Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

16 December 2008

Energy Economics

Inelasticity of Supply and Demand
Fixed Versus Marginal Cost
External Costs
Comparison Table and Conclusion

1. Introduction. Energy is the crying issue of our time, bar none. Even with oil prices down at $40 per barrel, we are still spending nearly half a billion dollars per day on imported oil, because we import ten million barrels a day.

Developed countries need energy to maintain their lifestyle and pace of innovation. Developing countries—especially the “BRIC” nations Brazil, Russia, India and China—need it to complete their process of orderly development and avoid social unrest. Least developing countries need it to overcome decades or centuries of poverty and avoid slipping further behind.

The era of cheap oil is coming to an end. Everyone knows it. Over the next several decades, humankind will have to make massive investments in new forms of energy to replace oil. The biggest question confronting us is in what sources to invest.

The alternatives are wind, solar, biofuels, nuclear and coal (including various forms of coal-derived “oil”). Natural gas may also provide an alternative, but the extent of natural gas reserves is still highly uncertain.

Which source(s) of energy we choose for our near-term investment will determine the health of our global economy, our people and our planet. There is no more consequential choice for the future of our species.

Fortunately, we do not have to choose in the dark. Economics may be a “dismal” science, but it’s still a science. Over the last several centuries it has developed some useful ideas that can help us make the choice. The most important are: (1) scarcity; (2) inelasticity of demand; (3) the difference between marginal cost and fixed costs; and (4) “external” or nonproduction costs of energy and fuel.

Among economists, all these ideas are well-established and non-controversial. Experts use them every day. Neither policy makers nor the public can understand the question, let alone find answers, without them.

2. Scarcity. Geologists disagree about whether we have reached “peak oil”—the point after which global oil production inexorably declines due to scarcity of untapped reserves. Some think we have; others think not. Some think (and many hope) that new technology will discover unlimited sources of new cheap oil. Part of the reason for the recent extreme volatility in oil prices is uncertainty over how scarce oil really is.

But economists and policy makers don’t have to worry about degrees of scarcity. You can make considerable progress in your thinking by defining “scarcity” much more simply. A commodity is “scarce” if its supply is limited over time scales of interest for current investment.

That is definitely true of oil. Investments in pipelines, refineries and drilling (especially the deep and undersea drilling now required to reach yet untapped oil), are designed to last several decades. Typically they are supposed to last thirty to forty years.

No one expects oil to act like an unlimited commodity over that time frame, especially not as BRIC countries double or triple their usage and global population expands by 50%. Geological processes take millions of years to produce new petroleum, and what we have on Earth now, wherever and however deep it may be, is what we’ve got. Oil is scarce in the sense of not being unlimited over reasonable investment time scales.

What about the alternatives? At the moment, the U.S., China, Australia and Eastern Europe all seem to have reserves of coal sufficient to last a century or more. That’s more than typical investment time, so coal is not scarce. The same can be said, with somewhat greater uncertainty, about natural gas.

Wind and solar power are even more unlimited. Based on then-current technology, with appropriate storage a set of solar thermal power arrays [see paragraph before heading “Replacing Oil”] equivalent to one twenty-ninth the land area of Texas could have supplied our entire national electrical power requirement for 2005-2006. Furthermore, both solar and wind power are in their infancy: wind power is just beginning to reach [search for “Global Wind Power”] its global exponential growth phase, and solar hasn’t yet seriously begun. For practical purposes of present investment, wind and solar power are unlimited, i.e., not scarce.

Nuclear and biofuels require more nuanced analysis. Properly designed “breeder” reactors can make their own nuclear fuel, forever. But for two reasons, no one is designing or building breeder reactors any more. First, the chief breeder fuel—plutonium—can make fissionable material for nuclear weapons, without expensive refinement or purification. Plutonium fuel is a proliferation nightmare.

Second, quite apart from its weapons potential, plutonium is one of the most dangerous substances known to humankind. As a heavy metal, it is highly toxic, much more so than lead. With its radioactivity, it is so poisonous that inhaling a single particle can cause lung cancer. Not for nothing is plutonium named for Pluto, i.e., Hades and Hell.

So current plans for expanding nuclear power rely on enriched uranium for fuel. Although toxic, too, it’s not nearly as bad as plutonium. And uranium enriched for power plants requires additional enrichment for nuclear weapons. So compared to plutonium, uranium is a much safer alternative.

