Reflexivity and the EU ETS 'Endgame'

In an earlier post for Carbon Risk I referenced an article published in the Financial Times called ‘Carbon price: efficient market does its bit for the planet’. Coming just weeks after the EU carbon price reached €100 per tonne the author concludes that, “Finally, carbon has reached a price high enough to reflect environmental costs and to change behaviour.”

Is it really true that the EU carbon market has become what can be called an ‘efficient market’ in classical economics; one that correctly prices in the cost of meeting the EU’s near term 2030 emission reduction targets and the longer term ambition of a net zero economy?

Classical economic theory assumes that market participants act on the basis of perfect knowledge, or at the very least act based on rational expectations. This means that even though not all participants are equally as informed, there is one single optimum, 'rational' view of the future, and eventually all participants in the market will converge on this view.

This deterministic way of thinking enables many of the same methods employed in the study of physics to be applied in the field of social sciences like economics. This is where impenetrable algebra and complex modelling are used in the pursuit of certainty (or at least to give the impression of it).

There is one key difference though. Unlike physics, economics includes the presence of subjects that have the ability to think. This means that rather than simply playing a passive role in the market, we also play an active role too, since our perceptions and our actions also influence the market. This introduces an additional element of uncertainty since there is likely to always be a divergence between what participants think, and the actual facts. Yet that thinking also has a role in shaping the facts.

George Soros, one of history’s most successful financiers, was the first person to develop and formalise the concept known as ‘reflexivity’. Here is how Soros summarises his General Theory of Reflexivity as it pertains to financial markets:¹

"I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments correctly, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection "reflexivity".

According to Soros participants thinking serves two functions. The first is to understand the world (the ‘cognitive function’), while the other is to advance the participants’ interests (the ‘manipulative function’). Participants’ thinking (subjective reality) and the actual state of affairs (objective reality) are connected in opposite directions:

When both the cognitive and manipulative functions operate at the same time they may interfere with each other. How? By depriving each function of the independent variable that would be needed to determine the value of the dependent variable. The independent variable of one function is the dependent variable of the other, thus neither function has a genuinely independent variable – the relationship is circular or recursive. It is like a partnership where each partner’s view of the other influences their behavior and vice-versa.

The upshot of Soros’ theory of reflexivity is that there there can be no genuinely independent reality from which to anchor your thinking on. How does this relate to carbon markets, and the EU ETS in particular? To begin to think this through we first need to consider what the ‘Endgame’ for the EU ETS might look like, and work back from there.