Beware the blunders of technology-blind financial wizards

1 December 2008

A happy hunting ground for inventive businessmen

However obsessively devoted we may have been to our jobs on or about power systems we can scarcely have failed to notice the financial world’s current upheaval. Horny-handed toilers like me may have been struck by the way deifiers of markets and market forces have seemed unmoved by the apparent impotence, or at least deficiency, of their gods, and by the possible inadequacy of market solutions to what a mere engineer might regard as mainly technical problems.

Much as one may marvel at the ingenuity of the financial fraternity in devising new business processes and products, often highly successful for a while even if not permanently, one cannot but notice that some of the ingenuities have been blamed for the ‘credit crunch’ and other crisis manifestations that have so upset the workings of our world’s economic system.

A power system engineer learns from the media, perhaps not altogether comprehendingly but almost certainly with wonder, of banks that have invented ‘structured investment vehicles’ for the transport of mortgages ‘off their balance sheets’, prospering greatly thereby until some hitherto unrecognised flaws in their ‘financial engineering’† have revealed themselves and caused widespread turmoil.

Not that the chains of causality in such upheavals have yet been completely identified by economists. Some commentators have suggested a singular genesis for an international outbreak of crises, blaming everything on a ‘genius’ (otherwise known as a rogue trader) whose manipulations reportedly relieved his employer (Société Générale, a pillar of the French banking establishment) of nearly 5 billion euros, a record-breaking sum. The young man apparently spent over two years exploiting mismanagement at the bank.

However, further dramatic revelations have raised suspicions that the bank may have been using the alleged fraudster as a scapegoat for its own sins. And the alleged fraudster has become a popular hero, with a cult following on assorted websites, and with fans sporting T-shirts honouring him as the Robin Hood of our time or as the Che Guevara of Finance.

The intellectual accomplishment of many business people has contributed to the economic advance of modern civilisation. A particular field to which some of these movers and shakers have devoted their talents has been the creation of a market specially interesting to power systematists. Ostensibly, if not a trifle overweeningly, it is intended for the purpose of fighting against anthropogenic carbon dioxide’s adverse effect on climate. As MPS readers will know, efforts to get such a market or markets going have not been lacking but neither have they been altogether successful.

The European Commission has been working on a plan thought to be the most ambitious venture of its kind undertaken by such a large economic entity. The scheme is for so-called carbon trading on an international scale. (The trading in view is of course not actually in carbon but in carbon dioxide emission allowances.)

Carbon trading has been a happy hunting ground for inventive businessmen. Schemes have included (possibly, in some cases, conscience-salving) commercial transfers of officially regulated emission rights by non- or lightly emitting enterprises to organisations that put out large amounts of carbon dioxide. The big emitters have thus been enabled to buy their way out of implementing technical solutions to their excess-emission problems. In global terms, carbon dioxide overproduction may remain for practical purposes virtually untouched by such manoeuvres.

A vexed question has been what price to set on ‘carbon’ for trading on a market or markets arranged to shepherd the trading partners into bringing down emissions by macroscopic amounts. The editor of the UK-based international business newspaper, The Financial Times, has declared in a leading article that ‘the best way to reduce emissions is to get the price of carbon right for the EU’s trading scheme and let the market find the most effective ways to deliver the cuts’. He went on to say that ‘in general the framework should be technology blind’.

Following his paper’s admirable policy of openness to diverse and opposing opinions, the editor has published an article by one of his contributors, Paul Betts, expressing a certain scepticism on this topic. Betts agrees that ‘it is sensible to put a price on carbon and force companies to address the environment challenge’ but adds that ‘no one should be under the illusion that . . . the actors will behave responsibly’.

Betts’ phrasing is refreshingly direct. He refers to the proposed market for trading emissions as ‘hideously complicated’ and warns that ‘the only sure thing about the creation of this market for carbon quotas and credits is that it risks opening a field for financial manipulation and speculation’. In the course of his critique he instances ‘the financial wizardry that brought down Enron’ but there has been a surfeit of further examples since that piece of black magic.

The time for technology-blind financial wizardry is surely over. But I do acknowledge that the law of unexpected outcomes applies as much to our kind of inventive ingenuity as to the kind that has been – on occasion disastrously – displayed by financial engineers.

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