Last week, the New Zealand Herald reported:
As of October 19, landowners and foresters who participate in the Emissions Trading Scheme (ETS) will be charged an additional annual fee of $30.25 per hectare in perpetuity.
A Ministry for Primary Industries (MPI) spokesperson says the $29.8m it costs each year to run the forestry ETS has been 100 per cent taxpayer-funded until now.
But from October 19, 63 per cent of those “administrative costs” will instead fall to ETS participants, with the remaining 37 per cent still funded by the taxpayer.
It seems fair enough to me that the landowners who benefit from the ETS should pay the costs of administering the system that they benefit from. However, what caught my eye in the article was this bit:
To cover that cost, [New Zealand Institute of Forestry president James] Treadwell says foresters will have to pass the problem on to farmers.
“I’ve got one farmer who is wanting to sell off about 120 hectares of their farm to cover their interest rates. I had to tell him the price has just dropped by $500 a hectare. He was pretty upset,” said Treadwell.
Why would a small charge of $30.25 per hectare per year lead to a $500 reduction in land values? It's because the value of the land is based on how profitable it is to own land. With the new annual fee, land is less profitable by $30.25 per hectare per year. And that translates into $500 in land value. The Efficient Markets Hypothesis suggests that new information is incorporated into the value of an asset immediately. And this appears to be what has happened here.
It's interesting to consider what that implies about the discount rate for landowners (or land buyers). Using the formula for the present value of an annuity, setting the value of the annuity to $500, and the value of the annual payment to $30.25, and solving for the discount rate R, I get an implied discount rate of 6.05 percent. [*]
That implied discount rate is interesting for a few reasons. First, it's very similar to current interest rates for farm loans. For example, ANZ currently has business term loans (including for farms) with a floating rate of 7.05 percent. At a discount rate of 7.05 percent, that $30.25 annual fee should reduce land prices by $429 per hectare. So, landowners (or land buyers) are reducing land prices by slightly more than expected given current interest rates. That may be because, while the annual fee is currently proposed to be $30.25, there is little stopping the government from increasing that fee later (at a rate that is higher than the rate of inflation), which would increase the amount of compensation, in terms of lower land prices, required now in order to offset the annual fee. So, perhaps that additional risk is being priced into land prices, and being picked up in the annuity calculation as a lower discount rate. [**]
Second, the discount rate is far higher than the social discount rate that is used in climate change (and many other) applications, which is often 3 percent (see here for more on this). If we applied the 3 percent social discount rate, the $30.25 annual fee should be reducing land values by $1008 per hectare. That suggests that landowners (and land buyers) are more focused on the present than the social discount rate implies, which is consistent with the idea of present bias from behavioural economics. Alternatively, we could interpret this as implying that society as a whole is much more focused on the future (as captured by the social discount rate) than individual landowners (or land buyers) are. Short-term profit motives strike again?
Finally, and perhaps most surprisingly to me, the implied discount rate is not wildly high (or low), implying that landowners (and land buyers) are not seriously overreacting to the introduction of this fee. Not only is the Efficient Markets Hypothesis working, but it appears that the landowners (and land buyers) have been relatively rational in terms of their response (as picked up in the change in land value). I guess it's not always the case that asset markets are crazy.
*****
[*] Ok, I admit that I didn't solve this by hand. It's not possible to do so easily. I used the 'solver' function in Excel, and set the number of periods to 10,000 (so, it's really a solution to the question: what is the discount rate that equalises an annual value of $30.25, paid every year for 10,000 years, and a one-time payment today of $500?
[**] If we used $30.25 per year for the first five years, then increasing to $37.25 for every year after that, then the implied discount rate that equates the annuity and the decrease in land values is 7.05 percent, the same as the ANZ farm loan rate. So, perhaps it is some calculation like that which explains the decrease in land values being higher than implied by current interest rates.
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