Uncharted Territory

March 28, 2008

Save the forests, save the world

It’s amazing what you can do with Excel. I thought I’d have another quick look before breakfast at my 450ppm stabilisation scenario (hey, kids, you can play this game at home!).

Here’s what I was referring to yesterday (all numbers approximate):

450ppm CO2 stabilisation scenario

To some extent I’m being optimistic. The 4AR mostly refers to scenarios that we would not now countenance as we’ve come out of denial over the last few years (I suggest they review their approach for the next report, 5AR). But if we look at the Scientific Basis, page 791 (I kid you not – strictly I should also be using a 3 line reference to the chapter – 10, section 4.1 as it happens), we see some discussion of stabilisation scenarios. The IPCC suggest a higher peak in fossil fuel emissions (about 12GtC/yr compared to the 9GtC I’ve shown), but with a steeper reduction. Their scenario allows 596GtC over the 21st century, whereas I came up with 566GtC. But the key point is that the IPCC also calculate some scenarios with positive carbon cycle feedbacks – that is, when we listen to the science and assume that warming will cause ecosystems to release carbon, or in actual fact merely to take it up more slowly than at present – and in these scenarios taking account of carbon cycle feedbacks we are “allowed” to emit 105 to 300GtC less. That is, even an aggressive scenario to stabilise CO2 at 450ppm relies on a get-out-of-jail-free card.

A more rigorous analysis – I would next separate out land use change (deforestation) from the fertilisation effect altogether – is unlikely to give a different conclusion, because the sanity check (total fossil fuel emissions) succeeds. This simple spreadsheet, adding together the main parts of the the carbon cycle is compatible with the sophisticated models cited by the IPCC. And it shows that, at first approximation (as the scientists say) we have to manage both components we can influence – fossil fuel burning and land uptake of CO2.

The critical point is that, if we want to save the planet, we’ve got to make sure that land carbon uptake over the next century – by natural ecosystems, such as forests, wetland and grassland – increases, not decreases. And if we plough them up and plant even more crops, then they will release carbon for a while and then store a roughly constant amount.

This is the macro reason why promoting biofuels is a really, really bad idea. In fact, it’s difficult to think of a worse policy response to the threat of global warming.


March 27, 2008

Baffled by BERN, but beware of biofuels

Filed under: Biofuels, Books/resources, Climate change, Energy policy, Global warming, Science — Tim Joslin @ 7:53 pm

Today’s project – well it was going to be this morning’s project – was to evaluate the two papers I recently tried to summarise one here: from Hansen et al and from Kharecha and Hansen.

The first question I asked myself was whether the conclusions of these papers are compatible with my Deep Green perspective. What is the Deep Green perspective? You may well ask. The point is that we have to attend to all parts of the Earth’s carbon cycle.

Both papers referred to something called the BERN carbon cycle model. At first I thought BERN was a place, then that it was a person (short for Bernie, perhaps). It turns out of course, thanks to Part 1 of the 4th IPCC Assessment Report (4AR, for short) – best doorstop I ever bought (tip, always ask for a discount) – that BERN is an acronym. I don’t know what BERN stands for, but I have learnt that it is an example of an EMIC – an Earth System Model of Intermediate Complexity, believe it or not.

What it seems is built in to BERN is the idea that a “pulse” of carbon emissions put into the atmosphere is gradually absorbed over time, such that a defined proportion remains in the atmosphere after t years (though it seems the model does allow this to be modified in order to simulate carbon cycle feedbacks). The equation is a series of exponential functions, given in Khurecha and Hansen. This is fine if we’re talking about a single emission of carbon – say a volcano going off in an oilfield – and its gradual re-absorption over time. But what appears to be being done is to try to apply this principal to emissions over a number of years by “integrating the results from 1850 to year t“. After much thought and fiddling with spreadsheets, I’m still baffled why anyone would want to do this.

Tied in with the BERN equation is the idea of the Airborne Fraction (AF) of fossil-fuel emissions, which has been observed to be remaining roughly constant at about 60% (AR4, p.139).

The justification behind both the BERN equation and the (dangerous) AF concept is, it seems, the idea that the processes that remove carbon dioxide from the atmosphere – ocean uptake and the fertilisation effect on land – remove a (roughly) fixed proportion each year of the difference between the current atmospheric level of CO2 and the equilibrium value.

Now, my point is that there is, in the real world, no necessary relationship between our emissions and the rate of uptake of carbon by the biosphere. Our emissions go into the atmosphere changing the level of CO2 – now over 380ppm, compared to about 280ppm before industrialisation – but the uptake processes depend on the level in the atmosphere, not the annual change in the level. It is therefore very dangerous to drift into assuming a constant AF.

To test my hypothesis, I stuck some numbers into a spreadsheet – mainly the rough CO2 levels and emissions between 1960 and the present, calculating absorption rates based on IPCC data (AR4, p.26) extrapolating into the future (spreadsheet available on request). All I’m doing is adding what carbon we’re putting in to the atmosphere, and what’s being taken out each year, to what’s already there to produce a time-series. And, lo and behold (actually I was a tad surprised), it is indeed the case that the AF is fairly constant under these assumptions at about 60%.

The trouble is, to my mind, thinking in terms of an AF and integrating annual pulses of emissions is really odd way to look at the problem.

The simple way to expose the limitations of this approach is to see what happens if you start to decrease emissions. And, sure enough, the AF drops considerably (and can even go negative) if you do this. In other words, the whole approach only works while CO2 emissions and atmospheric levels are increasing at a fairly steady rate.

But this is only a minor problem. The AF is extremely sensitive to saturation of the processes to remove CO2 from the atmosphere. And it appears that removal by the oceans is indeed saturated (AR4, p.26 & elsewhere).

If we allow for the fact that the rate of carbon uptake by the oceans is not going to increase, then (of course) we see that the AF increases, if our emissions continue to increase, as in the graph below:

AP 1960 - 2070 peak emissions 2045 JPG

The implication of all this is rather important. If we continue to increase our emissions, then we face a double whammy. A higher proportion of the higher level of emissions will remain in the atmosphere.

At this point I realised that I had constructed a rough carbon cycle model in my spreadsheet. I was able to test different emission scenarios, varying the behaviour of other parts of the carbon cycle. And I can report that we are indeed in big trouble. Here are some preliminary conclusions:

1. If we’re to keep CO2 levels below 450ppm – the absolute optimistic minimum to prevent dangerous climate change of 2C or more – global carbon emissions have to peak by 2015 and decline steeply, that is, by about 1.5% pa – my 2045 peak example led to 630ppm by 2070. I don’t believe anything faster than 1.5% is feasible – in fact, even that looks like a silly number to me, though I’m open to persuasion.

2. In a scenario where we do stabilise CO2 levels, then (of course) the AF declines dramatically, and eventually goes negative. The AF is a double-edged and misleading concept if used as part of a causal explanation. It can only be sensibly used – IMHO – to make the rhetorical point that increasing our rate of carbon emissions will make our problems much worse very quickly.

3. In my spreadsheet carbon cycle model, the outcome is sensitive not only to the emission peak and rate of decline and to the timing of the peak rate of ocean uptake (I’ve assumed 2010, which may be optimistic – AR4 implies it has already peaked). Critical, also, is the rate of land uptake of CO2. My model has the fertilisation effect dependent on the area of natural ecosystem. Now, here we have another double whammy. If we clear forest (and, worse, wetlands) to create grazing land, or to grow more crops – for example, biofuels – then we not only emit carbon as we do so, we also reduce the rate of carbon uptake by the fertilisation effect.

4. If land (and/or ocean) uptake of CO2 goes into reverse as the planet warms we are completely screwed, to put it scientifically. If this happens it will be almost impossible to keep atmospheric CO2 (not CO2 equivalent, just CO2) below 45ppm.

