Friday, September 9, 2022

Energy Agony

Two era-defining articles popped up in today's Wall Street Journal. 

In "the coming global crisis of climate policy," Joseph Sternberg writes 

...Anyone who still thinks climate change is a greater threat than climate policy to financial stability deserves to be exiled to a peat-burning yurt in the wilderness.

...the world’s central banks and other regulators are in the middle of a major push to introduce various forms of climate stress testing into their oversight. ...The fad is for quantifying, with preposterous faux-precision, the costs of reinsuring flood risks, or fire, or the depressed corporate profits of a dystopian hotter future.

Well, if you seek “climate risk” to financial stability, look around you. It has arrived, although in exactly the opposite manner to what our current crop of eco-financiers predicted....

The U.K. may be facing a wave of business bankruptcies exceeding anything witnessed during the post-2008 panic and recession...The culprit is energy prices...Matters are probably worse in Germany,...

Banks and other financial firms inevitably will find themselves right at the edge of the water if or when a tsunami of energy-price bankruptcies washes ashore.

If you've been living in that solar-heated yurt, you may not be aware that central banks and financial regulators (SEC) are moving headlong to de-fund fossil fuel investments via regulation. The fig leaf for this activity is the notion that fossil fuel companies, though funded almost entirely by common equity, pose "risks" to the financial system. (Lots on this in previous blog posts, click the "environment" tag.) 

Getting transition risk wrong. 

Sternberg got a detail wrong and unintentionally pulled a punch. Writing, 

The Federal Reserve, Bank of England and European Central Bank, among others, want to know how global temperature variations a century hence might weigh on Citi’s or Barclays’ or Deutsche Bank’s capital and risk weightings today. 

Actually, no. The "climate financial risk" stress tests aren't quite that transparently dumb, since bank balance sheets don't have risks more than 5 to 10 years out. Instead they start with the theory that extreme weather events will cause financial problems in this shorter horizon. When it's pointed out that even the IPCC says that the probability distribution of weather really isn't changing that fast, and economists point out that floods and hurricanes have never caused a financial system crash, they admit that's really not going to happen. They move on to stress test "transition risk," that governments might pass climate policies so extreme that they cause a financial meltdown. This is exactly what is just about to happen. 

That observation is the really devastating one: They were supposed to stress test "transition risk." But governments did pass transition policies that threaten a really big risk to the financial system. And  those were exactly the same policies that the aforementioned central banks wish to privilege as a result of these "stress tests," namely banning fossil fuels before replacements are available at scale and subsidizing electric cars, windmills and solar panels. But they got the sign exactly wrong. The transition risk to the financial system is not that governments would bankrupt oil companies. Duh, restrict supply, the price goes up, not down. The transition risk is that oil companies are swimming in profits and everyone else is going to go bust.  

Does anyone know what exactly any of this will mean for the financial system? Of course not. No one has seriously bothered to “stress test” catastrophic increases in energy prices.

The unraveling of risk regulation. 

Actually, the point is even deeper and more devastating.  What we are seeing is the fourth grand failure in 15 years of the whole idea that regulators can monitor bank assets and thereby keep the financial system safe. The financial crisis of 2008 erupted despite plenty of bank risk regulation. Rivers of new rules were adopted, including the US Dodd-Frank act and subsidiary regulations, along with stress tests, all aimed at regulators supervising bank assets. No sooner had the barn door been closed after the departing horse, but the European debt crisis broke out. This too was fundamentally a banking crisis: Allowing Greece to fail would have imperiled too many banks, French and German as well as Greek. So much for the asset risk regulators. 12 years of heightened regulation and stress tests later, along came covid-19, threatening another wave of bankruptcies, and another perceived threat to the financial system. No stress tester ever thought about "what if there is a pandemic," despite their repeated eruption through human history. The Fed bailed out treasury markets, money market funds, individual companies, state and local governments, and even issued a Mario-Draghi-worthy "whatever it takes" to prop up the price of corporate bonds. This time nobody even had the decency to worry about containing moral hazard. And that horse having just left the barn, here we are once more facing an even larger financial crisis... that not a single stress tester had the imagination to foresee as even a possibility. 

