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June 14th 2011 print

Ted Rule

The economics of inundation

“If you pull your head out of the sand for five minutes and take a look at the prices of beachside suburban properties you’ll see that they haven’t moved down and in some instances have boomed.” This I found profoundly disturbing.

It was quite a shock this morning when I opened my newspapers to the news “Shopping centres, office buildings, roads and railways worth $226 billion could be at risk if climate change causes the sea level to rise around one metre by 2100.” Greg Combet told us that, according to a report, "Assets at risk from the combined impact of inundation and erosion include between 5800 and 8600 commercial buildings, between 3700 and 6200 light industrial buildings and between 27,000 and 35,000 kilometres of roads and rail."

This shocked me. You see I own a couple of properties quite close to the waterline and even here in my 21st storey flat I had visions of remaining quite dry but being unable to get out for a carton of milk. Mr Combet is a very intelligent man and needs to be taken seriously. Something had to be done. 

I decided that since economics is a discipline which relies on the concept of value, the value of real estate would have to be where I started. If what was being said was true, smart investors would be unloading their properties with a degree of urgency. I decided to check with the professionals who know about these things, real estate agents. I found my own agent in her office, painting her nails bright red. She furtively hid the statements of my trust account, smiled broadly, and asked me my business. Yes, my agent told me, there had been some recent decline in seaside properties outside the capital cities. But she didn’t seem to have been reading the right things because she totally mistakenly believed that this was due to the GFC and the availability of capital for “lifestyle investments”. “Share prices collapsed, margin calls, what else cold they do but sell the beach house”. “But but…" I stammered, but this only seemed to spur her on. “If you pull your head out of the sand for five minutes and take a look at the prices of beachside suburban properties you’ll see that they haven’t moved down and in some instances have boomed.” This I found profoundly disturbing. 

To get further analysis of the situation I called in on my accountant. He’s not somebody whose company I normally seek out but after all economics ultimately depends on statements of value and who better than an accountant to give guidance on this. To my surprise he was mystified. “The problem is that I don’t quite see how they could’ve got that $226 billion number. We’re talking 100 years in the future, aren’t we? Well several issues here. Firstly, a true indication of future value would have to take into account depreciation. These things are pretty arbitrary but the tax depreciation scales are a reasonable measure of how we might see value depreciate and they allow a straight line depreciation of 2.5% per annum. So if we take this year as the last year that anybody would be stupid enough to build anything anywhere near the places which Mr. Combet tells us will be under water in 100 years time, then I guess that in 40 years time, well short of the 100 years, their value will be zero. And with the possible terrible consequences of which Mr. Combet and the authors of this report have been kind enough to remind us, I can’t imagine that anybody will be stupid enough to build or even repair anything in that area. So the actual losses to property in 100 years time will be zero. Incidentally this is well before we go into any more sophisticated time value of money measures. Are they talking 2011 dollars and why? The average increase in M3 is over ten percent which assumes an ongoing asset value inflation of a similar rate. Is he comparing 2111 dollars with 2011 dollars? Why? Will we even have dollars in 2111? My favorite is the old banking saw that after 14 years the value of principal is zero.” 

All of this seemed particularly unhelpful. Weren’t accountants supposed to be amongst the more sober sectors of society, maybe a tad boring but pitch perfect when it came to numbers like the scary ones being brought so properly to our attention by Mr. Combet? A sudden light bulb lit up in my head. Perhaps I could insure against future inundation. After all, time brought uncertainty. If house values hadn’t dropped, maybe I’d be able to find an insurer who would be prepared to take on the risk of my property, by then valueless, becoming inundated. “Well I possibly could at a pinch I guess but I probably wouldn’t and I suspect that it wouldn’t be in your interest either.” I scratched my head and asked why not. “Oh we’re in the uncertainty business but this is taking the concept of uncertainty much further than we’d probably be prepared to. In 100 years there are multiple uncertainties. Let me take just one. Given the record of history the chance that there will be a major war which could destroy a substantial part of value isn’t off the books and given the fact that there hasn’t been a major war for more than 65 years, I’d put the chances of that as high. And that’s only one risk.  From your perspective, the chance that we’d be here for you to collect when your property is inundated is slimmish.  Companies don’t last forever, you know. You’re a healthy looking cove but with the greatest respect, I know your drinking habits and I don’t really expect you to be round to collect either. It all seems a bit pointless. Why do you want to do this any way?” I mumbled something about moral responsibility and the interests of the next generation. “Moral? Hey! We’re not in the morality business. Ask anybody who doesn’t read the small print. This is about money, value, economics. And why are you living your kids’ lives and trying to make their decisions? They won’t thank you, you know. From what I see of their drinking habits, I wouldn’t be prodding the actuary too hard about their being round in 100 years either. If you want advice on morality, see a priest or a Greens MP. If you want a silly bet, see a bookie.”

Which I did. I caught him fresh from the morning training track, wiping the horse shit from his shoes and secreting a syringe. I put my proposition to him. “Intriguing”, he said. “How did they come to these conclusions?” I was shocked at his ignorance and pointed out that this was based on computer extrapolations made by some of the best brains in the world, brains whose conclusions he would ignore at his peril. “Ah yes, he pondered, “Extrapolations. You know I have a weakness for a small flutter and not just on the horses. I invest heavily in the stock market and even in private equity. And in that capacity I see a lot of extrapolations, predictions from brilliant mathematical brains based on the idea that in the future things will go on according to how they’ve gone on in the past. Son! Haven’t you ever heard of the random walk? I lost a lot of money that way. Stick to horses. At least with horses you know that past performance is some indicator of future performance. It rarely is elsewhere.”