In fact, my conclusion is that it will be practically impossible to keep CO2 below 450ppm unless we:

1. Start reducing fossil fuel carbon emissions within the next decade; and

2. Significantly increase the area of forest and wetland over the next century.

Given point 2, it might be a good idea to suspend all incentives and quotas for biofuels.

March 26, 2008

More on the immorality and hazard of policy based on moral hazard

Filed under: Economics, Housing market, Moral hazard, Northern Rock — Tim Joslin @ 3:22 pm

They say that the 1930s Depression was a result of a crisis exacerbated by policies to maintain a strong dollar. When the history of the 2000s Crunch comes to be written, they’ll say it was a result of a crisis exacerbated by policies to maintain another sacred cow – the idea of moral hazard. Both policies may have made sense in the 19th century, but not in today’s world.

Let’s first ask ourselves what the priorities of the central bankers should actually be. Well, I’m in the UK and it seems to me that Mervyn King’s overwhelming priority right now should be to slow the impact of the liquidity crisis on asset values, principally housing. Since this is not being done, the danger now is that price declines become self-fuelling, of a housing-market correction turning into a crash. Over the last year or so, I’ve wavered between predicting just a shake-out in the buy to let* (BTL) market in the UK and expecting large house-price declines across the board. The swingometer right now is well into the red of a general crash. And the people who will suffer most are people like the le Roux family reported in Saturday’s Guardian. Working people, IMHO, should be able to afford to buy the house they live in (um, isn’t that why we’re building these houses?). Ensuring they can should be King’s no.1 long-term objective – but more about that some other time.

The point of this post is to clarify my views on moral hazard. I may previously have given the impression that I consider the concept worthless. This is not the case. I consider it a special case of expectations. Expectations matter. If I expect to be robbed in a particular district I won’t go there. Or, say, if I expect a government to expropriate my assets I won’t invest in that country – or will at least demand a higher return for the political risk.

The idea of moral hazard is that we should be wary of behaving in a way that may lead people to think that we will behave the same way in future, when, in fact, we want to give the opposite impression. That is, we should not reward undesirable behaviour. If a child throws a tantrum and is rewarded with sweets to make them stop, then they will learn that next time a screaming fit is a good way to get hold of some more candy. So far, so good, but “punishing” banks – and specifically their shareholders – for becoming illiquid is a bad policy on a number of counts:

1. It is ineffective because it hurts the wrong people. In more ways than one.

a. Subtle differences are important. The devil is always in the detail. For example, it is absolutely critical, as I pointed out a while ago, and as Daniel Gros notes in today’s FT, that US mortgages are “no recourse”. This is not the case in the UK. Northern Rock couldn’t sell or borrow against its mortgages because everyone was in a panic, not because the Rock took on daft risks. The Rock went under because of a US crisis, not a UK one. The institution that has been “punished” is secondary to the crisis, and, here’s another “subtle” distinction, not insolvent, but illiquid. The Rock has been allowed to fail partly because it was relatively small. Larger banks more directly involved in the dodgy lending are likely to survive.

Because we now have an interconnected global market for capital, institutions around the world have been affected by the credit crunch. Central banks should not allow any to fail simply because they are illiquid (at least so long as, prior to a crisis they have met clearly-defined capital ratio and other regulatory requirements). Banks should be allowed to go under only if they are insolvent.

b. But how can you “punish” an institution? Individuals made the decisions that caused the problem. I’m sure many of the Bear staff who’ve (literally, I read) been crying on the stairwells were not involved in buying CDOs based on sub-prime mortgages.

The shareholders in both Rock and Bear have been (pending legal action) pretty much wiped out. This is unreasonable not just because (as noted above) they have not necessarily invested in a business that has allowed its liabilities to exceed its assets, but also because there is no mechanism in place for them to exert control over management to the extent that they could prevent it running into liquidity difficulties. If the FSA couldn’t do it, how could the Northern Rock shareholders?

And what’s more, the shareholders at the time a bank runs into problems are not the same as those at the time decisions are made. Specifically, in the case of both Rock and Bear, large holdings were owned by institutions and individuals who saw the companies as recovery prospects. As I noted before, (more than once, or even twice, it seems) at least some of these investors were prepared to put more capital in to these institutions.

2. Moral hazard based crisis management also has rather serious unintended consequences.

As we already know, in the UK we don’t have “no recourse” mortgages. In fact, Gordon Brown has just created real-life counter-terrorism units – I kid you not, 24 should sue for breach of copyright – to be staffed with real-life Jack Bauers who will no doubt, among their other duties, hunt down people who don’t pay their mortgage. So, a company like HBoS is not going to go bust. But what have we got? Short-selling. Now, there’s nothing wrong with short-selling – as Nils Pratley notes in today’s Guardian – but it’s wrong not just to profit from spreading false rumours, but also if the aim of short-selling is to drive a company out of business. And in the financial sector this is possible if the central banks allow runs to occur. Short-selling can undermine the confidence in an institution and cause investors to make an otherwise irrational decision (given that they lose out by withdrawing funds early). This was a factor in the downfall of Northern Rock, and it seems Bear, as well as in the attack on HBoS last week. Rumours are probably impossible to prevent and in any case, the sight of a falling share price may be enough when everyone is on edge. And if destructive short-sellers are actually rewarded – by, say, the nationalisation of Northern Rock, to take an example at random – why, of course they’ll do it again… Hmm, aren’t we talking about moral hazard?

No, if central banks don’t stand behind institutions – or stand behind them sharpening their knives – then it is inevitable that there will be attempts to force some institutions out of business to make a profit.

Readers will be forgiven at this point for thinking that moral hazard based crisis management is more about an assertion of authority, a demonstration of power, than actually solving the problem. Perhaps central banks don’t want to feel they are becoming just another market participant in the global market-place. And perhaps they are playing as well to the mainstream media, who – as is a recurring theme on this blog – consider themselves now to be the conscience of our society, ever ready to allow subjective value judgements to take priority over cold rational, objective decision-making. Maybe I’m being too harsh. I’m sure that ultimately the problem is that people want to read exciting stories of good and evil, not abstruse analysis of systemic failures! JPM good, Bear bad? Yeah, right.

3. Moral hazard based crisis management is an obstacle to fixing the real problem.

Citibank has pointed this out. “They [the BoE] still seem to be concerned about moral hazard, but we are long past that. It is not a question of bailing out the City. We’re faced with the threat of unnecessary damage to the real economy,” say Citi. Exactly right.

But here’s one response: “Isn’t this the bank that has already written off in excess of $20bn, or thereabouts? Doesn’t that mean, by simple rule of thumb, at a 5% Tier 1 capital requirement, this bank has just had to withdraw up to $400bn from the credit markets?”

This commenter has answered his own question. We read that credit markets are seized up, but that US Treasurys are flying. Why? Because the banks have had to write down capital. They can’t therefore lend out deposits without screwing up their capital ratios. But what they can do is lend it to the US Gov’t (or UK for sterling) by buying gilts because then they effectively hold cash. The inflated price of Treasuries tells us, I suggest, that there are plenty of deposits – whether retail or money-market – in the system (cash has to be put somewhere and it’s generally not under the mattress these days), but not enough shareholders’ capital to cover the perceived default risk – or more likely the liquidity risk – of investing it either in mortgages or existing debts, however low risk and profitable they might be. That is, if I find a stash of cash in the attic, and deposit it in my bank, it won’t allow them to write a mortgage for someone else, however low a risk they might be, because this set of transactions would increase the risk of all the mortgages on their books (and no-one will buy mortgages off them). On the other hand, if I suddenly discover I have some money in a bank account, withdraw it, and invest it in new shares in the same bank, then the bank would be able to issue more mortgages far in excess of the amount of money I have invested, because I have invested some more money in covering the risk associated with those mortgages.

