By now, many you have probably heard about the book by Nassim Nicholas Taleb which discusses the phenomenon known as "Black Swan"- highly improbable events that have extremely important consquences. These are the outliers that reside at the extremes of the bell curve-also known as the "fat tails". They are several standard deviations from the norm. Said another way, low or small probability events can result in large impacts- much as the meteor that wiped out the dinosaurs!
All too often, risk managers focus on the high probability events reflected in the middle of the bell curve and ignore the risk at the fat tail. While Taleb shows that these black swan events occur more frequently than thought, the key takeaway message is not simply enough to ask what the probability of an event is but it is the probability coupled with the magnitude of the event that must be evaluated.
An illustration from the stock market serves as a good example. History shows that the majority of time the stock market does not move very much. Then, suddenly it makes a giant move up or down, and returns to its prior stasis. Indeed, according to studies by Professor Javier Estrada, a finance professor at IESE Business School in Barcelona who has studied the daily returns of by the Dow Jones Industrial Average dating back to 1900, if one takes away the best 10 days of that period, two-thirds of the cumulative gains produced by the DJIA in the past 109 years would disappear. On the otherhand, if an investor happened to be out of the market on the ten worst days of the Dow, the investor would have enjoyed gains triple those of the DJIA. In other words, the moments comprising 0.03% of the stock market history (10 days out of 29,694) had a disproportionate impact.
He also warns that attention must be given to how about the risk data is presented because human beings have difficulty perceiving risk (the caveman who took time to think about a risk posed by a saber tooth tiger may not have had the opportunity to pass along this cognitive gene but that is the subject of another book-Outlier). For example, pyschological studies done by Dan Goldtsein have shown that if a person is told a certain event is likely to occur once in 30 years, that person is more likely to take the risk than if the risk is expressed as a 3% a year occurance.
So how does this relate to environmental due diligence? Well first, we've had the Black Swan event. The meteor has hit, it has wiped out the dinosaurs and those of us surviving are like the remaining small mammals. We can't sit around and worry when things are going to get better. There are vast ecological niches that will filled since we know nature abhores a vacuum (even in economics). Our job is to find those niches and provide value to our clients.
And how do we extract value? First, as Warren Buffett says, "Beware of Geeks Bearing Formulas". Talub shows that probablistic or statistical tools can fool the users. What we experienced in the last decade that I call the "Henny Youngman" economy was the commoditization of statistical products (and in the due diligence arena, the commodization of phase 1 reports). The rating agencies developed models that did not have inputs for property values to drop. AIG did not have input for rating agency downgrades in its credit-default swap models.
We have to understand that whether we are dealing with an underground storage tank that was abandoned 30 years ago, a former world war 2 bombing training ground or a Superfund site, we do ot understand all of the risks associated with those environmental conditions. Environmental issues are extremely complex and when we are wrong, the consequences can be enormous. The rarer the event the more inverse its consequences. As Donald Rumsfield once said "stuff happens" (the "unknown unknowns). We have to respect the risk and ask what are the consequences if a black swan would occur. Then the client can choose to accept the risk or try to protect itself.
Remember, in the 1950s, the conventional wisdom was that it was ok to dispose wastewater in unlined lagoons. Many of us have built careers on the mistakes of the prior generation. We are not infallible. We may have more knowledge but we do not have all of the answers and our decision-making is still influenced by the same flaws that have plauged humans since we first walked the earth. Our generation of environmental professionals are also going to have under-estimated risk despite our vastly increased knowledge and powerful computers. Just before the economy blew up, Ben Bernanke said that we lived in an era of stability and "great moderation".
Bernanke, Greenspan and our politicians fell for what Talub refers to as the "narrative fallacy". People found comfort in charts, curves, formulae and explanations that seemed comforting and reinforced our convictions, biases and inability to properly perceive risk. However, in reality, risk in the financial system was growing expontenially. And then the meteor hit. As the old saying goes, "Garbage in, Garbage out."
I close with the following thought. For the last two decades, upwards of three-quarters of the cleanups approved by EPA have been risk-based cleanups. These cleanups were usually approved based on modeling assumptions for natural attenuation of contaminants, efficiency of engineering controls or the enforcement of institutional controls. Aside from the moral issue of leaving future generations with vast swaths of unuseable groundwater, what assumptions were built into these remedy decisions (such as vapor intrusion or greater than expected toxicity) that may turn out to be Black Swans? The universe is not as ordered as we would like to think. Life (and death) is replete with randomness that cannot be explained. Do not confuse the absence of evidence as evidence of absence...and think about low probability events.
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