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Guardian: 'Oil reserves will soon be worth NOTHING!' (A bit like their stock tips, really)
Stern Review? Heard of it?
Worstall @ the Weekend It's not going to come as all that much of a surprise that those who worry excessively about climate change aren't really all that up to speed with economics as a subject in general. But it should produce a little amazement (or a chortle or two perhaps) when said usual suspects launch a new campaign that deliberately ignores a central piece of the economics of climate change itself. I assume it's because they're simply ignorant of their own supporting arguments rather than that they really are this dumb, but who really knows?
By the way, this is not an argument about climate change not happening, nor what we do about it if it is. So pauses, hide the decline, the imminent destruction of Gaia, no, we're not going into those. This is purely about an economic argument being made and the remarkable ignorance of the economics of climate change that underlies it.
The specific campaign I'm talking about is the one the Guardian has just launched, arguing that everyone should get their money the hell out of fossil fuel companies because if you don't you'll lose a packet:
The pragmatists argue the case on different grounds. It is simply this: that finance will eventually have to surrender to physics.
If – eventually – the companies cannot, for the sake of the human race, be allowed to extract a great many of the assets they own, then many of those assets will in time become valueless. So people with other kinds of fiduciary duty – people, say, managing endowments, pension funds and investment portfolios – will want to get their money out of these companies before the bubble bursts.
The egregious buffoon Richard Murphy also chimes in:
Fossil fuel companies are not just valued on what they make; they are also valued on the basis of the reserves that they hold. This is why they keep trying to find more reserves of oil, coal, and so on. But, in practice, we now know that the vast majority of the existing identified reserves of carbon fuels in the world will have to stay in the ground if we are to have any hope of keeping climate change below 2°, at which point it becomes potentially fundamentally dangerous to the future of human well-being. So, there is a very strong likelihood that the reserves of these companies are dramatically overstated, in practical terms, and as a result that their valuations are also massively too high.
The trouble with this idea is that it pretty much ignores the most famous piece of economics associated with the climate change debate: the very thing which is most often cited by Guardian readers as justifying urgent, expensive action against carbon emissions in the near term. You've probably heard of it and you would think the usual suspects above would have: it's called the Stern Review.
So, what's the single most important thing that Nick Stern told us in his eponymous Review? What did he amaze us with that was so different from what William Nordhaus had been telling us for a decade beforehand?
The big trick was to do with discount rates. It's entirely standard economics that human beings are subject to hyperbolic discounting. We're pretty good at making valuations of things that will happen now, in the near future or in a few years' time. But we're really not so good at giving a value today to something that might happen in a few decades' time. This shouldn't be thought unusual in a species that has, historically, generally only looked forward to perhaps 20 or 30 years of adult life. So our thoughts about time and payoffs and risks seem to be pretty good over such a time period but not for longer ones.
What Stern did was draw this out over the climate change question. Entirely correctly, he pointed out that if we use market interest rates to value things over a century or two (and of course market interest rates are simply the aggregate opinion of us all as to that value of stuff in the future rather than the here and now) then the net present value of vast damages in 2150 are spit now. So, we'll do nothing to avert those vast damages in 2150 which is something the people of 2150 won't thank us for.
It's not controversial, this basic point, I do want to emphasise. The Treasury's Green Book says that we can and should use market interest rates out to that 20-30 year time span but after that we've got to use lower ones. Not just for climate change: but in evaluating a new railway line or anything else that will last over long periods of time.
Stern's innovation was to make that proper discount rate, for climate change purposes only, very low indeed. Sure, some disagree with him: Richard Tol thinks he's an idiot for example. Sir Partha Dasgupta would never, as the august being that he is, use such language but he did point out that if Stern's discount rate is correct then we should be investing 98.5 per cent of the current economy in building for the future. That's the academic manner of calling someone an idiot for it's an obviously absurd conclusion.
However, we are where we are and that very low discount rate has been accepted and it's in all of the climate change calculations these days. It underpins all the arguments for drastic carbon action in the near term: that's how the carbon tax ends up at $80 a tonne rather than the $20 that a “better” discount rate would leave us with. But, you know, meh. I'm just mentioning this to show that the Guardian and Murphy should be familiar with the fact that markets place very little value on things beyond the near future.
So let us now consider the value of fossil fuel company reserves (and resources, if we want to get technical, the difference being that reserves are “proven” and resources are not - proven that we can make a profit extracting them with current technology at current prices). The book value of reserves and resources which may be exploited in the future we can calculate - just as with the damages from climate change - by applying a discount rate to them. And of course we do apply a discount rate to them: we apply the market interest rate to them. The net present value of a share is the net present value of all future income (ie, dividends) from that share and of course we are discounting that at market interest rates.
D'ye see where this is gannin' yet? Quite: the net present value of reserves that may or may not be exploited in 50 years' time is pretty much nothing. Because discounting these large sums at 8 or 10 per cent market interest rates means that the net present value is piss. And yes, market interest rates are up at those sorts of levels, not at government bond levels of 2 or 3 per cent, because obviously stocks in resource companies are not “risk free” like Treasuries and Gilts are.
BP isn't valued at whatever the value is of the oil fields it will be sucking in 2050 is. Nor is Exxon. The value of Cuadrilla is barely changed by what happens to shale gas in 2049 and the price or use of coal in 2051 makes pretty much no difference at all to the value of Peabody today. And the reason is simply the reverse of that very problem about climate change that Stern identified. Using market interest rates to discount future sums of money just makes things out in the future worth pretty much nothing today.
So we've therefore got an entire campaign based on the idea that we should all disinvest from fossil fuel companies because their value might go down when we all realise that they'll not be able to use their reserves in 2050. But the current value of those reserves is barely visible in their current market cap, for the very reason that the climate change economics bible explained. Market interest rates used to discount future sums make things in the far future completely unimportant today.
Before we all march off to laugh at the dunderheads eating their crayons over at the Guardian let's just do a check on this idea. Shell's reserves (just reserves, not resources) in 2013 were some 14 billion barrels of oil equivalent. At the prices of that year call that $1.5 trillion or so. Shell as a company in that year was actually worth about $200 billion. Sure, there's production costs and taxation to be taken into account but we've still got pretty good evidence that the current valuation of Shell isn't really related to the valuation of its reserves, don't we? Because, you know, discounting at market interest rates.
Perhaps we should all buy stock in Crayola at this rate of crayon consumption?
Rather more importantly than whatever it is that the Guardian is misunderstanding this week there's a Bank of England committee looking into this very subject. The report is due out later this year and I for one will laugh like a drain if they make this same mistake. Funnily enough Nick Stern was, before his elevation to secular sainthood, actually a Bank of England economist and a rather good one too. ®