I stress that banks can’t lend because they are worried not just about default risks, but also about liquidity risk (otherwise the price of debt would, I suggest, have found a floor by now), that is, to put it bluntly, by the risk of a bank run. Because the central banks (OK at least the Fed and the BoE) have not drawn a line in the sand, no bank is safe from becoming the next Northern Rock or Bear. So the markets are seized up, I suggest, as a direct result of moral hazard driven crisis management. I hope everyone feels better that the “greedy bankers” have been punished (and here’s silly me thinking that the way to deal with inequality is by policies to deal with inequality, not by destroying institutions that have taken many decades to create, reducing competition, and thereby making banking services more expensive for everyone in the future, allowing the surviving bankers to pay themselves even more…).

Now, the problem is not going to resolve itself until we get more capital into the banking system. Since the sovereign wealth funds may not do this, I suggest the banks make rights issues.

Unfortunately, thanks to moral hazard madness, for a bank to suddenly announce a rights issue would be a sign of weakness, and they’d be torn apart by the wolves.

Ergo, the correct central bank policy is to take the illiquid assets onto their books, albeit at a penalty rate, committing to rolling the facility over for (say) 6 months. But, I’m a taxpayer, thanks very much, not in the mortgage business, so the quid pro quo must be that the central banks make the banks commit to substantial rights issues over that 6 month period. At the end of it, they’ll have the capital they need to take the assets back off the central banks and start trading amongst themselves.

It’s very simple. If a huge hole gets blown in the capital base of the world’s banking system then it’s got to be filled in again. Blathering about moral hazard does not achieve this.

4. Moral hazard crisis management is a poor substitute for effective long-term expectation setting.

If setting expectations is going to work – and I agree that it is necessary – then it has to be done on a deep, long-term basis. It has to be drilled into the nation’s psyche over a long period of time.

Just punishing almost at random a few managers, employees and shareholders – most of whom simply happen to be in the wrong place at the wrong time – will not be effective. It will simply leave these people feeling unfairly treated and aggrieved. Maybe they’ll simply invest their time and money in some other sector of the economy.

The sort of expectation it might be worth setting over time is that you have to pay your debts. This would have helped prevent the US housing meltdown spilling over into the whole global economy. Heck, it might even have helped prevent the bubble developing, since, at the margin, a few people might have questioned whether they really could afford the debt they were taking on. Clearly, though, no-one is ever going to be able to sell “no recourse” mortgages on the open market ever again.

Hmm, maybe we shouldn’t say never! This is the problem with moral hazard based policies. Those who are punished essentially leave the game. Those who profit (e.g. the banks that survive) are re-affirmed. JPM good, Bear bad. Yeah, right. And we end up repeating the same mistakes in the next cycle, because no-one’s left to remember the lesson.

5. An underlying cause of instability is the propensity of housing markets to develop bubbles. A moral hazard based approach will not prevent this, since it is not irrational to participate in a bubble (as I said before). Policies are needed to stop prices rising too steeply.

So the underlying cause is the fault of the regulatory authorities.

And their response has made the crisis worse.

Good work guys. But you’re right about one thing. It really is time to put those thinking caps on. This is starting to get a bit irritating for the rest of us.

* Postscript: I meant to say why BTL “investors” deserve to be hunted down by Jack Bauer. They don’t have the excuse of simply wanting somewhere to live, but nevertheless made reckless bets that house prices would continue to rise. They could make no money any other way than by capital gain. The point is that their market was tenants who couldn’t afford to buy property (at first it was people renting for convenience…). How, pray tell, can a rational investor expect tenants to pay the mortgage on a property they can’t afford to pay the mortgage for (otherwise they’d have bought it) and cover agency fees in order to provide the “investor” with a profit? Unbelievable.

March 25, 2008

Implications of “peak oil” – Tim’s Translation Service

Filed under: Books/resources, Climate change, Energy policy, Global warming, Science — Tim Joslin @ 6:57 pm

No sooner had I digested the Target Atmospheric CO2 paper than another one (pdf)* arrived, courtesy of James Hansen’s mailing list.

The paper “Implications of ‘peak oil’ for atmospheric CO2 and climate”, Pushker A. Kharecha and James E. Hansen (pdf)* makes a similar argument to that in “Target Atmospheric CO2”, though there are some differences.

I’ll try to keep the translation brief this time.


The paper seeks to show that we can keep CO2 below 450ppm [Hansen argued for less in “Target Atmospheric CO2”] by avoiding burning coal to the atmosphere, and using a high price of CO2 to deter the use of unconventional (e.g. tar sand) and other expensive sources of oil. Various Peak Oil scenarios imply that we can keep below 450ppm CO2, based on the Bern carbon cycle model, with both a static pulse response function (PRF) and a dynamic PRF. That is, even if some carbon cycle feedbacks are allowed for, CO2 can be kept below 450ppm if we burn all the existing conventional oil and natural gas reserves.

Points of note

1. The authors acknowledge that the concept of “reserves” of fossil fuels is flawed – if the price of oil (say) goes up, “reserves” magically grow, simply because more of the resources become economically exploitable.

2. The authors acknowledge that they have provided only “an approximate lower bound for the proportion of fossil fuel CO2 emissions that remain airborne.” i.e. they are being optimistic. But they don’t consider that climate feedbacks will kick in below 450ppm, so as long as we stay below that we’ll be OK.

3. We have to keep “cumulative global emissions from coal between the present and 2050… to ~100GtC or less” (note that the IPCC considers proven global coal reserves to be >1200GtC).

*Postscript (9/4/08): There were some problems with the links to the Hansen and Kharecha a paper. These now refer to teh Arxiv version, which will hopefully stay there.

Target Atmospheric CO2 – Tim’s Translation Service

Filed under: Books/resources, Climate change, Energy policy, Global warming, Science — Tim Joslin @ 6:15 pm

The venerable James Hansen has drafted a paper (pdf) taking a broad step-back look at global warming (GW) science. This is important, because I don’t believe all the bad news is yet in the market. Unfortunately the paper is written in the Scienglish dialect, so I will try to translate.


Estimates of the temperature rise due to emissions of greenhouse gases (GHGs) only take account of “fast feedbacks”. The expected temperature rise should therefore be doubled (it turns out) if we take long-term “slow feedbacks”, such as changes in the planet’s albedo (reflectivity) due to the melting of ice-sheets. Therefore, to keep the temperature below dangerous levels, we need to keep atmospheric CO2 below 350ppm. We can do this by not burning coal to the atmosphere – carbon capture and sequestration (CCS) would be OK – and by ensuring agriculture and forestry practices capture and retain carbon.


Point 1. The global community, e.g. the UN’s Framework Convention on Climate Change (UNFCCC) in 1992, has agreed that greenhouse gas (GHG) levels in the atmosphere must be stabilised at a level preventing “dangerous anthropogenic [caused by humans] interference with the climate system”. But what does this mean?

Point 2. The EU considers a rise of 2C or more over pre-industrial levels to be “dangerous”, the intergovernmental panel on climate change (IPCC) goes for a 2-3C rise. Hansen goes for 1.7C (or 1C after 2000). All much the same, given the uncertainties.

Point 3. The big question is what level of CO2 in the atmosphere will prevent more than a 2C rise? In this paper, Hansen et al argue that we have to take long-term feedbacks into account. The magnitude of these can be determined from looking at what has happened in the past.

Point 4. If CO2 is doubled i.e. to about 560ppm from pre-industrial levels, then temperatures would increase by 3C (a best guess). This doubling – due to fast feedbacks – represents an increase in energy (a “forcing”) of about 4W/m2 averaged over the planet. Climate sensitivity is therefore about 3/4C per W/m2 forcing. This can be validated by comparing temperature and atmosphere records over the last few ice ages (this information is known from Antarctic ice core and other records).

