Email to the Reserve Bank

The Reserve Bank says climate change is a risk to financial stability. It is proposing to regulate accordingly. A recent paper by the Federal Reserve Bank of New York finds weather disasters are profitable for large banks because they increase loans. In view of the apparent gulf in the two positions, and the lack of any credible evidence so far from the Reserve Bank for its position, the Bank needs to reconcile the gap between its position and the evidence.

Yesterday, I sent the following email to the Reserve Bank. It includes a promise to OIA the Bank at the end of February with a goal of finding out what the Bank has done with these papers:

From: Matt Burgess
Sent: Thursday, 18 November 2021 6:20 pm
To: xxxxxxxxxxxx@rbnz.govt.nz
Subject: Research on climate change and financial stability

Dear xxxxxxxx

In view the Reserve Bank’s interest in climate change, I attach a paper from the Federal Reserve Bank of New York titled “How Bad Are Weather Disasters for Banks?”

Here is the abstract:

Not very. We find that weather disasters over the last quarter century had insignificant or small effects on U.S. banks’ performance. This stability seems endogenous rather than a mere reflection of federal aid. Disasters increase loan demand, which offsets losses and actually boosts profits at larger banks. Local banks tend to avoid mortgage lending where floods are more common than official flood maps would predict, suggesting that local knowledge may also mitigate disaster impacts.[my emphasis]

The paper includes a literature review:

Our main findings are generally consistent with the few papers that study the bank stability effects of disaster. Looking across countries, Klomp (2014) finds that disasters do not effect default risk of banks in developed countries. Brei et al. (2019) find that hurricanes (the most destructive weather disaster) do not significantly weaken Caribbean banks. Koetter et al. (2019) finds increased lending and profits at German banks exposed to flooding along the Elbe River. The study closest to ours by Noth and Schuewer (2018) finds default risk increases at U.S. banks following disasters but the effects are small and short-lived. Barth et al. (2019) find higher profits and interest spreads at U.S. banks after disasters but did not look at bank risk. Based on four case studies of extreme disasters and small banks, FDIC (2005) concluded that …”historically, natural disasters did not appear to have a significant negative impact on bank performance.”

These findings appear to be directly relevant to and substantially at-odds with the Reserve Bank’s position on the financial stability effects of climate change. I have found no record of any of these papers on the Reserve Bank’s web site.

Here are the references to those cited papers with their abstracts:

Barth, J., Y. Sun, and S. Zhang (2019). Banks and natural disasters. SSRN Working Paper

Natural disasters are not rare and costless events. Indeed, the evidence indicates there has been an acceleration in the number of disasters and the associated costs over the past century. Such disasters can cause severe property damage in the communities affected. Typically, insurance policies and government disaster relief fail to cover the full amount of damages. In this case, banks can play an important supporting role in providing additional funding for the necessary reconstruction that takes place after disasters. We provide evidence that following natural disasters, banks with branches in the affected areas raise both deposit and loan rates, but the latter more than the former so that net interest margin increases. This, in turn, leads to an increase in return on assets for such banks, but not sufficiently large enough to indicate profiteering. At the same time, banks increase the use of brokered deposits after natural disasters to help fund the increased demand for loans by individuals and firms in affected communities. Thus banks located in the disaster-prone areas contribute to helping communities recover from natural disasters.

Brei, M., P. Mohan, and E. Strobl (2019). The impact of natural disasters on the banking sector: Evidence from hurricane strikes in the Caribbean. The Quarterly Review of Economics and Finance 72. https://ideas.repec.org/a/eee/quaeco/v72y2019icp232-239.html

While natural disasters cause considerable damage and a number of studies have attempted to investigate the nature and quantify the magnitude of these losses, there is a paucity of empirical evidence on the impact on the banking sector. In this paper we construct a panel of quarterly banking data and historical losses due to hurricane strikes for islands in the Eastern Caribbean to econometrically investigate the impact of these natural disasters on the banking industry. Our results suggest that, following a hurricane strike, banks face deposit withdrawals and experience a negative funding shock to which they respond by reducing the supply of lending and by drawing on liquid assets. There are no signs of deterioration in loan defaults and bank capital. Therefore, the withdrawal and use of deposits rather than an expansion in credit appears to play a significant role in funding post hurricane recovery in the region. This points to the importance of an active reserve requirement policy.

Klomp, J. (2014). Financial fragility and natural disasters: An empirical analysis. Journal of Financial Stability 13 https://doi.org/10.1016/j.jfs.2014.06.001

Using data for more than 160 countries in the period 1997 to 2010, we explore the impact of large-scale natural disasters on the distance-to-default of commercial banks. The financial consequences of natural catastrophes may stress and threaten the existence of a bank by adversely affecting their solvency. After extensive testing for the sensitivity of the results, our main findings suggest that natural disasters increase the likelihood of a banks’ default. More precisely, we conclude that geophysical and meteorological disasters reduce the distance-todefault the most due to their widespread damage caused. In addition, the impact of a natural disaster depends on the size and scope of the catastrophe, the rigorousness of financial regulation and supervision, and the level of financial and economic development of a particular country.

