Out of sight, out of mind – similarities between sub-prime and climate change

The Financial Times recently quoted George Soros in the context of the sub-prime crisis. Securitisation had the effect of transferring risk from people who are supposed to know risk and know the borrowers to people who don’t. This observation points to a general truth about the way our economies work, and is relevant for a range of environmental problems including climate change.

Securitisation eliminates the direct link between borrower and lender. Two important things happen as this link is broken. First, important information is lost – information which can be used for making investment decisions. Some factual information can easily be digitised and passed along to investors. But deep, personal knowledge of borrowers which is needed to make judgment on the risk of loan defaults, is not passed on in the process of securitisation. This leaves the next level of investors handicapped.

The second thing that happens when the link is broken is a loss of the borrower’s sense of responsibility. In a town community, the borrower knew his bank manager and his family, and the borrower had a sense of duty or responsibility towards the bank manager. Securitisation means that you end up owing money to a fund manager 10,000 miles away. As a result you have significantly fewer qualms about defaulting on the loan.

Information helped the lender to evaluate risk. Responsibility mitigated the risk of default. As securitisation deleted these concepts, it is not surprising that the risk of the system increased, unnoticed.

Scandals in publicly traded stocks often result from the same problem. As the distance between shareholder and manager grows, the quality of information available to the shareholder deteriorates at the same rate at which the manager’s sense of responsibility to the shareholder weakens.

Many environmental problems reflect the same phenomenon: a food producer in Beijing does not feel a strong sense of duty towards his customers in Basingstoke. The bond which once linked producer to consumer and which was a conduit for a sense of mutual responsibility, is severed in a Tescocracy. The ability of the consumer to manage risks is limited because they know nothing of the person who produced their food.

The operator of a coal-fired power plant cannot stand face-to-face with those who will suffer from climate change; and rarely does the buyer of electricity have enough information to evaluate his supplier.

We can assume that the neighbours of the executives of Newmont Mining have luscious gardens. But tailings from a mine in Asia are unlikely to trickle back into the groundwaters which feed those gardens. Thus pollution, like debt default, brings no shame.

In the financial world, the risks of an extended supply chain tend to be sorted out sooner or later by the market. The spills of the sub-prime crisis are quickly mopped up by gloriously wealthy Arabs and Chinese. Investors injured by share scandals are forewarned of the limitations of the system, and have plenty of choice for alternative investments.

In the environmental field, the market is less effective at addressing the risks of an extended supply chain. First, we have less information to make our choices. Regulations on disclosure in the financial world are strict and extensive, but requirements to disclose information on the environmental risks of a product or services are still in their infancy. While the impact of financial risks can be seen on a bank statement, the impact of environmental risks is much harder to know.

Second, there is asymmetry between the beneficiary and the victim of an environmental risk. The victim of an environmental risk is usually a plant, an animal, or an unborn human being. But unlike in the case of financial investment, the downside is suffered by someone or something quite different from the person who enjoys the upside. This asymmetry of risk and return means that the balance of risk and reward cannot be relied on as a natural regulator of environmental transactions.

Third, the development of alternatives to products with high environmental risk is slow – a bank can bring out a new product in a few weeks, but physical technology takes much longer to be developed and adopted. So the market signal of consumer response is weak.

A regular response to crises is to tighten up regulation and disclosure. Unfortunately disclosure only works if the disclosed information helps the user make a materially more informed decision. However, as long as deep knowledge is needed to make a good decision, incremental disclosure of data is unlikely to have any effect. Rules which capture deep knowledge would be unworkable.

Society will best address these problems through cultural change rather than regulation. Investors and buyers of financial products need to learn to work in a culture of carefulness and scepticism. They need to be trained to ask tough questions, and continually probe along the length of the supply chain for greater understanding of risks. This is a job for educators and managers, not for regulators. In terms of environmental risks, consumers need to adopt a culture of curiosity, scepticism.

Policy-makers, when dwelling on the benefits of the extended supply lines implied by global free trade and global finance, must carefully take into consideration the way that economic and environmental risks increase as lender and borrower, investor and investee, buyer and seller, and supplier and off-taker become more and more remote from each other.

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