Was watching this video the other day and it took my thoughts down a familiar rabbit hole of infrastructure maintenance! Always a fun one. When I go out and purchase a car or a bicycle or even an axe, I spend a fair amount of time thinking about “how am I going to maintain this thing?” The car will need oil changes and tire rotations. The bicycle will need chain lubrication. The axe will need its blade sharpened. All of this periodic maintenance can be called the “total cost of ownership” of the thing itself. A bicycle doesn’t cost $1,000 one time to purchase; that is the cost floor. The small bits of required maintenance add up over time and the true total cost of ownership can be a fair bit higher.
The Edenville Dam in Michigan failed in May 2020. The Practical Engineering video below reviews a report which suggest age and maintenance contributed in part to the failure.
Lots of local politics also came into play, but the total cost of ownership thing kept popping up in the back of my mind. People are bad at planning ahead for this!
Related, Matt Levine writes in Money Stuff on 14 October 2021:
The way a natural gas well works is that you drill a well, and then you pump gas out of it for a while, and then it runs out of gas, and then you have to “cap” the well, fill it in with concrete so it doesn’t just leak methane into the atmosphere forever. In the U.S., state laws impose this capping requirement on the owner of the well; it is a sort of liability that comes with the well. If you drill a successful well, you get an asset (a hole in the ground that produces natural gas that you can sell for money) and a liability (the obligation to spend money in the future to fill the hole with concrete). Early in the well’s life, the asset is worth a lot (it produces a lot of gas) and the liability is worth a little (you will not have to fill it in for many years, so the net present value of the money you will eventually spend to fill it in is low). You open the well and you have a $100 asset and a $5 liability. Good work. But then you pump for a while and you deplete most of the gas and now the asset is only worth $10 because it won’t produce much more gas. And you know that in a year or two you’ll have to pay $20 to cap it, so you record that liability at a present value of, you know, $18 or whatever.
A future liability. Bit like those car tires that will someday need replacing. He continues:
But then someone comes to you and says: Look, this well will produce $10 more of gas, and I can sell that gas and make a profit and spend it. And I can do this much slower than you: You will just pump the rest of the gas out and have to cap the well in a year or two, but me, I’m in no rush. I will drag out the process so that I can produce a little gas for like 20 years. Then in 20 years regulators will say “okay time to cap the well” and I will turn my pockets inside out and gesture comically to my lack of money. Maybe I’ll say “just give me 20 more years,” and the regulators will say okay, because what’s the alternative? And then in 40 years, who knows, maybe I’ll cap the well, but I’ll definitely have spent all the money by then.
Interesting model. Why do this?
How much is that well worth to that buyer? I dunno? Maybe $7? They get $10 worth of gas and have $3 of hassle and expense in deferring the capping liability indefinitely? If they buy it from you for $2, you make a profit – you had the thing valued at negative $8 ($10 asset, $18 capping liability), and now you have sold it for positive $2 – and they make a profit (since they paid $2 for a stream of profits worth $7). Everybody wins! Except, you know, the well never gets capped and methane leaks into the atmosphere forever.
The title of this newsletter is “It Pays to Not Pay Your Debts” - and perhaps it does! A key pillar of our financial system is the ability to strip the concept of risk out of something and sell that risk off to another party. Some people want risky assets and associated higher returns; some want safe assets and low returns. The financial system makes that happen, and can manufacture those instruments when they don’t occur naturally because people will pay for them.
However, incentives are misaligned. Selling off the liability of capping the well makes economic sense (as explained by Levine), but it doesn’t make sense for the environment where we all live! These are negative externalities and in the case of natural gas wells the environmental and social outcomes are not priced in. Solutions can be a cap-and-trade like program or higher taxes on products which harm us (e.g. cigarettes). There is no incentive for the current liability-holder to account for paying that liability in the future.
In the case of a car I own, the total cost of ownership is borne by me because my incentives are aligned to paying for them. I want the car to continue working well and providing safe transport, so I’m going to put those new tires on it in five years time. If it was economically advantageous for me to just dump the car in a ditch (or sell it to someone who would) and buy a whole new car instead of fixing the one I’ve got, that outcome would be good for me and bad for society. Lots of waste tossing the car in the ditch!