Published On: Thu, Oct 25th, 2012

Establishing a price floor for energy

Capitalism is a wonderful system for providing pricing signals to businesses to produce more or less of a particular product.

If demand for the new iPad mini is strong, Apple will order its suppliers to produce more sub components, its assemblers to assemble more devices and it will then ship them to eagerly awaiting customers.  Even for a company like Apple, however, there is a lag between demand and what they can supply: typically they will be planning new products 12-18 months ahead of their actual launch.  This is a real challenge for Apple’s management, who are trying to predict consumer demand for a new product. By the time of launch, other competitors could have released cheaper, superior products.

It is significantly harder in the energy industry, however, to effectively respond to pricing signals.  While consumer products have a 12-18 month development cycle, the energy sector moves at a snail’s pace and has a development cycle that lasts between 2 and 15 years.

New CCGT gas fired power stations can take 3-7 years to get planning permission and to secure financing.  Build times can take 12-24 months.  Large wind projects can take 2-5 years to get planning and financing and take 6-18 months to build. Nuclear power stations can take over 10 years to obtain planning consents, and 2-5 years to build.

And that is just for electricity generation.  Conventional natural gas and oil fields require experimental drilling, which is very expensive to do.  Most wells end up dry.  Obtaining consents can take over 10 years and a build out can take another 5 years.  An LNG terminal can take over a decade to obtain permissions and financing.

In the meantime, the overall economy can require more or less energy.  During a recession, growth in energy demand slows or even falls.  If you are power station that comes on line in the depths of a recession your early revenues could be badly hit.  In the US, natural gas from fracking has completely up-ended the energy industry.  New gas is flooding the market, driving down the price of natural gas.  This has left multi billion dollar LNG terminals that started development over ten years ago, and are only now being completed, in terrible financial trouble.  New wind projects, which were developed on the assumption that they could be built with no government subsidies as they were in good wind locations and had good wholesale power prices that they could sell their electricity to, teeter on the edge of default.  Coal power stations who have long enjoyed their role in providing the base load of electrical supply are being shut down or switched to reduced capacity, destroying the economics of these expensive plants.

As a response to this, investors shy away from building new capacity: the pricing signals show that power prices are low and are going to stay low.  In the meantime, the economy recovers, power demand goes up, electricity, oil and gas prices rise and then spike.  In places like the UK investment in new energy production is so low that the government is predicting brown outs and black outs in the years ahead. There is then a flurry of development of new power plants to respond to this demand, which will come on line 5-10 years later.

From the perspective of resource and capital optimisation, this is a terrible system and incredibly wasteful.  If you are lucky with timing, you stand to make a fortune. If you are unlucky, you will drag your investors down with you.

During the period of low energy costs, pricing signals tell companies and individuals that it is fine to be wasteful with energy.  Big gas guzzling cars and trucks are sold.  Big energy consuming houses are built, miles away from shops and offices.  Perfectly good power stations are shut down or are idled, causing bankruptcies.

Later, during the period of high energy costs, there is a flurry of new power construction, families are forced to cut back on basic needs to pay for fuel for transportation and and houses are abandoned as being too expensive to run.  Resale values of second hand large vehicles plummets, causing financial problems for lease car companies.

Beyond these specific problems, these wild pricing fluctuations mask a long term trend: with more people on Earth expecting an affluent, energy rich, lifestyle and a long term downwards trend in the availability of fossil fuels, the price of energy has only one long term direction:  up.  And since energy infrastructure lasts for 25-60 years the pricing signals at any one moment in time have an impact that can last one or two generations.

But isn’t the private sector capable of dealing with this problem?

In a word: “No”.

The reality is that most business hate uncertainty.  The post Civil War years of the 1870-1910s were arguably the most dynamic in terms of US capitalism.  There were very few rules and regulations.  Most had not yet been written.  It was the era of Cornelius Vanderbilt, first with his shipping line and then with his huge interests in the railways,   John D Rockefeller, with his Standard Oil Company, Andrew Carnegie with steel, JP Morgan with finance and Henry Ford with cars.

Each of these entrepreneurs helped to create new industrial sectors, upending existing industries and companies.  That was the exciting part.  Once they were on their way to dominance, however, their main preoccupation was with creating stability for their companies.  To do this they tried to establish monopolies and to wipe out any competition. With no competition they could obtain levels of certainty, and reduce the chances of ruin by new competitors entering their markets.

Nothing has really changed.  Established companies in established industries all like stability.  It is only through anti monopoly legislation that they are not allowed to establish monopolies.  Uncertainty is ideal for new entrants as it creates opportunities to exploit market niches that established players are likely to ignore or not be interested in.  But most companies are in established industries and they like certainty.