Point 5. But, argues Hansen, over the ice age cycle the changes in the albedo (reflectivity) of the planet were secondary or long-term feedbacks, resulting over a longer time period from the warming/cooling caused initially by changes in the Earth’s orbit and amplified by changes in GHG levels. Changes in GHGs are (according to the paper) a fast feedback and only slowly affect the distribution of ice and hence the albedo (reflectivity) of the planet. Well, the paper might be saying what I just wrote, but is relying only on the simpler point that when gauging the effect of increased GHG levels over a long period of time, we should ignore other forcings – these should be treated as secondary. Anyway, if we do this and ignore everything except GHG levels, the actual forcing changes to produce the ice age cycle temperature fluctuations of 5-6C averaged over the globe were only about half that to produce the short-term feedbacks. i.e. climate sensitivity is nearer 1.5C/W/m2.

Point 6. So, argues Hansen, as well as the 0.6C warming we’re all being told is already in the system (due basically to seas taking centuries to warm up fully), there’s also another whopping 1.4C after that [assuming atmospheric GHG levels remain where they are now (385ppm CO2, ~420ppm CO2 eq) indefinitely]. “This further 1.4C warming in the pipeline is due to the slow surface albedo feedback”.

Point 7. But is this conclusion from the ice age period valid as the Earth warms from where we are now? To decide this we have to look at the whole Cenozoic, i.e. the last 65.5 million years (my), i.e. since bye-bye dino time. Over the period from 50 million years ago (mya) to the ice ages, the global temperature fell 14C and CO2 in the atmosphere from 1000-2000ppm to less than 500ppm over the last 35my when we’ve had icecaps – the Antarctic iced up when we got down to around 450ppm is Hansen’s best estimate. So yes, is the answer. The Earth’s temperature will rise by 2.5-3C per W/m2 of forcing from the current temperature, presumably due to loss of the remaining ice-sheets and darkening of N continental areas.

Point 8. But we can overshoot the forcing that would produce long-term feedbacks, because they are um, slow.

Point 9. What should the target be? Hansen is mainly concerned about CO2. Other GHGs (principally methane, NH4 and nitrous oxide, N2O) can be controlled. Answer: 350ppm max. The current level – about 385ppm – is already too high.

Point 10. Because “a large fraction of fossil fuel CO2 emissions stays in the air a long time”, must leave some fossil fuels in the ground, by phasing out coal (unless the carbon emissions are captured and sequestrated, i.e. we employ CCS technology) by 2030.

Point 11. Just leaving coal in the ground (but burning all the gas and oil) is not quite enough. But reforestation and carbon sequestration in soil (by creating “biochar” by pyrolysis of organic material, e.g. rather than “slash and burn”) can make up the 50ppm difference by 2150. CCS from biofuel would be even more rapid.

Point 12. Need a CO2 price that forces CCS to be used, and to reward agricultural practices that sequester and preserve carbon.

The paper includes quite a bit of “Supporting Online Material”, including:

  • an analysis of ice age forcings (GHGs and ice-sheets) which implies a sensitivity of 3/4 +/- 1/4C per W/m2.
  • the variability of the forcing caused by orbital changes – the Milankovitch forcings which triggered the ice ages and deglaciations – are relatively small, < +/- 3W/m2. (This assumes “present-day seasonal and geographical distribution of albedo”).
  • an analysis of the reserves of oil, gas and coal.
  • a graph showing that the “CO2 airborne fraction”, i.e. the proportion of annual CO2 emissions remaining in the atmosphere, has been moreorless constant at about 56% since 1957 (when Keeling first measured atmospheric CO2 accurately).

March 24, 2008

Northern Rock nonsense: deconstructing demonisation

Filed under: Economics, Housing market, Media, Northern Rock — Tim Joslin @ 5:30 pm

OK, I know I said I wasn’t going to write any more about the Rock.

But this story in Saturday’s Guardian Money section has been bothering me all weekend.

I read the Guardian because, like at least some of the people who write it, I believe in a fairer world, with a great deal less inequality. Maybe it’s incipient middle-age, but it’s becoming increasingly apparent to me that, whereas I live in a world where the economy is based on people buying and selling goods and services, in short, on markets, this is not the case on Planet Guardian. Yes, across vast distances of time and space, in this strange and wonderful world, under the rose-tinted light of a gentle star, people seriously believe that if we vote for the right people they’ll create a fairer society by willpower alone. Nevertheless, I continue to believe I share core values with the institution that produces the newspaper – such as a belief in objectivity. This conviction is still being sorely tried over Northern Rock, although the newspaper’s triumphalism that accompanied the nationalisation of the bank – and the attempted expropriation of the assets of the shareholders – was mercifully short-lived. But it still seems that editorial policy is – in common with the other papers – to demonise Northern Rock.

I was very interested to read “The families who bear the brunt” on Saturday to get a feel as to where the credit crunch is leading. And it’s not pretty.

But it’s not purely NR’s fault. The article doesn’t say how typical the le Roux family are of NR borrowers, nor whether NR have a higher proportion of customers in difficulty than do other lenders. But let’s let this pass. This is a human-interest story in a newspaper, not a peer-reviewed academic paper in an economics journal.

I’ll also ignore the way Northern Rock is referred to ad nauseam throughout the piece, which could otherwise have been presented as an example of a problem no doubt affecting many borrowers with many different lenders. The paper needs a hook for the story. And it would attract fewer readers if the strapline was: “They are trapped in a Bath Building Society mortgage…”

But what I can’t ignore is the apparent spin put on the story itself. First, we are told that:

“The crux of the problem is that they [les Roux] owe nearly £170,000 to Northern Rock, but their home is only worth an estimated £152,000.”

But (OK, OK, I can see I’ve got “but”ter typing fingers today!) when we read the article carefully, we see that:

“They also have a £15,000 secured loan on the house from a company called Welcome Finance that is costing them a further £307 a month.” [My emphasis].

This, it seems to me, is the crux of their problem.

Without this loan they would just need to roll over a mortgage – £139,630 – secured on a house valued at £152,000. Lenders look at two things: the security on a loan and the customer’s ability to pay back the loan. Surely, in the case of the le Roux family, they’d have a sporting chance of remortgaging, were it not for the Welcome Finance loan. They need about 92%. Heck, if they had a car they could trade down they ought to be able to get it down to 90%. But who’s going to touch them with the extra 15 grand secured on the house? Lenders will be put off by the Welcome Finance loan secured on the property much more than they will be by the unsecured NR loan.

Then there’s the ability to pay. In addition to the mortgage, les Roux have not one but two chunky debts. And whilst a lot of borrowers will have the extra unsecured loan with NR or any of the lenders that have offered similar deals, it seems to me the killer is the Welcome Finance loan – an extra £307 a month they have to find. In comparison, the NR unsecured loan would cost les Roux £390 a month if they take their mortgage to another lender.

And the NR loan at least is not at a punitive rate. A box in the article is headed: “The cost of quitting? A massive 15.59%”. I hardly think 15.59% interest on an unsecured loan is excessive (try borrowing on a credit card). At random, there was an ad from Jessops, the camera chain, in the same edition of the Guardian. Jessops’ buy now, pay later deal charges a lot more than 15.59% for credit (though just a relatively small fee if you only need to borrow for less than 12 months). And is 15.59% really a lot more than les Roux are paying on their Welcome Finance loan? Their repayment to Welcome of £307 a month is £3684 a year. If £1500 of this is repayment of capital (i.e. we assume it’s a 5 year loan with constant payments and that the average balance outstanding is half the principal), this works out at a rate of approximately 14.4%.* But (oops, sorry) maybe it’s a 10 year loan (at about 19.5%) since, if we look at the Welcome Finance website, they’re currently offering secured loans from 22.1% or 19.9% for cars (of course, these rates could be a lot higher than those on offer last summer, because of the credit crunch). Welcome’s unsecured loans are a bargain at 64.1% (sic(k)).