Koetter, M., F. Noth, and O. Rehbein (2019). Borrowers under water! Rare disasters, regional banks, and recovery lending. Journal of Financial Intermediation Forthcoming. https://libkey.io/10.1016/j.jfi.2019.01.003?utm_source=ideas

We show that local banks provide corporate recovery lending to firms affected by adverse regional macro shocks. Banks that reside in counties unaffected by the natural disaster that we specify as macro shock increase lending to firms inside affected counties by 3%. Firms domiciled in flooded counties, in turn, increase corporate borrowing by 16% if they are connected to banks in unaffected counties. We find no indication that recovery lending entails excessive risk-taking or rent-seeking. However, within the group of shock-exposed banks, those without access to geographically more diversified interbank markets exhibit more credit risk and less equity capital.

Noth, F. and U. Schuewer (2018). Natural disaster and bank stability: Evidence from the U.S. financial system. SAFE Working Paper 167.

Our analysis provides new evidence that weather-related disaster damages in the banks’ business regions indeed weaken bank stability and performance. This is reflected in significantly lower bank z-scores, higher probabilities of default, higher non-performing assets ratios, higher foreclosure ratios, lower return on assets and lower equity ratios in the two years following a natural disaster. For a relatively small number of (non-weather-related) geological disasters in the United States, such as earthquakes and tsunamis, we show that these disasters have even relatively stronger adverse effects on bank stability. Overall, the evidence reveals that natural disasters jeopardize borrowers’ financial solvency and decrease bank stability, despite potential insurance payments and public aid programs. On a more positive note, we find that banks generally manage to recover from the adverse shock from weather related disasters (but not from geological disasters) after some years, which is reflected in the bank stability and performance measures of affected banks that are not significantly worse than those of unaffected banks two or three years after a disaster.

Given the extent of the apparent gap between these research findings and the Reserve Bank’s position on the financial stability effects of climate change, I trust the Reserve Bank will consider this research seriously and be able to reconcile its position with these findings.

Given the public interest in this area and the significant steps the Reserve Bank is considering around disclosure and possibly other regulation, at the end of February 2022 we will submit a request to the Reserve Bank under the OIA for all documents and emails which refer to these articles.

I hope you will find this research interesting and useful.

Best regards,

Matt Burgess

—

And a reminder that none of those five papers appear anywhere on the Reserve Bank web site, according to Google on 17 November, despite their obvious relevance to the relationship between climate change and financial stability. #smh

Contrasting substance on climate

The Reserve Bank keeps saying climate change threatens financial stability. It has been saying that for three years. No previous Reserve Bank Governor agrees, judging by their silence on the matter. As I said in last week’s report on the Reserve Bank, after three years of looking the Reserve Bank has not been able to come up with any evidence for their theory. I’m sure it is due any minute now.

Via John Cochrane, the Federal Reserve Bank of New York has taken a different approach. It has actually looked at the evidence. Its paper, called “How Bad Are Weather Disasters for Banks?” includes this as its opening sentence in the abstract: “Not very.”

It goes on:

Disasters increase loan demand, which offsets losses and actually boosts profits at larger banks. Local banks tend to avoid mortgage lending where floods are more common than official flood maps would predict, suggesting that local knowledge may also mitigate disaster impacts.

Here is their literature review:

Our main findings are generally consistent with the few papers that study the bank stability effects of disaster. Looking across countries, Klomp (2014) finds that disasters do not effect default risk of banks in developed countries. Brei et al. (2019) find that hurricanes (the most destructive weather disaster) do not significantly weaken Caribbean banks. Koetter et al. (2019) finds increased lending and profits at German banks exposed to flooding along the Elbe River. The study closest to ours by Noth and Schuewer (2018) finds default risk increases at U.S. banks following disasters but the effects are small and short-lived. Barth et al. (2019) find higher profits and interest spreads at U.S. banks after disasters but did not look at bank risk. Based on four case studies of extreme disasters and small banks, FDIC (2005) concluded that …”historically, natural disasters did not appear to have a significant negative I impact on bank performance.”

So, a small, short lived increase in default (not stability) risk, followed by higher profits as a result of higher lending for the recovery. Larger banks see the greatest boost in profitability.

Oh.

