09 December 2011

Stern's Strange Argument

Apple is one of the world's largest companies, according to its market capitalization, even briefly exceeding ExxonMobil earlier this year. How can this be? Think about it. Every single product that Apple produces today will be obsolete in near future. Not many people carry around a first generation Ipod, or work on an Apple IIe. The certain death of Apple's product line must present economists and financial experts with a great paradox. Therefore, shorting Apple's stock seems like a no-brainer, right?

Well, wrong. Obviously.

But this is the exact line of argument that Nicholas Stern of LSE (author of the Stern Report of 2006) presents in today's FT on the apparent "contradiction" between the valuation of fossil fuel companies and government polices focused on emissions reductions:
There is therefore a profound contradiction between declared public policy and the valuations of these listed companies, based on their fossil fuel reserves, which appear to assume that the world will not get anywhere near its targets for managing climate change.

This contradiction is important. It means that the market has either not thought hard enough about the issue or thinks that governments will not do very much – or somewhere between the two. This presents problems for markets’ assessment of risk; for governments’ credibility; and for regulators, whose approach appears to contradict their own governments’ policies.

This argument makes no prediction of where the world may go. It points to a logical contradiction between what many governments are saying and what markets appear to believe – implying severe risks both to the markets themselves and to the environments that shape lives and livelihoods across the world.

We should recognise that this kind of tension affects not only producers of fossil fuels, but also the industries that use them intensively and the fiscal position of governments holding large reserves.

Surely honesty and transparency require that this contradiction and its implied risk to the balance sheets of large companies – or to the planet, or both – be recognised and tackled.
There is no contradiction here. The world will continue to burn fossil fuels until there are better alternatives available. Governments can certainly help to make markets work better, for instance by eliminating counter-productive subsidies, but such action faces severe political obstacles in many parts of the world. Obviously there is zero risk of governments turning the lights out.

Further, governments are not going to make the price of fossil fuels appreciably more expensive -- not if they wish to stay in power.  This of course is the "iron law" of climate policy.  If and when we see the end of fossil fuels -- whether due to scarcity or substitution or both -- no more means the end of fossil fuel companies than the certain obsolesce of today's Apple product line means the end of Apple.

That is economics and innovation 101.