Monthly Archives: July 2007

107 – Why don’t farmers use futures markets more?

Most of us prefer to avoid risk if we can. Some farmers reduce their risk by “hedging” – that is by locking in the sale price of their production in advance using futures contracts or fixed-price contracts. However, only a minority of farmers do so. Why is that?

The simplest economic models of price hedging indicate that producers should always hedge all of their production. This will eliminate their risk of the sale price falling by the time they have produce ready to sell. Of course it will also eliminate the chance of the price rising, but for most people, falls matter more than rises (i.e. most people are “risk averse”).

From that description, hedging seems like a great opportunity to reduce one of farmers’ main risks. Why then, is hedging not a dominant practice in agriculture. There are several reasons.

One is that the simplest models are too simple. They neglect several factors that tend to reduce the attractiveness of futures contracts.

  • Transaction costs. Participating in the futures markets takes time and costs money. For example, in futures markets, producers have to meet margin calls, which require them to pay money in advance for a proportion of the value of the contract. This is inconvenient, and it has interest costs. It has been estimated that the transaction costs amount to about 2% of the value of futures contracts in Australia.
  • Basis risk. When a farmer signs up for a futures contract, it is usually not for exactly the same product as the farmer is producing. The future market price of the product specified in the futures contract will probably vary in a (hopefully slightly) different way to the product the farmer is producing, so the contract doesn’t exactly cancel out the price risk that the farmer faces.
  • Production risks. If you allow for the fact that the amount of product that will be available for sale at the end of the growing season is not known with certainty, it can be preferable to hedge only a portion of the expected production (depending on other circumstances).

Another reason is that hedging does not only affect the riskiness of the farmer’s outcome – it also affects the expected level of payoff (“expected” in the statistical sense of a weighted average). Most economic research publications on hedging make the assumption that the farmer’s expectations about price match the market’s; their expected price is the same as the futures price. In reality, a population of apparently similar farmers has a wide variety of price expectations. For those who are relatively optimistic about prices, there is a disadvantage in locking in at what they perceive to be a low price. Doing so would reduce their expected income, so they choose not to hedge.

Then there is the question of how much a farmer has to gain from hedging. If the farmer is among the majority of farmers who are not very risk averse, there may be little benefit in hedging. Figure 1 shows one example. The horizontal axis shows the proportion of expected wool production that the farmer might hedge, and the vertical axis shows the payoff from doing so. The payoff is called the certainty equivalent, which consists of the expected profit minus a risk premium. For a wool farmer with low risk aversion, and with price expectations that match the futures market, the potential gain in certainty equivalent by moving from zero hedging (the left edge of the top curve) to the optimal level (56%) is tiny. In other words, the payoff function is very flat (another example to add to those discussed by Pannell (2006)).

Figure 1.

There is a more substantial gain from hedging possible for highly risk-averse farmers (the dashed curve), but we know from empirical studies that they are a minority. Given this result alone, it is not surprising that the majority of farmers have a limited interest in futures markets.

David Pannell, The University of Western Australia

Further Reading

Pannell, D.J., Hailu, G. Weersink, A., and Burt, A. (2007). More reasons why farmers have so little interest in futures markets, submitted to Agricultural Economics, pre-publication version available here (132K pdf file).

Pannell, D.J. (2006). Flat-earth economics: The far-reaching consequences of flat payoff functions in economic decision making, Review of Agricultural Economics 28(4): 553-566. Prepublication version here (44K).

106 – The Great Global Warming Swindle

On July 12 ABC TV in Australia aired “The Great Global Warming Swindle”. This followed saturation promotion in days leading up to the broadcast, including items in various current affairs and news programs. They followed the broadcast with an interview with the film maker, and then a panel discussion of “experts”. It was one of their highest-rating programs for the year, but altogether it was an uninspiring two hours of television.

The main messages of the film were (a) that the key driver of climate change is not carbon dioxide, but is variations in solar radiation, and (b) that there is a climate change science industry that has a vested interest in creating alarm in order to generate an ongoing flow of research funds.