Unfortunately, uranium is much like oil insofar as scarcity is concerned. We know that its quantity in the earth’s crust is limited, but we don’t yet know just how much there is. The deposits we know of are localized in certain countries, mostly outside the developed world, in places like Niger. So transportation cost and political risk add to the element of scarcity. Therefore nuclear power, practically speaking, is a scarce commodity, although probably not as scarce as oil.

Biofuels are also scarce, i.e., limited, because they require land, fresh water and energy to grow. The Earth’s land area is finite, and its arable land even more so. Most of the arable land is already spoken for; we use it to grow crops for food. In addition, biofuel crops take fresh water to grow. Even switchgrass, although it needs less water than corn, takes energy to plant, fertilize, irrigate, harvest, and pulp its cellulose, as well as to grow and handle the enzymes or genetically modified bugs that convert raw pulp to usable fuel. Like land and fresh water, most of these resources are limited.

This point is not just theory. Most economists believe that last summer’s anomalous global spike in food prices reflected futures markets digesting plans for diverting agricultural land from food to fuel production. Those markets’ anticipation had a predictable effect on food prices. No doubt they overshot, as they often do. But the effect was real and to be expected. Biofuels are scare in the sense of relying on limited resources—land, fresh water, and other fuels. In any foreseeable future scenario they will remain so: they will compete with scarce food for land, fresh water and agricultural investment and energy.

3. Inelasticity of supply and demand. The second fundamental concept that should guide our energy choices is inelasticity of supply and demand. A commodity is said to be “inelastic” if small changes in its supply or demand cause big changes in market prices. That happens when there are few or no substitutes for the commodity and consumers’ costs of switching to substitutes are high.

For demand, I’ve explained this concept in detail in another post. It’s actually quite simple. If you’ve spent $40,000 on a big SUV that runs only on gasoline, you have no choice. You can’t switch to substitutes like ethanol or diesel because they’ll ruin your engine and devalue your $40,000 investment.

You might take public transportation, but it is inconvenient and, in many parts of our country, unavailable. So you’ll pay whatever gas costs to get to work to earn a living. As gas prices rise, your only alternative is to write off your $40,000 investment and buy another form of transportation.

But you may have noticed that, except for the Prius, other forms of transportation are not exactly ubiquitous. So, at a very personal level, your demand is “inelastic.” You buy gas, whatever it costs, or you stop going to work and taking your kids to school, i.e., you stop living.

This sort of inelasticity is exactly what has yo-yoed prices of oil and gasoline over the last several years. The price of a barrel of oil has gone from $40 to nearly $150 and back again. That’s nearly a factor of four!

During that time, what changed? Human population certainly didn’t go up and down by a factor of four. Nor did the number of cars worldwide, which is slowly but steadily increasing.

What caused the rise was slow but steady increases in global automobile production and usage, with further increases expected. The percentage increases were in the low single digits. Yet they caused price to vary by a factor of four. That’s inelasticity!

Now that the global economy is slowing, futures prices have dropped dramatically. But actual demand for oil is only beginning to slow, so far by only one or two percent. Futures markets, which are predictive and often overshoot, are telling us the very same tale of inelasticity: little changes in demand produce big changes in price because demand is highly inelastic.

Supply is also inelastic because oil is scarce. Even if it weren’t scare, new sources of gasoline (oil wells, pipelines and refineries) take decades to bring on line. And there is also the ever-present factor of geopolitical risk, include war and terrorism in the Middle East.

Inelasticity relates intimately to substitution and scarcity. Your personal demand for gasoline is inelastic because your car won’t run on any other fuel. You have no substitutes. At the same time, the supply of gasoline is inelastic because oil is scarce. Even Saudi Arabia can’t ramp up production indefinitely or immediately, even to exploit oil prices near $150 per barrel. So you suffer and pay the price, economizing in other areas, even food. That’s inelasticity!

Now imagine that you had a “flex-fuel” car, which could run on either gas or ethanol. As the price of gas rose, the price of ethanol would constrain your cost of transportation. If a gallon of ethanol cost less than a gallon of gas, you could switch. But as we have seen, biofuels are also scarce, so in the long run that might not be much of an improvement.

