The Carbon Bubble vs The Financial Crisis

There have been a slew of recent news articles reporting on a new paper published in Nature Climate Change, Dietz et al (2016) "‘Climate value at risk’ of global financial assets". This paper described modelling work on the asset value implications of both climate policy and climate change. Its calculations include the fossil fuel asset write-downs required to implement a particular emissions path, and a DICE climate-economy model is used to project a damaged global output path given this emissions path. The impact of this path on asset values is estimated assuming a constant profit share of GDP. It is found that "the expected value of global financial assets is 0.2% higher along the mitigation scenario [2oC limit] ... this reflects the reduction in asset values brought about by paying abatement costs in the economy—including, for instance, the stranded assets of fossil-fuel companies".

This paper therefore goes beyond the "Carbon Bubble" warnings of the Carbon Tracker Initiative, which are about the fossil fuel asset write-offs required to be consistent with stated climate change policy, in the dimension of also considering the damages to asset values caused by climate change itself. In forthcoming work, I consider another dimension: what about the business cycle response to writing-off all these fossil fuel assets? The financial accelerator mechanism would suggest that writing-off so many assets would induce a large recession, and impede the investment needed in alternative energy infrastructure. Katy Lederer has an article in the New Yorker describing some other work along the same lines.

The Dietz et al paper provides a couple of useful numbers to help calibrate the "bursting of the Carbon Bubble" against the 2008 Financial Crisis. They say that "the total stock market capitalization today of fossil-fuel companies has been estimated at US$5 trillion", and that the "Financial Stability Board ... puts the value of global non-bank financial assets at US$143.3 trillion in 2013". So fossil fuel company valuations represent perhaps 3.5% of total financial assets. To validate this figure we could note that fossil fuels represent 80% of energy generation[1], and that energy is around 7.4% of expenditures[2] so fossil energy assets should represent 5.9% of total assets if they have the same term as the average of other assets, and less if they are shorter duration. Further, many fossil fuel assets (e.g. the Saudi oil industry) are wholly state owned and so may not be in the $5tn figure (although likewise they also will not be in the denominator in this case too).

The financial crisis began with the realisation that the fundamental value of subprime mortgages (and the CDOs into which they were bundled) was much lower than had previously been recognised. Hellwig (2009) estimated that the total value of subprime mortgages outstanding was $1.2tn in the second quarter of 2008. Whilst this is a big number, even a complete loss of this value should represent a relatively mild adverse event to a well diversified investor. Instead we saw the financial crisis in which the stock market lost almost half its value, and corporate debt also saw negative returns (although non-PIIGS government bonds performed very well as yields collapsed). A well diversified investor lost perhaps 20% of the value of their portfolio[3], and Global GDP fell by 6%[4].

So given the financial crisis, what would the impact be of "bursting the Carbon Bubble"? The Carbon Tracker Initiative estimate "Only 20% of the total reserves can be burned unabated", while the International Energy Agency say "No more than one-third of proven reserves of fossil fuels can be consumed". Consistent with these estimates (since the financial value of resources and low quality reserves will be less than the financial value of high quality reserves, per unit carbon), let's assume that the total value that must be written-off is 60% of the value of fossil fuel companies. Assuming that the Financial Crisis was precipitated by a $1tn write-off, then we compare this to a Carbon Bubble figure of 60% of $5tn = $3tn, and we see that the balance sheet impact of the credible implementation of the climate policy needed to keep global temperatures 2oC above pre-industrial levels, may be around three times that which caused the Financial Crisis. If fossil fuel assets are 5% of the global asset base, then the Carbon Bubble necessitates writing-off 3% of assets. What will be the impact of this given that we saw total asset price falls of 20% and GDP falls of 6% in response to the Financial Crisis when investors realised that the repricing of their subprime mortgage holdings had caused a 1% fall in the value of their assets?

Without deliberate policy to recapitalise investors or to socialise investment, implementing climate policy that "bursts the carbon bubble" risks seriously damaging the economy, and specifically harming the very sector of the economy that should be investing in replacing the present fossil fuel infrastructure.

[1] See either Newell, Qian & Raimi (2016) "Global Energy Outlook 2015" or Table 1.2 Primary Energy Production by Source of http://www.eia.gov/totalenergy/data/monthly/pdf/mer.pdf

[2] The 20 year average for Energy Expenditures as Share of GDP, from Table 1.7 "Primary Energy Consumption, Energy Expenditures, and Carbon Dioxide Emissions Indicators" of http://www.eia.gov/totalenergy/data/monthly/pdf/mer.pdf is 7.4%

[3] Approximate calculation: assuming asset values are split 80% private and 20% public; public asset value proxied by government debt value which rose as yields fell (assume +10% return); funding of private assets is split by capital structure of firms: assume 40% corporate bonds (-10% return) and 60% equities (-40% return); gives overall return of -20%.