The film itself looked slick, and content-wise it had its moments, but overall there were too many flaws. In relation to the first message, I felt that the position put was far too black and white, with no ifs or buts. This made the film an easy target, because there are always ifs and buts. The ABC journalist Tony Jones showed that the key graph illustrating a tight correlation between solar radiation and global average temperature had been truncated in the 1980s, and that since this time the relationship has apparently broken down. There were various other points of criticism made, but this was the most telling. The response to this by film maker Martin Durkin was very unconvincing.

Solar radiation surely is one important driver of climate, but there are strong theoretical reasons to expect elevated CO2 to have some influence too. Predicting how much influence is extremely difficult, and as a modeler I don’t think the long-term predictions from climate models are at all reliable, but that’s not the same as saying that elevated CO2 levels will have no impact at all.

In relation to the second message, the film maker overplayed his hand badly by making the bald and untargeted statement that “we are being told lies”. In my view, the judgments of many climate scientists have been influenced by non-scientific factors, there are problems with the politicisation of climate science, and there is great overconfidence about predictions from complex computer models.

But I don’t think there are many scientists who knowingly and strategically tell lies. (A few appear to, but even they probably don’t think they are doing so.) The accusation of lies is easy to counter by wheeling out some passionate and well-informed climate scientists who clearly are not lying.

The real story about climate change is not as black and white as claimed by this film, nor by its opposition. As in most big environmental issues, the decision problem is complex, murky, and fraught with uncertainties and imponderables. And even if one takes the IPCC’s predictions at face value, one can still reasonably not support taking dramatic immediate action. That actually seems to be the position taken by most economists working in the area (notwithstanding the Stern report).

In the interview with the film maker, he came across (to me at least) as nervous and rather slippery.

The panel discussion was just awful.

The protagonists were again too certain of their positions. It is all black and white, apparently (or white and black if you’re on the other side).

The ABC had asked only two scientists (Bob Carter and David Karoly, from opposing camps) onto a panel of eight for a discussion about the science! These two got into an argument over the trend of global temperatures since 1998 which was just ridiculous. You can’t tell anything about climate on such a short time scale. They both should have known better. Apart from that, Karoly was a better performer in the debate, but it wasn’t much of a debate.

Two of the panelists emphasized that some big businesses are taking action, but this was completely irrelevant. As Michael Duffy (a journalist on the panel) pointed out, there are good business reasons for them to do that irrespective of whether they believe the science. In any case, why would we believe the opinions of business leaders (or, for that matter, of journalists – there were two on the panel) on questions of science?

The other journalist, Robyn Williams, contributed two of the lowest points of the discussion: appearing to cast aspersions on the credibility of Richard Lindzen (a well respected climate researcher who is a prominent critic of climate change orthodoxy) because he is a smoker; and claiming that the National Academy of Science review vindicated the Mann “Hockey Stick” graph of past temperatures, which is complete nonsense, but went uncorrected. In fact the Hockey Stick would have been an easy target, having been completely demolished by competent statisticians, but the program didn’t mention it.

Audience question time was even worse, and further highlighted the degree of polarisation that exists on the issue. Some audience members seemed rather unhinged and a number of the comments were completely incomprehensible. Where did they find these people?

There is a serious debate to be had, but this clearly wasn’t it!

David Pannell, The University of Western Australia

105 – A carbon tax?

Most of the attention in discussion of climate change policies has been on a carbon market. But what about a carbon tax? Some well-qualified economists have expressed a preference for it.

In PD#104 I talked about a market for carbon emissions, which is the approach taken in the Kyoto Protocol. Kees van Kooten (from the University of Victoria in Canada) emailed to ask, what about a carbon tax?

In a sense the two options are mirror images:

(a) A market for carbon emissions is based on direct restrictions on the quantity of emissions. The price of emissions adjusts according the supply of emission permits – more restrictive supply, higher price.