So the interesting questions in the Guardian’s human interest story (perhaps we can have another exciting instalment next week) are around the Welcome Finance loan:

  • how did les Roux come to have this additional debt?
  • did it already exist when “[t]hey borrowed £169,630 from Northern Rock last summer“? [my emphasis – actually they changed the security on the debt by moving house]
  • if so, did they tell NR about it?
  • if not, how come they’ve gone further into debt? If I was lending money secured on a property I’d want to know about (and probably veto) any other debt to be secured on the property. Did NR know about the Welcome debt?
  • was the Welcome Finance loan an attempt to keep paying the NR mortgage les Roux could never afford to pay in the first place?
  • is the Welcome Finance loan anything to do with why NR “is not offering them anything else in terms of deals” and that “they would be better off taking their business elsewhere”? Would NR have offered to roll over their mortgage were it not for the Welcome debt?

There’s a lot about this story that is puzzling. But (doh!) my point is this: I get the distinct impression that the Guardian is still – consciously or unconsciously – trying to paint as bad a picture as possible of NR.

The psychologists will eventually have a field day with all this. This is the situation: we now all feel bad because we’ve all been borrowing too much and gloating over our rising house-prices. Now the chickens have come home to roost. So what we’re doing is bundling up all those bad feelings (the shrinks would say) and loading them onto the banks, and specifically the fattest scapegoat that makes the best sacrificial offering – aka Northern Rock. How do I know this? Amazing what you pick up in an MBA these days!

The point about scapegoating is that it does not necessarily – and usually doesn’t – address the root causes of a problem. I’m told that ancient South American civilisations would regularly sacrifice their priests when droughts came. Maybe there were a few fewer mouths to feed, but the value of this behaviour in preventing or even predicting the next drought was approximately nil. If only they’d known about the El Nino climate phenomenon! (Actually, there’s reasonable evidence that some farmers in the region are able to predict an impending El Nino by changes in cloud patterns. Maybe a few priests were on the verge of spotting this when they were slaughtered…).

For some reason I thought the Guardian would be immune from the scapegoating syndrome. I now ask myself why I thought this. How could I be so wrong? I guess it’s because I thought it was in the Guardian’s DNA to be against prejudice of any kind. They don’t even have “actresses” any more on Planet Guardian – we all have to work out some other way whether the “actors” we’re reading about are male or female. A small price worth paying for whatever it is we’re trying to achieve, of course. They have principles at the Guardian. Heck, they’re not even prejudiced against Old Etonians.

* Postscript: this method is highly dubious for the hypothetical 5 year loan – it’s too few years to make the simplifying assumption of even payment of principal. A spreadsheet suggests that paying £3684 a year for 5 years would in fact pay off £15,000 lent at about 7% which is unlikely. Over about 7 years would come in around 15% and 10 years around 20% as I suggest. Incidentally, the £390pcm doesn’t pay off the NR unsecured loan – at 15.59% this just covers the interest.

March 21, 2008

April 15th: Biofools Day – Downing Street, London, be there

Filed under: Biofuels, Books/resources, Energy policy, Global warming, Media, Media critique — Tim Joslin @ 6:24 pm

I was reading Flat Earth News by Nick Davies this morning. Flat Earth News is all those misconceptions and false stories that flood the media. It seems to me that the potential for Flat Earth news is greatest where the flaws of the scientific process slam headlong into the flaws of the mainstream media. Especially when numeric arguments are involved, because, of course, journos don’t have to be numerate.

Biofuels is a case in point.

I was at a talk last night about Wicken Fen near Cambridge. Apparently the idea (the “Wicken Vision”) is, over time, to expand the existing wetland reserve to an area of 50 sq kms. The National Trust is snapping up farmland in the designated area as fast as it can. It hopes to own the whole area in 100 years.

There was a lot of discussion of peat. Much of the whole area east of Cambridge – north towards the Wash, south through Essex – much, much bigger than 50 sq kms – was covered in peat, metres deep, up to a few centuries ago. Now, this is what got me scribbling during the talk. Get this, just this 50 sq km area would once, the speaker claimed, have held 27Mt** of carbon.

Now 27Mt over 50 sq km is 5000 tonnes of carbon per hectare [for any journos reading, there are 100 hectares (100m x 100m) in a sq km (1000m x 1000m). 27 000 000 tonnes (i.e. 27Mt) divided by 5000 hectares is about 5000 tonnes/hectare, rounding down.].

[Is this feasible? Yes. 5000 tonnes/hectare is 500 kg/sq m (100×100=10000 sq m in a hectare), i.e. 5 kg per 10cm x 10cm area. I choose this area because at the density of water 10cmx10cmx10cm (1 litre) is 1kg. So could we have 5kg of carbon in 10cm x 10cm x (say) 3m (300 cm) of peat? Yes, I would have thought so.* This is just a sanity check – all I’m doing is re-engineering the calculation that gave us the 27Mt/hect, which would have been based on empirical measurements of the average amount of carbon actually stored per sq m of peat.].

Virtually all this 5000 tonnes/hectare has been emitted to the atmosphere as a result of farming the land.

Now, remember we have established that crops grown to produce biofuels in Europe can displace at best 2 tonnes of carbon emissions (before allowing for fertilizers and energy inputs and so on) per hectare per year.

And remember that devoting even existing farmland to biofuels will inevitably cause further human encroachment into the world’s remaining wilderness areas.

Let’s say we look ahead for the next century. If we grow biofuels continually we may “save” 100 x 2 = 200 tonnes of carbon emissions per hectare of land devoted to biofuel crops (it needn’t be the same land every year).

What would the odds of food production being displaced onto wetland somewhere in the world have to be for us to justify diverting existing farmland in the UK (or anywhere else in the world) to the production of biofuel feedstocks?

Let’s do some division: Carbon cost of 5000 tonnes/hectare divided by “saving” of 200 tonnes/hectare = 25.

Conclusion (1): Even if there is as little as a 1 in 25 chance that devoting land in the UK to growing biofuels displaces other activities (such as growing food) onto wetland somewhere in the world, it’s not worth growing the biofuels. Remember, this argument applies to the one reason alone of loss of wetland and takes no account of all the other arguments against and costs of producing biofuels.

Now, it might be worth bearing in mind that one area of the world where farming is likely to be displaced into if we increase the human ecological footprint is – as the world warms – further north than is farmed at present in Canada, Russia, Scandinavia etc. Because these areas are cold, there is a lot of wetland, and peat, even if much of it is frozen a lot of the time right now. (Much of the tundra is, of course, frozen peat, and – since it seems it stores something of the order of 5000 tonnes of carbon/hectare – it might be a good idea not to warm it up at all!). Of course, tropical wetlands exist also and are already being drained – some for biofuels – in Indonesia, for example.

I’d say the chance – if we divert a hectare of farmland to biofuels here in Europe, and instead import a hectare’s worth more food from elsewhere in the world – that this will lead to a hectare more wetland being drained and turned into farmland somewhere in the world, than would otherwise be the case, is a lot higher than 1 in 25. Wouldn’t you?

We can look at this on the small scale as well. The Fen peat, last night’s speaker said, was laid down over the period from 7000 to 2500 years ago. That is, over about 5,000 years (rounding up). That is, at the rate of about 1 tonne carbon/hectare/year. Now, in this argument I can’t make the generous assumption that growing biofuels will displace 2 tonnes of carbon per hectare. We have to look a little deeper at the cost of producing biofuel. To justify growing biofuel on land to the east of Cambridge, taking account only of the slow process of laying down peat (i.e. ignoring all the trees etc. that would also grow on the less boggy bits of the land) that could otherwise be allowed to revert to wetland (with all manner of co-benefits) we’d have to be convinced that cultivating biofuels would result on a sustained long-term basis in the displacement of at least 1 tonne/hectare of carbon. And, even using UK Government figures, such a claim cannot be justified (e.g. see my paper on Biofuel Payback Periods).