I don't fault them, they're only human. The point: the whole project of counting on armies of bureaucrats to foresee risks and safeguard bank assets is hopeless.  If it's hopeless for real estate, soveriegn default, pandemic, and war (when our side has visibly invited the Trojan pipeline in), goodness gracious the idea that the same system can foresee "climate risk to the financial system" is ludicrous.  

Fiscal crisis? 

What next? Well, stress testing having failed once again, here comes the bailout and stimulus, which seems to be our governments' only response to anything. 

European governments aren’t blind to the energy-price threat—an awareness that, perversely, creates a threat of its own. The only politically viable solution for this winter will be subsidies on a monumental scale. Hundreds of billions of dollars for households and businesses (and utilities) across the Continent already have been announced, and desperate capitals won’t stop there. This will require substantial borrowing on top of the fisc-wrecking bond issuance during the pandemic.

And also  

...on top of the additional borrowing governments normally do during recessions to finance social-welfare assistance. All of this while interest rates start rising after resting for more than a decade on (or below) the floor.

There is no lack of demand mysterious Keynesian economics afoot here. This is a good old fashioned shoot-self-in-foot supply shock. Borrowed or printed money cannot make a nation better off. 

I have been opining that the next crisis, with trillions in bailout and stimulus might be the one in which investors finally say no more. We shall see. 

Meanwhile, back in the UK; economic fallacies

 U.K. Government to Cap Household Energy Prices for Two Years

The U.K. government said it would cap household energy prices over the next two years, a costly bailout aimed at staving off a deep recession and bringing down inflation, but one that could add to growing worries about the British government’s financial health.

The package, which economists say is likely to be worth more than $120 billion, ... also marks the first big act in office for new U.K. Prime Minister Liz Truss...

Ms. Truss was advertised as a libertarian. I see that lasted about 10 minutes.

Perhaps the most basic principle of sound economics is, "don't transfer income by distorting prices." Don't silence the incentive. If one wishes to cushion the effect of a shock, then send people money to keep their real incomes constant, but don't subsidize the thing in short supply. 

Yet the political system inexorably controls prices. Usually that means rationing,  though the UK may be able to import what people demand at the controlled prices instead. 

Why? There must be a question to which this is an answer. And I suspect this is it: Citizens of a democracy don't really care about the effects of energy prices on overall income distribution. What they really want is to go about their business as before. They don't want a 2,000 pound check and still have to figure out a way to save gas. They want to drive to bloody work just as before. They don't want precisely the pain of substitution that relative prices would signal. And politicians of a democracy give them what they want. 

In this theory, politicians aren't dumb. They're doing what people want them to do. 

"Bringing down inflation" is another economic howler. What a brilliant idea! We can just stop inflation altogether! Just require that every store charge exactly what it did a year ago, and the government will borrow or print money to make up the difference! I hope you can see the problem here. Economic principle #2 for today: Cheaper to the individual, at the point of sale, does not mean cheaper to society as a whole. You can pay at the pump or you can pay the tax man. This fallacy pervades the recent "inflation reduction act" in the US. Subsidies to solar panels, windmills, electric cars, and price caps on prescription drugs do not make them "cheaper" to society. It just changes where you pay. 

"Growing worries" You bet. We create inflation by printing up money and debt and handing it out. Then, to solve the problem we... print up more money and debt and hand it out. You can see where this is heading. Another economic principle: there is always supply and demand.  Politicians blame "supply" for higher prices, but the prices would not be high if people were not demanding all those expensive goods, and willing and able to fork over the money. 

“Extraordinary challenges call for extraordinary measures, ensuring that the United Kingdom is never in this situation again,” Ms. Truss said.

Or ensuring that the United Kingdom is perpetually in this situation, perhaps.  


  1. An incredibly insightful yet depressing post.

  2. Excellent and depressing blogging. Yes, we face an existential crisis from burning fossil fuels except we want to subsidize the cost of burning fossil fuels.

