Black Swans and Turkeys

Deck: 

The industry isn’t as robust as we might think.

Fortnightly Magazine - November 2010

Nassim Nicholas Taleb has become something of a celebrity in the past couple of years. Taleb’s 2007 book, The Black Swan: The impact of the highly improbable, warned decision makers about the folly of relying on econometric analysis to manage risks, because unprecedented “black swan” events eventually show up and turn that analysis on its head. The subprime mortgage bust seemed to prove Taleb’s theory, catapulting him to rock-star status in the world of financial economics.

Taleb’s Black Swan Theory is illustrated in a parable—ironically about a different bird: the Thanksgiving turkey. From the turkey’s point of view, life is predictable and stable, with daily feedings, care and protection by the farmer. But then Thanksgiving rolls around, with a big surprise the turkey couldn’t have foreseen from its lifetime of experience.

Taleb isn’t saying people should try to be like smart turkeys and predict their own Thanksgiving doomsdays. Instead he’s suggesting that we should altogether avoid the turkey’s problem—that we shouldn’t rely on strategies that leave us vulnerable to unprecedented events.

Taleb writes on his website, www.fooledbyrandomness.com: “While most human thought (particularly since the enlightenment) has focused us on how to turn knowledge into decisions, I focus on how to turn lack of information, lack of understanding and lack of ‘knowledge’ into decisions—how not to be a ‘turkey.’”

Toward this end, Taleb identifies several steps for protecting the economy against black-swan events (see “Ten principles for a Black Swan-proof world,” Financial Times, April 7, 2009). While Taleb’s 10 steps are mostly aimed at big-picture policy issues, many of them also can be applied to a given industry or organization.

The good news for the U.S. investor-owned utility industry is that our business is inherently structured to avoid some of the pitfalls Taleb identifies. The bad news is we’re not impervious to black-swan events. Our collective necks are vulnerable to the farmer’s axe.

Cassandra Sight

The parable of the turkey contains two key lessons. The first is that, like the turkey, we don’t know what we don’t know; our critical mistake is to assume our individual lifetimes of daily experience accurately represent our futures.

The specific lesson for the utility industry is that we shouldn’t rely on probabilistic, econometric analysis in our planning and risk management, because such analysis can’t compute the black swans—the radical changes that can and do happen in economics, technologies, resources, and social structures.

Everybody knows our world is in a state of flux; this fact is made starkly evident by today’s uncertain policy environment (see “Legal Battleground”). But few understand just how disruptive a black swan can be. Imagine, for instance, what would happen if a global currency war collapsed the greenback, dried up international debt sources and bankrupted the U.S. Treasury. Or what if the greenhouse effect suddenly reached a tipping point, and the global climate went haywire beyond Al Gore’s worst nightmares? Or on the flip side, what if researchers achieved a bona-fide revolutionary breakthrough in cold fusion, or dirt-cheap photovoltaics and battery storage?

Unlikely? Yes, but not impossible. That’s the nature of black swans. They don’t come along frequently. But when they do, they change everything.

Setting aside for a moment the dilemma of planning for the unprecedented, the second point in the parable is this: the turkey is clueless about Thanksgiving, but the farmer knows all about it. In other words, the truth is out there somewhere—but like the turkey, we can’t access the information.

Taleb’s argument focuses on the first point of the parable; the second point, the farmer’s role, Taleb defines as basically metaphysical. The farmer is the equivalent of an omniscient angel: Just as the farmer could explain everything to the turkey, with no effect whatsoever, so too could an angel reveal the future to us humans, and we’d either fail to understand it, fail to believe it, or fail to do anything about it.

Nevertheless, it’s tempting to think the turkey’s first mistake lies in failing to ask questions, or in failing to pay attention to what the farmer is saying. The equivalent for us humans would be failing to perform enough research, or failing to heed the counsel of those who actually do foretell black-swan events.

For example, during the past decade, while mortgage bankers and federal lawmakers were busy blowing up the real-estate bubble, some people were correctly predicting a catastrophe. As long ago as 2004 Rep. Ron Paul (R-Texas) warned, “[T]he mortgage market is hopelessly distorted. Millions of mortgages in this country are federally insured, and the tax bill for defaults could be astronomical if the housing bubble bursts.”

Yet Paul’s predictions didn’t stop lawmakers from voting to loosen credit requirements for federal mortgage insurance, just as his warnings today about monetary policy haven’t convinced Wall Street to stop trading U.S. Treasury notes. That’s because we human turkeys feel most secure relying on assumptions we’ve developed over a lifetime of experience, and we naturally distrust anybody who says our beliefs are based on erroneous or incomplete information.

So are we doomed? Or can the utility industry become truly black-swan proof?

Getting Robust

Utilities are known to be cautious—sometimes maddeningly so—about jumping on any particular bandwagon. No technology or process gets adopted until we’ve put it through almost endless scrutiny and pilot testing. This protects us from much of the fragility that Taleb warns against.

And the regulatory compact offers another layer of protection—barring franchised companies from extracting monopoly rents beyond what’s justifiable to maintain reliable service. In principle at least, this structure should prevent the perverse incentives that Taleb says create institutional vulnerabilities. And our 50-state patchwork of regulation virtually eliminates the too-big-to-fail problem that Taleb excoriates in his analysis of the financial industry.

So investor-owned utilities might seem fairly robust. Nevertheless, we’re not impervious to black swans, and Taleb counsels that the quantitative approach to risk management can’t help us. As hard as we try, we can’t hedge against risks we can’t measure.

This might seem like an irresolvable dilemma, but a couple of Taleb’s principles can serve to guide the industry’s policy and strategic approaches in ways that will help ensure we’re not destroyed by a black-swan event.

Namely, Taleb’s 5th principle says, “Counter-balance complexity with simplicity.” This goes directly to the tangled mess of incentives, requirements and mandates that utilities are dealing with today. For example, between government grants, loan guarantees, renewable portfolio standards, tax credits, feed-in tariffs, smart-grid mandates, demand-response pricing, decoupling plans, incentive rates, and cap-ex tracking mechanisms, it’s impossible to know the true market value of any resource or asset. Uncertainties around EPA efforts to regulate greenhouse gases further exacerbate the problem.

Taleb might argue we need a simpler approach—perhaps a carbon tax that replaces the whole morass of provisions with a single policy signal for the market to price-in.

Consider also his 8th principle: “Do not give an addict more drugs if he has withdrawal pains.” And the energy industry is definitely on drugs, in the form of countless government subsidies that prop up every corner of the business. Taleb’s 8th principle suggests we should eliminate all such incentives, even if it causes some private-sector companies to suffer withdrawal.

As radical as it might seem, following Taleb’s advice could wean the industry from its dependence on unsustainable and overly complex public incentives—and deliver us safely past our metaphoric Thanksgiving Day.