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Understanding The Likelihood of Cap and Trade With Game Theory

|Includes: D, DUK, FPL-OLD, SO, Exxon Mobil Corporation (XOM)
To determine what the likelihood of something like Cap and Trade being passed is, it's first necessary to identify what would lead to regulation in this sort of field.  To do this, I'll use game theory to determine why we're at the current situation we are and under what circumstances we would change course.

To begin, I'll have to posit some assumptions, for which if one were to disagree with would inherently prevent the same conclusions I am about to draw from being reached:
 
(1) Pollution has a negative impact on everyone's health, yet remains unpriced because of a tragedy of the commons scenario and an incapability of observing its true cost
(2) Ceteris paribus, a firm earning a profit has positive externalities for society in so much that either through direct distribution or wealth trickle down effects, people are better off (i.e. profit seeking is positive for society, all other things staying equal)
(3) Earning a profit is not a zero sum game, in that if someone is making money someone else does not have to be losing money.
 
To start off, let's imagine a basic scenario of two polluting companies, G and E. These two companies produce the exact same product for the same market and the only two choices available to them are whether they're going to implement capital intensive pollution control devices or not. This breaks out in to a game theory problem.
The picture above represents the payoff matrix for firms G and E in the market described earlier

We'll say that the market is fixed in terms of demand and whichever company can produce the product the cheapest is going to capture the entire market. In the case where the cost of producing the good is the same for the two firms, they will split the market. In splitting the market in the 'Not Pollute' scenario, both firms' payoffs are less than in the 'Pollute' scenario because of the cost of the pollution limiting capital expenditures, let's presume.

The payoff matrix is quite simplistic, but the goal is to convey that in a situation where the winner is the company that can produce the product the cheapest, the Nash equilibrium is going to be that the firms will pollute (in this case, [4,4]).
 
Now this might not be the most beneficial situation for society, based on the cost we place on pollution (or value on clean air). Let's say cost of pollution to society is 10, such that even though the firms in aggregate would be making a profit of 8 in any combination involving pollute, society as a whole would be incurring a negative payoff even with the addition of this 8 of profit. 
 
In this scenario, it might be in the best interest of the society (of course not for the companies individually) for the government to require a certain level of pollution control, thus forcing the [2,2] payoff to be the Nash equilibrium by preventing the choice of pollution. Presuming this 10 cost is eliminated in this scenario, there's a positive 4 aggregate payoff where before there would have previously been a negative 2.
 
This can generally be summarized such that the government should intervene when the aggregate payoff from not polluting is greater than polluting, or:
 
Er(Diminished G and E earnings, bureaucracy costs, no pollution payoff) ≥ Er(Heightened G and E earnings, pollution cost)

In light of this generalized statement, a Cap and Trade agreement or similar pollution regulation bill would be passed if those voting on the bill determined the expected return of the left side to be greater than the right.  To an investor involved with the G or E firms of the world, a big chunk of the valuation of your investment is determining what the likelihood is that this will happen, i.e. the value the Representative or Senator and their constituents place on clean air.

Perhaps this is why in a Democratic regime coal burning utilities and other environmentally questionable investments have gotten crushed.

Disclosure: Long MIR