    If you want to reduce fossil fuel burning, then tax fossil fuel burning.

    Endless regulations on banks or others will be less effective.

    By the way, within memory of some older people is a time when Europeans had heavy blankets, hot water bottles and endured cold winters by wearing coats indoors.

    Becoming dependent on autocratic governments is another bad idea- - see Russia, China.

  3. A couple of observations: (a) a graduated rate income tax shifts the burden from households in the lower income tax brackets to households in the higher income tax brackets, and (b) demand for certain goods are highly inelastic, if not perfectly inelastic, and price increases reduce demand only minimally. (a) is the effect that 'progressive' social planners rely on to make the case for their tax and transfer policies--the beneficiaries of the policies are only lightly burdened by the cost of the policies. (b) is a characteristic of the basic essentials of life and the basic conveniences of modern living.

    The modern politician is well versed in this reality, as you note above. They wouldn't be politicians for long if it were otherwise.

  4. You don't even touch on the expropriation of clean energy producers! Europe is set to straight up steal from clean energy producers because they don't actually care about anything beyond this year... so much for caring about future climate change.

    1. Yes! So much insanity, so little time. Expropriating profits reduces incentives to invest. The whole business case for renewables was, when the time comes and fossil fuel prices rise to the stratosphere, you'll make money. Well, here we are.

      Of course, one could make a contrary argument, that renewables were implemented entirely on government subsidies, so what the government giveth the government taketh away; why let people who got subsidies to invest then get profits when those investments work out. Investment was and is not made with the probability of high fossil fuel prices in mind, but only with the probability of more subsidies in mind. Then it's less objectionable.
      I also left out the mud that energy prices are controlled anyway.

    2. Subsidies distorted the economic incentives for production of wind turbine farms and solar photovoltaic utility scale installations. The incentives (feed-in tariff rates) and subsidies lowered the effective cost of entry and as the marginal cost of an extra kWh of electricity is close to nil (the "fuel" cost being zero), the profit is "economic rent". Economic rent has always attracted government taxes, and so it is not at all surprising that governments will resort to "windfall-tax" levies to cover some part of the extraordinary expenditures government will be forced to undertake to prevent widespread curtailment of economic output if electrical energy supply costs force plants to shut down and layoff their workforces.

      There is no right in law to a specified level of profit; the only constraint on government's power to levy taxes is the reaction at the ballot box at the next general election. If the investor in a wind turbine farm decides she won't produce electricity because the government isn't allowing her to earn the maximum profit possible, then the government in its discretion can use its legislated power to force the wind turbine farm to continue producing electricity despite the levy of a wind-fall tax on the farm's profits. It seldom serves to complain about such injustices.

  5. Setting price ceilings is a way to subsidize consumption. Subsidizing consumption in a diminishing supply market makes no sense. But, these same decision makers made the decision leading up to this market place. Where's the common sense supporting these decisions? Where's the cost benefit studies and the successful engineering examples supporting these crazy Net Zero energy decisions?

    Some one please, please show them to me.

  6. I don't know what terrifies me more, the insane Central Bank lead regulation in the name of climate change or the fact that every economic downturn implies a green light for stimulus money. Seriously, when i was in highschool during the early 2000s, Stimulus was not the defacto policy that it has become today.

  7. No one turn out the light when they leave, it won't be powered anyway.

  8. Thank you for providing a thought provoking piece. I tend to view the current energy price problem as the result of political constraints. The productive capacity of a few oil producing countries have been artificially constrained by the US in particular. I have read that oil prices would halve if all producing nations were allowed to supply the market. The provision of Russian gas to Europe is potentially in the same category, as is gas from Iran to alleviate imposed import bans. Supply is not the problem, as oil and gas producing countries will sell if they were permitted to do so. Thus, prices appear to be a reaction to extra-territorial political constraints.

    The climate change effects versus policies hypothesis is probably right as the transition to no, or low, carbon fuels appears to be pushed faster than technology, infrastructure and investment (and dis-investment) can keep pace with. Here in New Zealand, the insurance industry is hiking premiums for those living in areas where there is greater incidence of flooding and sea level rise; earthquake areas are also subject to higher scrutiny, but that is a separate phenomenon to climate change.

