Economic tools and the choice of energy options

with specific reference to Renewable Energy options

Lecture at Sustainability Institute, 25 July 2012by

Martin de Wit

Questions

• How do we solve the tension between affordable and sustainable energy?

• How do we solve the choice between renewable energy systems and increased efficiencies of conventional energy systems?

• Do these tensions and choices matter for human wellbeing?

Definitions of economics

• The social science that deals with the production, distribution, and consumption of goods and services and with the theory and management of economies or economic systems (freedictionary)

• A social science that studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy unlimited wants (Investopedia)

De Wit Sustainable Options (Pty) Ltd 4

Some basic concepts in economics

• Microeconomics:– Behaviour of economic agents (actors,

decisionmakers): maximising utility• Macroeconomics:

– How entire economies operate• Opportunity costs• Property rights• Market value

Simple economic model

Source: Wikipedia

A more complex economy

Cost-benefit

• Pleasure-pain (Bentham)• Cost-benefit analysis (CBA):

– Benefit-cost analysis (BCA), also known as cost-benefit analysis, aims to inform the decision-making process with specific types of information, namely measures in monetary terms of willingness to pay for a change by those who will benefit from it, and the willingness to accept the change by those who will lose from it. (Evans School Public Affairs)

– Money as common metric

De Wit Sustainable Options (Pty) Ltd 8

Economic appraisal tools

• Net present value (NPV)– Present value of all benefits > present value of all

costs or NPV>0• Benefit Cost Ratio (BCR)

– PV of benefits / PV of costs– BCR >1

• Internal rate of return (IRR)– Rate at which PV of benefits equals PV of costs– IRR > ‘hurdle rate’

Results of economic evaluation on energy options

• NBER 2009 (Geofrey Heal):– main renewables face a major problem because of their

intermittency (the wind doesn’t always blow nor the sun always shine) and that this has not been adequately factored into discussions of their potential.

– Without new storage technologies that can overcome this intermittency, much of the decarbonization of the economy will have to come from nuclear, carbon capture and storage (CCS) and energy efficiency (geothermal and biofuels can make small contributions).

– Nuclear and CCS are not without their problems. New energy storage technologies could greatly increase the role of renewables, but none are currently in sight.

Results of economic evaluation RE in Africa

• World Bank (Deichmann et al 2010) tested the conventional view that renewable power remains too costly for large-scale applications in countries where poverty alleviation is the primary objective.– for a majority of households, decentralized power supply is unlikely to be

cheaper than grid supplies any time soon– Levelized costs for wind energy are very low, but wind potential is limited to a

relatively small share of each country. – Solar PV would cover less than ten percent of all households under realistic

technical change scenarios over the next 20 years. – And electricity generated with biodiesel generators—as well as conventional

diesel—tends to be more expensive than grid supplied power for most areas. – Furthermore, where decentralized electricity generation is not already cheaper

today or, after considering likely cost reductions, over the next 20 years, carbon taxes or equivalent premiums for renewable investments are unlikely to make the difference under realistic rates per emitted ton of CO2 avoided.

– All things considered, our evidence suggests that the economics of decentralized renewable power may be compelling for large regions of rural Africa.

Summary of results

• Energy storage solutions needed to make RE more viable– Nuclear, CCS and energy efficiency important in

de-carbonization of economy• Costs and benefits over time and spatially play

important role in roll-out of RE• Role of decentralised RE applications

Limitations and new developments

• Opportunity costs of using non-renewable resources (resource economics)

• Environmental costs of energy transformation not counted (environmental economics)

• Thermodynamics and natural limits (ecological economics)

• Transitions (evolutionary and institutional economics)

Resource Economics

• Apart from finite availability, many other important factors including exploration, capital investment, and heterogeneous reserve quality are important for the economics of energy depletion and development (Krautkraemer & Toman)

• Discovery of new deposits and technological progress, which lower the costs of extraction and processing, have greatly mitigated the impacts of finite availability on costs and supply of depletable fossil fuel resources.

• When the marginal cost of using a traditional fuel type exceeds the marginal costs of alternative fuel options, a transition from traditional fuels to alternatives occurs, assuming that the alternatives provide the same energy services as traditional fuels.

