09 December 2011

Stern's Strange Argument

Apple is one of the world's largest companies, according to its market capitalization, even briefly exceeding ExxonMobil earlier this year. How can this be? Think about it. Every single product that Apple produces today will be obsolete in near future. Not many people carry around a first generation Ipod, or work on an Apple IIe. The certain death of Apple's product line must present economists and financial experts with a great paradox. Therefore, shorting Apple's stock seems like a no-brainer, right?

Well, wrong. Obviously.

But this is the exact line of argument that Nicholas Stern of LSE (author of the Stern Report of 2006) presents in today's FT on the apparent "contradiction" between the valuation of fossil fuel companies and government polices focused on emissions reductions:
There is therefore a profound contradiction between declared public policy and the valuations of these listed companies, based on their fossil fuel reserves, which appear to assume that the world will not get anywhere near its targets for managing climate change.

This contradiction is important. It means that the market has either not thought hard enough about the issue or thinks that governments will not do very much – or somewhere between the two. This presents problems for markets’ assessment of risk; for governments’ credibility; and for regulators, whose approach appears to contradict their own governments’ policies.

This argument makes no prediction of where the world may go. It points to a logical contradiction between what many governments are saying and what markets appear to believe – implying severe risks both to the markets themselves and to the environments that shape lives and livelihoods across the world.

We should recognise that this kind of tension affects not only producers of fossil fuels, but also the industries that use them intensively and the fiscal position of governments holding large reserves.

Surely honesty and transparency require that this contradiction and its implied risk to the balance sheets of large companies – or to the planet, or both – be recognised and tackled.
There is no contradiction here. The world will continue to burn fossil fuels until there are better alternatives available. Governments can certainly help to make markets work better, for instance by eliminating counter-productive subsidies, but such action faces severe political obstacles in many parts of the world. Obviously there is zero risk of governments turning the lights out.

Further, governments are not going to make the price of fossil fuels appreciably more expensive -- not if they wish to stay in power.  This of course is the "iron law" of climate policy.  If and when we see the end of fossil fuels -- whether due to scarcity or substitution or both -- no more means the end of fossil fuel companies than the certain obsolesce of today's Apple product line means the end of Apple.

That is economics and innovation 101.


  1. "Obviously there is zero risk of governments turning the lights out". Really?

    That is EXACTLY where the current UK government is heading. The head of our national grid has told us that we should prepare ourselves for an intermittent supply.

  2. "The world will continue to burn fossil fuels until there are better alternatives available." "We will reduce our emissions by 20% by 2020." It sounds like a contradiction to me.

    "Further, governments are not going to make the price of fossil fuels appreciably more expensive -- not if they wish to stay in power." This is maybe true of US politics, but utter ignorance when it comes to most of the rest of the world. A quick survey of taxes on fuel (on unleaded petrol) shows roughly:

    Germany - 58% of the cost is tax
    Netherlands - 68% of the cost is tax
    UK - 58% of the cost is tax
    Australia - 35% of the cost is tax

    These are only the direct taxes on fuel - many also tax vehicles depending on their rate of CO2 emissions.

    Governments have *already* increased the price of fossil fuels appreciably - eye-wateringly in some cases - and it has not led to revolution yet. While it is climbing up the list, up to 60% tax on fossil fuel is not even a dominant political problem for these governments. Perhaps the "iron law" is not quite so iron as all that?

  3. The "contradiction" is only imaginary as there is a world of difference between reality and political rhetoric and markets clearly distinguish between the two.

  4. Tom, the reason why there is no revolution is that the share of fuel cost as a percentage of income in the countries mentioned above has not risen much - between 1985 and 2000 I think it actually went down. Governments kept on increasing fuel duty to keep their tax base on the same level.

    People have gotten richer, they can afford it.

  5. -4- Pirate,

    Aren't these tax levels also justified on a more general basis? Which is to say, existing government spending priorities, as opposed to a climate tax.

    It's not a revolution, but there's plenty of push back in Australia on the new Carbon Tax there, which is being justified purely in climate terms.