Further conclusion (2): We’d be better off letting farmland near Cambridge return to its natural wetland state than we would growing biofuels on it. We don’t even have to plant trees, or worry about them burning down.

Final conclusion (3): It is not worth devoting land to growing biofuels. It only conceivably makes sense to use crop residues to produce biofuels, so that no land additional to existing farmland is required to produce biofuels.

Methinks it might well turn out that it would be better to leave crop residues in the soil (e.g. to reduce the need to use fertilizer) than turn them into biofuels with clever GM bacteria.

But, even if we don’t look too closely at the pros and cons of using crop residues to produce biofuels, let’s just ask if it is a sensible policy to subsidise biofuels and force everyone to use them through targets such as the UK’s RTFO, from April 15th 2008.

We don’t have to look far. We need to know how to turn crop residues into biofuels. Do we, perchance, actually know how to do this? That is, do we know how to make biofuels from cellulose?

This is what Scientific American (April 2008 ) has to say: “…no company has yet demonstrated a cost-competitive industrial process for making cellulosic biofuels. … ‘The oil companies say that it takes 10 years to fully commercialize an industrial processing route’ warns [the expert]…”

So in the meantime we only have first generation biofuels – produced from food rather than “waste” (though I have my doubts whether this term is valid) such as stalks. Remember this the next time someone says “not all biofuels are bad”. What they are in fact talking about are things that do not yet exist.

Yet I find in my Inbox this morning, courtesy of Biofuelwatch, the information that the Gallagher Review of “The Indirect Effects of Biofuels” starts from the assumption that: “Biofuels have the potential to deliver significant environmental benefits,…” (the start of the terms of reference). No, no, no! This is what we’re trying to establish. The fact that the Gallagher Review has been set up is great news, but it’s important that it starts with a clean sheet of paper.

And it’s shocking that the RTFO has not been suspended pending the Gallagher Review. Instead, it will come into force on 15th April – Biofools Day.

So if anyone can make it please go to the demonstration in London against the RTFO at 6pm on 15th April.

*Postscript: a study on Indonesia (pdf) suggests between 45 and 90kgC/m3 of peat – here I’ve derived a value of about 165 kgC/m3 (5kg in 3/100 m3), but then the UK’s temperate climate and Indonesia’s tropical one are likely to produce peat with different characteristics, and my estimate of peat depth was a guesstimate – there’s therefore no reason to disbelieve the estimate from the National Trust.

**Postscript (2): The 27Mt is from the notes I took at last night’s meeting. The link supplied gives 1.5 times the annual emissions of the UK’s cars. The total UK road transport emissions in 2006 were about 32MtC (based on DEFRA data), so the 27Mt figure tallies, as 18MtC/year from cars is compatible with 32MtC/year for all road transport (I don’t know where to find a breakdown).

March 20, 2008

How to play dominoes – FT rules

Filed under: Economics, Media, Northern Rock, Rights issues — Tim Joslin @ 9:12 am

Well, it is very encouraging after yesterday’s post to find Gillian Tett in the FT explaining about sacrificial Bears being led to the slaughter. Gillian asks: “So will this blood-letting work?”. Well, my readers will already know the answer.

But another learned piece in today’s FT also tries to answer the question. Anil Kashyap and Hyun Song Shin agree with me that “recapitalising the banks should be the priority”. Trouble is they don’t understand the existing shareholders either. Apparently these gangsters who are “the very shareholders who allowed their banks to create the current mess, which now threatens to cripple the financial system… will no doubt resist dilution”. Kashyap and Shin note that:

“The quickest solution is to identify some buyers before the next spiral down. One obvious set of buyers are the Middle Eastern sovereign wealth funds. They have stepped up once and were burnt on their first wave of investments.”

It seems they want to sell Wall Street to the sovereign funds. How they intend to make this happen is not entirely clear.

The whole point is that these outsiders may not buy. Probably they are already not buying, as at least some banks are most likely trawling the Middle East and China for investment already. But the sovereign fund managers have now seen NR and Bear. Right now, none are going to put a few $Bns into a bank that actually needs it, I suspect. The risk of being wiped out subsequently in a fire-sale is just too high. No, as I said yesterday, the existing shareholders have the best incentive to keep their banks afloat.

I suggest Merv has a gentle nudge and gets the UK banks to start announcing rights issues, starting with one that is obviously strong – e.g. Lloyds TSB or HSBC could announce they were raising a few £bill to “pursue acquisition and other investment opportunities and strengthen their capital base” – so that the move is seen as a sign of strength, not weakness.

It might help if a few FT writers stopped demonising shareholders. The shareholders in the world’s major banks are all of us – through pensions and mutual funds; blameless employees (and ex-employees, such as yours truly, and I’m lilywhite, I can tell you!) – those delivering the internal mail are often keenest to join staff share purchase schemes, etc etc. I find this attitude bizarre. We’re not talking about Division 2 football clubs here.

I also meant to mention yesterday that there is another unintended consequence of the scapegoating going on at the moment. Size is becoming a significant determinant of banks’ chance of survival. If you don’t like the fat cats in the City, then it might be worth bearing in mind that the bigger and fewer the institutions, the bigger and fatter the fat cats will get. Bigger pots of cash with cream on top to skim off and less competition to keep them honest. And more potential for bigger errors to blow bigger holes in the finances of the banking system in the next crisis. Diversity is one way to defend against this.

I also meant to mention I liked this piece by Stephen King in the Indy, which makes some recommendations to address the liquidity squeeze part of the problem (a second order effect, which we appear to be thinking is a first order effect, incidentally). The “mark to market” accounting is daft.* If done over a short period at a time, it could value all bank’s assets at the firesale prices achieved by one or two distressed market participants. The market price has to be averaged over a significant period – a year or more – IMHOP. The job of the authorities should be to slow market adjustments. This – and policy based on market hazard, Merv – speeds them up instead. Foot, meet gun.

I’d add to King’s list though, another regulatory change. Banks’ liquidity (capital ratio) requirements must take account of off-balance sheet vehicles, that are either a) vital to their business model (e.g. NR and Granite) or b) have to be taken onto their balance-sheet in extremis for reputational reasons (several examples). In other words, such vehicles should be on banks balance-sheets for capital ratio purposes.

And of course we shouldn’t forget John Gieve’s regulatory reform, which makes a great deal of sense.

*Postscript: More on mark to market in the FT here.

March 19, 2008

How to play dominoes

Filed under: Economics, Film, Media, Northern Rock, Rights issues — Tim Joslin @ 5:21 pm

I keep getting an error (good old Beeb) when I try to post on Robert Peston’s blog. What I wanted to say was:

“Rob, Why does the link to this blog entry [Postscript: broken, i.e. story changed – unprofessional by the Beeb, as usual, where’s the audit trail?] refer to a ‘secret bank meeting’? Be careful. Btw, I don’t agree with Robin Bruce that the NR accusations against you are ‘unfair’.”

Here, in my space, rather than Rob’s, I’ll go further. I fail to understand why Peston is receiving awards for the scoop of the year (the NR “emergency” loan). I suggest that we make appropriate laws so that the next reporter that provokes a bank run instead finds themselves “helping with police enquiries”. Laws that will also ensure that the next media organisation that allows this to happen is instead the organisation that has to lay off 1/3 of its staff and whose shareholders are “punished” and executives disgraced.