Physical Scarcity? Case of oilThere is increasing evidence that the physical scarcity of fossil fuels is a serious possibility – stagnant or declining production

Oil Reserves (I)

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

-

20 000

40 000

60 000

80 000

100 000

120 000

140 000

160 000

180 000

Oil Proved Reserves, million tonnes

Sources: Gap Minder, Wikipedia

Oil Production Costs

Source: The Oil Drum (2010)

Oil Prices

Rising demand, stagnant production, and rising prices may signal physical scarcity impacts on the marginal cost of production

Environmental economics

• Rise of environmental economics– market failures and external costs, the costs of pollution,

pollution abatement, economics of regulation in normative framework of efficiency

• The environment provides many services to mankind. In general, one can distinguish between three important economic functions:– supply of raw materials and energy inputs in the economic

process; – assimilation of emitted waste of the economic process, i.e the

‘sink’ function; and – provision of general life support.

Ecological economics (I)• Field born out of the limited

interpretation of ecology as presented in environmental and resource economics (Van den Bergh, 2001).

• Baumgärtner et al. (2008:385), ‘the subject matter of EE [ecological economics] is the relationship between the economic and the ecological system, and its underlying central aim is to provide knowledge for a sustainable management of this relationship.’

Ecological Economics (II)

• According to Costanza (2009), ecological economics has the following ideals:– ‘Ecological economics is a transdisciplinary field that seeks to

integrate the study of humans and the rest of nature as the basis for the creation of a sustainable and desirable future.

– It seeks to dissolve the barriers between the traditional disciplines and achieve a true consilience of all the sciences and humanities...[allowing]

– to build a world that is both sustainable and desirable and that recognizes our fundamental partnership with the rest of nature.’

Ecological Economics - principles

• Roots in systems ecology • Economy as subsystem

– thermodynamically closed system – Economic models cannot violate biophysical principles

• Ecological limits and thresholds (e.g. planetary boundaries)– Limits in substitution of natural resources and environment –

thermodynamics, material and energy inputs in human needs, essential natural capital

• Normative framework of efficiency, justice and sustainability

Newer developments in economics

• More empirical economists study the behavior of institutions and individuals, rather than continuing to model abstract utility functions (Sagoff 2011. The rise and fall of ecological economics)– Behavioural and institutional focus

• WTP (adjusted utility) and CBA in itself are challenged as having little effect on public policy– Evaluation tools and techniques are in development

Energy TransitionsTake Time

• Previous energy transitions were made in a MINIMUM of 30 years for diffusion to dominance

• Previous energy transitions were made because the new technology was perceived to be better and cheaper.

• Consumers consumed more energy after the transition than before.

Fouquet, R. 2010. “The slow search for solutions: Lessons from historical energy transitions by sector and service.” Energy Policy. vol. 38, pp. 6586-6596.

U.S. Oil Prices and Recessions

http://netenergy.theoildrum.com/node/5304

The economic importance of oil far surpasses its cost share

Oil Prices and Energy Transitions

Today

Impacts on evaluation of energy systems?

• Recessions or transitions are both possibilities• Supply, cost and price of alternatives to

conventional fossil fuels – heavy oils, natural gas – also matter

• RE solutions operate in broader energy and world economy context

• Economic tools may help in estimation costs and benefits, little guidance in predicting smooth or abrupt transitions

Policy instrumentsPolicy Types Information Incentives Disincentives Regulations

Examples promoting grants, subsidies (FIT), tax exemptions/rebates, consumer rebates, low-interest loans, mortgage rate reduction

carbon taxes targets and quotas

Economic tools: Adding value to RE debate?

• How do we solve the tension between affordable and sustainable energy?– CBA, but add time and space. Limitations on predictions. Understand why

limited impact on public policy– No vested interests either in conventional or RE energy domains; economics

of non-conventional oils, natural gas and nuclear to better understand and guide transitions

• How do we solve the choice between renewable energy systems and increased efficiencies of conventional energy systems?– Include analysis of transitions, include behaviour of institutions and people.

Get sense of quantum on efficiency gains.• Do these tensions and choices matter for human wellbeing?

– External costs need to be included– Most end-users interested in affordable electricity, transport