There is more substance in that quote above than anything the Reserve Bank has written on climate change. Look at this tripe, from their the Reserve Bank’s Climate Changed report:

A key concern for us is the exposure of the financial sector, including banks and insurers, to climate-related risks… We take our role seriously, so in 2018 we launched our Climate Change Strategy to understand and manage our direct impacts on climate change, incorporate climate change into our core functions, and lead through collaboration… Without significant action there will be serious impacts on our economies.
There is more that we can collectively do to integrate climate considerations throughout the financial system. It is encouraging to see national and global progress – for example, progress in setting a framework to disclose climate-related risks and some firms beginning to disclose, the delivery of the Climate Change Commission’s first set of advice, and the launch of Toitū Tahua, the Centre for Sustainable Finance. Internationally we are heartened by collaboration in international groups such as the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and the Sustainable Insurance Forum (SIF), and the focus on finance at this year’s United Nations Climate Change Conference (COP26).
A key challenge is that financial stability is best maintained when all relevant risks have been identified, priced and allocated to those best able to manage them. Work is underway to increase our global understanding of these risks.
Yet we need to be realistic in measuring our collective global progress against the scale of the risks before us and the transition required. While tools like disclosure and scenario analysis are critical in helping us understand and prepare for climate risks, we cannot let a desire to perfect such analysis paralyse us…

Etc. The Reserve Bank could have written that literature review quoted earlier. It decided not to. Instead, the Bank chose to pump out its risible agitprop which might as well have come from Greenpeace.

As Cochrane points out:

This is a courageous paper to write… “We looked and there is nothing here” is not going to go down well. It’s hard to publish papers and get jobs as climate and finance researchers these days if you come up with the “wrong” answers.

A reminder that John Cochrane is delivering a public seminar for the New Zealand Initiative on 2 December. You can sign up here.

—

Post script: The Fed’s literature review, the part that covers stability, has references to five academic papers. These papers have pertinent titles: “Financial fragility and natural disasters,” “The impact of natural disasters on the banking sector,” “Borrowers under water! rare disasters, regional banks, and recovery lending,” “Natural disaster and bank stability,” and “Banks and natural disasters.”

According to Google, none of those five papers are mentioned anywhere on the Reserve Bank’s web site. Quelle surprise.

Untrue statements as boilerplate

Stuff reports:

A group of more than 100 New Zealanders, including two former All Blacks and musician Neil Finn, has written an open letter to New Zealand Rugby saying it is going against its own leadership principles by making a major deal with an oil, gas and plastics company.

Good luck to those who have signed the open letter.

But where is the open letter that complains about all the emissions policies which the government says will cut emissions but don’t?

Just yesterday, for example, the government announced it will spend $13 million on a welter of new projects. Together these projects will reduce emissions by exactly zero tonnes because every one of them is in the ETS cap.

Thousands of officials continue not to understand that if an emissions cap decides total emissions then anything that is not an emissions cap does not affect total emissions. This advanced logic continues to elude public servants.

I’m sure former All Blacks are penning their outrage as you read this.

Stuff ends its article with this:

No, Stuff. The Earth is not basically on fire. It has warmed by 1 degree since 1850. The IPCC says so.

Untrue statements aren’t just in the news. They’re boilerplate.

The case for a carbon dividend in two charts

A carbon dividend takes the revenue from auctions of emissions units for the ETS and gives it back to households. This year, the sale of emissions units will raise around $1.3 billion.* That is around $750 per household.

The following two charts show a) low-income households spend more of their incomes on carbon than other households, but b) have a smaller carbon footprint.

Source: Figure 4.3, Report 2.

Source: Figure 4.2, Report 2.

The charts come from a UK analysis by the London School of Economics. I know of no equivalent analysis for New Zealand, although these findings from Infometrics appear consistent.

So what does this mean?

Carbon pricing is generally thought to be regressive because low-income households spend a higher share of their incomes on goods and services which produce or lead to emissions.

However, a carbon dividend reverses this, making carbon pricing progressive. Giving households the revenues from the sale of emissions units disproportionately benefits low-income households. This is because their absolute carbon footprint is smaller than other households, meaning less exposure to the carbon tax, but dividends are paid on (something like) a flat rate.

Studies find different carbon dividends are progressive under most allocation rules, including a simple flat payment per person. Here is a list of studies on the equity effects of carbon dividends.

Studies also find that carbon dividends mean carbon pricing overall is a net benefit for a majority of households. The mid-range estimate seems to be around 60% of households. Low-income households benefit the most from a dividend: one of the studies, from the US, estimates 84% of low-decile households would receive a net benefit from carbon pricing after a dividend payment.

So if you are worried about protecting the most vulnerable households from the costs of lowering emissions – and many who work on climate change say they do – then a carbon dividend should be attractive to you.

On the other hand, if you are concerned about whether it will be possible set a carbon price that is high enough to achieve emissions targets without compromising popular support, then a carbon dividend should be attractive to you. A carbon dividend allows governments to go faster and harder on raising the carbon price, since payments back to households are shelter from higher power bills and petrol prices that necessarily follow from pricing carbon. The fact that dividend means most households win from carbon pricing, with the largest proportionate benefits going to those on low incomes, should increase voters’ tolerance for aggressive efforts to lower emissions.