Now suppose your car could run on electricity, by charging good batteries. Then you could run it on wind, the sun, hydroelectric power, coal, nuclear energy, natural gas, or even geothermal energy. Your options to satisfy your demand would be vastly increased, the more so because the supply of some of these sources (especially the wind and sun) is not scarce. And supply would be flexible, i.e., not inelastic, for the same reasons.

Whatever source of energy was cheaper, you could use. That in a nutshell is why the Chevy Volt could be a transformational product, which Congress should not just save, but expedite, at all costs.

4. Fixed versus marginal cost. The third fundamental concept of energy economics is the difference between fixed and marginal cost. These terms sound complex but are quite simple.

Let’s go back to that $40,000 SUV. If it’s your only car, $40,000 is your “fixed cost” of transportation. It’s a one-time, sunk investment—a lump sum, a done deal.

Fixed costs are not easy to reduce or reverse. You could sell your SUV used, but you’d take a big loss on the original purchase price. The equivalent on the supply side (although much more expensive) is a field full of oil wells, a pipeline or a refinery. Try to sell a used oil field that is running dry, and you’ll discover what the terms “fixed” and “sunk” costs mean. (For our purposes these terms are roughly equivalent.)

Your marginal (incremental) cost of transportation is (neglecting maintenance and insurance) what you pay for gas. Let’s say you now pay $ 2 per gallon and get 20 miles per gallon. Your marginal cost of transportation is 10 cents per mile. If gas prices go up to $ 3 per gallon again, so does your marginal cost; it goes up to 15 cents per mile.

The key difference between marginal and fixed cost is that marginal cost is optional. You can’t “unbuy” your SUV. But whatever the price of gas, you can save on marginal cost by driving less. You can even cut your marginal cost for gas entirely by taking public transportation and not driving at all. But in doing so you would devalue—and eventually have to write off—your $40,000 fixed-cost investment, less what you might sell your used SUV for.

The distinction between fixed and marginal cost is absolutely crucial for making intelligent energy choices. Why? Because marginal costs vary dramatically depending upon the source of energy we choose.

Here’s where wind and solar energy shine (pardon the expression). Their marginal cost is zero because the wind and sun are free.

Not only that: once society has incurred the fixed cost of building a grid to take wind and solar power to cities, the costs of transportation are free, too. Electrons glide to market on their own Coulomb forces; they don’t have to fill up their tanks with costly fuel. In contrast, oil, gasoline, natural gas, uranium—even biofuels—require effort, energy and transportation at every stage from extraction to use. Transportation of heavy liquids or volatile gases is a significant part of their marginal cost.

There are small costs for maintaining windmills, solar arrays and electric grid. But we can safely ignore them for first-order analysis. They are a drop in the bucket compared to the cost of extracting, processing, storing, safekeeping (especially nuclear fuel), transporting and marketing physical fuel. Because electrons don’t weigh anything and transport themselves, nothing can compare to electricity in minimizing marginal cost. And nothing can compare to means of generating electricity that, like wind and solar power, don’t require any fuel.

There are other “free” sources of electricity besides wind and sun. Hydroelectric, geothermal, and tidal power are among them. But unlike wind and sun, these sources are localized and limited geographically and therefore scarce. Wind and sun are ubiquitous and, at our current stage of human development, virtually unlimited.

In comparison, the marginal cost of fuel-based energy is much higher, whatever the fuel. Moreover, scarcity increases the financial and practical risk of fuel costs. As demand inevitably increases with population growth, scarcity (defined as limited supply) produces steadily increasing prices. Equally important, uncertainty of supply—including political risk and varying “guesstimates” of actual reserves—mean increasingly wild price fluctuations as futures markets guess at a continually changing global balance of supply and demand.

To some extent these points apply to every physical fuel: oil, natural gas, tar sands, uranium, biofuels—even coal. As human population increases 50% over the next four decades, and as demand for energy increases accordingly, the price of every fuel will increase dramatically. Those fuels for which supply estimates are uncertain or varying, including oil and uranium, will experience wild price gyrations, as did the price of oil over the last several years.

In contrast, the energy value of windmills and solar arrays will depend only on long-range predictions of weather patterns, i.e., warnings of dramatic, secular changes in wind and sun. They will not include political risk in foreign lands. And because the generators will be widely distributed geographically, they will dramatically reduce the risk of terrorism to energy infrastructure. (Biofuels also have this advantage of geographic dispersion, although their scarcity will likely make their prices more volatile than those of solar and wind energy.)

