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November 29, 2012

Facing Up To The End of Cheap Resources - Part I

By Anthony Harrington via QFinance

It will have occurred to many consumers in the colder climates of Northern Europe and North America that heating bills in particular, and energy bills generally - including transport fuels - are increasing considerably faster than average wage growth. There is a simple reason for this, as is made clear in the McKinsey Global Institute (MGI) Report, "Resource Revolution: meeting the world's energy, materials, food and water needs".

What households are seeing in their monthly or quarterly utility bills is a reflection of the fact that the beneficial trend of ever cheaper commodity prices which held good all through the 20th Century, has now reversed. The MGI report presents a very detailed analysis of past, present and probable future resource usage. As the authors point out, the fact that resources became progressively cheaper through the 20th century is in itself astonishing:

"Key prices (for resources) as measured by the MGI index fell by more than half in real terms (through the 20th Century). This was astounding given that the global population quadrupled in this era and global economic output increased by approximately 20-fold, together resulting in a jump in demand for different resources of between 600 and 2,000%."

What lay behind this continuing miracle of "more for less" despite the huge rise in demand, which traditional economists would have expected to drive prices dramatically upwards? According to MGI, the key was the huge technological improvements in extraction techniques and the continued discovery of low cost sources of supply. On top of these improvements the 20th Century also benefited greatly from the fact that the true cost of many resources was not factored in to the sales price. Many costs were "externalized", which is to say, foisted off onto the wider community or, as with global warming, onto the global community.

Even today, carbon emissions trading, which seeks to pull externalized costs back onto company books, is really just beginning to get off the ground on a global scale. Water is still regarded as a free commodity in many countries despite the fact that water scarcity is looming larger and larger as a problem, and many governments offer substantial supplements to hold down energy prices as a way of placating citizens who might otherwise take to the streets.

However, once emerging markets showed that they could turn in high single digit growth year in and year out, their impact on global resources began to be felt and prices started to climb. It is now clear that the "free lunch" in terms of low cost commodities that had helped to drive advanced market growth post World War II is virtually over. As MGI notes, by the time another two decades have passed, around three billion more middle-class consumers will be looking to improve their lifestyles. India and China are growing at ten times the speed that the UK saw through the Industrial Revolution and they are doing it on a scale that is 200 times larger.

"Demand from the new middle classes will also trigger a dramatic expansion in the global urban infrastructure, particularly in developing economies. China could every year add floor space totaling 2.5 times the entire residential and commercial square footage of the city of Chicago. India could add floor space equal to another Chicago annually."

As the world "urbanizes" this "citification" will be at the expense of a large number of hectares of arable land. The 3 billion new members of the middle classes can be expected to expand their diet and demand more meat at exactly the same time as the cities are spreading out over what was good arable land. "New and expanding cities could displace up to 30 million hectares of the highest quality agricultural land by 2030 - roughly 2% of the land currently under cultivation," the report's authors say. The raw resources needed to sustain that growth can't be met from existing production facilities. For example, MGI reckons that the world will see an 80% rise in the demand for steel in the period from 2010 to 2030. Already in the period between 2000 and 2012 there has been a 147% increase in real commodity prices. Agriculture price increases, which form a considerable part of that 147% rise, have pushed an additional 44 million people into poverty, according to the World Bank, the report says. To meet the increase in demand for resources, the world is going to have to invest at least $1 trillion more in what the report calls "the resource system" each year.

However, MGI does not take a Malthusian view of our future. There is every chance that the market will once again rise to meet the burgeoning need, but for it to do so, the old industrial habit of externalizing costs and not costing carbon and water properly is going to have to come to an end. Pricing these costs in will have an inevitable impact on commodity costs in the initial instance, but will lead to massive efficiency gains. Faced with the real costs involved in their activities, competition will force companies and producers to find efficiencies and they will find them, MGI argues. In Part Two we look at MGI's view of where efficiency savings might lie - and key to this, the report argues, is a requirement to price carbon properly, which means a carbon price of at least $30 per tonne.

Courtesy Anthony Harrington via QFINANCE (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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