  6. The real irony is that the environmental policies and regulations make it harder to discover and develop new oil reserves lead to price increases that increase the value of fossil fuel companies.

  7. With regard to the notion that Apple's products have a shelf life of only a few years: isn't it also true that Exxon's product -- gasoline -- can only be used once? Now THAT is a short shelf life!

    The valuation of both Apple and Exxon has to do with estimates of future earnings. If Apple starts to seriously lose market share, or if Exxon gets booted out of more countries or if the price of oil were to decline (not very likely any more), then the valuation of each would decline.

  8. @Tom
    Indeed. One wonders what exactly Roger means by 'appreciably'.

  9. -8-Marlowe Johnson

    It is in the book;-)

    As I write there, people are willing to accept higher costs of energy for a range of reasons, including environmental objectives, but that willingness has limits (everywhere, and at different levels in different places).

    That limit is below the level that would result in a reduction in GDP or GDP growth. More in Ch.2 of TCF.


  10. Roger that isn't really answering the question. You're merely saying the same thing. What is an 'appreciable' reduction in GDP? Why the heterogeneity in people's willingness to pay?

    What are the practical implications in terms of carbon prices for the short, medium, and long term?

    Saying that people won't pay infinite amounts of money for energy to support a particular objective isn't particularly insightful.

  11. -10-Marlowe Johnson

    Fortunately, we can look at experience to see at what level people get upset about fuel price increases and demand change.

    At what level do farmers in Belgium and France complain by parking their tractors on city streets? How about pensioners in the UK complaining to their MPs about the fuel duty escalator? At what price proposal has the public rioted in India and Indonesia when subsidy reform is proposed? How much higher are US presidential candidates proposing to increase fuel prices?

    Now compare those numbers with the price increases recommended by advocates for action on climate change (e.g., Stern, Krugman, etc.). The answer is something like a factor of 100 in India and more in the UK (details provided on this very blog!).

    You can do the math from there I think.

    Practical implications? Obvious. You cannot transform the energy system via carbon pricing. But you can talk about it forever. ;-)

  12. Roger you would have a point if carbon pricing schemes weren't designed to be approximately revenue neutral. Since they aren't, you don't.

  13. except for that time china shut off the lights to hit its energy intensity target.... iron fist indeed!

  14. -12-Marlowe Johnson

    I can do better than revenue neutral -- the Australian carbon tax is revenue negative! How will that work for emissions reductions? ;-)

    Ultimately, we can talk about this until the cows come home.

    I suggest that we simply agree to disagree -- you try to increase the costs of energy for people around the world and I look for alternative approaches. Then, let's compare notes in five years and see how effective we each are;-)

  15. In the UK there were various road blockades in protest against fuel prices, esp. the government's fuel tax escalator. The most significant was in 2000.

    From Wikipedia:

    "By 2000, tax accounted for 81.5% of the total cost of unleaded petrol, up from 72.8% in 1993.[1] Fuel prices in the UK had risen from being amongst the cheapest in Europe to being the most expensive in the same time frame.[1] The protesters said that higher transport costs in the UK were making it difficult for haulage industry to remain competitive.[4] The worldwide price of oil had increased from $10 to $30 a barrel,[5] the highest level in 10 years.[6] Drivers in the UK were now paying an average of 80 pence a litre for unleaded and 80.8p for diesel.[6] The government had already abandoned the fuel tax escalator in early 2000.[7]"

    The price of petrol today is 137p, diesel 140p.

  16. Roger I suspect we actually disagree less than you think; in the end, it probably comes down to differences in emphasis and staging of policies rather than the policies themselves.

  17. Given the choice of the market, where people bet their own money, or the government, where people bet someone elses money, I'll go with the market every time. The market will be wrong, but not as often as governments.

  18. re 12 Marlowe Johnson wrote
    Roger you would have a point if carbon pricing schemes weren't designed to be approximately revenue neutral. Since they aren't, you don't.

