen social and environmental goals. A new type of organization - one whose rewards would be inextricably tied to its success in achieving society's goals - would come into being. Even under a bond regime, people would disagree with some chosen policy priorities. But, having been able participate actively in the selection process, they would be more inclined to buy in to targeted goals. Of course, even then we might still opt to tax the poor and subsidise big energy and big agriculture. But we'd be doing so with our eyes open, not as a result of being excluded from the decision-making process.

16 July 2010

The unimportance of outcomes

President Gamal Abdel Nasser brought Egypt dictatorship, economic ruin and humiliation in the six-day war with Israel. On his sudden death from a heart attack in 1970 Egyptians erupted in grief; some 5m people mobbed the funeral. His successor, Anwar Sadat, freed political prisoners, revived the economy and won a peace agreement with Israel that got back what Nasser had lost. When he was assassinated in 1981, Egypt fell eerily silent. His funeral was attended by foreign leaders but very few of his own people. After Mubarak (subscription), 'The Economist', 15 July
Charisma, televisual appeal, soundbites or superficiality of any sort are not a sound basis for choosing policy. Currently though, we have little alternative; even those of us who aren't Egyptians. We are allowed to choose policymakers rather than policies; and we choose them on the basis of image at worst, or their stated policy priorities or ideological leanings at best. Rarely are we given the chance to target desirable outcomes.

The reasons for this are mostly historical. People were less educated and had less time to take an interest in policy. But we ought now to be in a position at least to move toward outcome-based policy. That would mean public participation in the choosing and prioritising of social and environmental goals. Social Policy Bonds lend themselves to a gradual transition to this sort of policymaking: by focusing on outcomes to be targeted they would be more transparent than the current policymaking process. They would generate more consensus, or at least - and, just as important - buy-in, for chosen goals. A transition to a Social Policy Bond regime would be quite easy to arrange, with funding to existing activity-based bodies (mostly government agencies) being reduced gradually, at the same time as funds for Social Policy Bond redemption rise. (See my book for further details.)

Nasser is not the only charismatic personality in recent history who led his people to disaster. Choosing policymakers is fraught with problems, even if they happen to be televisually appealing, trustworthy, genuine and honest. It's time to move toward choosing outcomes; there are plenty of alternative careers to politics for people with charisma and ambition.

15 July 2010

The unimportance of being right

In a series of studies in 2005 and 2006, researchers at the University of Michigan found that when misinformed people, particularly political partisans, were exposed to corrected facts in news stories, they rarely changed their minds. In fact, they often became even more strongly set in their beliefs. Facts, they found, were not curing misinformation. Like an underpowered antibiotic, facts could actually make misinformation even stronger. How facts backfire, Joe Keohane, 11 July
It's a scary, but not unexpected, finding. With so much information and misinformation about, we tend to ignore the facts that go against our prejudices. All the more reason then, you might think, for policy debates to concern themselves with social and environmental goals, rather than the different - prejudiced - views about the ways of achieving them. The world is too finely grained for most of our political prejudices. We are fairly sure, for instance, that central planning, as practiced by the Soviet Union and China, was a disaster for human welfare. But central planning isn't always a bad thing. Far better to let unprejudiced actors work out for themselves what works best for any particular social goal, on the basis of evidence and an incentive to get things right.

That's where Social Policy Bonds could enter the picture. Investors in the bonds would have powerful incentives to work out the best approaches to social and environmental problems, and to terminate failures. Careful definition and targeting of society's desired goals would mean that the bondholders' interests would be exactly congruent with those of society. If bondholders held mistaken views about how to achieve these goals, they would lose. They certainly wouldn't profit by pumping more resources into their failed projects. That's in stark contrast to the current system, whereby government agencies face few sanctions even if they make huge mistakes and persist with them for decades.

11 July 2010

Non-linear processes

In the fields of economics, ecology and social affairs, small differences in where you start can have a huge impact on where you end up. This is the path dependency that led to driving on the left hand side of the road (in the UK), or the near-universal use of the (supposedly) inefficient QWERTY keyboard. Since tiny causes can have large effects on complex systems then 'even knowing 99% of what you need to know leaves you vulnerable to large errors. And 100% knowledge is impossible.' (Source).

All this is one reason for considering Social Policy Bonds for, especially, those social and environmental goals that have many possible causes and are characterised by time lags and seeming intractability. The peaceful resolution of conflicts, for instance, or the promotion of biodiversity, or the avoidance of natural or man-made catastrophe.

As society becomes increasingly complex, you would think that policy instruments that reward positive outcomes but do not prejudge how to achieve them, such as Social Policy Bonds, might be considered more widely. I did try to interest the Santa Fe Institute in Social Policy Bonds. It conducts research into complexity. However, I didn't receive a response to my approach (made nearly two years ago).

10 July 2010

Government by television

One of the main policy drivers, clear to all, but rarely acknowledged, is the urge not to look bad on television. Failure is acceptable, provided it doesn't take the form of tv footage.

A Social Policy Bond regime would be different. Objectives would be chosen in a calm, rational manner. Unlike under the current regime, they would be stable over time. Stable objectives would mean that rational allocation of resources would not be undermined by high-profile events. For instance, in the aftermath of a tragic rail disaster in London that resulted in the deaths of 40 people the UK Government came under considerable pressure to order the installation of an automatic braking system for trains that go through red signals. Cold calculations showed that this would cost around $21 million for each life that the system could be expected to save. This is around five times the figure that the UK Treasury used as its benchmark valuation of a human life, which means that if the government had succumbed to pressure to install the automatic braking system it would have diverted funds from more cost-effective life-saving projects, and so caused the loss of more lives than it would have saved.

A Social Policy Bond regime that had as its objective the maximising of the number of lives saved per government dollar would not waver in the face of spectacular one-off events.

02 July 2010

How policy is made

When [Tony] Blair announced that 50 per cent of young people would be able to go to university, the first the civil servant in charge of higher education knew about it was when he heard it on the radio.... Things like that and the scheme to take drunken yobbos to cash points to pay on-the-spot fines were mainly dreamt up in the back of a car when Blair was on his way to a meeting or a TV studio. As quoted by Sue Cameron, 'Notebook', Financial Times, 1 July
What is particularly striking is how, at the highest level of national government, big decisions appear to be made on the basis of reactive, primal emotion. Rationality and the long-term interests of the people politicians are supposed to represent hardly figure at all.
…policies are often adopted on the basis of less careful analysis than their importance warrants, leaving wide room for mistakes and misperceptions. Forces of knowledge destruction are often stronger than those favoring knowledge creation. Hence states have an inherent tendency toward primitive thought, and the conduct of public affairs is often polluted by myth, misinformation, and flimsy analysis. Source (pdf)
This type of thinking is particularly dangerous when military conflict looms. An article about Henry Kissinger's role in US foreign policy quotes him saying to US President George W Bush’s speechwriter, about radical Islamic opponents: ‘We need to humiliate them’. Comments like this abound in high politics. George W Bush himself cried ‘bring ‘em on’ at an early point in the invasion of Iraq. These are not examples of high-level thinking.

One of the benefits of a Social Policy Bond regime would be the clarification of social goals, and the transparency of the process that targets them. Goals would have to be articulated before targeting. It's unlikely that random emotional outbursts would crystallise into policy in such a policymaking environment, however eminent the people who make them.