The Copenhagen Conundrum: Doesn't Risk/Reward Analysis Matter?

Professor Michael Mainelli, Executive Chairman, The Z/Yen Group

[An edited version of this article first appeared as "The Copenhagen Conundrum - Doesn't Risk/Reward Analysis Matter", Journal of Risk Finance, The Michael Mainelli Column, Volume 7, Number 1, Emerald Group Publishing Limited (January 2006) pages 101-104.]

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 analysis for 10 challenges and have these analyses rated by eight leading economists (in the event, three of the eight 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 was “where should the world invest, say, $50bn extra over the next four years to do the most good?” - $12.5bn extra over four years. Starting with a long list of 33 challenges facing humanity, the Consensus team focused on 10 they believed to be most promising; they didn’t shirk tackling the genuine ‘Biggies’.

• climate change;
• communicable diseases;
• conflicts and arms proliferation;
• access to education;
• financial instability;
• governance and corruption;
• malnutrition and hunger;
• migration;
• sanitation and access to clean water;
• subsidies and trade barriers.

The Consensus team then focused on 17 options for dealing with the 10 big challenges. The results were that these leading economists felt that public policy monies were best spent on curing the communicable diseases of AIDS and malaria, liberalising trade and tackling malnutrition and hunger by providing micronutrients.

Something Rotten?

The final results have startled a number of people and generated quite a bit of controversy, particularly the low ranking of climate change initiatives. For instance, initiatives for stopping climate change are ranked not only well below trade liberalisation, 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 noir 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 characterised 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 or the timeframe. He believes that more money would allow more choices to be pursued;
• ab initio rejection - you just can’t do this kind of analysis;
• garbage in, garbage out – the data was poor or the starting set of opportunities was poor, particularly for the environment.

If this Copenhagen Consensus approach is so good why does it come up with an answer many, e.g. the environmentally concerned, feel is so wrong? We have plenty of scope to conclude that “1. Our Approach Is Wrong And We Got The Wrong Answer”. We can critique cost/benefit analysis on many inputs such as cost calculations, benefit calculations, timeframes or discount rates. Can you 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’, i.e. could we wind up unwittingly passing a point of no-return on climate change?

We could also conclude that “2. Our Approach Is Right, But We Got The Wrong Answer” if we 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.

We could also conclude that “3. Our Approach Is Right And We Got The Right Answer”, but we feel we’re wrong because we have to change our perceptions of risk. Perhaps “We’ll Never Know If Our Approach Is Right or Wrong – Or The Answer Is Right Or Wrong”. Perhaps our progeny want to live in a world where they huddle around oxygen-generators in a 65-degree Celsius world? Perhaps some futuristic, intelligent CO2-breathing lizards will thank us. Yet I have some sentiment for an approach favouring 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. Our Approach Is Wrong But We Got The Right Answer”. A happy accident despite the application of our 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 these 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 whinging 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 & wrong answer – 2
• right approach & wrong answer – 2
• right approach & right answer – 4
• wrong approach & right answer – 0
• abstentions – 2

Although 6 out of 8 non-abstainers felt that the Copenhagen Consensus was the right approach, nevertheless, 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, hope for a continuous process of some form, e.g. repeated every few years. This was important because, at the least, repeating the exercise would encourage:

• production of better data
• 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, much of them based around cost/benefit analysis or risk/reward analysis. Our greatest economic minds and policy makers seem unable to persuade us to re-order our priorities for the world based on rational analysis of costs and benefits. Shouldn’t we be concerned about the world – are we making the wrong choices? Shouldn’t the leading global economists and policy makers be concerned – are they irrelevant? And if they are irrelevant, aren’t we too?

Further Reading

Bjørn Lomborg (ed) et al, Global Crises, Global Solutions: Priorities for a World of Scarcity, Cambridge University Press, (2004).

Further Surfing

www.copenhagenconsensus.com

Thanks

My thanks to Richard Sealy and Science Club for hosting the discussion and helping to clarify my thoughts.

Professor Michael Mainelli, PhD FCCA FCMC MBCS CITP MSI, originally did aerospace and computing research followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen (Michael_Mainelli@zyen.com). Z/Yen was awarded a DTI Smart Award 2003 for its risk/reward prediction engine, PropheZy, while Michael was awarded IT Director of the Year 2004/2005 by the British Computer Society for Z/Yen’s work on PropheZy. Michael is Mercers’ School Memorial Professor of Commerce at Gresham College (www.gresham.ac.uk).

Michael’s humorous risk/reward management novel, “Clean Business Cuisine: Now and Z/Yen”, written with Ian Harris, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.

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