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

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