Price of non-renewable & renewable resource: Revisiting the climate change paradox

It was 1931, when Harold Hotelling, the Stanford Mathematician & Economist, wrote the treatise on renewable resource extraction. The summary of his treatise was simple; price of non-renewable resource will go up with interest. For most resources that are limited in our eco-system it is easy to understand that the prices eventually will move up in the extraction path.

If the prices are low at any given time it is because of over-exploitation that dampens the prospect of price. But it cannot last in the long term. Over-exploitation is a dynamic condition, but it also depends on interest rates. If interest rates are low it attracts over-exploitation as well. Then we have a demand side story as well.

 Imagine, you are an oil producer and you have a fixed reserve. If climate change discussions limit the amount of emissions by nations, what would you do in the short term?

A rational self-interest would ordain higher extraction that will lower prices in the short term.

It was not like this may be ten years before when many nations like U.S. protected its reserves and was under-exploiting it with a very long term view. That seems to have changed with time and with new technologies that reduced costs of extraction. It changed with interest rates as well.

But over-extraction is precisely the world’s problem, over-extraction at the wake of the climate change imperative that is imminent. The more we discuss sanctions, the more will be the extraction over demand, the higher the probability that price of such resources would remain low.

This has just the reverse and negative effect on renewable resource. As prices of non-renewable resource reaches the neutral point it prevents further investments in the renewable resource as it becomes non-remunerative.

This is exactly the world’s problem, which is known as the climate change paradox. But is there some solution to this paradox?

The extraction path of a natural resource will depend on marginal costing, as long as marginal costs are lower than the prevailing price, extraction will progress on that path. Higher the extraction, lower will be the marginal cost and therefore the higher propensity to extract against an overall lower price syndrome prevailing due to demand side issues or other external factors.

This could change if the interest rates change. A sudden change in interest rates will drive the marginal cost up. There has to be a supply response otherwise prices at current levels of demand cannot change dramatically. This will change the neutral point and therefore it would create a cascade of events that would influence renewable investments.

Imagine a car running on battery that has a very high hurdle rate now as the oil prices remain low. If the neutral point shifts, the hurdle rate goes down significantly thus allowing elbow room to invest.

Much of what we are discussing here would depend on expectations. And expectations are influenced by a plethora of information drives, from sources of all kind. On one hand you have banks who have borrowers of all kind and the on the other you have businesses in the resource area who have their books stretched out.

How the world would react to information depends on how that gets channelized into our daily lives. Around the Paris Climate change talks the world came to a consensus of some sort that action is needed now than later. The effect on the other hand was just the reverse; while demand came to a plateau the non-renewable energy output never got curtailed.

What is the current consensus, do nations believe that it is now that we should have the current generation pay for the externalities? Well, I am not sure and the jury could be out.

Raising the price of fossil fuels through climate change actions on the other hand would allow the renewable energy industry to thrive and investments would get attracted easily as financials work out well.

When on the other hand we have a situation of low fossil fuel prices, the inaction looks ominous.

So our current generation will continue to enjoy at the cost of the next for sure.

Hotelling’s Rule therefore is partial, given the climate change imperatives; the short term aspect of low non-renewable energy prices is a reality.

For those who are in the resource heavy businesses, the important pointer is that while it is very true that more action now is better than less action later, it is also to be kept in mind that it would have implications on short term prices versus long term prices.

A lower short term price versus a higher long term price is a balancing act that every resource heavy company must take a view on.

“In the long term we may be all dead”, but the world must survive today as well as tomorrow, without putting additional burdens on the future generations, while the current could be enjoying better times.

Balancing credits, carbon credits included, is an important imperative.