    Carbon taxes are said to be designed to be revenue neutral. However they are not neutral in the sense that they are intended to create a significant change in the lifestyle of the population. People are not fools. They know that the imposition of theses taxes is intended to affect them dramatically. If not, why are they being imposed? Why can't AGW proponents just be candid. Why do we have to parse every statement they make to understand just what they are trying to conceal? People are not fools and they know when someone is trying to sell them something and not being candid about it. They know the political strategy of creating a fait accompli.

  19. Has anyone drawn parallels with what is happening in Europe and what is happening in Durban. In Europe a monetary union was created by the technocratic elite. It had fatal flaws, known from the beginning, that were ignored in the face of the greater purpose of avoiding future European wars. In Durban, the European technocratic elite is leading the effort to create a new economic and political system to fulfill the higher purposes of climate security.

    Is there a form of symmetry here?

  20. "There is no contradiction here. The world will continue to burn fossil fuels until there are better alternatives available.."


    This statement is true to a point.

    When the opiate addict is found dead with the needle in his/her arm, is it stated that "He/She
    has found a better alternative.."?

    "Experience" is, they say, "a hard teacher."

    Increased value will be ascribed to CO2 emissions: hopefully while "money" still has "value."

  21. There is a substantial difference between an addict O.D.'ing and climate change. The addict's cause of death is indisputable and easily determined by autopsy. The claim has been, and commenters here would seem to support, that manmade GHGs are the "primary" cause of global warming. However, the data indicates that other causes are also important, which requires that the focus be broadened. Stern’s review in 2006 resulted in a lot of debate (e.g., Richard Tol, William Nordhaus and others) on whether or not the assumptions were loaded on the issue of cause and effect, and in re to the assumed “pure rate of time preference” (social discount rate) which tended to magnify the positive effects of distant benefits from the mitigation of (modeled) damages caused by manmade GHGs. Due to the nature of the science there may never be a single correct answer saying “this is the general (climate) forcing function and the correct form of all its variables.” However, there is much more to learn and this will come from empirical science and not in a Kuhnian court of public opinion. I agree with Roger that the sensible policies will recognize that fossil fuels need to remain major components of our long term energy portfolio while encouraging alternatives and giving proper due to efficiency and emissions.

  22. In regard to taxes being "revenue neutral", a recent political controversy in British Colombia is pertinent. Before the last election, the ruling Liberal Party indicated that they were not considering the imposition of a value added tax (called the HST or Harmonized Sales Tax in Canada). After they won the election, they immediately imposed it. As would be expected there was a huge controversy. The government defended by the HST by saying that it would benefit industry and that it would be "revenue neutral". The opposition called it a massive transfer of taxes from business to consumers.

    The government and business interests brought out innumerable economists who said that the HST would be beneficial to industry and the BC economy in general, They claimed that it was "revenue neutral" but could not bring themselves to admit that taxes on consumers would rise. They lengthy explanations of the operation of the HST in newspaper op eds but could not admit that being "revenue neutral" necessarily and that taxes would rise on consumers. Industry would benefit because it would pay no taxes on export goods and would therefore be more competitive. BC industries would be able to compete more effectively in the export market and would bring more money and jobs into the province. The economy and consumers would benefit because of this. However, to make the tax "revenue neutral" to achieve these benefits and to maintain government revenues, the proportion of taxes paid by consumers would have to rise. Overall consumers would receive a net benefit but would gain this benefit by paying a higher proportion of taxes just as the opposition said..

    However the government would not put out this simple explanation. They refused to admit that the proportion of taxes paid by consumers would rise. Instead they continued with their lengthy and obscure explanations and refused to admit that consumers would be affected by these taxes. They harped on "revenue neutrality". As a result of this, the HST was defeated in a referendum and the old sales tax regime was reestablished. The premier of the province resigned as a reviled unelectable figure

    The "revenue neutrality" of carbon taxes seems to be going the same way. Proponents of AGW mitigation simply will not admit that this "neutrality" does not detract from the fact that the intention of the tax is to dramatically change the way that people live their lives. The choices in the places that they live, the food that they consume and much more are intended targets of these taxes. There may be net benefits to people from this. However if mitigation proponents do not describe this issue with candor, the HST result in BC could be repeated with carbon taxes.

    Carbon taxes are not "neutral". That is their entire point.