What will happen to global efforts to limit greenhouse gas emissions when the current commitment period of the Kyoto protocol ends in 2012? There are hopes that the United Nations (UN) climate change conference that started on 3 December in Bali will outline a road map for a successor agreement that might be reached in late 2009.

To know what is going to happen in 2012 and beyond is not only relevant for future generations but for a wide range of investment decisions today:

  • Should you buy that flat in a riverside building?
  • Should companies invest in R&D on carbon capture and storage technologies?
  • Should governments provide more money to wind farm development or rather improve flood defences and relocate people living close to the coast?
  • Should an energy intensive company relocate its production from an industrialised country to a developing country unlikely to be covered by a pollution target?

To make these choices wisely, we need forecasts on the likely outcome and design of any post-Kyoto agreement. There is no shortage of opinions on what is going to happen. But whom should you trust? Opinions will be influenced by wishful thinking and strategic positioning alike as well as being based on different insights into parts of the puzzle. For example, living in the rich world, you might have a good sense of what the typical voter in your country thinks about pollution targets, but what about Indian voters or the Chinese communist party?

If the UNFCC – the UN body in charge of the climate change negotiations – was a publicly listed company whose profits depended on the climate change reduction targets it achieves, a good way of getting an idea on what’s going to happen is to have a look at its share price rather than public statements of its bosses or shareholders. This is obviously not a possibility. But what is possible now might be even better.

Last week, Intrade.com, the Irish prediction market company, started trading in a range of financial contracts whose payoff depends on specific outcomes of a post-Kyoto climate change agreement. The contracts, which were designed together with the Centre for Economic Performance (CEP) at the London School of Economics, capture which countries will participate in a post-Kyoto agreement as well as how stringent any pollution reduction targets might be.

How does this work in practice?

All climate change contracts on the Intrade market are binary contracts. Consider, for example, the US.TARGET.DEC09>10% contract. If by December 2009 the UN negotiation process has led to an agreement that implies a 10% reduction target for the United States relative to 1990, this contract pays $10. This is good news if you bought such a contract for less than $10, because you have then made a profit.

Of course we do not know for certain today if there will be such a target for the United States. The only way for you to buy such a contract for less than $10 is because some other market participant believes the United States will not accept any agreement limiting their emissions.

If enough traders who are sufficiently informed participate in such a market, the realised prices are not only a reflection of the market participants’ beliefs but might also be good predictors of the actual outcome. In other words, if contracts trade at a price of $7, our prediction is that there is a 70% chance that the United States will accept a 10% or higher target.

Nobody has examined if this works for climate change related contracts. This is one of objectives of the current initiative. But there are encouraging results from other contexts such as elections.

How to participate?

Contracts are traded on Intrade both in terms of real money and play money. Either way the first thing to do is to open an account. Then look at the various markets, the last trading price and the bid and ask offers that have been placed by other traders.

Note that for technical reasons prices are reported in tenths of (US or play) dollars. So if an ask price is 75.0, it means that you would have to pay $7.50 to buy the contract.

Make your own prediction on the likelihood of the binary event happening based on what you know or based on the information sources you trust. If the ask prices are lower than your estimated likelihood of the event you should buy the contract in question.

For example, suppose the contracts are currently sold for $7 but you think that the United States will sign a target of at least a 10% reduction with an 90% chance then you should buy this contract at $7 because you expect the price to increase to $9 in the future, which gives you a profit of $2 (ignoring for simplicity that on each transaction you will also have to pay a small fee to Intrade for running the website).

Alternatively, suppose you think that the United States is almost certainly not agreeing to any such reduction. For example, say your personal likelihood is 10% (which equals a price of $1) but there are people around willing to buy such contracts for a (bid) price of $7. In that case you should sell such contracts.

You can do that even if you do not own any contracts yet. Technically what is happening is that you buy two contracts from the bank (Intrade): one paying $10 if the event is true, and one paying $10 if the inverse event is true, that is, United States not agreeing to a 10% target.

The bank is happy to sell you such a pair because whatever the state of the world at the end of the contract they will be even. The ‘yes the event will happen’ contract you can then sell on to the trader who is willing to pay $7 for it. You do not actively have to buy the contract pair from the bank. It happens automatically when you sell more contracts than you already own. At any rate, the net cost for you is consequently $10-$7=$3, which will be deducted from your deposit.

If it then turns out that you were right and the event does not happen, you will get $10 at the end of the lifetime the contract implying a profit of $7. Alternatively, suppose that before the end of the contract the asking price drops to $5. Then you could buy a contract at this price and return a ‘yes’ and ‘no’ contract pair to the bank receiving $10 for it. Your profit is consequently $10-$3-$5=$2.

This might be rational if you are not entirely sure that the event will not happen and that therefore the price might bounce back to higher levels. Again you do not actively have to return the contract to the bank. It is simply what happens if you are holding a negative position of ‘yes the event will happen’ contract and then start buying contracts from other market participants.

Finally, it might be the case that none of the current bid or ask offers corresponds to the transactions you would like to undertake. In that case you can simply place a buy or sell offer there that remains on the market even when you log off your computer. Your desired transaction might then take place whenever another trader logs on willing to match your offer.

What about other climate change issues?

The outcome of the UN climate negotiations is of course only one of many uncertain factors relevant for making good policy and investment decisions related to climate change.

Other issues include the correctness of many of the scientific theories and assumptions on which climate and economic models are based, the scope for different technologies to mature and to be adopted, unilateral actions by various governments, behavioural changes by consumers, actions by businesses etc. Many of these can potentially be captured by prediction markets.

There are a number of factors that have to come together if prediction markets are usefully to be employed. These include:

  • There must be an event or state of the world which is uncertain before it happens but clearly observable for everybody involved at the end of a contract.
  • The outcome of the event must be contentious which usually happens if all relevant information to predict an outcome is dispersed with different people having access to different subsets of the complete information set.
  • Sufficiently many traders with access to relevant information subsets need to be attracted to participate in the market for whatever reason: they might be interested in profit opportunities, the subject matter or simply the thrill of gambling.

To explore where these conditions are met within contentious issues in the climate change debate is an ongoing project at the CEP.

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