Geopolitics on the rocks

Massimo Nicolazzi

The secret to energy transition

The energy transition we are witnessing today, from fossil fuels to renewables, is mandated by the tragedy of horizons, rather than by cost efficiency. Why to succeed it will need both public policies and private investments.

I.

It all started with food as fuel and muscles as the engine or prime mover. Food was multiplied through agriculture and muscles through animal domestication. Except for mills and the contribution provided by wind and water, the sources and movers remained strictly organic for most of human history. The Agricultural Revolution resulted in wealth and population growth. There was, however, an implied cap (the finiteness of the earth as an organic energy source provider) on growth ability and once it was reached, Europe’s economy and population remained substantially stagnant through the centuries.

Then came the great energy transition. Fossils met technology and were turned into fuel. The source became fossil and the engine a real (and inorganic) machine. In this shift, the ability to produce advantageous work, which is what energy is all about, became virtually unlimited. Classical economists and their idea of the economy leading to a stationary state (Stuart Mill for the definition, but Ricardo and Malthus for the concept) are useful only for academic purposes. In one century, world population multiplied by 700% and (consolidated) GNP even more. One can to a certain extent thank penicillin (as far as population is concerned). One could then thank finance and its ability to multiply money and therefore capital available for investment. But remove the energy transition, hence fossil fuels, from the scenario and very little if anything of the Schumpeterian embarras de richesse would remain on the table in the 20th century.

Today we are discussing a new energy transition. From fossil fuels to renewables, to sun, water, wind and organic fuels. A backward transition, so to speak. For the first time in history a transition from a higher (fossil) to a lower energy density source. This implies more space (acreage, classical economists would say…) needed for production and an inherently less efficient energy process. We need T (as in “Technology”) to develop rapidly in order to avoid a lag.

There is nothing in the market that mandates the transition. The lower density of “new” sources makes them marginally more expensive than fossil fuels, gross of their direct and indirect infrastructural costs. A strong argument could be made that this is so simple because. Historically, we have failed (or refused) to incorporate fossil fuels’ negative externalities into fossil fuel’s source prices. This is true, but the fact remains that (over 100 years after the publishing of Pigou’s Economics of Welfare) negative externalities, so far except for marginal cap and trade/carbon tax schemes, are still not priced[1] and that therefore, if left alone, price signals would adjust in favour of fossils.

With this comes the second feature of the next transition. At this stage of T, it cannot be a market by-product. We cannot as a rule predict the timing and direction of improvements in Technology, which largely explain the ex post inability of business-as-usual models to explain anything. But the energy density gap should allow one to predict that the increase in sector investments and consumption that would be needed to drive the process, and its size, will not properly materialise without massive regulation and state intervention.

II.

The transition, we are told, is mandated by climate change. Except for a small minority (less than 5% of the existing literature can be defined as “negationism”), peers endorse the idea that anthropogenic emissions are primarily responsible for a rise in atmospheric concentrations of carbon dioxide that have been recorded since the coming of the Industrial Revolution and that this concentration, as part of the overall concentration of GHG, is a primary factor in the global warming drama. Hence the drive towards moving away from fossil fuels as the primary energy source.

To achieve this, governments, or rather states, need to intervene. Consistency and (in the case of sun, water and wind) the intermittency gap must in practice be narrowed. The energy transition is (also) a matter of appropriate state policies.

The state usually has three main tools available for this purpose; taxes, incentives and prohibition.

Prohibition is mainly linked to environmental standards. Zeroing, hence allowing sulphur dioxide emissions at sea, where implemented, has the secondary effect of promoting gas (LNG) propelled engines over traditional diesel, thereby substituting oil with a less polluting (although hydrocarbon) fuel. Incentives are what made photovoltaic possible, and, at times, even excessively possible as has happened in Italy. Taxes in turn could and should be used as a tool to incorporate externalities in pricing.