So, a carbon dividend ticks a lot of boxes.

Naturally, the government has all-but ruled out a dividend. One the few concrete new policies in last week’s Emissions Reduction Plan was to dismiss the dividend idea. Here is what the government said (pp. 34-35):

Given the breadth, scale and duration of the transition to low-emissions economy, we need to ensure adequate, durable and certain public funding for climate action. The Treasury and the Ministry for the Environment are currently considering how the public finance system can provide this, including:
…
4. how we can recycle revenue from the New Zealand Emissions Trading Scheme (NZ ETS) into climate spending.

I understand James Shaw has subsequently confirmed no dividend.

Next time you hear Shaw or the PM or any other minister talking about a “climate crisis” or “climate justice,” keep in mind that they have ruled out about the closest thing you can find to a magic bullet in climate change policy. The one thing, other than a carbon price, that could do more to cut emissions and protect the most vulnerable, simply and easily, than anything else.

That’s what they rule out first.

* Excluding revenue from the sale of 1.6 million “backed” units. These are additional units, issued and sold at the auction on 1 September to defend the ETS price cap. Backed units have to be offset by the government in some way such that they do not raise global emissions.

Not about emissions

With its Emissions Reduction Plan released last week, the government is promising unprecedented control over every aspect of your life.

How you move. What you eat. Where you live. How you heat your home.

It is little short of a revolution. Between its emissions plan and next year’s Budget, which will also be about climate change, future governments of this country will have more to say about everything.

The problem is that existing policies already have this country firmly on track to deliver emissions targets.

In both its draft and final reports, the Climate Change Commission said current policies and a $50 carbon price will be enough to deliver net zero emissions in 2050. Its analysis did not show undue reliance on removals by exotic trees, although Ministers and officials have repeatedly made misleading statements about the Commission’s findings.

Today’s carbon price is $65. So we are ahead of schedule.

Which makes the government’s Emissions Reduction Plan redundant. We get to our targets without the Plan. Emissions will come down about as quickly with the plan as without.

New Zealand should get more credit for its progress on emissions. On a per-capita basis, greenhouse gases have been falling since 2006. They are down 22% overall, and down 34% if agriculture is excluded.

Net emissions of long-lived greenhouse gases – relevant for the net zero target – are down 25% per person.

And it is not pine trees that are doing all the work. More than 100% of the fall in net emissions is due to lower gross emissions.

So current policies are already doing the business demanded by environmentalists. There is no need to add thousands of dollars to the cost of vehicle imports, or any of the many other impositions being looked at, since we are already on track to deliver the stated goal.

There should be no question existing policies will deliver all of our emissions targets if they are given the chance. That is because, apart from methane, New Zealand has set net emissions targets. Both domestic law and international agreements recognise three pathways to lower net emissions: lower gross emissions; removals by trees and other carbon capture technologies; and offshore mitigation.

Removals and offshore mitigation are each affordable and scalable enough on their own to deliver net zero emissions in 2050.

But voters prefer reductions. Fine.

So the task for emissions policies is to assemble a mix of reductions, removals and offshore mitigation which

delivers emissions targets; and
reflects the premium voters are willing to pay for more reductions, less removals and less offshore mitigation.

The government is not thinking about climate change this way. In fact, it does not seem to be thinking about emissions at all. It has published an Emissions Reduction Plan which will bring down emissions by about the same amount as existing policies to achieve the same emissions targets.

What, then, is the point of an Emissions Reduction Plan if it does not reduce emissions?

Judging from its effects, the point is control. The plan will have two clear effects. Ministers will decide how and where emissions come down, not you. Second, you will pay more – ten times more, on the government’s own analysis – for the benefit of their judgment.

What a terrible deal. For the environment. And for your back pocket.

And all based on the twin lies that reducing emissions requires central control, and that the government’s Emissions Reduction Plan reduces emissions.

How do officials think about the costs of expropriation?

The government has introduced legislation which will allow the Minister of Health and the Director General to take over private companies doing COVID testing (further description is here). The likely target of this change is Rako, which has sought a commercial negotiation with the government for the last year. The amendment, which is before the Select Committee, will give the government the option of taking Rako’s property and unilaterally determine compensation.

So, what do officials see as the costs of de facto nationalisation of COVID testing?

Here is what the Ministry of Health has to say in its Fact Sheet 5: Regulating COVID-19 laboratory testing and managing testing supplies and capacity:

The proposed change will not have any direct impacts. Orders made under the new provision may impose obligations or restrictions on testing laboratories to ensure quality of testing, integration of test results with the public testing repository and regulation of testing consumables.
It is important to note that an Order to requisition supplies or redirect capacity to the public health response would only be made if there was significant COVID-19 resurgence where there is insufficient testing capacity in the public system.

