Land owners – should I stay or should I grow?Friday 28 Jul 2023
One bit of the Climate Commission’s draft advice, released in March, seemed particularly strange. The Commission worried that a surge in forest planting in New Zealand over the coming years would bring about a collapse in ETS prices in the 2030s and put New Zealand’s net zero commitments beyond 2050 at risk. It seemed particularly strange for those who remember Howard Hotelling’s work on pricing of non-renewable resources over time. It’s standard drill on how to think about these kinds of problems. Its absence from public discourse around carbon prices is hardly surprising: Howard Hotelling is possibly even less of a household name than Armen Alchian. But his work’s absence from the Commission’s thinking is a worry. Howard Hotelling was a mathematician and statistician who turned to problems in economics. In 1931, he published work that helped shape how economists have thought about pricing. His paper, The Economics of Exhaustible Resources, set a simple-looking problem. Suppose you own a mine. It contains only so much ore, though you could expend resources to be able to make use of more of it. There are other mines in the world. If you own one of those mines, you have to decide how much ore to extract from the ground today, how much to leave to extract in the future, and how much to sell of what you have processed. How should you decide? After a lot of application of the calculus of variations, which made his work inaccessible to a lot of economists for a few decades, he wound up demonstrating what’s now called “Hotelling’s Rule”. To put it simply, the path of prices for a non-renewable resource should wind up following the path of interest rates. And it’s fairly easy to see why. Suppose that you could earn $100 by extracting, processing, and selling a tonne of ore today. And suppose that interest rates are 5%. If the futures markets say that a tonne of ore will be worth $102 next year, then you should want to extract ore today and sell it rather than wait. If you sell ore today, and put $100 in the bank, you’ll have $105 next year. And that’s more than $102. If the futures markets instead said that a tonne will be worth $110 next year, then you should want to hold back production. The ore is literally worth more left in the ground to use next year, because $110 is more than $105. As different owners make their decisions, the current and future prices of ore change. Whenever the price path expected in futures markets diverges from the path of interest rates, mine owners have reason to either extract more quickly, or more slowly, to push them back into alignment. It’s a handy result. Pure profit-seeking by diverse owners leads them to follow an extraction path that mirrors overall preferences between current and future consumption – the interest rate. That’s the simplest version of the model. More complicated versions bring in technological change, changes in demand, and changes in the cost of extracting ore. But the core intuition holds. If the mine owner thinks more money can be made by waiting to extract ore rather than digging it up today, balancing expectations about future technology, changes in costs, and interest rates, the owner will do that. What you don’t see in these models is owners deciding just to dump all of their ore rather than holding it for later sale despite expecting higher prices tomorrow. Why would they? They would be throwing money away. And that brings us back to the Climate Commission’s odd view of the 2030s and beyond. The Commission makes a few assumptions to get to its odd result. First, it assumes that current forest planting rates will continue into the future. Second, it assumes that forest owners earning credits are likely to sell them soon after receiving them. For those familiar with Hotelling’s work, those assumptions combined with a price collapse in 2030 make little sense. More >> Source: nzinitiative | ||
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