Alone in the Wilderness

I’ve been thinking a lot about risk tolerance and discount rates lately, and how they profoundly shape our perception of the economic costs associated with minimizing climate change.  Basically… if you’re willing to vary your preference for the present over the future or the level of uncertainty you’re willing to accept, then you can make mitigation cost whatever you want.  All else being equal, low discount rates and low risk tolerance make taking action cheap, while high discount rates and high risk tolerance make it expensive.

Unfortunately, we live in a society with high discount rates and high risk tolerance.  Or at least, that’s what you’d infer from our collective behavior.  It’s also what you’d gather from a lot of the rhetoric around climate action, and our obsession with trying to make it “economically efficient”, to the point of maybe not doing it at all.  Our risk tolerances and discount rates aren’t really objectively measurable.  They are fluid, and context sensitive.  The same person in different situations will not behave consistently.  Different people in the same situation may come to different conclusions.  How we deal with uncertainty and the value of the future is a personal as well as cultural decision.

For some reason, I find myself with a low pure time preference, and an aversion to many kinds of risk.  This is part of why I find our unwillingness to act on climate infuriating, and why I’m working on climate policy.  I got to wondering, how did I end up this way?  Why isn’t it more common?

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Climate Change and the Insurance Industry

http://flickr.com/photos/that_chrysler_guy/8139133299/

As the entire eastern seaboard slowly recovers from its lashing by Sandy, insurance companies are bracing for the hurricane’s aftermath and the possibility of another Katrina-scale loss.  If there’s any major incumbent business with an incentive to publicly acknowledge the risks and costs of climate change, it’s the insurance industry, and especially the re-insurers — mega-corps that backstop individual insurance companies by pooling their risks globally.  These companies can do the math, and what they’ve seen over the last couple of decades is a steady upward trend in both the number of extreme weather events and the resulting insured losses that they’ve been on the hook to cover.  The situation is well summarized in a new report from Ceres, entitled Stormy Futures for U.S. Property/Casualty Insurers.  They suggest that insurers face an existential risk from climate change.

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Could utility ratepayers be paid to accept fuel price risk?

Risk isn’t free; it’s a traded commodity with a price.  Most prudent financial entities with a lot of exposure to the prices of natural resources try to manage unpredictable fluctuations in those prices by trading in risk.  Producers worry about prices being too low; consumers need to protect against prices being too high.  Risk trading (hedging) allows the two types of parties to share these risks, and so create a more stable market overall.  Stable prices are good for business.  You can plan around them in the long term, even if they end up being a bit higher on average.

In regulated electricity markets like we have in Colorado, fuel price risk often ends up being borne primarily by the rate payers rather than by the utility companies.  In theory, state regulators ought act on behalf of the public (energy consumers) to accurately represent their tolerance of or aversion to risk in the resource planning process.  Historically, the implicit assumption has been that the rate paying public is fairly risk tolerant, i.e. very little has been done from a regulatory point of view to avoid the potential detrimental effects of future fuel price volatility.  This is a historical accident.  Until recently, we didn’t have much choice in the matter.  Of all the major sources of power available a century ago when we began electrifying society, only hydroelectric is similar in terms of its capital and operating structure to distributed renewables like wind and solar.  All three have relatively large up front capital costs, and low ongoing operating and maintenance expenses.  But for most of the time we’ve had electricity, most of that electricity has necessarily been dependent on fossil fuels, and so the question of whether or not customers wanted to take on the risk of future fuel cost fluctuations was immaterial.  Fuel was the only option for expanding our electricity supply once we’d tapped the easily accessible hydro — if you wanted lots of power, it simply came with fuel price risks.  This is no longer the case.  Today, we have options that trade off between cost and risk, but so far as I can tell we haven’t done a good job of talking about the entire spectrum of possibilities.  Broadly they seem to fall into four categories:

  1. Traditional fossil fuel-based power, that exposes rate payers to the full range of future price fluctuations.
  2. Capital intensive, fuel-free power like wind, solar, enhanced geothermal and hydro which have a range of prices, that are very predictable over the 20+ year lifetime of the capital investment.
  3. Fossil fuel-based power that is aggressively hedged, in order to protect rate-payers against future fuel price fluctuations.
  4. Fuel-free power with predictable future costs, combined with someone else’s fuel cost risks, which rate-payers would be paid to take on.

The first two options are the most commonly discussed.  The third — hedged fossil fuels — is becoming somewhat more common, with some public utility commissions requiring the utilities they regulate to dampen fuel cost fluctuations.  However, they generally do not require the utilities to hedge to the point where the risk profile of the fossil fuel option is similar to that of fuel-free power sources.  This is what makes the fourth option interesting.

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Hot Air About Cheap Natural Gas

When people compare the cost of gas-fired electricity and renewables, they usually don’t price fuel cost risks, and at this point that’s really just not intellectually honest.  Risk-adjusted price comparisons are very difficult because nobody will sell a 30 year fixed price gas supply contract, and that’s what you’d need to buy to actually know how much your gas-fired electricity will cost.  Even a 10 year futures contract doubles or triples the cost of gas.  You can’t buy renewables without their intrinsic fuel-price hedge, and that hedge is valuable.  The question shouldn’t be “Is wind the absolute cheapest option right now?” it should be “Given that wind will cost $60/MWh, are we willing to live with that energy cost in order not to have to worry about future price fluctuations?”  And I think the answer should clearly be yes, even before you start pricing carbon.