Here is what the Regulatory Impact Statement says about costs:

There may be modest costs to the Crown in administering any regulatory regime should this be required. There may also be administrative and other costs for public/private laboratories depending on what is proposed. These costs would be assessed at the time any order is made.

The RIS essentially repeats that last sentence when it says, “A full cost assessment would be undertaken should a COVID-19 Public Health Order (Order) be proposed using the new provisions.”

As for benefits, the RIS says “[t]his proposal will ensure flexibility in the legislation to make orders to effectively manage laboratory testing (if required) to ensure appropriate regulation of quality control and minimum standards in relation to testing, integration of COVID-19 test results into the public health, management of the supply of testing consumables.”

Set aside the fact that officials who cannot secure MIQ or order vaccines on time obviously cannot deliver any of those benefits.

Focus on costs. Officials seem to operating with a cost model that threatening to take a company’s IP is costless, and costs crystalise only when property is actually taken.

I wonder what Rako’s investors and employees think about that view? In fact, I wonder what every owner of intellectual property in every sector thinks about the Ministry’s view.

Because the cost of taking companies’ property is not the administrative overhead, as officials suggest in the RIS.

The cost is all the investment in innovation that will not happen in the future.

Those costs are large, big enough to be measured in percentages of GDP. So it is laughable that officials could list administrative costs as the only real downside of their proposal.

Do officials at the Ministry of Health understand how investment in specific assets works? Do they understand that investment in intellectual property, and in all sunk assets, depends on the credibility of the government’s promise not to take the property once it is created? Do officials recognise that even threatening such opportunism in one sector could have wider ramifications about security of property elsewhere? That prospective investors in wind turbines or EV charging infrastructure won’t notice the government putting in place machinery to take the property of medical companies?

Could officials and the government be any more short-sighted?

Just when you thought it could not get any worse

Having banned saliva testing for more than a year, the government is now proposing to take it. As in, expropriate inventors and manufacturers of COVID testing products.

Newsroom ($) quotes the Chief Executive of Rako, Leon Grice:

There is other legislation where the Government can come in and expropriate or requisition private property – that’s the Public Works Act. But that has more protections, like a process to determine a market rate that the Government must pay…. They can just insist we give up our stock and our reagents and our premises that we need to do our work.

This is real. The government really is proposing to give the Minister of Health the right to “insist we give up our stock and our reagents and our premises that we need to do our work.” The COVID-19 Public Health Response Amendment Bill (No 2) 2021 says:

11 Orders that can be made under this Act
(1) The Minister or the Director-General may, in accordance with section 9 or 10 (as the case may be), make an order under this section for 1 or more of the following purposes:
…
(e) requiring the owner or any person in charge of a specified laboratory that undertakes COVID-19 testing to—
(i) deliver or use, in accordance with directions given under the order, specified quantities of COVID-19 testing consumables that the Minister considers necessary for the purposes of the public health response to COVID-19:
(ii) undertake COVID-19 testing solely for the purposes of the public health response to COVID-19 while subject to the order, whether or not the laboratory is contracted by the Crown for that purpose.

The bill says the Minister will be able to set quality control standards in labs, manage the supply of testing consumables, and set different rules for different classes of testing.

Presumably the government’s target is Rako.

The bill provides for compensation and appeal:

11A Compensation or payment relating to requisitions
(1) This section applies if an order is made under section 11(1)(e).
(2) The owner of a testing laboratory injuriously affected by the requisitioning of testing consumables is entitled to receive compensation from the Crown at the market rate for the consumables requisitioned.
(3) The owner of a testing laboratory required to undertake COVID-19 testing solely for the purposes of the public health response to COVID-19 is entitled to be paid by the Crown for its services at the market rate for those services.
(4) All questions and disputes relating to claims for compensation or payment under this section must be heard and determined by the District Court, whose decision is final.

However, the bill does not define “market rate” or say who decides it. If the answer is Ministry of Health officials – the purchaser – then clearly there is a problem.

As I understand it, Grice has been asking for a commercial negotiation for the best part of a year. How is expropriation even on the table?

Expropriation is likely even if the quoted provisions are never used. The government will have a commanding position in any commercial negotiation when in its back pocket it has the option to take the property of the counterparty and decide compensation.

It is… breathtaking that a government which is borrowing a billion dollars a week wants to nickel and dime the developer of the one thing we need more almost than anything else right now: a ~~rapid~~ fast, saliva-based PCR test for COVID. If Grice’s technology means ten fewer minutes of lockdown, pay him. Let him have his millions. Or make a deal with a competitor. Either way, it’s worth it. And not just for COVID-19. We want the Leon Grices of the world to turn up in the next pandemic, too.

But, no. This government is threatening to take the property of the one company which could do more than any other to get us out of lockdowns. I look forward to the government’s explanation for how that is in the public interest. The judgment seems astoundingly poor. This looks like world class bad faith from officials and ministers.

