Harold Hotelling
Natural Gas
Global Warming

Comments on the Work of Harold Hotelling by Francis de Winter

Harold Hotelling was a Professor in the Department of Geology at Stanford University, and his article, "The Economics of Exhaustible Resources" (see below), is cited very frequently by those who are interested in sustainability. The first two pages of the Hotelling paper which are posted give a glimpse only into his fears and concerns, but not for the "free market" problems of discounting for which the article is normally referenced. This is described in the following paragraphs.

The Harold Hotelling paper is often referenced because of its description of the "Free Market" mechanism by which our descendants are systematically deprived of any significant access to the finite natural resources which we currently have at our disposal. This mechanism works as follows.

If one "owns" an oil well, one has to decide whether to "produce" (i.e. extract) and sell the oil now or later. If one produces and sells the oil now, one can put the money in the bank, and it will grow because of the interest it will earn. If on the other hand one produces and sells the oil later, one has to discount the money one will get for the oil, because one is getting the money later, and not now. With either way of looking at this, there is only an incentive to produce and sell later (rather than now) if one has the certainty that the oil in the ground is appreciating as fast as the money in the bank (in annual percentage rate), or as fast as the annual discount rate used in the operation one runs. Many operations (companies, etc.) use an annual discount rate of 10% or even larger.

Consider an annual discount rate (or interest rate) of 10% and a 25 year-long generation. In 25 years, a compounded 10% annual interest rate will multiply an original investment by a factor of 10 (yes, ten), and an annual discount rate of 10% will decrease a later money receipt by a factor of 10. What does this mean? It means that an oil well owner using a discount rate of 10% has no incentive to leave any oil in the ground for our children 25 years from now unless there is a certainty of getting the children to pay 10 times as much for the oil as we are paying now, and our grandchildren 50 years from now would have to pay 100 times as much as we are paying now.

Tradition has it that when the American native tribes made some serious decisions, they took care to consider the needs of their descendants seven generations ahead. What message does the current "Civilized Free Market World" have to future generations regarding the needs they may have, as per the mechanism first described by Harold Hotelling in 1931? Put most politely, the current "Civilized Free Market World" has essentially no concern or interest in the needs of future generations. The "Free Market" can almost be guaranteed to provide the future generations with a world devoid of any crude oil. All of it will have been used to drive cars which should have been much more efficient, to heat houses which should have been built to be self-sufficient (i.e. super-insulated and passive solar), and to power other inefficient devices. There may be no oil (or natural gas) left, but it may have been converted to enough carbon dioxide in the earth's atmosphere so that the world climate may be radically different, with many of the flora and fauna species now extinct, and much of the infrastructure built by humanity inappropriate to the new climate in which it is now located.

In 1985, I was invited to present a paper entitled: "Economic and Policy Aspects of Solar Energy" at a plenary session of the Solar World Congress of the International Solar Energy Society (ISES) in Montreal. At the time I still knew nothing of Harold Hotelling or of his 1931 article, but I had discovered the Harold Hotelling mechanism independently. I became as horrified at its implications as I still am today. In my paper* I wrote that when many different owners tap into the same oil field, any restraint in production only serves to help the competition, and then I wrote:

"Even when one has clear title to an oil field or gas field, there is an incentive to produce it rapidly. Money in the bank earns interest. Oil or gas in the ground just sits there, and the value of producing it years from now (rather than now) must be discounted by the discount rate. Unless one can expect the fuel cost escalation to be higher than the discount rate, there is an incentive to produce now rather than later.

"Discounting the value of future resources is very destructive, and is really a quite extraordinary approach. In virtually all societies, and virtually at all times, humanity has striven to make this a better world for future generations. Everywhere one finds buildings, roads, bridges, dams, music, books, poems, equations, stories, techniques, paintings, or other creations which have lasted hundreds of years. To those who originally produced these things it was a matter of intense pride and joy that they were contributing to future generations. It should be recognized that at a 10% annual discount rate the value of the future production of fossil fuels is discounted by a factor of 10 in one generation of 25 years. Society will only refrain from using a fossil fuel resource now if it has the certainty our children will value it 10 times as much, and our grandchildren 100 times as much. This does not bode well for the future.

"If the effects of discounting may sound terrible, the reality is worse. For politicians long range planning concerns preparation for the next election; for management it concerns preparation for the next board meeting. Most executives would not dream of cutting back on production - and reducing profits in the current quarter (!) - just to keep some reserves for the future. The benefits would likely as not not accrue to the executives, but to those hired to replace them. If current production is subjected to any restraint whatsoever, it is likely to be primarily to keep prices from weakening. For many the present is very important, and the future takes care of itself.

"Private ownership of mineral wealth or fossil fuel resources is not by any means a basic human right, or an indication of a free market at work. Quite the contrary; it is an indication that society (i.e. government, or the state) chose to give individuals the right to claim, own, inherit, and sell such resources, and to exploit them subject to specific laws, with government protection from claim jumpers. In the absence of government involvement one might physically occupy the territory of a claim until physically shoved aside by someone with more physical power. Private ownership of a mineral resource as we know it now, however, could not exist. It is not a matter of human rights. It is an invention of government, of the state.

"The most important justification for private control over minerals or fossil fuel resources is the speed and efficiency of development and production. A government bureaucracy is generally not a dependable mechanism for getting resources produced efficiently and rapidly. Private interests are. Examples are available everywhere. The question to be asked is whether it is still desirable, as it was often in the past, to develop and produce our fossil fuels as fast as possible when the end of the resource begins to be in sight. We should probably begin to limit production and use, not to encourage it."

Essentially, the Hotelling mechanism, acting through "The Free Market," has society automatically acting like a loan shark towards all of the future generations, for all of the finite resources that by right should be theirs as much as ours. Those who have "The Free Market" as their religion may well consider this reasonable, and I have met some who do. I consider it a catastrophe.

* F. de Winter: "Economic and Policy Aspects of Solar Energy," Proc. of the Ninth Biennial Congress of the International Solar Energy Society, Montreal Canada, June 23-29, 1985, Pub. by Pergamon Press, NY., 1986, Vol. 4, pp 2207-2218.

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