[4] Constant GDP per capita for the World, from FRED: "normal" times have real growth per capita of between 2% and 3% per annum, but this fell to less than -3% per annum during the Financial Crisis i.e. around 6% lower than normal.

Talent and/or agglomeration

Bosquet & Overman (2016) find, using data from the British Household Panel Survey clustered by local labour markets, that the elasticity of wages with respect to birthplace size is 4.6%, which is around two thirds of the 6.8% elasticity of wages with respect to current city size. So the size of place of birth “explains” most of the well-known productivity enhancing size effects.

The authors claim that their results suggest that (1) the effect of birthplace on current location (clearly a high correlation between the two); and (2) inter-generational transmission (i.e. the correlation between incomes across generations); largely explain the effect of birthplace. In contrast, they find no role for (3) human capital formation (it’s not the case that people born in a high wage location gain better school results, conditional on parental income etc). Their results “highlight the importance of intergenerational sorting in helping explain the persistence of spatial disparities”, and show that “there is a geographic component to the inheritance of inequality”.

What does this tell us? Well (1) is just the usual agglomeration story: people can be, on average, identical across locations, but in bigger locations they are more productive through greater scope for specialisation etc. Given the high correlation between where people are born and where they end up, birthplace size will statistically “explain” the extra wages that actually come from pure size effects. And (3) tells us that educational quality does not vary systematically with size.

(2) however, is about talent. Talent is heritable, and partially explains the relatively high positive correlation between the earnings of parents and their children (though advantage and privilege also play a role in explaining this correlation). This paper is measuring a geographical concentration of talent. Highly paid talented workers are clustering in larger locations, and producing talented children who, on average, also stay in these locations and go on to earn high wages.

(1) is potentially a positive sum game: on the production side, productivity is higher if everyone clusters in a single large location, rather than spreading out evenly, because the scope for specialisation is higher; and on the consumption side, product variety is higher because it is much more worthwhile to supply niche products in a large market[1]. It is easy to imagine that the consumption benefits of size may be scale invariant: city 2, twice the size of city 1, will be able to support x% more niche markets than city 1, independent of the absolute size of city 1[2]. On the production side however, it seems that the positive externalities are more highly localised and hence less scale invariant. Ahlfeldt et al (2015) find that “externalities are highly localised within the city and after around 10 minutes of travel time, … externalities fall to close to zero”. This seems to imply that once a city is big enough to support some highly productive cluster, sector or industry, then doubling the size of the city cannot be expected to further increase productivity.

Conversely, (2) is a zero sum game: talent in one location is talent that is not located anywhere else.

Further, it is not clear that increased size ends up providing benefits to the inhabitants of a location since increased size also increases congestion, pollution and land costs. Paul Cheshire claims that the current literature suggests that “doubling a city’s size produces about a 5% increase in total factor productivity, holding everything else constant”, but points to French research that suggests that the benefits from this higher productivity are entirely swallowed by increased land costs if land supply is fixed, and 40% absorbed by increased land costs if land is elastically supplied.

To the extent that large cities are exploiting potentially positive sum gains from (1), it is possible that it is worthwhile, at the margin, to have public policy that encourages the movement of people from smaller places to the largest cities (so long as we ensure open-access and freedom to build so that the land costs are more like the 40% of agglomeration benefits, rather than the 100% of agglomeration benefits under inelastic supply of housing). But to the extent that the gains from size are actually due to the zero sum game of moving talent around, then it would be stupid for public policy to encourage talent to move to large congested, expensive cities and so not be present in places where land is cheaper.

And, of course, the UK seems to take the potentially less intelligent option. The Centre for Cities 2014 report, Cities Outlook 2014, had some fascinating statistics on migration flows within the UK. The following picture was particularly striking:

 

And this is not the only way things can work: in Switzerland for example talented young people who want a career in finance move to Zurich, but if you want to be an engineer then Basel is likely your destination, while for diplomacy it’s Geneva, and for government it’s Bern. The highly localised production externalities created by creating a cluster of firms in a particular sector can still be exploited, but everyone does not all try to move to the same place, land price differentials and congestion can be minimised, talent is spread out, and geographical inequality is much much lower.

Update: The Paul Cheshire CityTalks episode from 23rd June is good. Don't agree with everything he says (in particular he only focuses on the benefits to the people who move, not the costs on the people who don't) but it is interesting throughout.