Another worrying aspect of the bill are the proposed changes for section 12. The government wants to remove the prohibition which says a COVID-19 order “may not apply only to a specific individual”. Changes in section 12 and elsewhere in the bill are clearly designed to enable the Minister and Director-General to issue orders to specific individuals.

This is draconian legislation, yet it seems to be slipping under the radar. It deserves attention.

Here is the legislation: https://www.legislation.govt.nz/bill/government/2021/0068/latest/LMS552303.html

Here is where to make a submission, which closes next Monday, 11 October:

https://www.parliament.nz/en/pb/sc/make-a-submission/document/53SCHE_SCF_BILL_115898/covid-19-public-health-response-amendment-bill-no-2

Here is the Ministry of Health analysis and RIS: https://www.health.govt.nz/our-work/diseases-and-conditions/covid-19-novel-coronavirus/covid-19-response-planning/covid-19-public-health-response-amendment-bill-no-2-2021

Here are marked up changes to section 11: https://www.dropbox.com/scl/fi/vpqwry2bzd0v6fypz1hs4/11_diff.docx?dl=0&rlkey=armucq7yh1w4qejp8yy7ppf1c

And to section 12: https://www.dropbox.com/scl/fi/sidz80ck8yaalfx50d2ss/12_diff.docx?dl=0&rlkey=7mbivhxfbo5bayrkcvtj53phz

A climate policy framework

John Cochrane has written a long essay in National Review called ‘Climate Policy Should Pay More Attention to Climate Economics’ with a subtitle of ‘Without numbers, we will follow fashion.’

The article is beautifully written, hardly a single one of the 3,500 words is wasted. In arguing for economics in climate policy, Cochrane covers many of the major ideas for thinking about how to reduce emissions. The article is comprehensive enough to be a framework.

In this post, I attempt to distil the main ideas in Cochrane’s article.

To avoid doubt, Cochrane (and I) believe climate change is real and is a problem which justifies a policy response. He disputes none of the climate science. He takes the findings from science as given and thinks about the consequences for climate policies. He highlights the harmful mismatch between scientific findings and popular rhetoric on climate.

Most of the following text is directly from Cochrane, with or without quotes. I have put my favourite soundbites in italics:

Climate science and climate policy are different. Climate science concerns the relationship between greenhouse gas emissions and climate. Climate policy is about reducing greenhouse gas emissions. Attacking policy is not attacking the science. “You don’t have to argue with one line of the IPCC scientific reports to disagree with climate policy that doesn’t make economic sense.”

Climate change is not that expensive. “The U.N.’s IPCC finds that a (large) temperature rise of 3.66°C by 2100 means a loss of 2.6 percent of global GDP. Even extreme assumptions about climate and lack of mitigation or adaptation strain to find a cost greater than 5 percent of GDP by the year 2100… Five percent of GDP is only two to three years of lost growth. Climate change means that in 2100, absent climate policy or much adaptation, we will live at what 2097 levels would be if climate change were to magically disappear. We will be only 380 percent better off [instead of 400%]. Or maybe only 950 percent better off [instead of 1,000%]… Northern Europe has per capita GDP about 40 percent lower than that of the U.S., eight times or more the potential damage of climate change. Europe is a nice place to live.”

The central uncomfortable fact is that the output of an advanced industrial economy like the U.S., moving headlong into services, is just not that sensitive to climate or weather. The worst heat waves, floods, and storms just do not move national GDP.

To be clear, a modest cost is no reason not to act on climate. But a modest cost places a modest cap on the benefits of emissions policies, so caution is necessary to avoid emissions policies doing more harm than good.

Growth risk is an order of magnitude larger than climate risk. “The cost of climate change to India is trivial compared with the benefits India could obtain by adopting economic institutions more like those of the U.S. — which themselves are far from perfect.”

If the question is, “What steps can we take, perhaps costly today, to improve GDP in the year 2100?” hurried decarbonization is not the answer. If the question is, “What steps can we take to improve the well-being of the world’s poor?” climate policy is not the answer, with many zeros before you get to the decimal point. Sturdy pro-growth policies, however unpopular to so many in today’s political class and incumbent businesses and labor organizations, are the answer.

GDP is imperfect, but if anything it understates the benefits of economic progress. “It leaves out a lot — the tremendous value of free or nearly free goods, the value of clean air and water, good health, long life, a free and egalitarian society, and so forth. But all of these things are better when GDP is better, and far worse where GDP is worse.”

If the question is how to blunt the economic impact of climate change, adaptation has to be a major part of the answer. There seems to be a great disdain for adaptation, clearing the brush, building dikes and dams, moving to higher land, installing air conditioners, moving or engineering crops and so forth. Spread over a hundred years, the costs of adaptation are not large. Perhaps climate-policy advocates dismiss talk of adaptation because, by reducing the damage that might be caused by greenhouse-gas emissions, it makes emissions less scary. Climate models are also short on adaptation and innovation, perhaps for the same reason.

