Land owners: Should I stay or should I grow?

Dr Eric Crampton
18 July, 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 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.

There is a lot of land that could be turned into carbon forests, but that amount of land is not unlimited. Once you turn a piece of land into a carbon forest, you cannot do so again – though you can turn it back into a paddock later on if you cover your resulting carbon obligations as well as the cost of clearing the forest.

Land that can be turned into carbon forests can be thought of as a Hotelling-style non-renewable resource.

Just like Hotelling’s mine owner, New Zealand’s paddock owners face timing decisions. If carbon forestry stacks up for a piece of land, does it make most sense to plant today, or to wait a decade?

If planting today would mean getting carbon credits in the 2030s, and if you think carbon prices will be low in the 2030s, it might make more sense to wait to plant. You can keep earning revenue from beef or lamb in the meantime. Or, you could plant now but only sell any carbon credits when the prices are high enough – though you would be missing out on beef and lamb revenues by doing so.

What would make no sense at all would be to plant today, take credits in the 2030s, and sell them off even if you expect carbon prices to be a lot higher after 2050. If you sold the credits early and put the money in the bank, you’d have less money than if you’d just held the credits to sell when prices were higher.

Current forestry decisions don’t jeopardise net zero beyond 2050. They’re part of getting to net zero and staying there.

Except for one thing.

Gérard Gaudet’s excellent survey of Hotelling’s Rule showed that governments can break the mechanism with one neat trick that governments do love to try.

Imagine that you’re the mine owner, but you expect a ban on mining in a decade. And suppose that, if that rule were not looming over you, it would make more sense to leave ore in the ground to extract tomorrow.

Instead, uncertainty about the institutional regime within which you’re working means you should pull every bit out of the ground today. Ore left in the ground will not be worth anything after the ban. And you can always sell extracted ore later.

Insecure property rights can undo the optimal paths that Hotelling described.

And we’re already seeing it in carbon forestry. The government keeps sending worrying signals about the place of carbon forestry in the Emissions Trading Scheme. Will it ban new carbon forests? If so, you might want to plant in a hurry, to get ahead of a ban. Will it mess up how existing forestry credits are treated? If so, you might want to dump those credits in a hurry if you cannot bear that risk.

CarbonNews reported that carbon market participants are switching to non-forestry carbon credits, and a split-market is developing, because the government has been scaring the hell out of small forestry owners. Those owners are dumping their credits because of worries about what would amount to expropriation.

And others, who expect existing forests to be grand-parented after a rule-change, will be turning paddocks into forests as quickly as possible – in case government bans future conversions.

One sure way to screw up Hotelling’s Rule is by messing around with the underlying property rights.

By threatening those property rights through the ETS review, the government is bringing about some of the outcomes that it claims to want to avoid: a current tanking in ETS prices combined with a lot of forestry conversions.

The government ought to be bulletproofing the ETS. Perhaps if the government, and the climate commission, read a bit more Howard Hotelling, they’d be less likely to accidently shoot holes in the thing.

Read here

Stay in the loop: Subscribe to updates