The tools are there. But the will to use them in a coordinated manner and achieve accountable goals is apparently below expectations. COP 21 execution is based on a voluntary non-enforceable mechanism involving Nationally Determined Contributions (NCD)[2]. But the tendering of such contributions appears to be less than enthusiastic.

The issue with government action on climate change has much to do with what Governor Mark Carney in 2015 defined “the tragedy of horizons.” “The catastrophic impacts of climate change will be felt beyond the traditional horizon of most actors – imposing a cost on future generations that the current generation has no incentive to fix.”[3] Damage will materialise in the years to come, but so as to prevent it money must be spent now. Investing in prevention implies asking constituencies to spend their taxes to avoid something they do not (yet) suffer from or (i.e. via carbon tax) to pay more to buy what they are used to buying for less. The climate drama will take some decades and elections are tomorrow. Even worse, if one applies a high discount rate to the model, one may even end up proving that fixing climate change damage in 2050 would be less expensive than preventing it today. This is exactly the argument that British Conservatives opposed to the findings of the 2006 Stern Review.[4]

III.

Deciding on a policy needed to arbitrate between today and tomorrow is ultimately a decision concerning a selected discount rate. Applying (underlying) high discount rates is a popular electoral exercise. Discounting is one of the conditions for the transition to materially progress.

Can a majority constituency gather around a low discount rate policy, thus assuming responsibility itself instead of delegating to future generations?

Contrary to expectations, there are some indications that this may be starting to happen.

The first is that the ‘tragedy of horizons’ is already coming into view and doing so in the form of current issues. The combined worldwide growth of population and GNP is multiplying the impact of fossil fuels’ negative externalities and imposing a cost on budgets not aimed at preventing the evils of tomorrow, but simply to remedy those of today. At COP 21, China did not “convert” to the environmental cause; it simply cannot withstand the consequences and potential further rise in the pollution it suffers from today. President Trump’s election may not necessarily contradict this trend. It is too early to tell, but even his administration’s “America First Energy Plan” recognizes that “our need for energy must go hand in hand with responsible stewardship of the environment.” Only time will tell whether this acknowledgment will in practice translate into an oxymoron. In all likelihood, the transition process may just move forward more slowly than it would have with support provided by a proactive policy, while still leaving room for a manageable process.[5]

It is up to constituencies to endorse energy policies. Not even the Trump energy policy is immune to endorsement. Then there is a second indication that a proper transition policy may still be politically viable. This indication is ultimately a “mood” issue. This is a mood that in segments of Western societies seems to be gradually shifting, to put it rhetorically, towards the acceptance of the idea of paying more today to have a better planet tomorrow. It is a mood that goes so far as to buy widgets available on the market on the basis of considerations other than just the price or efficiency of the specific product. When, for example, the Tesla Powerwall hit markets, it generated a huge amount of literature claiming to prove its economic inefficiency. Nonetheless it sold. It is true that, like other storage appliances in some countries, it was made economically efficient through preferential tax treatment. But in the United States it found a niche market even in the absence of public support.

There are thus niches in the “green market sector”, that, even in the absence of public policies, are becoming established and growing. Supply, apparently, is starting to create demand. Alone it may not suffice, but it may help establish consensus for a transition policy.

IV.

And yet the path we are going down is doubtful. Targets for GHG emission reductions could be met, but (failing massive state intervention) still also largely missed. The potential scenarios are virtually unlimited and winners and losers impossible to identify. The lesser the mitigation of climate change, the stricter in principle the attention we should pay, amongst others, to the insurance sector in terms of its ability to cover the increasing climate-linked liabilities supposedly associated to progressive global warming. The quicker the transition, the higher the danger to the carbon industry, which may inter alia face the need to write off its net worth reserves that are no longer productive (“stranded assets”). As there is no such thing, however, as a long term portfolio (the rule still being that operators just act opportunistically…) it is still too early to come to a final conclusion as far as most of these issues are concerned.