Which brings us back to the energy sector.  The long term trend for energy is that of higher global demand and lower global supply.  That means higher prices.

If you are a government, it makes sense to introduce government policies that help your economy get to that inevitable energy dynamic as quickly and as cheaply as possible.  Let other economies flounder around aimlessly, using pricing information that is five to ten years out of date.  Instead, government policies should be used to provide a competitive edge for national champions.  That will result in greater profits, greater tax revenues and greater geopolitical power.

So what should an aggressive, capitalist orientated government do?  The simplest mechanism is to provide price floor certainty.  This means that a government will pledge to do nothing to INCREASE the cost of energy through taxation.  However, it can provide certainty to industry by legislating that energy prices will also never DECREASE.  What does this mean in practice?

Take oil as an example (we could use electricity markets as well).  Suppose global oil markets are at $100 a barrel of oil.  If demand increases, the price of oil should increase to a higher number, $110 a barrel, for example.  Normally, as a result of increasing prices, demand should go down.  As demand falls, oil, prices should go down as well.  To $100 a barrel, for example.  Since oil and energy prices go up and down all the time, it introduces noise to the overall trend, which is higher energy prices.  When prices are low, companies and individuals will be less worried about energy costs and so will be more tempted to buy power guzzling equipment that has a low up front cost, even though it might be very expensive to run in the long term.  And since most energy consuming devices last a very long time, this could introduce long term higher energy costs to companies and individuals.

On the other hand, if the government made a signal to the market that prices would never go down, individuals and companies would always be incentivised to purchase equipment that used very little energy, resulting in a long term competitive edge over countries that did not introduce these policies.

In this scenario, if oil prices went up, due to increased demand, from £100 to $110 per barrel, everything would be the same as the business as usual example stated earlier. As a result of this, demand should go down, and prices should follow thereafter.  As with the previous example, global prices should drop from $110 to $100 per barrel.  If the government pledged, however, to tax the drop so that the price of oil to consumers never went down, individuals and companies would not enjoy that $10 drop as the government would tax oil by an additional $10 per barrel.  The maths would be as follows:  oil prices rise from $100 to $110 per barrel.  Oil prices then drop from $110 to $100 per barrel, but the government introduces an additional oil tax of $10 so oil stays stuck at $110 per barrel.

This creates three immediate potential problems: it could be seen as a stealth tax, it could make industry less competitive globally and could be a barrier to new, low cost energy sources.  All problems can be overcome.

First, it is true that it might be seen as a stealth tax.  One way of solving this issue  is that for every $1 of additional tax revenue generated by this form of taxation  $0.90 of tax is deducted from the corporation tax of the company buying the energy.  A company would add up how much their fuel bill had been for the year, the government would calculate how much of that had been due to increased fuel taxes and that amount would then be deductible against income, reducing their income taxes by a level similar to that of the as the increased costs. And why only a 90% rebate on the tax increase?  This is to incentivise companies to reduce their energy consumption.

Second, it could make industry less competitive as their energy costs would be higher than those in other countries that did not introduce this tax. This is wrong. Since the tax would be deductible against income, the net impact to the company’s post tax profit should be the same as it was without the tax.  In addition, because energy costs are a function of energy consumption multiplied by energy prices and energy prices will always be high, companies will be permanently incentivised to find ways of reducing energy consumption.  This effort to reduce energy consumption will mean that they should also be more competitive in other countries that they operate in, resulting in a permanent competitive advantage.

Third, aren’t higher energy prices a disincentive to new low cost energy supplies?  No, not at all.  If the global market price for oil is $110 per barrel and you have a way of producing oil at $90 per barrel you will see a profit of $20 per barrel.  If the global market price drops to $100 per barrel and the government imposes a $10 per barrel tax there is nothing stopping you from selling at $110 per barrel and maintaining your $20 per barrel profit.  As a result, a minimum price floor should prove a boon to new energy companies who should see significantly higher levels of profit than they normally would see, coupled with higher levels of certainty.  It will also drive significant innovation in energy efficiency as customers can reduce their energy costs by reducing their energy consumption.

This policy will introduce much greater economic certainty for the energy sector.  Energy consumers will know that the cost of energy will not go down, but that they can save money by being more energy efficient. Energy producers will know that cost reductions will result in greater levels of profit, driving innovation. Energy efficiency companies will do particularly well as anything that they sell will always drive down costs for their customers.  This certainty reduces market risk, reduces the cost of capital and thus allows for greater technical and economic innovation.