And now it’s happening all over again with Bear. People who’ve invested their entire working lives into the organisation have been wiped out overnight: “‘My life has been flushed down the drain,’ one senior figure [said]”. Imagine how this must feel, all you so quick to apportion blame. Imagine, Mr King, as you still apparently smugly believe: “…there should be some ‘moral hazard’ in the system and… banks should not expect the central bank to step in to ease their funding crisis.”

I went to a discussion yesterday evening about “money” – the topic being “where does it come from?”, I think. It was quite clear that the average (educated) person has little clue how the financial system works, so perhaps it might be best if I don’t bandy about terms like “liquidity” and “risk” on the assumption that people will be clear what I am trying to say. Let me first try to explain a few points, and maybe convince a few people that “moral hazard” is a bankrupt concept, morally and intellectually.

First point – I know nobody understands money – but let’s nevertheless talk about risk. Who takes the risk when a loan is made, say to buy a house? Well, the answer is it all depends. In some US States, the bank takes all the risk, as I noted before. Yeap, can’t pay the mortgage, just walk away, yippedee doodaa! And this, of course, is the root of the entire global credit crisis.

That may seem a bit odd to those out there who, like me, lay awake night after night in the early ’90s worrying about the negative equity over their heads. No, indeed, ‘cos over here in the UK, we’re tough. Walk away and the banks will hunt you down. In fact, there’s still the occasional story in the papers of court cases from the ’90s crash, only now finally being resolved.

Let’s put it in starker terms. You’ve all been to the movies. I watched “Mean Streets” on DVD the other day. Borrow off the local hoodlum, and it’s you that’s taking the risk, not him.

See what I mean, there are risks to all parties involved in a lending transaction – and, as Scorsese demonstrates in “Mean Streets”, to third parties as well.

For the record, IMHO, the UK system is superior. It is in the general public interest for losses to the banking system, in which we all have a stake, to be minimised. It won’t stop people making mistakes, but it is in the general interest for people who take on debts to pay them back (and IMHO, bankrupts and IVA beneficiaries should have to pay back their debts forever, if necessary, as long as they are earning enough money, in a similar way to student loans, or by having a higher rate of tax).

So, second point, what is a systemic problem? Answer: it’s a problem that affects an entire system. While house prices are rising, all those involved in the mortgage-lending transaction are hunky dory. When prices start to fall, then problems arise for those carrying the risk, which, as I’ve demonstrated, is arbitrary – it depends to a large degree on local circumstances.

One way to contain the problem is for individual home loans to be as isolated from each other as possible. That is, they have to be paid back (i.e. via mortgage indemnity insurance and/or being hunted down by Jack Bauer). The impact on the bank – and the banking system which we all rely on – can only be minimised in that way. This is why I believe the UK system as it operated in the ’90s to be superior. Somehow the Building Societies survived, perhaps against the odds. Who knows what this daft Government will try to do this time, though.

A systemic problem, then, is one affecting a whole system, in the case in point the US housing market and banking system – at first parts of them, and now pretty much the whole caboodle, not to mention much of the rest of the global economy. Whoops.

What we have is a uncontained systemic risk problem. One that we have so far failed to solve.

Third point, let’s introduce another concept: scapegoating. Scapegoating – making one or more people the scapegoat – is a great way to deal with systemic problems. Instead of fixing the system, those involved agree that only some people are wholly to blame for the problems – whether they are in fact solely guilty or not. These people can be stoned, sacrificed or shot depending on societal preferences, or, in the case of financial systems in our civilised modern world, bankrupted and/or disgraced.

Fourth point, scapegoating works best when people can be convinced that it is not in fact scapegoating, but true apportionment of blame. In the modern world, some kind of intellectual justification tends to work best. And this is where the concept of moral hazard comes from. It is at best a bit of fashionable pseudo-science. The idea is that if you bail people out when they run into problems “of their own making” – especially due to risks they’ve taken – then they will repeat the same behaviour.

And that’s why, when Northern Rock ran into difficulty, the people who had bought mortgages from it were forced to sell their houses to pay the bank’s depositors who wanted to withdraw their money. And with everybody selling at once, most people had to sell their homes for less than they bought them for and were hunted down by Jack Bauer… Oh, sorry, that’s not what happened.

No, moral hazard is why Northern Rock’s depositors lost their savings… Oh, sorry…

No, in this case Merv and Gordo decided (while Darling fetched their coffee) to blame Northern Rock’s management and shareholders. That’s right, the intermediary between the lenders (the depositors) and the borrowers (the mortgagees) was deemed solely to blame for the “excesses”. Get rid of them and we don’t have to fix the system. We are not all to blame – we, the depositors, the homebuyers, and most of all those (Merv and Gordo) supposedly overseeing the whole system and responsible for its health, no, we‘re not to blame – so we can blame Adam Applegarth and the Northern Rock shareholders. And we’ll try to regulate the banks even more… and history will repeat itself (with a few twists) in another 10 or 20 years.

Let’s sum up:

  • scapegoating doesn’t solve the problem because it doesn’t fix the system (and in fact makes it more difficult to fix the system, because it implies the cause is understood – it was those wicked people, um, doing their job);
  • moral hazard is a pseudo-intellectual justification for scapegoating.

What might improve matters?

Fifth point, let’s introduce another concept – expectations. It is scientifically proven that people make decisions according to their expectations of the future. Momentum investing (buying assets that are already rising – or falling – in value) is illogical (since the market should already have determined the value of particular assets), but works [I’ll supply a link if I find it].

The moral hazard concept is insidious, because it is partly true – it is based on not setting false expectations. The trouble is, it does nothing to address movements in the value of assets such as houses. It is in fact entirely rational to buy when house prices are rising. And to loan money to people buying such houses. Everyone expects prices to continue to rise, because they know that’s what everyone else expects. No-one has any way of knowing when house prices are about to peak. And, as I say, it has been scientifically proven that whatever the absolute value of an asset, such as houses, if it is rising, it is more likely to continue to rise than not.

Hmm, so how do the authorities stop bubbles and subsequent busts? Well, they can either adopt policies aimed at keeping price growth at a certain level or they can try to slow the crash. And they’ve done neither.

House prices are not included in the otherwise successful targeting of inflation.

And back to our game of dominoes, the authorities have made the problems worse by failing to assist the intermediaries – banks and building societies – enough. Or rather, they’ve failed to make it easier for them to help themselves.

Let’s introduce some more concepts.

Point six is the idea of the balance sheet. Banks have assets – in particular, loans, such as mortgages, which provide an income, and which they could sell – and liabilities – in particular, deposits, which could be withdrawn at any moment. Assets minus liabilities gives some idea of the value of the bank.

Now, what’s happened is that some of the assets for some banks have suddenly become worthless. Now, assets, such as mortgages for x pounds, are risky – they may be worth £x + interest or somewhat less than £x. Nobody knows yet. Banks have to avoid the value of their assets falling below their liabilities at all costs. When some assets turn out to be worthless, they can do two things:

  • stop lending to ensure that the x pounds they have remains worth x, instead of an indeterminate amount;
  • raise more capital (or retain more profits).

That is, they can sell more shares in the bank, so that the difference between their assets (those mortgages) and their liabilities (those accounts) is higher. This gives them more headroom for taking on those risks, that is, for writing mortgages. Allowing people to buy houses again and stop prices falling

So, point seven, and this is what I’m leading up to, what you really want to do, is to get more private capital into the bank – and, if you’re Merv, or Ben/Hank – and I should say, Hank has stated this explicitly (link when I find it) – into the banking system in general.

So what’s happened? NR: shareholders willing to put up £700m. Amount of extra capital put into the UK banking system by nationalisation instead? £0.

Bear: Citic (China) offering to invest $1000m. Amount of extra capital put into the US banking system via Bear Stearns? $0 (JPM took out Bear with shares rather than cash, Citic cancelled investment).