Transitions take time. In most cases, changing the energy source implies changing its prime mover and building the infrastructures needed for change. “Energy transitions taking place in large economies are inherently protracted affairs.”[6] Take electric cars, for example. Today we are still below 1% worldwide. The International Energy Agency has called for this figure to rise to 1.7% in 2020 and to 10% in 2030. Others are less optimistic. Crude oil energy density seems difficult to displace from the transport sector and if one wants to change the source one needs to change the car.

The good news here is that reaching COP 21 emission targets does not call for an excessively accelerated transition. The 2016 World Energy Outlook 450 scenario (deemed to be consistent with the objective of limiting the average global temperature increase in 2100 to 2 degrees Celius, compared to pre-industrial levels) projects the fossil source - still 74% of world’s primary energy sources in 2025 - and to progressively decrease thereafter to 58% in 2040. There still seems to be time to drive a process consisting of progressive steps and avoid the shock of sudden change.

Step one. Before and during the substitution of fossil fuels, we still have a window of time to consume less by consuming more efficiently.

Energy intensity (i.e. energy consumption per unit of Gross Domestic Product) has decreased on a global average by 32% between 1990 and 2015. Historically this trend appears as a continuum with rare yearly exceptions. In practical terms, this implies that within the EU 28’s GDP one could sustain an almost 2% per annum rise without increasing year-on-year energy consumption.

More can be done. The fall in energy intensity has been so far mainly market driven. But there is still a great deal that state policies can do to stimulate energy efficiency, hence our ability to reduce the energy consumption of a system in performing a specific function. Transport, housing and industries have each still a great deal of leeway for improvement, even under already existing technology. The timeframe for improvement is however largely a function of the end users’ financial assets. Here too, we have one main issue. To make heating more efficient, one must invest in changing the boiler. On this subject state policies seem responsive at least in Europe and tax incentives (via tax credits ) have been chosen as the favourite policy tool. Investing in energy efficiency can induce a positive economic stimulus and makes for an emission reduction policy in which the ‘tragedy of the horizon’ is of limited or no importance.

Step two. One can for the moment replace fossil fuels with (lower emission) fossils. In this case one has a priority issue affecting both sectors and sources. As far as the sectors are concerned, the priority is mandated by existing technology. One can quite substantially contain the quota of carbon sources used in power generation (by resorting to nuclear power, one could in fact technically already manage without fossil fuels), while the energy density issue involves long-term problems to be addressed in the transportation sector.

As to source priority, natural gas is the obvious choice. The transition power generation mix would ideally be natural gas plus renewables, with natural gas fully substituting coal as the flexible provider. The substitution costs would, in principle, be sustainable for the consumer, but this notwithstanding, nothing or little seems so far to have materialized in this direction. In principle, graduation of a carbon tax so as to shift consumer choices towards less emissive source should be the priority. But it is nowhere to be seen.

In “green” Germany, for example, in 2016 over 40% of electricity was coal produced (with lignite accounting for 60%) while gas was at 12.4%. Renewable expansion is constant (in 2016 up to 29%) However, in spite of the Energiewelde, establishing a base fuel price is a priority over the environment. This cannot be taken as an example of the ‘tragedy of the horizons’, but compared to state policies applied to energy efficiency, it looks at least like a close relative.

Whatever the policy, transportation will take longer. Attempts are being made to favour the substitution of oil with gas as the transportation fuel, but this is basically for bulk cargoes (ships and heavy trucks) and is subject, at least in Europe, to favourable taxation, bridging the implied cost gap with diesel. Electric cars are here to stay, but it may take decades before their spreading becomes emission-based (and provided they are not fuelled with coal-generated electricity). Policy here is (to a certain extent) impotent, if not matched by substantial technological development.