Miami might be six feet underwater in 2100, but Amsterdam has been six feet underwater for centuries. They built dikes. By hand. Amsterdam is a very nice place, not a poster for dystopian end of civilization. Buildings decay and need to be rebuilt every 50 years or so. Just start building in drier places.

We need rigour in climate policy. “For a small donation, pictures of cuddly animals might do. For trillion-dollar costs and regulations, they do not. To justify such costs, we need some dollar value on specific environmental damage of climate change. Yes, the numbers are uncertain. But those numbers are the only sensible framework to discuss spending trillions of dollars on climate now.”

Cost-benefit analysis matters for making the best use of limited resources. “Naming costs and benefits is particularly useful to analyze whether some of those trillions are not better spent on other environmental issues. For example, species extinction is a real problem. We are in the middle of a mass extinction. But the elephants will die from lack of land and poaching long before they get too hot or dry. For a trillion dollars, how much land could we buy and turn over to complete wilderness? How many more species would we save that way, rather than spending similar amounts of money on high-speed trains and hurrying the adoption of electric cars? The oceans are in trouble. For a trillion dollars, how much over-fishing, chemical pollution, plastic garbage, or noise could we fix? Economics is about choice, and about budget constraints.”

Even though we don’t really know the economic or environmental cost of carbon, cost–benefit analysis is vital so that we do whatever we do efficiently. Avoid doing incredibly expensive things that save little carbon, and don’t ignore unfashionable things that might save a lot of carbon at lesser cost.

Without numbers, we will follow fashion. Today it’s windmills, solar panels, and electric cars. Yesterday it was high-speed trains. The day before it was corn ethanol and switchgrass. Actually addressing climate change in a sensible and effective way is likely to involve unfashionable technologies, and new technologies without political backers. A focus on cost–benefit, carbon per dollar, is vital to allow different technologies to compete, and new technologies to emerge. The alternative — and current predilection — is for different technologies to compete for political favor, a mechanism we all know well, along with its disastrous results, especially regarding innovation and cost reduction.

[MB: This is an important point. One of the costs of an ad hoc winner picking approach on climate is lower innovation. Subsidising EVs, for example, must reduce incentives for R&D in politically-disfavoured rival technologies, including technologies we do not yet know about.]

The policy prescription is simple: price + carbon dividend + R&D. “From an economic perspective, the ideal policy combines a carbon tax, whose revenues reduce other marginal tax rates, with strong support for basic R&D.”

Thus, if the question is how to reduce carbon as much as possible while damaging the economy as little as possible, an evenly applied carbon tax — even to the coal emissions used to create solar panels and car batteries — is the answer, in place of regulation and subsidies.

A carbon tax bakes in cost–benefit analysis, and otherwise incalculable carbon-reduction pledges. Just buy the cheapest option and you’re doing your bit.

Maybe rather than buying a Tesla, you should move closer to work — or carpool. Maybe cutting out one international trip does more than buying the Tesla. Maybe zoning and permitting reform will allow building houses so people don’t commute in the first place. Is it easier to decarbonize transport, home heating, cement, steel, or agriculture? Only by setting a price can we know the answers, and incent the millions of little daily decisions that go in to reducing carbon emissions efficiently.

A weak consumer response to a carbon tax argues for a carbon tax. “A carbon tax is a win-win. Many climate advocates disparage the carbon tax, on the view that people will not reduce energy consumption and carbon emissions when the price goes up. If so, great! A bankrupt government can raise a lot of money, and reduce other heavily damaging taxes. If people drastically reduce carbon emissions to avoid a small tax, the government doesn’t earn much money. Great! We save the planet at low cost.”

Carbon policy is full of economic fallacies. Mother Earth does not care if solar panels are made in the U.S. or China. She just wants them to be cheap. “Millions of green jobs” are a cost, not a benefit. Financial regulators are now taking on climate change, justifying this dramatic expansion beyond their legal authority by endlessly repeating a fantasy that “climate risk” imperils the financial system in the near future.

There is nothing in the science that justifies uniting “climate” with a left-wing political agenda. Yet even the IPCC mixes climate change with “sustainable development, poverty eradication and reducing inequalities.” Mixing anti-capitalist politics with climate change makes those skeptical of the rest of the agenda wonder about the objectivity of climate science, and whether the planet really is in such danger.

There is nothing in climate science to justify apocalyptic rhetoric. If the question is, “What threatens the collapse of civilization,” war, nuclear war, civil war, pandemic, crop pandemic, and social and political disintegration are far higher on the list. No healthy society fell apart over a slow and predictable change that came over a hundred years. There is nothing in climate science to say life on earth is threatened.