(b) A carbon tax is based on setting the price of emissions, and allowing the quantity of emissions to adjust – higher tax, fewer emissions.

William Nordhaus is probably the leading economic researcher working on climate change. He has a new paper out that argues the case for a carbon tax, instead of a carbon market. Advantages of a tax approach (mostly taken from the Nordhaus paper) include the following:

  • One of the difficult issues in negotiating the Kyoto protocol was reaching agreement about the target emission levels for each country. In a carbon tax system, there would be no need to haggle about the targets of individual countries. Emitters in each country would face the same tax. “Countries would not be advantaged or disadvantaged by their past policies or the choice of arbitrary dates” (Nordhaus, 2007, p. 36).
  • We would like to strike the “right” balance between economic activity and emissions abatement, but because of the great uncertainty about almost everything in the climate change problem, we don’t know which quantity of permits or which tax level would strike that balance. Given that we are likely to get the permit level or the tax level wrong, which mistake is likely to be worse? This is a question first posed by Martin Weitzman in a famous paper back in 1974. Nordhaus argues that, in the case of climate change, the scope for costly mistakes is greater for a market system. For example, Pizer (1997) estimated that, for this reason, the expected net benefits of a carbon tax would be five times greater than for a market system.
  • In a carbon market in the short term, the supply of permits is fairly fixed, while the demand for them is not very responsive to price. This means that prices can be very volatile, as they have been in the European CO2 market. Such volatility can be very costly as people constantly attempt to adjust. The price of a carbon tax is set administratively, and so is not volatile at all.
  • The receipts from a carbon tax can be used to reduce taxes on income or other goods or services.
  • Quantity-based systems probably have a greater potential to generate corruption. In a market system, emission permits have a value, and so who gets them at what price can be manipulated by corrupt regimes and officials.
  • The administrative apparatus already exists for a tax system

On the other hand, there are some disadvantages of a tax approach, including the following.

  • Even once the tax was in place, it would be difficult to tell what effect it was having on emissions.
  • There would still be a need for haggling on a country-by-country basis, although on different issues. For example, some countries already have higher taxes on transport fuels. How should these be considered when setting a new carbon tax?
  • People just don’t like taxes. Their unpopularity may affect the acceptability of the policy in some countries.
  • When the market approach is introduced, the permits can be given to current emitters, increasing the political acceptability of the system.
  • There may be equity concerns about applying the same tax rate in developing and developed countries.

Overall, Nordhaus concludes that a carbon tax would probably be better than a carbon market. Given the above disadvantages, it’s possibly not a clear-cut thing, but he may be right on balance. It’s at least worth considering in the debate.

An interesting side issue in Nordhaus’s paper was that he put the carbon price in the context of current fuel prices. According to Nordhaus, a CO2 price of $30 per tonne (which sometimes is discussed as the sort of thing we should expect) would result in a rise in petrol price of 6 cents per litre (22 cents per gallon). I was really surprised at how low that was. It’s roughly the magnitude of weekly fluctuations in retail petrol price where I live, and less than the range among petrol stations at any point in time. It seems to me that this would have a tiny impact on carbon emissions, at least from transport fuels, and probably from other sources as well. Given the very large emission reductions that scientists claim are necessary, it suggests to me that the carbon price required to achieve the desired emission reductions will be much higher than the prices we’ve heard about so far. (Either that, or we’ll be needing some radical new technologies, and hence a strong focus on technology development.)

David Pannell, The University of Western Australia

Further Reading

Nordhaus, W.D. (2007). To tax or not to tax: Alternative approaches to slowing global warming, Review of Environmental Economics and Policy 1: 26-44. http://reep.oxfordjournals.org/content/1/1/26.full.pdf

Pizer, W.A. (1997). Prices vs. quantities revisited: The case of climate change, Discussion Paper 98-02, Resources For the Future, Washington D.C. http://www.rff.org/documents/RFF-DP-98-02.pdf

Weitzman, M. (1974). Prices vs. quantities, Review of Economic Studies 41: 477-491.

104 – How would a carbon market work?