Which takes us to the last but most important driving force. Step three. Technology will have a great say in the timing and feasibility of the transition to come. Where this will go is certainly unpredictable, but one of the game changers will be its ability to economically overcome the shortfalls of renewables’ intermittency. Electricity storage progress will mark the transition’s advancement. So far, over recent years the learning curve has been impressive. But it was also a creaming curve. Further progress may thus prove slower and more difficult.

V.

Mix state policy with technology, wrap in energy efficiency, season with the less emissive fossils, and you have the recipe for an energy transition. Except that, there being no free lunches, the recipe needs to be financed. Guesses about what the bill will be are proliferating. Professor Paul Ekins[7] authoritatively suggests that we are talking about generating some US$ 3 trillion per year to invest in low carbon investments. The recipe, in other words, does not work without funding.

Public policy will not resolve the problem. It can facilitate low carbon emissions, but in no scenario can these be sustained only or even predominantly via state budgets. Private investment is already playing and will continue to play a major role. But to be generated, private investments need the prospect of reasonable and risk-related returns. This in turn calls for state tools to be exploited so as to accelerate the bridging of the cost/price gap and create the framework for low carbon sources to become price winners.

This is where the energy amateur must leave the floor to the finance professionals. Within an appropriate framework, the technology of choice, as well as the infrastructure chosen or the creation of small and distributed choices, will be neither priced nor rewarded simply on the basis of their technical merit. Marketing, consumers’ inclinations, affordability, integration with existing systems and other factors will play a role in this beauty contest. The ability to attract capital will ultimately decide and, like it or not, it will be up to finance to pick the winners.

NOTES

[1] The amounts at stake are difficult to estimate. A 2015 IMF working paper labels the refusal to price fossil negative externalities as a “subsidy” to the industry (“post tax consumer subsidies”) and estimates the 2015 yearly worldwide subsidy (i.e. the amount that should be captured through a proper carbon tax) at $ 5,3 trillion. Coady,D.;Parry, I; Sears,L; and Shang, B., How Large Are Global Energy Subsidies?, IMF Working Paper, 15/105

[2] Under the system, the plan to contribute to emission reduction and the specific targets thereof are decided at individual State level. Control and enforcement are thereafter also fully in the hands of the individual state, with no mechanism for international sanctioning.

[3] Speech given by Mark Carney, Governor of the Bank of England, to the Lloyd’s of London, 29 September 2015, www.bankofengland.co.uk

Mark Carney as Chairman of the Financial Stability Board has promoted the Task Force on Climate-Related Financial Disclosures, which aims at developing “voluntary, consistent climate-related financial risks disclosures for use by companies in providing information to investors, lenders, insurers and other stakeholders”.

[4] The Stern Review on the Economics of Climate Change, released on October 30th, 2006, purported to provide a thorough analysis of the costs and risks associated to climate change. The Review argues strongly in favour of the adoption of an immediate mitigation policy, alleging that ex post remedial action would be by far more burdensome and expensive. The economic model of the Stern Review did not adopt a single discount rate; but ex post the mean rate actually implied was approximately 1.4%. Some critics noted that just by resorting to a higher discount rate the economic balance would have tilted for policy purposes in favour of ex post remedial action.

[5] There are a number of assumptions that should be factored in before passing judgment and forecasting future impacts. The call for energy independence is a call for maximising fossil production, i.e. to sustain an industry that has always been playing an upfront role in the economy of a number of US states both in terms of workforce and the magnitude of stakeholders. However, trying to boost production may not and does not translate automatically into an increase in (national) consumption. Coal production has been environmentally rehabilitated, but in recent years gas has effectively displaced coal in US power generation, not because it was cleaner but simply because it was cheaper, and the “rehabilitation” will not by itself reverse the process. Individual states, furthermore, in the absence of Federal standards will retain an ability to regulate at state level and it is difficult to see how the Federal Energy Plan may, for example, have an impact on California’s environmental policy and standards, And so on…

[6] MIL,V, Energy Transitions, Praeger 2010, viii

[7] UCL – Institute for Sustainable Resources