The Copenhagen conundrum - doesn't risk/reward analysis matter?

Citation

Mainelli, M. (2006), "The Copenhagen conundrum - doesn't risk/reward analysis matter?", Journal of Risk Finance, Vol. 7 No. 1. https://doi.org/10.1108/jrf.2006.29407aaf.002

The Copenhagen conundrum - doesn't risk/reward analysis matter?

The Copenhagen conundrum - doesn't risk/reward analysis matter?

A bold, bold question

In 2003, Denmark’s National Environmental Assessment Institute came up with an initiative to evaluate the costs and benefits of alternative public-policy actions in a wide range of key policy areas. The basic idea was to produce cost/benefit analyses for ten challenges, and have these analyses rated by eight leading economists (three of whom were Nobel laureates). The idea was championed by Bjørn Lomborg, Director of the Institute, and the controversial author of the book The Skeptical Environmentalist. The Economist newspaper supported the idea and reported on a number of the challenges as well as the overall consensus in mid-2004.

The focal question of the Copenhagen Consensus (see www.copenhagenconsensus.com) was “Where should the world invest, say, an extra $50 billion over the next four years to do the most good?” (i.e. $12.5 billion extra over each of the four years). Starting with a long list of 33 challenges facing humanity, the Consensus team focused on ten that they believed to be most promising (and clearly didn’t shirk tackling the genuine “biggies”):

1. 1.

   climate change;

2. 2.

   communicable diseases;

3. 3.

   conflicts and arms proliferation;

4. 4.

   access to education;

5. 5.

   financial instability;

6. 6.

   governance and corruption;

7. 7.

   malnutrition and hunger;

8. 8.

   migration;

9. 9.

   sanitation and access to clean water; and

10. 10.

    subsidies and trade barriers.

The Consensus team then focused on 17 options for dealing with the ten big challenges. The results were that these leading economists believed that public-policy funds were best spent on curing the communicable diseases of AIDS and malaria, liberalizing trade, and tackling malnutrition and hunger by providing micronutrients.

Something rotten?

The final results (see Table I) – particularly the low ranking of climate-change initiatives – have startled a number of people and generated quite a bit of controversy. For instance, initiatives for stopping climate change are ranked not only well below trade liberalization, but even below reducing the costs of starting a new business. The controversial elements are exacerbated by Bjørn Lomborg’s reputation – he is a bit of a bête noire for environmentalists. But a number of less passionate critics also feel “something is rotten in the analysis of Denmark,” when the need to stop global warming is ranked below lowering barriers to migration for skilled workers. A critical consensus (sic) seems to have arisen among gainsayers:

• •

  The Copenhagen Consensus is discriminatory. The economists, particularly Lomborg, are characterized as systematically discriminating against environmental challenges, e.g. via the use of an inappropriate discount rate. Or the process would be different if much more money had been allocated in the focal question. Lomborg believes that the process is relatively indifferent to either the amount allocated or the timeframe. He believes that more money simply would allow more choices to be pursued.

• •

  Ab initio rejection. One simply can’t do this kind of analysis.

• •

  “Garbage in, garbage out”. The data were poor, or the starting set of opportunities was poor, particularly for the environment.

One might ask: “If the Copenhagen Consensus approach is so good, then why does it come up with an answer that many – e.g. the environmentally concerned – feel is so wrong?” We have plenty of scope to conclude that “(1) The approach is wrong and they got the wrong answer.” We can critique cost/benefit analyses on many inputs such as cost calculations, benefit calculations, timeframes, or discount rates. Can one divorce benefits from values? Is the currency used for these decisions – “quality of human life” – measurable or right? Does this kind of analysis encourage “train wrecks”? That is, could we wind up unwittingly passing a point of no return on climate change?

We also could conclude that “(2) The approach is right, but they got the wrong answer” if they used poor data or inconsistent data across these enormous issues. Policy decisions depend on having options to implement. Perhaps climate-change investment is the most important policy area, but we don’t yet have good options for investment. Perhaps we should invest in creating more innovative options.

Another conclusion is that “(3) The approach is right and they got the right answer,” but we feel they’re wrong because we have to change our perceptions of risk. Or perhaps “We’ll never know if the approach is right or wrong – or if the answer is right or wrong.” Perhaps our progeny want to live in a world where they huddle around oxygen generators in a 65°C world? Perhaps some futuristic, intelligent CO₂-breathing lizards will thank us. (Yet I have some sentiment for an approach favoring solutions that are geared towards making people behave better, e.g. reducing corruption, rather than just spending money on fixing a problem.)

Finally, we could conclude “(4) The approach is wrong but they got the right answer” – a happy accident despite the application of the finest minds. If the approach is wrong, what do we suggest as an alternative? Perhaps we’ll never know if we’re right or wrong – we live in the wrong world, one with the wrong political systems to implement these sorts of decisions or one with voters not swayed by rational decision-making processes.

This Copenhagen Consensus approach is important, because the cost/benefit approach the economists used to tackle our biggest worries is the same approach that economists and politicians believe to be core to effective policy making, and the same one risk managers and financial managers believe is core to making effective business decisions. The Copenhagen Consensus was one of the first great commerce experiments of the 21st century. If the approach and results are right, then our priorities should change rapidly. We should stop whining about Kyoto and declare total war on malaria.

All right on the night

Science Club, an informal group of primarily financial people, got together in London this year to discuss the Copenhagen Consensus. At the end of a lengthy discussion, a vote was taken among the ten participants:

• •

  wrong approach and wrong answer – 2;

• •

  right approach and wrong answer – 2;

• •

  right approach and right answer – 4;

• •

  wrong approach and right answer – 0; and

• •

  abstentions – 2.

Although six out of eight non-abstainers felt that the Copenhagen Consensus was the right approach, there was also a definite feeling that the Copenhagen Consensus approach could be detrimental if it were just a “one-off”. The group, along with Denmark’s National Environmental Assessment Institute, hopes for a continuous process of some form, e.g. a repeated effort every few years. This is important because, at the least, repeating the exercise would encourage the production of better data and the generation of better ideas and options for investment.

The implication for risk-finance decisions is clear. Risk managers use the same, or similar, tools to rate projects, many of them based upon cost/benefit or risk/reward analyses. Our greatest economic minds and policy makers seem unable to persuade us to re-order our priorities for the world based upon rational analyses of costs and benefits. Shouldn’t we be concerned about the world? And are we making the wrong choices? Shouldn’t the leading global economists and policy makers be concerned? Or are they irrelevant? And if they are irrelevant, aren’t we too?

Michael Mainelli

AcknowledgementsThe author wishes to thank Richard Sealy and Science Club for hosting the discussion referred to and helping to clarify his thoughts.