Wednesday, March 30, 2011

Why “the Green Paradox” is (probably) nonsense

The “Green paradox” is a phrase coined by economist Hans-Werner Sinn, and it refers to the idea that fossil fuel producers will shift their extraction to earlier periods to avoid future (more stringent) climate policies. The idea seems to be that fossil fuel resource owners see themselves as holding an exhaustible resource, and that they have optimized ala Hotelling’s rule: The resource owners can pump an extra unit of oil today and put the money in the bank, or keep it in the ground and sell it at tomorrow’s price. They equalize these two alternative uses of the oil, and design the extraction path that gives an expected price increase equal to the rate of interest.
The Green Paradox follows quite simply from this model: Assume that carbon taxes are credibly announced for tomorrow. This depresses future demand and thus future price, and the resource owners extract more today – until today’s price + rate of interest is again equal to tomorrow’s price (after the carbon tax). Same thing if the world’s government invest in environmental tech R&D  or effective demand reduction/energy efficiency initiatives – if this is thought to have a significant impact on future costs of green energy or demand for fossil fuels, it will decrease the future oil price and cause resource owners to extract more today – thus undoing or at least reducing the impact of the policy.
I should admit I’m not really into this area of economics, but a five-minute googling makes it seem that this is mainly a theoretical concept used in a number of formal models (even when they seem to be asking an empirical question, as here). My skepticism, however, is related to whether this is a mechanism worth taking seriously as an important empirical phenomenon. It’s a subtle mechanism with a lot of moving parts, and each of them, it seems to me, has to work for the mechanism to actually matter: There’s a lag of several years from the time you start building a new well to the point when the new oil comes online. The “early period” you shift your extraction into therefore has to be at least a decade or something unless we assume a lot of spare capacity lying around. That means the oil price forecasts that affect your extraction rate has to at least be oil price forecasts looking 10-30 years into the future. You need to believe in your forecast sufficiently to invest substantial amounts in infrastructure on the basis of them, and these forecasts need to be sufficiently detailed that they can assess the likely effects on market price of future regulation that is, in itself, of uncertain type and uncertain magnitude.
What makes me sceptical of this? To begin with, oil prices are not very predictable – neither oil futures, expert opinions or various modelling approaches that have been tried are any good at predicting even short term changes in the oil price (up to a year, which is short term in our context). From an article in the Journal of Applied Econometrics:
We conduct a systematic evaluation of the out-of-sample predictive accuracy of oil futures-based forecasts and of a broader set of oil price forecasting approaches based on the forecast evaluation period 1991.1–2007.2. A robust finding across all horizons from 1 month to 12 months is that the no-change forecast tends to be more accurate than forecasts based on other econometric models and much more accurate than professional survey forecasts of the price of crude oil. Likewise, both forecasts based on oil futures prices and forecasts based on the oil futures spread tend to be less accurate than the no-change forecast under standard loss functions including quadratic and absolute loss. They also are more biased than the no-change forecast.
The result that oil futures prices fail to improve on the accuracy of simple no-change forecasts contradicts widely held views among policymakers and financial analysts. It also differs from some earlier empirical results in the academic literature based on shorter samples.
If the current oil futures price perfectly predicted the future price of oil, then a plot of the 12-month futures price would be an exact replica of the actual price shifted one year to the left. In other words, it would look like this (annual data – 2009 dollars – source BP energy review 2010):
image
In reality, the article shows that this diagram looks quite different  - it seems (based on a very off-the-cuff and cursory look) that it is rare indeed that the futures price pre-dates the actual price to any impressive extent. The article argues that even the sign of “change-one-year-down-the-road” estimated from the futures price is no better than flipping a coin.
nfig001
When markets are crap at estimating prices one year down the road, the likelihood that they can predict well on a ten year basis seems rather slim – especially when we take into account how off experts have been. Consider US President Jimmy Carter’s energy crisis speech to the US nation from 1977:
The oil and natural gas we rely on for 75 percent of our energy are running out. In spite of increased effort, domestic production has been dropping steadily at about six percent a year. Imports have doubled in the last five years. Our nation's independence of economic and political action is becoming increasingly constrained. Unless profound changes are made to lower oil consumption, we now believe that early in the 1980s the world will be demanding more oil that it can produce.
[…]
Each new inventory of world oil reserves has been more disturbing than the last. World oil production can probably keep going up for another six or eight years. But some time in the 1980s it can't go up much more. Demand will overtake production. We have no choice about that.
In reality, oil consumption dipped slightly as OPEC dug in their heels, and then continued growing:
image
Not only that, but prices collapsed from late-70s levels and stayed (relatively) low until closer to 2000:
image
Investment in new oil rigs are actually very sensitive to the current price, which seems odd: With the swings observed above, long-term forecasts should be more independent of current price (or?).
image
To recap: current investment is mostly related to current spot price, and the current price is largely unforeseen by futures prices and experts, and I think we all would have heard if the collapse of the Copenhagen climate process in 2009, or the climategate emails etc. had provided large and persistent shocks to the oil price (either current or in the future) and caused radical changes in the investment levels of the oil industry. The Green Paradox is a nifty theoretical curiosity, but I would be sceptical of anyone pushing it as an important practical policy-issue.
As usual – I’m open to being wrong (but probably psychologically resistant to being proved wrong all the same ;-) .

Addendum: Svenn Jensen pointed out that if the intertemporal extraction-decisions are factored into the price futures this will complicate things. True. Will think about that some other time - at least unexpected info that made future climate policies less likely would cause immediate price increases as producers saved the oil in the ground for the now "greener" (in dollar-terms for them) future.