Green And Green
Conservation and the cost of capital.
Over the last 50 years there has been a greater emphasis and awareness on environmental stewardship. Minimization of waste, efficiency of energy use, and the means by which energy is extracted, generated, and transmitted. This is, from most any point of view, a good thing. We have gotten there by the confluence of awareness, education, attitudes, technology, policy and regulations.
At the same time other things have occured that have pushed us in the opposite direction. These other things that have happened are generally due to unintended consequences of policies and the fungible nature of currencies and products.
A forced solution
Well meaning central planners see something that needs to be fixed and so they’ll do what appears to create a fix by regulation. But it’s often a whack-o-mole game and does the opposite of what was intended. In 1973 Congress passed the CAFE (corporate average fuel economy) vehicle efficiency standards. It did what it intended, the automobile industry quickly pushed out the more fuel efficient Ford Pinto, the Chevy Chevette, AMC Gremlin, Chrysler K-Cars, and many other frauds purporting to be motor cars.
Every county in the United States is dotted with vast lots of rusting steel, peeling paint, hulks of glass, aluminum, rubber, and plastic as a memorial to the exercise. Soon after, Americans for the first time suddenly developed a taste for minivans, extended cab pick-up trucks, and SUV’s. — These light trucks were a sort of loophole in the rule that didn’t require the same fuel efficiency of cars. Americans didn’t want the small cars forced upon them, so the light truck loophole became the way around it. How much was the environment harmed by the poorly utilized resources now rusting away in junk-yards? How much extra fuel has been burned in high profile SUV’s and trucks than would have otherwise been burned in aerodynamic cars?
A far better approach than the blunt hammer of the CAFE standards, would have simply been a fuel tax. Consumers would have decided on their own whether the Pinto was worthy of the trade-offs and if driving less in a big Buick was better than driving more in a sketchy Gremlin. The consumer would have picked their solution and the market would have responded in time as it was ready and able. But a fuel tax would have been immediately as unpopular as the Ford Pinto is today. The 1973 congress ran for re-election in 1974 while the world was still blissfully living pre-pinto.
The whack-o-mole occurs when the government fixes prices and then the shelves suddenly empty as the black-market picks up the signal that the legal market can no long hear. It happens when rent control freezes mobility and removes the incentive for landlords to invest in upkeep. And when the regulatory hammer falls on the on-shore manufacturer the externality just deepens and is pushed off-shore to an unseen sweatshop or strip-mine. Anything that can fit in a shipping container will be manufactured where the devil deals. A place with more (costly) regulation pushes markets and capital to where there is less regulation. It is only avoided by protectionism of the regulated industries. It is avoided only with regulations to protect the regulations.
Textiles, Steel, Automobiles were once produced on a massive scale within the United States. Today, many of those things are produced in areas with less regulation and lower labor costs. While it has resulted in lower costs for many products, the externalities of environmental degradation and human suffering have simply been pushed to where they are unseen and unregulated.
People respond to incentives. Individually and collectively we optimize and respond to regulations, but also around regulations. And the unintended consequence is typically only seen in the rear view mirror ex post facto.
Today, the biggest thing regulated impacts everything and is creating the biggest unintended consequence in the history of mankind. That regulation is the central banks coordinating the world-wide pushing down of the cost of capital to near zero. Indeed, for some, their stated goal is to keep interest rates lower than inflation. That is to say, the real cost of capital is nothing. This has resulted in any project that can maybe show a cash-flow becoming viable. It is profitless revenue. It is strip-malls and windfarms. It is copper mines and McMansions all over the world. Any project that can fog a mirror gets built. Any person with a W2 gets approved for the new car. I heard a CEO exclaim “any idea that elicits a warm response will be funded”. The banks are creating money ex nihilo to fund it all. And because the interest rate is lower the McMansion becomes bigger. And the consumer doesn’t buy just enough, but rather the maximum payment that the lender will squeeze her into. Most consumers buy to the limit of what they can swing in the form of credit. At the end of it all, is more land use, energy use, and empty rooms.
Source: U.S Census data, CPI inflation database, Bureau of labor statistics
Homes have increased in size even while the average number of people in a home has decreased. While it’s true that the air conditioner was mandated to be more efficient, what good is it when the size of the home has doubled?
Conservation Interupted..
In building a business case one must show that the internal rate of return is better than the hurdle-rate. In other words, the benefits outweigh the costs. The hurdle-rate is usually just above the cost of capital for the organization. So when the cost of capital becomes zero in real terms (net of inflation) the hurdle to justify a project becomes a just good story.
The more dear capital becomes, the higher the hurdle rate must be to justify doing a project. Things only get done that add value in greater amounts than the underlying costs to do the project. It is materials, energy, and labor. And indeed, the biggest part of the cost of steel, concrete, asphalt, aluminum, copper, etc. is usually the underlying energy that is devoted to its extraction, processing, transport, and installation. A non-trivial cost of capital incentivizes and demands conservation and efficiency. A high hurdle rate rations capital and sorts and sifts projects so only the most efficient and worthy are pursued.
While low unemployment and easy access to cheap credit is a boon for the ability of the average person to consume more, it comes at a cost. Those identifying themselves as “Green” like to virtue signal and call themselves conservationist while implying that other people are not. But the truth is every capital allocator is a conservationist in direct proportion to the cost of capital. Energy has cost. Materials have costs. Labor has costs. The capitalist must drive her project so the costs and benefits result in a internal rate of return greater than the cost of capital. Driving that rate of return up requires efficiency and conservation. When capital is properly priced the conservationist incentive is a built-in and reinforcing feature. When monetary policy is loose, the hurdle rate is lower and the costs that go into denominator drop as well. When capital is loose, Mother Earth had better gird her loins.
Governments want to centrally plan environmental policy, consumption, production, and essentially all activity. They do this via regulations that mandate miles per gallon of automobiles, efficiency of air conditioners, renewable portfolio standards and industrial regulatory regimes. They do all this while at the same time lowering the cost of capital to where the hurdle-rate to do a project is vanishingly small. In fact the cost of capital is lower than inflation many corners of the globe. While the central planning folks may pat themselves on the back and say it does not matter because we’ve regulated everything to be green and efficient, it shows up in different ways. The size of homes, number of cars in driveways, imported plastic junk, longer commutes, landfills, and second homes. Regulation cannot anticipate second order effects.
The drive towards efficiency diminishes as the cost of capital lessens. This includes energy efficiency, labor efficiency, and you-name-it efficiency. It just isn’t required. At the end of it all we will have used-up land, poorly erected un-used buildings, ugly McMansions, and junk yards and landfills as far as the eye can see. The road to hell is paved with good intentions. As more green gushes into the economy, the less green we become.
