Externalities in energy production

OK - today a slightly non-finance post.

There has been much hand wringing recently over the Solyndra Solar scandal in which it is alleged that the solar company received government support without proper controls.  Solyndra filed chapter 11 and is now being investigated by the FBI.

In the same way that I don't think subsidies for agriculture make sense, I don't think that subsidies for certain industries make sense either.  The government shouldn't subsidize solar power.  But it also shouldn't subsidize fossil fuels either.  Turns out that fossil fuel subsidies are a lot larger than the solar subsidies.  A whole lot larger.  This of course, doesn't get Solyndra, its management or the government off the hook in the current scandal.

(graphic from the Environmental Law Institute )


But the Solyndra case is a distraction to the bigger issue.  Even ignoring federal subsidies of fossil fuels, these industries are able to provide low cost energy because they impose negative externalities on other parties.  These externalities are primarily airborne pollution which have a very significant effect on the economy overall.   A recent paper published in the American Economic Review (the very top journal in Economics) finds that the magnitude and costs of these externalities are huge.  If the article is a bit dense, Paul Krugman gives a nice summary of the article.

The solution is to impose a Pigovian Tax - a tax on carbon.  A carbon tax works by raising the cost of carbon fuels towards a point that more accurately reflects their true cost (externalities included).  The key element of such a tax is that it is revenue neutral.  This means that all proceeds are rebated back to tax payers.  The most obvious way of doing this would be to reduce payroll taxes.  Greg Mankiw, the noted Harvard economist, who will admit to being on the opposite side of many debates to Paul Krugman, is a huge fan of a Pigou Tax.

With such a tax in place, and the removal of federal fossil fuel subsidies, the playing field would then be fully leveled for alternative fuels to compete based purely on their merits.

Price risk in the junk bond market

In one of my classes we've been talking about price risk and reinvestment risk for bonds.  These occur when market rates move from the initial YTM that an investor purchased the bond off of.  A great example is the current junk bond market where yields have risen very high and resulted in prices falling dramatically.  As a result year to date returns on these bonds are now negative.

Article here, HT Felix Salmon

Why do firms break up?

Aswath Damodaran has put together a really fantastic post on why firms break up or spin off divisions.  This is well worth a read.

Berkshire Hathaway to buy back shares

This story is a few days old, but Berkshire Hathaway is planning to start a share buyback.  This is pretty big news in that the company has never distributed cash to shareholders before.  Warren Buffet claims that the stock is significantly undervalued.  If this is so, then the buy back probably makes sense.  The evidence on buy backs is a little mixed, but in general there it supports the view that firms that do buy backs usually do so when their stock is undervalued.  We know this from two observations.  First buyback announcements are usually greeted with a positive stock price reaction, and second, valuation models show that firms that commence buybacks are, on average, undervalued compared to other firms.

Goodbye Wachovia

Here in Raleigh NC, the Wachovia building has long dominated the downtown skyline.  Not anymore.  It's now the Wells Fargo building.   My local newspaper has a nice set of pictures showing the transformation.

Robert Shiller on Stock Valuations

From Greg Mankiw: Robert Shiller thinks stocks aren't that cheap.

Pension fund returns

My colleague, Craig Newmark, links to an article on why Public Pension Plans can't be expected to earn returns of greater than 8% in the future.

The article argues that because the real risk free rate of interest is very low - close to zero, the expected return on pension assets should be reduced also.  I agree, but I would also point out that a non-trivial part of the historic return earned by pension funds comes in the form of inflation.  A far more sensible approach would be to  create pension plan return expectations in real, not nominal terms.

I've posted on this topic before.  Aside from over optimistic return assumptions, the other problem of state pension plans is that they discount their liabilities at the same return that they use for their assets.  Pension plan liabilities are virtually risk free and should be discounted at a much lower rate.  The net result of doing this would be to increase the value today of those liabilities and most likely reveal that most pension plans are horribly underfunded.