Climate advocates have done themselves and the planet a great disservice by wrapping climate policy in increasingly shrill, apocalyptic, partisan, and unscientific rhetoric. “Global warming” became “climate change,” reflecting in part effects on rainfall or different geographies, but also inviting media commentary on every weather event to become a sermon. In the Green New Deal and comparable movements, it became “climate justice,” wrapping climate inexorably in a far-left-wing politics of anti-capitalism. The required vocabulary moved on to “climate crisis.” Still not enough: In April the (formerly) Scientific American proclaimed that, in coordination “with major news outlets worldwide,” it would start using the term “climate emergency.” Will “climate catastrophe” be next?

Finally, here is what I think is Cochrane’s most important point:

Actually doing something about the climate will require decades of consistent policy. That will not happen by today’s elites crying wolf and cramming regulations down the throats of a disdained and temporarily distracted electorate. [MB: That will also not happen by seat-of-the-pants ad hoc policies, nor will name-and-shame work. Consistent policy means a system – consistent, clear, enduring rules to lower emissions. The ETS is a fine example of a rules-based approach. Policies like 100% renewable electricity are not.]

The ETS is extraordinary

Just a reminder of what an extraordinary achievement the New Zealand Emissions Trading Scheme (ETS) is. Introduced in 2008, the ETS covers around 96% of GDP. Apart from the carve-out of agriculture, the ETS has no domestic exceptions. Many offshore schemes exclude small businesses, and/or transport. Ours does not, making it probably the most comprehensive carbon price in the world. Agriculture, our main export earner, is on track to introduce some form of carbon price from 2025.

Look at how different things are in the United States, even under a Democratic White House. From John Cochrane:

[C]arbon taxes are right now a political nonstarter. You can see this most clearly in the hilarious plea from the White House for OPEC to increase production in order to keep gas prices down. This from the same administration that canceled Keystone, “suspended” the issue of new oil and gas leases on federal lands, and is spearheading a “whole of government” move to rapid elimination of fossil fuels before alternatives are in place, all of which must raise the price of gas. What’s going on? Well, clearly, governments find they must take underhanded, obscure regulatory steps to drive up the price of gas, with plausible deniability, rather than enact simple, transparent, much more effective and much less costly carbon taxes, which voters will notice.

The fact that we have an ETS which is comprehensive and puts a hefty $60 per tonne price on carbon, while remaining feasible, is exceptional.

Big picture, people

According to a tweet by the NBR, pundits are calling the Emissions Trading Scheme (ETS) dysfunctional after its $50 price cap was breached at Wednesday’s auction.

Big picture, people.

Wednesday’s auction was roaring success for the credibility of the ETS system, of the government’s emissions budgets, and of the political sustainability of a carbon price north of $50. The market told us it thinks carbon pricing is here to stay and that current and future governments will maintain the commitment to lower emissions.

As far as I know, Wednesday’s auction was functional and orderly, played out according to the legislated and regulated rules.

The market operator received bids. It determined an interim clearing price that was above $50. All 7 million units in the Cost Containment Reserve were made available for an offer price of $50. There were enough bids for all of those units to sell them all. The final clearing price was $53.85. You can read a step-by-step walkthrough of the price-setting process here.

Note that although the government offered those extra 7 million units at $50 a piece, it received the final clearing price for those units, $53.85 – fair market value at the time of the auction. Later, market prices shifted to reach $59 the following day.

The breach in the price cap was not surprising. Prices for New Zealand Units (NZUs) were trading above $50 on secondary markets in the days leading up to the auction, a clear sign that a breach in the price cap was a possibility.

Remember, the reason why the price cap can be breached at all is because of changes in 2020. The government exchanged price certainty for quantity certainty. That is, it gave the ETS a hard emissions cap, with the tradeoff being a soft price cap. Until 2020, it was around the other way. The government would issue unlimited emissions units to defend the price cap, thus raising emissions. Now it only has 7 million units to defend the cap.

The extra units issued to defend the cap will not raise emissions. The legislation requires any extra units must be backed. That means the government must offset the extra units elsewhere so that overall emissions do not increase. The government can choose to back units here or overseas, and it has at least three years to solve this (non-trivial) problem.

Structurally, this is a sound setup. Combining a price cap with a backing rule gives the government a way to manage the domestic carbon price, which is essential, without putting the country’s emissions track at risk. However, while the structure is right, settings need to change because as it stands the government does not have control of the domestic carbon price.

Governments need control of the domestic carbon price to protect the system. The ETS and emissions reduction more generally has to be politically sustainable every day between now and 2050 and beyond. I will talk about this further in future.

The outcome from Wednesday’s auction was predictable and inevitable. The process which delivered it was fully functional.

Wednesday was also a significant win for the environment, a vote of confidence in the commitment to lower emissions and reach its emissions targets, and that the ETS – widely understood to be the most effective tool we have to lower emissions – is here to stay.

That is worth celebrating and is a credit to the Climate Change Minister James Shaw.