    A comparable area of economics is that of governments subsidising industry to repatriate or promote national production. Corporates are not driving change and possibly don’t see the investment case. I don’t know, but to me it smacks of the return of centrally controlled command economies and perhaps edging towards autarkies. What does this mean for the future of capitalism itself?

  9. Andy Kessler of The Wall Street Journal wrote an article that appears in this weekend's edition, titled "INSIDE VIEW: The Hot-and-Cold Economy--With plenty of jobs and high inflation, the U.S. is between boom and bust."

    It describes a situation that seems all too likely -- recession + stagnation caused by monetary policies that delay the winding down of the FRB's asset portfolio coupled with high interest rates prolonged by an inflation rate which is "sticky" downward.

    Fiscal policy (anticipated or expected) continues to support demand through subsidies to favored industries and regulation to deprive unfavored industries of capital and profits, in Kessler's article.

    The divergence from the 'steady-state' assumption undermines the 'small perturbations' NK DSGE model predictions even in 'rational expections' mode that are the foundations of 'the fiscal theory of inflation' (or 'price level', take your pick).

    In the year 1914, L. Bachelier's article titled "Le Jeu, la Chance et le Hasard" was published. Le Jeu refers to games of chance where the odds of specific outcomes are calculable a priori. La Chance refers to gambles that can be handicapped based on prior experience, e.g., insurance underwriting. Le Hasard refers to events for which there is no experience and that have random outcomes defying mathematical odds calculations. According to A. Kessler's viewpoint, we are about to enter (or, we have already entered) a prolonged period of 'le Hasard' for which there is no scripted exit and many unknown unknowns (hazards).

    I continue to work through the paper "Phillips.pdf" (which describes the 'expectations and the neutrality of interest rates' thesis of the prior weblog posting). I suspect, but have yet to verify, that the benign response of inflation, ascribed to 'rational expectations', is a mathematical artifact. Replacement of the expectations Eₜ{πₜ₊₁} and Eₜ{xₜ₊₁} (with realizations πₜ₊₁ and xₜ₊₁ , and forecast errors ε(πₜ₊₁) and ε(xₜ₊₁)) does not demonstrate the desired imprimatur of stability. The forcing of Eₜ{xₜ₊₁} to zero does appear to have a stabilizing influence, but this is an artifact and the results cannot be expected to hold in the general case. Needless to say, the theory is difficult to come to grips with.

  10. I've been in business since 1971 and well remember the Arab oil embargo, long lines at the pumps and the absurd price-control ideas of the Nixon administration. Can you spell Stagflation? Nothing much seems to have changed, even the fact that no one appears to pay any attention to history. My question is what is the chance that someone(s) in Europe decides that full-scale war might be less costly than paying up for energy extortion? A little escalation of the Ukraine conflict could be all it takes.

    1. a little escalation might solve all our problems for ever, as Russia’s 6000 toys might come alive…
      ….Russia is not going to accept military and geographical humiliation without going nuclear, and that is a pretty sure bet…

  11. In medicine, an iatrogenic disease is a malady caused by ill advised medical treatment. We need to incorporate that term into economic descriptions of national policies that make our problems worse.

  12. The Use of Knowledge in Society by Hayek is a fundamentally important paper virtually ignored by today’s economists. With no markets there is no information. When the central banking world controls interest rates, interest rates don’t provide information. Since interest rates work on and affect several marginal choices (as explained by Patinkin), this leads to problems. How stress testing can actually work without objective market price information is beyond me?

  13. Energy, housing policy, everywhere you look: Progressive "solutions" are undermining American prosperity.

  14. "You can pay at the pump or you can pay the tax man." The Labour party here propose a third way, taxing profits. I'd love to hear your counter to this argument.

    Surely "expropriating profits reduces incentives to invest" isn't the best (or even only) counter argument?

