Commodity risk premia

Here's a discussion I had with Michael Roberts in the comments of this post at Greed, Green and Grains. The themes of risk premia for natural resources commodities and the implications for asset pricing and discount rates are pretty interesting for someone with a finance nerd inside them.

Teaser/spoiler: this will also be of interest to anyone interested in arguing that climate policy cost-benefit analysis should use a low discount rate, i.e. should value the future almost as highly as the present, rather than discounting it heavily.

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My dissertation, which I never published, argued that these negative risk premiums help to explain why natural resource prices haven't trended up over time. A negative adjustment for risk means Hotelling's interest rate is probably close to zero.

I'm a little less confident than I used to be about this story. But I still think there is some truth to it. I really need to dust off that paper...

R:

Not sure I understand your dissertation thesis - I thought that for Hotelling's theory the relevant interest rate (/risk premium) was that available in broader financial markets? I.e. even if a resource extractor can't get a positive risk premium from holding natural resources, they could by buying a bond...

Michael:

Yeah, I could have been way clearer in this post. Sorry, this was really more of a note to myself than a genuine effort to communicate an idea.

I'll try to give the intuition briefly.

Take oil, for example, say back 10-30 years ago. Prices generally bounced around due to news about supply or potential supply in the future. The really big price spikes came from oil embargoes, wars, etc. If prices go up, those who own the oil are very happy. But the rest of economy is not so happy. A reduction in oil supply is a real shift inward in the productive capacity of the aggregate economy.

Now asset pricing theory tells us that in equilibrium we should expect the risk premium to depend on the covariance with the aggregate economy. So, if oil prices go up when the aggregate economy goes down, going long on oil is like buying insurance for a bad economy. Insurance, like buying and holding oil, has a negative risk premium--it's an investment that loses money on average but you're willing to do it because it pays off most when you need it most.

Assets like stocks are the opposite, they pay most when the economy is booming and you need the money least.

Now Hotelling is just asset pricing for natural resources. It says prices should generally go up at the rate of interest. The thing is, for some basic commodities, the risk-adjusted rate is about zero. So prices don't go up in the long run.

Today demand shifts are driving oil prices, and that changes things. But I think the story still holds for precious metals and natural gas where supply uncertainty remains significant.

The same idea applies to climate change discounting. Investment in curbing global warming reduces the chance of a bad thing happening. It is an investment that pays off a lot of climate change is a really bad thing and an investment that pays nothing if climate change really isn't so bad. This means the risk premium is negative.

Somehow many of my colleagues (especially environmental economists) seem to forget or overlook this essential fact. Weitzman gets it. So do the macro/finance guys who care about climate change. So does John Quiggin. Rank and file environmental economists don't get it, and it really shows in the literature.

R:

Ah, I understand now - thanks for the longer explanation.

So what are the practical implications of the negative risk premium for investing in climate change prevention? (e.g., what mistakes would policy made based on the work of the "rank and file" be prone to?)

And does the asset pricing analogy really hold for climate change or other environmental public goods, where the "proceeds" of investment are shared broadly, rather than captured by the investor alone?

Michael:

Yes, I think all of this matters a lot for climate policy. A big part of the debate in economic circles pertains to the discount rates that should be used in weighing the benefits and costs of regulation.

If someone naively things the risk premium is positive, then the future--where all the benefits of climate change mitigation reside--gets discounted heavily. If we see it is actually a negative risk premium, then we discount the future much less.

Strangely, depending on one's assumptions, all of which may seem reasonable, one can get discount rates anywhere from slightly negative to 10% or more. And these different assumptions lead to cost/benefit calculations for curbing C02 that range from HUGE, like approaching 100% of GDP to basically nothing.

This ambiguity is not inspiring for economists...

R:

Nice - as an advocate of something being done about climate change sooner rather than later, I like this argument for why the financial discount rate should be low (for those who don't believe a lower "social" discount rate is appropriate).

Back to the original point, the more I think about it, the more I struggle to believe that natural resource commodities (even aside from oil) have a negative beta. Natural gas, iron ore, copper, phosphate fertilizer, most ag crops - pretty much you name it, it spiked in mid-2008 and fell dramatically when the world economy nose-dived. I'm sure someone has actually run the numbers before, but it seems anecdotally that demand is a big driver for all of them and they're only occasionally countercyclical.

Unfortunately that's as far as the conversation got (unfortunately because I think there is more to be done to hash this out completely) - but hopefully this is a good starting point for exploring these issues further in the future.

P.S. For anyone confused by the asset pricing jargon, here's Wikipedia on the Capital Asset Pricing Model (CAPM). The key idea relevant here is that diversification is valuable, so investors are willing to accept lower rates of return for assets whose returns are less correlated with the overall market (and this correlation is called beta).