5. External costs. Over the last forty years, one of the most important developments in economics has been the notion of “external” costs. These are real costs that market prices do not reflect.

Coal provides the most extreme example. The market “price” of coal reflects only extractive costs, i.e., what it takes to dig the mines, bring up the coal, and prepare it for marketing. All other costs the market price excludes.

What are these other costs? There are many. First, there is the cost of transporting coal from mine to power plant. Second, there are the immediate environmental effects of mining, including displaced soil threatening mining towns, burying local streams, and polluting local aquifers, plus the cost of harm done by local air pollution produced directly by mining operations. Third, there are health effects on miners and their families, including injury, death, and things like “black lung” disease, which proper mining operation can reduce but never eliminate. Coal mining is still one of the most dangerous occupations in the civilized world.

Fourth, there is sulfur dioxide pollution (which forms sulfuric acid when combined with water, as in rain or fog). There are children’s asthma and its treatment, other respiratory diseases, and “acid rain” throughout our northeast, which federal regulation and interstate compacts are just beginning to get under control after decades of effort. Fifth, there is mercury pollution, which poisons our rivers, lakes and oceans. Coal-generated mercury already has required warnings against pregnant women eating too much tuna and anyone eating too much sushi. Sixth and most important, there is global warming, with all its implications for climate change: rising sea levels, increasing severity of storms, increasing drought, the relentless march of tropical diseases northward (or in the southern hemisphere southward), the loss of ice habitat for native people and animals in polar regions, the imminent loss of low-lying tropical land in the Maldives and South Pacific, and the possibility of mass human migration and war caused by the submergence of low-lying areas worldwide.

It’s hard to put a price on all these many consequences of burning coal. It’s even harder to put a price on millions’ loss of life’s enjoyment as pollution increases, mosquitoes and other disease-bearing pests move into densely inhabited temperate urban areas, and poverty and desperation increase worldwide while we lose low-lying arable land and coastal areas to a rising sea.

All these costs are real or imminent. Proposals for so-called “cap and trade” carbon credits or a “carbon tax” are designed to monetize them and include them in our market pricing system, so that the market prices of coal and other fossil fuels reflect all their costs, including societal and long-term costs.

Yet even these proposals don’t account for all external costs. A carbon credit or carbon tax, for example, would treat coal the same as oil or natural gas, despite that fact that burning oil or natural gas does not create significant sulfur dioxide or mercury pollution.

So far, complete estimates of various energy sources’ external costs are only educated guesses. But we can say three things about these costs. First, for coal and other fossil fuels, they are huge. Global warming, which threatens to remake the planet on which we evolved, are among them. Second, they are highly uncertain. Most current estimates are likely to be low because there are so many possible consequences and so few of them can be quantified. (Quantitative analysts tend to ignore things they can’t quantify, just as the derivatives ratings agencies ignored the risk that housing prices wouldn’t keep going up.)

Finally, while we cannot estimate external costs precisely, we can prioritize our energy alternatives in terms of descending external costs. Coal has by far the most deleterious and wide-ranging external costs. Other fossil fuels, which pollute less but still produce carbon dioxide, are second worst. Oil is worse than natural gas because it produces hydrocarbon smog while natural gas does not.

Nuclear power produces no air pollution or carbon dioxide, but it does produce a small amount of radioactive solid waste requiring transportation and careful disposal. Biofuels should produce little or no air pollution; they do not contribute to global warming because the carbon dioxide produced by this year’s burning is taken up in growing next year’s crop. Yet biofuels increase the prices of land and food as they usurp resources used for food agriculture. They also generate some incidental air pollution and carbon dioxide as they use fossil fuels for agriculture and transportation. That, too, is an external cost.

“Natural” means of producing electricity have by far the lowest external costs. They produce no pollution or carbon dioxide whatsoever. Hydropower may disturb riparian fish migration, as is happening with salmon in our Pacific Northwest. Geothermal energy may release subterranean sulfur dioxide and hydrogen sulfide. But wind and solar produce no pollution and disturb nothing except views of sagebrush and (absent simple precautions) maybe some particular paths of migratory birds. Thus wind and solar power “win” the external cost comparison hands down.