Now, point 8, we have certain beneficiaries of these exercises to wipe out those shareholders as the evil Professor Roubini puts it. Let’s try to work out who these are:

  • the UK taxpayer – but only in the long-term if they succeed in privatising NR and don’t lose court cases to the expropriated shareholders (and I think they’ll lose hands down);
  • JPM;
  • competitors of NR and Bear (who may have had a hand in cutting off their lines of credit);
  • short-sellers in NR and Bear, rumour-mongers among them.

Remember, you need shareholders to provide the capital to take risks. Writing mortgages is inherently risky, and until banks restore their capital, they can’t write mortgages, house sales will be sluggish, and house prices will keep falling, and there will be more defaults, wiping out bank capital… perpetuating a vicious spiral.

Now, NR’s assets are very likely greater than its liabilities. Why should the UK state benefit? And why should short-sellers of NR and Bear stock benefit?

Ditto, Bear, though there is some doubt as to the value of its assets. But why should JPM Chase benefit?

Now, maybe the NR and Bear shareholders are less deserving than the UK state and JPM, but let’s just take a step back from all the judgementalism and emotion. Let’s try to be practical. There are two important questions to answer from a general public interest pov:

Q1. Will the nationalisation of NR and Bear takeover lead to more capital being put into these banks than would otherwise have been the case?

Q2. Will the nationalisation of NR and Bear takeover lead to more capital being put into the banking system as a whole than would otherwise have been the case?

A1. This is very easy to answer. No. It would be illegal for the UK Gov’t to put more capital into NR. That’s sorted! And if JPM wanted to raise more capital it could have done so anyway.

A2. OK, so far, we’re £700m of risk capital down on NR and $1000m on Bear. That’s ultimately a bit of a bummer for the old Ango-Saxon housing market, but not that much dosh in the great scheme of things. But, and here’s the $64billion question, is it now more or less likely that people will go to their 100% taxpayer guaranteed UK or US savings account, take the money out and buy shares in their bank instead? Well, my friends, I need hardly spell out the answer. Yours truly will not be buying any more bank shares in a hurry. And certainly not while short-sellers are trying to wipe out HBoS and LloydsTSB.

The domino effect is that the failures of NR and Bear have made further bank failures more, not less likely. Boils may have been lanced, but MRSA has infected the wounds.

Now, here’s the big idea.

Instead of saying the shareholders should be “wiped out”, a less face-spiting idea (not everyone’s nose is insured) might be to say: “the shareholders better put up some more capital or risk being wiped out”.

What I suggest is that in the event of the next NR or Bear the bank in question (could be anybody now) is taken into a sort of Chapter 11 for banks. Protected by the overseer (Fed, BoE, ECB) and ordered to raise more capital on pain of bankruptcy/firesale etc. I believe it is rational for at least some existing shareholders to invest more. The value of the bank is uncertain. If they don’t invest more they definitely have £0. If they do, they have the £x they put in, plus £y that the bank is actually worth. Unless they believe £y to be negative they should put up more dosh.

Like quite a few other people, I thought exactly this sort of capital raising exercise was what was happening in the case of NR, which is why my opinion of Messrs Brown and King is now unprintable.

I fundamentally do not believe that banks should be allowed to fail because they run out of liquidity alone, if shareholders are prepared to put up more capital. This is a recipe for dominoes to fall. The financial system should in any case be a machine to find out which risks were ultimately worth taking and which weren’t. For this to happen the game must finish. If only the biggest banks can survive each crisis, then even bigger losses are ultimately possible. Because, the way the game is being played now, at least some banks are going to fail in every crisis. And we have no way of knowing whether this was because the business they did was bad or not.

But the main point is that when we stop this childish game of punishing shareholders, we start to see that there are ways of getting more capital into the banking system.

If the Fed and the BoE end up holding vast mortgage portfolios, whilst no-one is writing mortgages, because they’re losing money year after year, and can’t raise capital, because investors see their stock as a gamble and not as an investment, then the taxpayer will really suffer.

I see no reason why house prices anywhere – US, UK, Europe – wouldn’t drop by 50, 60, 70% in such a scenario, before enough people could afford to buy property outright to arrest the fall.

So, Rob, if HBoS ever were in trouble, then I’d hope Merv and Gordo were having secret meetings. Put the kettle on, would you, Darling?

March 13, 2008

Biofuel Payback Periods revisited

Filed under: Biofuels, Energy policy, Global warming — Tim Joslin @ 8:50 am

A sustainable development talk yesterday made the point that we have to be careful not to focus purely on carbon emissions to the atmosphere, since if we do this we may make other environmental problems worse. The examples of acidification and eutrophication (elevated levels of nutrients e.g. nitrogen) were mentioned, but I’d certainly add water availability to the list.

At first sight, different problems of sustainability may seem to be incommensurable. But I suggest they can be related in various ways. For example, we could set up tradable quotas of all different emissions to the atmosphere allowed in a given geography – e.g. globally or in South Cambridgeshire – and establish financial markets for all resources, in particular water and land, and allow the market to sort the problem out for us. Having a Carbon Budget alongside the fiscal Budget, as our friend Alistair Darling has announced the UK will do from 2009, in fact represents a reinvention in a limited form of that clever tool we call “money”. The wrong approach, IMHO. What’s needed is political courage, not a new currency. If it is indeed necessary to postpone from April to August a 2p/litre rise in fuel duty, then we’re only pretending to solve the problem. You can’t make meringue without breaking eggs, Chancellor.

Until and unless we monetise all environmental resources, we can nevertheless make ad hoc analyses to try to work out whether we are doing the Right Thing. The use of biofuels is a case in point. Here, the crucial resource is land, because land (that we humans have deemed is not required for food production or other uses) can be used either to grow biofuels or left alone to sequester carbon. There may be other reasons for using land to grow biofuels, but here we are only concerned about global warming. We therefore consider growing biofuels to be a way of employing land to try to alleviate global warming, using a resource (the land) to (supposedly) reduce a liability (carbon emissions in the atmosphere). Since land stores carbon naturally (go for a walk in the woods!) there is an opportunity cost in terms of carbon emissions of the land we use to grow biofuels. The crucial question is how long we have to grow a given biofuel for on land with a given carbon carrying capacity (dependent on climate conditions etc.) in order to produce a net carbon saving.

A few years ago we were all talking about our “ecological footprints”, i.e. how much land we need to support our lifestyles. If we switch from fossil fuels to biofuels we obviously increase our footprint. Land use therefore seems to me the obvious measure of whether biofuels are indeed sustainable.

I’ve made a few small changes to the document I previously posted on this topic. Sorry about the delay (blame Microsoft/Adobe: it’s a long story). Anyway, here is Biofuel Payback Periods v1.11 (pdf).

Once again, for a little more discussion around the issue, please see my original essay on this topic, Biofuels Are Not the Answer (pdf).

Postscript (1): Note that my argument is not particular to biofuels. It can also be applied to other land uses. We need to take the opportunity cost of the land required into account when, for example, deciding what food to eat or how to produce energy. In the case of renewable energy, my method is really no different to taking into account the carbon emissions (and/or energy) “embedded” in the hardware. PVs, I’m reliability informed, take about 1 year to pay back the energy cost of their manufacture. If the purpose is to “displace” carbon emissions, and we start to cover fields with the things (as apparently is being done in Germany), then we also need to consider the payback period for the land being used – a PV “farm” is no longer able to support an ecosystem, such as a forest. Obviously, the best place to put PVs is in the desert, where there’s also more sun per square metre and less cloud, and not artificially divert the world’s limited supply of solar panels to Northern Europe.

Postscript (2): Oops, I lost track of what year it is! This post previously linked to Biofuel Payback Periods v1.1. I’ve now (17/3/08 ) amended it to version 1.11 which knows it’s now 2008!

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