  15. As a counterpoint to all this energy agony and scepticism for "climate policy" supposedly worsening the situation for the world's energy supply: here is a CFTC subcommittee report published last year with chairman Bob Litterman stating "“I was amazed and gratified that the CFTC asked for this report, and I was honored to chair the subcommittee, but I think what is most unique about this effort is that more than 30 financial market participants agreed on so much,” said Litterman, founding partner and Risk Committee Chairman of Kepos."
    Bob Litterman is looking at the threat from carbon (and methane) emissions for our overall global climate and the associated consequences for humans from a risk management standpoint, which is a meant to free the debate about the necessary steps by countries in terms of policies out of the ideological sphere. Every house owner insures against fire and (if possible) flood damage, while in a functioning market the insurance industry will price the insurance to reflect those risks while at the same time prescribing steps to avoid moral hazard. No house owner assumes that fire damage is a highly likely event, and nonetheless takes steps to prevent fire damage and insures her property.
    And as stated by John several proposed stress testing scenarios actually do assume that prices for "stranded assets" such as fossil fuel reserves will decline in the transition period - indeed a somewhat heroic assumption given that coal, oil and natural gas have many other uses than simply to power cars and heat homes (i.e. as sources of energy), and those uses will not suddenly go away. (See preliminary findings by Jung/Engle/Berner in a 2022 working paper "Climate Stress Testing" based on a published paper Engle, Robert F, Stefano Giglio, Bryan Kelly, Heebum Lee, and Johannes Stroebel, “Hedging Climate Change News,” The Review of Financial Studies, 02 2020).

  16. There are many ways to stress test institutions and/or portfolios. To address one criticism by John and Sternberg: as a risk manager I know that stress testing a rise in oil (or energy ) prices has been standard for many decades and is nothing new. In fact, such stress tests are typically required by regulators. Energy markets have always been volatile, and drastic changes in their market prices can have profound changes on portfolios and financial institutions. What is new is that during this phasing in of climate policies such an oil price shock is happening, and is hardly the result of climate policies. An OPEC + (i.e. including Russia) restraint on global oil production after the flooding of oil markets by Saudi Arabia has now been widely worsened due to Russia's use of natural gas as a policy tool during the Ukraine war and the sanction regime imposed by western nations. This crises has only highlighted the need to diversify energy sources, but is hardly the result of "climate policy". Individual steps in Germany's push towards less emissions have contributed to an energy vulnerability. Nonetheless a viable transition plan towards cleaner energy sources will have to include the continued use of fossil fuels for some time as well as will necessitate the use of nuclear energy as the European Commission has recently acknowledged in a policy release outlining the path to sustainability, and was ratified by the current German government which includes the anti-nuclear and pro-environment Green Party.
    Therefore, I find it bewildering that both the WSJ columnist Sternberg and John are more afraid of the consequences of climate policies than of the dangers from global warming.
    While as Litterman states the US needs to put a meaningful price on carbon as a first best policy, the political fact is that given the current the difficulty to find consensus in a highly partisan political system, a regime of subsidies and regulatory guidelines is a second best way to address the climate-based threats. These threats are a risk management issue, and should not be pinballs for a debate on optimal policies which is ignoring the negative tails from virtually any climate scenario published. Not the rising average temperature alone should be the issue although bad enough considering the effect of a warming ocean on severity of damage from hurricanes (are you denying this effect ?), but the higher variability of weather related catastrophes including droughts, forest fires, flooding and land slides.
    Hoping for a rational debate on policies which can mitigate the current effects of climate change and help prevent future preventable serious consequences - in the bad tail of the distribution. Even if the distribution "of weather" does not widen the tail will nonetheless get worse; it is the potential damage from weather changes that matter, not the distribution "of weather".

    1. I share John's concern over the regulatory function's involvement in energy policy formulation and implementation. I am not moved by Litterman's enthusiasms, nor by the CFTC's inquiries. I can well imagine the CFTC withdrawing energy contracts from the trading firms out of a caution for stranded assets at some indefinite future date. What would be the effect? Contracts that would otherwise have been traded on the futures exchange will move to the forward OTC markets. What then will the CFTC subcommittees have to say?


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