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What can be predicted are the consequences of our actions
The beginning of a new year is a period rife with forecasts and predictions. Among them, economic forecasts have an especially prominent place. Looking at the array of competitions held by business and financial press, one can get the impression that forecasting is an economist’s main job.
Participants of the most-accurate-forecast competitions can contend in multiple categories, from economic growth, to foreign exchange, to inflation and jobless rates. But the combined event of making forecasts in all those categories at once is not exactly popular, as economists know very well that a correct forecast can only be produced by chance, and correct forecasts in several categories would be a borderline miracle. Having no awareness of that, the audience regard economists as some kind of fortune tellers. And since most forecasts fail to materialise, they eventually lose all confidence in those who make them. This is how the seemingly innocent fun harms the profession. The gist of the problem is that economists are not concerned with telling the future, and economic forecasting is something entirely different from what it is commonly believed to be.
Let us discuss forecasts first. They do not answer the most frequently asked question of what will happen – simply because nobody knows that. The future differs from the past in that it may develop in a variety of ways, depending on what we do, what others do, and what surprises fate has in store for us.
Random events cannot be predicted, but can be prepared for. Let me give you an example. Your aunt calls from afar, announcing she will visit this weekend. You arrange to meet on Saturday. To mark the occasion you buy her beloved meringue cake, which is not your favourite treat. But fate decides otherwise and the meeting does not happen after all because of a railway traction failure. You are disappointed and, to boot, you have borne the unnecessary cost of the cake. Let us take a look at this example through the eye of an economist. What you know about the future is that your aunt is planning to visit. You also know that you want to play a good host, allocating for that purpose a certain sum within your limited budget. Finally, what you know is that randomness makes the future uncertain. So, what decision regarding the purchase of a cake should you make to properly receive your aunt while reducing the cost of the cake that may prove unnecessary? You have a choice between a perishable meringue cake that your aunt adores and a gingerbread cake that she is somewhat less fond of but that can be stored for a long time. Which option to choose?
The science of economics comes to your aid, offering a universal recipe that can be successfully applied on a daily basis. The recipe is to examine the ‘opportunity cost’, also known as the economic cost. Such cost is borne when you attempt to satisfy certain needs but have limited resources and need to choose between several options. An opportunity cost is involved in any decision to choose between two or more options. In our example, the opportunity cost of choosing a meringue cake is giving up the budget-saving gingerbread. On the other hand, the opportunity cost of choosing a gingerbread cake is giving up the meringue that your aunt prefers.
The examples are endless. If you are planning a holiday in the mountains or at the seaside, the opportunity cost of going to the mountains is a lost holiday by the sea. The opportunity cost of getting married is giving up the benefits of a single life. With the concept of an opportunity cost, economics teaches us that there is no such thing as a free lunch. It is not the decision-making process that is of a scientific nature here but the method of arriving at a conclusion.
In our previous example we demonstrated that the starting point of economic activities is a vision of what we want to achieve. But the effects will depend not only on what we do but also on how our external environment behaves. For instance, when making the decision to build our first CCGT plant we knew well its design process parameters. What we did not know, though, was whether the project would be profitable. Meanwhile, the plant’s projected profitability depended both on the actions of others (our competitors, energy consumers or governments) and purely random events, such as natural disasters (like the one in Fukushima), conflicts (tariff wars between China and the US) or new technology advances (like efficient energy storage).
These factors influence future relationships between the prices of primary (fossil and renewable) energy sources and emission allowances, determining which power generation technologies would gain prominence and what the profitability of our project would ultimately be. Therefore, its projected profitability could only be considered under certain conditions: what would happen if... a specific scenario of how business and governments behave should our project be carried through materialised. Of particular relevance was how shale gas production would develop in the US and globally, what impact this would have on gas price paths over the next 30 years and what would be the future of climate policies in Europe and worldwide. It is important how these factors translate into the prices of carbon emission allowances.
By adopting specific assumptions (conditions) about natural gas prices and the cost per tonne of carbon dioxide air emissions, one can refer to economics, the science that examines and measures the reactions of households and businesses to changes in price relationships, using them to predict how the power plant’s operating environment would change in a specific scenario. However, no similar predictions can be made about what governments would do, as it is governments that actively shape the price relationships, influencing individual decisions of both households and businesses. Indeed, the aim of an economic policy is to prompt households and business towards certain desired behaviours, for instance in environment and climate protection. This is achieved through regulation affecting the price relationships.
In a nutshell, the profitability of our power plant is subject to risks which ultimately depend on alternative (variant) economic policies, that is on government actions.
When developing regulations, governments choose between alternative paths to achieve their goals. Since their choice (being a set of economic policy measures) is made within limited resources, it is accompanied by a projection of how businesses would behave in a given regulatory reality. A comparison of such projections gives an idea of the opportunity cost of specific economic policies. Long-term economic projections are therefore an important tool used by international organisations, governments, energy companies and leading think tanks to shape the future of the energy sector. They do not answer the question of what will happen, but what would happen if an assumed policy scenario materialised.
Obviously, a different energy or climate policy scenario leads to different projections, their comparison providing an insight into the opportunity cost (economic policies in the energy sector) that can be used to influence business decisions. When it comes to exerting influence, credibility is an essential instrument. The credibility of the energy sector’s long-term projections is predicated on the credibility of energy and climate policies. The harder it is for businesses to predict which energy policy scenario would be implemented, the greater the regulatory risk and the lesser the propensity to invest. The measure of this risk is the likelihood of regulatory changes and its price is the effects of these changes. The regulatory risk varies widely between countries, particularly in the area of climate policies, leading to differences between how their energy sectors develop. Since businesses are unable to manage the regulatory risk, they factor it in otherwise, including its price in the cost of capital. The cost of capital impacts the profitability of capital projects and the choices made. This is how the forecasting loop closes. Projections foresee the future insofar as they actively shape it.
Decisions are always about the future, which is why it is important to predict their consequences. We do this to make better decisions. Since we have limited resources, there is no such thing as a free lunch in the world of economics. No decision is also a decision that carries with it the cost of an opportunity forgone. In complex cases, the opportunity cost is calculated through economic projections that describe the reactions of business to changes in price relationships. Rather than predicting the future, such projections answer the question of ‘what would happen if’. They are ‘accurate’ only under given assumptions defining an economic policy. Changing these assumptions would lead to alternative projections.
Projections measure the opportunity cost of an economic policy, facilitating a choice between various policies to achieve specific goals. In this sense, projections are an economic policy tool.
The article ‘What can be predicted are the consequences of our actions’ was published on December 21st 2019 on the wszystkoconajajwaważniejsze.pl website.