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[1] The impact of higher productivity will show up in GVA statistics, but the gains from enhanced product variety do not show up in GVA statistics: rather £1 of expenditure on consumer goods buys more utility in a larger market because of this wider product variety.

[2] Although an individual’s utility likely increases by less when product variety rises by x% from an initial high level of product variety compared with an initial low level of product variety.

Asymmetric thinking on Council Tax revaluation

Glenn Campbell tweets:

LOCAL TAX: 1991 property values will still be used. @NicolaSturgeon says she has "no plans" for revaluation as it would hit some hard

— Glenn Campbell (@GlennBBC) March 2, 2016

But there are as many winners from revaluation as losers (there are as many properties that are in currently too high a band as in too low a band). These "revaluation winners" are being "hit hard" by the decision not to revalue.

And something for the SNP to think about: the Yes vote in 2014 was correlated with levels of deprivation i.e. it was highest in precisely those areas which have not seen the big house price rises since the last revaluation in 1991. A revaluation would, on average, benefit Yes voters and cost No voters. Therefore the decision to not revalue is effectively a gift to No voters - though perhaps that's the point since the SNP still need to convince people in these areas...

'Helicopter Money' and 'Fee & Dividend'

Helicopter money is being increasingly discussed as the economic outlook darkens with policy rates still extremely low. Simon Wren-Lewis discusses Two related confusions about helicopter money and Miles Kimball says that Helicopter Drops of Money Are Not the Answer. Both these pieces define Helicopter Money as QE + Fiscal Policy i.e. central banks create new money and use to buy government bonds, whilst governments run deficits, effectively giving taxpayers money via reduced tax bills (SWL: "HM is a large fiscal expansion", MK: "Printing money and sending it to people is equivalent to printing money to buy Treasury bills and then selling those Treasury bills to raise funds to send to people").

I think this is too broad a view of helicopter money, which effectively incorporates the QE that we've seen over the past decade. HM could be differentiated from this QE by considering it to be new issues of central bank money that are not used to purchase any assets, but are rather given away. This would mean the exercise of a HM policy would be much more aggressive monetary policy than QE since it would be much more irreversible (the central bank would have fewer assets relative to liabilities with which to defend the value of the currency, unless it were to be recapitalised by the fiscal authorities).

If the view of helicopter money could be narrowed to: the central bank creating new money, all citizens having an account at the central bank, and the new money being deposited on an equal per capita basis in these individual accounts; then there are two further issues that such a putative HM architecture could clarify:

1) Central bank independence in terms of the output-inflation trade-off from the level of fiscal policy. Suppose the monetary authorities have lowered interest rates to zero, and still inflation is below target; the central bank decides to engage in QE, creating money to buy government bonds; demand for bonds rises. However the fiscal authorities do not change their tax and spending plans; There is a mild stimulatory impact from lowered long term borrowing rates, but there has been no "Printing money and sending it to people". Under HM = QE + Fiscal Policy, the central bank cannot decide the level of monetary stimulus without some agreement with the fiscal authorities. If instead HM was a distribution into citizens' individual accounts, then there would be a monetary expansion without any reference to the fiscal authorities. The central bank could exercise this policy lever autonomously in line with its (inflation targeting or other) mandate.

2) Central bank independence in terms of the distributional effects of monetary policy. If the fiscal policy under HM = QE + Fiscal Policy was eliminating corporation tax, capital gains tax, and higher rates of income tax, then this would meet the definition of HM as "Printing money and sending it to people". But "the people" chosen is a highly political choice (in this case the very wealthy). A technocratic monetary authority should not be making, or party to, such political choices: and it would be if monetary objectives mandated QE that gave "windfall" resources to a particular government at a particular point in time with which to make a politicised distribution of this money. Per capita distribution i.e. a lump sum transfer, would of course be a political choice as well. But if this were the instrument specified in legislation and in the political process that set up the HM architecture, then that political choice would have been made appropriately ex ante, and the exercise of the policy lever could be made entirely on grounds of meeting monetary objectives.

Anyway, those are my thoughts on helicopter money. It struck me recently though that setting up a HM architecture of this form would also enable the climate change policy advocated by James Hansen: Fee & Dividend. This is a carbon tax policy, the revenues from which are distributed on a per capita basis. This means that climate policy doesn't cost the average citizen anything (they get back all the extra money they spend) but it changes prices in a way to incorporate the carbon externalities of their consumption choices. The individual accounts at the central bank are a perfect vehicle for paying the dividends associated with the F&D policy.

Always nice to present a single proposal that solves multiple problems...