Information Landmine

"The Americans keep telling us how successful their system is. Then they remind us not to stray too far from our hotel at night." - An un-named EU trade representative quoted during international trade talks in Denver, Colorado, 1997.

Tuesday, October 10, 2006

The FT has a couple of interesting articles about the risk business today. The first is John Kay's amusing analysis of mathematical models of risk analysis in hedge funds. The essential point is that those relying on these models fail to take into account the (one would have thought rather obvious) fact that the models aren't perfect. Apart from being a spectacular example of the sort of tale of groupthink-induced-madness that seems to crop up time and again in financial settings, catastrophes of the sort of magnitude that Amaranth apparently was do make you wonder what exactly the point is of all the number-crunching risk assessment that seems to be a feature of everything from high finance to university field trips.

I'm fairly sure I've seen papers by much smarter people than me that essentially argue that this is all a way of divesting risk onto the little guy, but I can't be bothered to find them right now because what I really want to talk about is the second, much more interesting, article by Tony Jackson about the new Institutional Investors Group on Climate Change. Take the time and read the whole thing, because this is pretty interesting. He's got a few big points about why fund managers might push in a green direction. The first is that, as we see above, fund managers have an almost unreasonable passion for making calculations about risk, and so tend to push governments into regulating early rather than leaving it all up in the air - even to the extent of lobbying in the opposite direction to industry. This dove-tails with the fact that some investments in a managers portfolio might lose value due to environmental problems created by other companies that it invests in, and managers are in a very good position to put pressure on the polluters. I would like to talk more about the possible effects of this situation where managers are "no longer valuing shares in isolation", and scenarios in which you could see people investing in environmentally sound policies. Sadly, I have a stats class (oh, the irony) so, instead, here are some highlights in case the article's only available to FT subscribers:


There is a groundswell of irritation among professional investors – not only in the IIGCC – over governments’ slowness in formulating policy.

For instance, the EU system of emissions trading lapses in its present form in 2012, as does the Kyoto agreement. For a fund manager trying to figure out threats and opportunities, this presents an obvious problem. As one group member puts it, “you can model cash flows for maybe two years out, but after 2012 it’s a black hole”.

It is a particular irritation that employer groups, such as the UK’s Confederation of British Industry, seem to have the ear of governments. And employers, naturally, are opposed to regulatory costs – at least until they apply to all their competitors worldwide.

Investors, by contrast, are not necessarily bothered either way. They just want the data so they can do their sums. So one of the explicit aims of the new group is to lobby governments with counter-arguments.


That apart, the group has a rather subtler motive. Suppose you own shares in a coal-fired generator. In pragmatic terms, you might prefer it to blast away regardless of pollution and thus maximise its cash flows.

But suppose you also own shares in a water company, which in the long run will incur heavy costs in mitigating the effects of pollution. You could then be facing a net drop in the value of your portfolio.

But if you went to the power company and asked it to change its practices merely because of your holding in another company, you would be shown the door. Hence the importance of a group. If you can turn up speaking for a large chunk of the company, you’re not asking, you’re telling.

This adds a new layer of complexity to the business of fund management. In effect, you are no longer valuing shares in isolation.


The IIGCC mainly represents fund managers rather than investors themselves. And investors or their representatives, such as pension fund trustees, have a habit of hiring or firing managers on the basis of short-term performance.

So an implicit part of the agenda is to get greater freedom for the managers to think in the long term. In this context, that might seem mere common sense. But it is an argument in which the managers are interested parties.


In Europe, global warming is now seen as a fact of life rather than a left-wing theory. Indeed, there is palpable excitement at the opportunities it might throw up, especially if business in other parts of the world is slow to catch on.

Polluting companies, meanwhile, need to be alert. There is a parallel with the corporate governance movement, which commentators first dismissed as political correctness. They were wrong about that. It would not do to be wrong again.


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