I recently did a radio interview in which the journalist asked a lot of really basic questions about how a market for carbon might operate. It made me realise that many people have little idea about this extremely topical question, so here is a brief primer.

There are many details that could vary, but this description provides an outline of a standard cap and trade system, which seems to be what policy makers are thinking about.

To start with, “carbon market” is a misnomer. Assuming that a market is created, it will not actually be a market for carbon dioxide. It will be a market for permits that allow the holder to emit carbon dioxide. That might sound backwards, but it does make sense.

This sort of market has several components:

1. The government sets a quantitative limit on emissions (e.g. of carbon dioxide equivalents), at some reduced level.

2. The government creates permits that allow people to emit no more than that level of carbon dioxide, and distributes them somehow (e.g. by giving or selling them to current emitters).

3. The government enforces compliance. If anyone emits more carbon dioxide than the amount for which they have permits, then they are penalised. The level of penalty, and the probability of detection, have to be high enough to encourage high levels of compliance.

4. The government sets up and manages a system that allows people to buy and sell permits from each other.

The first three components are the elements that control the degree of reduction in carbon dioxide emissions. Without the fourth element, the system would be similar to a simple regulatory approach that required people to cut back their emissions.

The fourth component means that the cost of reducing emissions is substantially reduced. It means that reductions in emissions are redistributed such that we achieve the reductions at least overall cost. People or businesses who have the least to lose by reducing emissions are the ones who actually make the reductions.

An example

Suppose ABC Electricity Company does not own any permits, but wishes to emit 10,000 tonnes of carbon dioxide in the process of generating and selling electricity. Suppose that, if it was prevented from making these emissions (i.e. if it was prevented from producing and selling electricity), it would miss out on profits of $2,000,000.

XYZ Mining Company owns 10,000 tonnes worth of emission permits. It could either use the permits and continue mining, with a profit of $500,000, or it could sell the permits to someone else.

If ABC Electricity bought the emission permits from XYZ Mining for, say, $1,000,000, both businesses would be better off than the status quo. The profit for ABC would rise from zero (with no permits) to $1,000,000 ($2,000,000 minus $1,000,000 to buy the permits). The profit for XYZ would increase from $500,000 (if the permits are used to continue mining) to $1,000,000 (if the permits are sold).

As a result of the trade, the total cost of reducing emissions would fall from $2,000,000 (from preventing the operation of ABC) to $500,000 (from curtailing mining by XYZ).

In reality there would be lots of buyers and sellers in the market, and the actual price would depend on the overall balance of supply and demand among them all, but the example illustrates the basic logic of the approach.

The permits have value in this system (i.e. buyers are willing to pay good money for them) because they allow the holder to avoid an even greater cost involved in reducing their carbon emissions. Not everyone can avoid this cost, only those people who value the permits highly enough to be willing to buy them (or, if they already own them, to be willing to forego the income from selling them).

A fifth component is the possibility for people to sequester carbon dioxide, such as in a tree plantation. These people would be issued with new emissions permits to match the level of sequestration, and they could sell these permits on the market. The existence of the market would encourage this option if the cost of sequestration is lower than the cost of just cutting back on emissions. This is, therefore, another way of reducing the overall cost of reducing emissions.

Yet another pathway to reduced costs is through innovation. If an existing emitter is able to use a new technology or management system that reduces emissions for a given level of production, they don’t need so many emissions permits any more, and can sell some. In this way a market creates ongoing incentives for innovative ways to cut emissions. There would be no such incentive in a simple regulatory approach.

On another issue, I’ve heard someone say that the price of carbon permits would reflect the benefits of avoiding climate change. This is unlikely to be correct. It would actually reflect the marginal cost of reducing carbon emissions. The price would be higher if the permits were scarcer, requiring more expensive abatement measures to be implemented. If the number of permits was just right, then the price would match the resulting climate-change benefits, but given the massive imponderables and uncertainties in the system, this could only occur by luck.

David Pannell, The University of Western Australia