This is good for industry, consumers and the environment.

 

 

 

 

 


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About the Author

- Tristan Fischer is the author of all the articles on History Future Now. He is the Chairman of Lumicity Ltd, a company developing renewable energy infrastructure projects, Chairman of Fischer Farms Ltd, a vertical farming company using hydroponics, and a board Director of Fish From Ltd, an onshore salmon company. He previously worked for Camco International, Shell Renewables and Citigroup. He was educated at Cambridge University. If you liked this article and want to read more, the ebook edition of History Future Now, is now available from the Apple iBookstore!

  • Article: Energy policy needs to change to drive down costs, increase innovation whilst increasing certainty. Read it. http://t.co/e9tOZ5VL

  • Daniel Murray

    Daniel Murray • This is a shallow self serving attempt by an industry wanna be. How do you account for a game changing technology in this warm and fuzzy gov’t blanket you’ve wrapped yourself in? There is freedom and there is security, I choose the former.

    • Tristan Fischer

      This was discussed:

      “Third, aren’t higher energy prices a disincentive to new low cost energy supplies? No, not at all. If the global market price for oil is $110 per barrel and you have a way of producing oil at $90 per barrel you will see a profit of $20 per barrel. If the global market price drops to $100 per barrel and the government imposes a $10 per barrel tax there is nothing stopping you from selling at $110 per barrel and maintaining your $20 per barrel profit. As a result, a minimum price floor should prove a boon to new energy companies who should see significantly higher levels of profit than they normally would see, coupled with higher levels of certainty. It will also drive significant innovation in energy efficiency as customers can reduce their energy costs by reducing their energy consumption.

      This policy will introduce much greater economic certainty for the energy sector. Energy consumers will know that the cost of energy will not go down, but that they can save money by being more energy efficient. Energy producers will know that cost reductions will result in greater levels of profit, driving innovation. Energy efficiency companies will do particularly well as anything that they sell will always drive down costs for their customers. This certainty reduces market risk, reduces the cost of capital and thus allows for greater technical and economic innovation.”

  • Jim Mckirdy

    Tristan, As you are on the solar investor section of linkedin. Solar energy is a renewable source of heat and electric power. In the last 50 plus years the cost of electric energy has increased 8-10% every year. The cost of fuels have increased from 18 cents a gallon to now from $3.50 to $6.00 a gallon. The reason for this increase is cost is simple. “We are running out of fuels!”. No one will admit these facts. To prolong the oil below our earth’s crust we have added ethanol to the mix to make the world’s oil last at least 10% longer over time. Now to further incease the date when we expired all the oil we are not extracting oil from rocks or shale stone.
    The evidence is being shown to us and yet we still don’t understand that we are running out of oil. What we really need is a Energy Economy. Watch this buz phase be used by the world’s political leaders.We no longer live in the 19th century. Yet we are un-aware that oil and coal really have no future in this century. When we do run out of coal and oil our way of life will end and we will being going to burn wood and all kinds of things to make electric power. What we also need to understand that we have outgrown the world’s electrical grids. We have wireless communications yet we do not have a good handle on wireless electric power. Or do we? Electric cars are wireless. Subways are wireless. Well back to the subject. Once you take the cost of fuels out of the cost of energy then all governments will realize that they can not tax wind or solar electric generating systems. About 3 years ago solar and wind reached the levelized cost of energy. What that really means is the cost of a kW is the same as the prices or cost of electric energy 3 years ago. But since the cost of fuel and electric power keeps on increasing in end users cost on the gird’s electric cost is now 24% more cost than the cost of wind or solar. For this simple reason more and more electric power companies are owning their own wind and solar farms. Yet the customers that are on the grid keep on seeing a yearly increase in the cost of electric power. Well wind and solar do not use fuel to generate electric power and still there is a charge for fuel with every electric bill. This is going to change to home owners and businesses along with commercial and industrial sites will have had enough of the cost of energy and then the market will change again for energy. Once everyone is off the grid with their own systems the cost of oil and coal will become even more costly. The electric energy producers understand this and this is why they want to use renewable energy as their main source of generating electric power. Here are some thoughts. Do you know of anyone that wants to pay for electric power for the rest of their lives?
    Posted by Jim Mckirdy

  • Saturday Read: the UK is going to experience brown outs over the next decade. Why and what to do about it. http://t.co/e9tOZ5VL

  • Establishing a price floor for energy – Capitalism is a wonderful system for providing pricing signals to… http://t.co/xMD8bdTYd7 #HFN

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