5. Comparison Table and Conclusion. We can now summarize this discussion in the following table:

Marginal Cost3Uncertainty4External Costs5Reliability6
WindLowLowZeroLowVery lowHigh
HydroHighHighZeroMediumVery lowHigh
OilHighVery HighMediumVery HighMediumLow

1.“Scarcity” means the extent to which supply is or will be limited in the relevant time frame for investment. Lower is better.
2.Solar and wind have low supply inelasticity because their power arrays are infinitely scalable and quick and cheap to site, permit and build. Biofuels have low inelasticity because there is always room to grow new crops. (Displacement of food crops is a factor in “Marginal Cost,” “Uncertainty“ and “Reliability.”) Lower is better.
3.Marginal cost of producing a unit of energy, including fuel (if any) and transportation and labor costs, but excluding the cost of maintaining plant and infrastructure. Lower is better.
4.Uncertainty in marginal cost, including temporal uncertainty, medium-term economic uncertainty and geopolitical risk. Lower is better.
5.Complete assessment of external costs, including all forms of pollution, health effects, global warming, and probability-discounted catastrophic effects, such as nuclear-plant terrorism or meltdown or radioactive storage leak. Lower is better.
6.Medium-term reliability of supply. Reflects similar factors to “uncertainty” but focuses on risk of severe supply disruption. Higher is better.
7.Assumes uranium-based fuel cycle; plutonium fuel cycle is deemed too risky for widespread use.
8.The primary factor here is not accidents, but the cost of uranium. It takes 15-20 years to design, site and build a nuclear power plant. No one knows what the price of uranium will be at the end of this long process. Changes in the global market could render an investment made fifteen years earlier uneconomic, before any power is generated.

* * *

As this table shows, wind and solar energy beat the other sources in almost every respect. They are so superior that you wonder why we aren’t already engaged in a massive program to exploit them.

The only disadvantage of wind and solar is that they are intermittent. Wind doesn’t blow all the time, and the sun doesn’t shine at night or every day.

But there are places in this country where the wind blows almost all the time, even at night. And there are also places in this country, including most of New Mexico and Texas, where the sun shines about three days out of four. We know where those places are, and we can build our windmill and solar arrays there. The only thing that might shut them down for extended periods is (God forbid) a nuclear winter.

As for routine intermittency, there is a simple answer. We are already using the worst possible fuel—coal—to make over half our electricity. Until wind and solar power reach that same fraction—half—of our power needs, we can simply use them, however intermittently, to replace coal. Every kilowatt-hour made by sun or wind is a kilowatt-hour for which we don’t have to burn coal (or even natural gas), with all its horrendous direct and indirect consequences, including asthma, acid rain, mercury pollution and global warming,

It will be a decade, at least, maybe two, before we get to the point where wind and solar replace coal and other fossil fuels, even just for electric power. We don’t have to worry about intermittency until we get near that point. By the time we do, we will probably have good batteries to solve the intermittency problem decisively. And as soon as we have good batteries in plug-in hybrids like the Chevy Volt, wind and solar power can start replacing oil as the energy source for transportation, too.

Millions of laptops, iPods and cell phones use nontoxic, nonpolluting lithium-ion batteries reliably right now, today. It is only a matter of time before we scale them up for commuting and household use. The nation that first does so will have a jump on what is likely to be one of the biggest markets of the twenty-first century.

A final advantage of wind and solar power—which does not appear in the table—is that investments in them are infinitely scalable. They can run from a single windmill or small solar array for a little town to a massive array for a city. Whatever their size, their low level of danger and environmental impact mean that siting them and assessing environmental effects will proceed quickly. In many cases the permitting process can take months, as compared to years for coal-fired power plants and decades for nuclear plants. Wind and solar are fine technologies for quick-start, geographically dispersed power generation.

So we have a clear glide path to energy independence with zero pollution, zero marginal cost (except maintenance), and the lowest external costs of any known energy source. Any rational business person, policy planner or economist would take that opportunity and run with it.

That’s why President-Elect Obama has emphasized wind and solar power throughout his campaign and does so now. (Whether his new energy man, Steve Chu, overemphasizes biofuels is another issue, which I’ll address soon.) Did I mention that Obama has strategic vision?


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