Orphaned Wells, Wind Farms and Net Present Value

Wells left behind by industry threaten to overwhelm Western states.

Source: ‘Orphaned’ oil and gas wells are on the rise (High Country News)

A good High Country News story about the problem of orphaned methane wells in Colorado & Wyoming. Well operators “become bankrupt” and walk away, leaving the public to cover cleanup costs. In theory, operators have to put a bond up to get a permit, but the bond isn’t enough to cover cleanup costs. One operator named Atom recently forfeited a $60K bond on 50 wells, which subsequently cost the public ~$600K to clean up.  The same problem exists with reclamation bonds covering coal mines on federal land in Wyoming, except the dollar values are three orders of magnitude larger.

If the bond amounts were much larger, the money vs. time curve of a methane well or coal mine would start to look much more like that of a wind or solar installation, from capital’s point of view. Big reclamation bonds would look like part of a big up front investment, which is then followed by a long trickle of income as the mine or well produces over its lifetime.

You can slosh the costs & profits around through PPAs and other arrangements, but at a basic level, that big up front cost + long trickle of income is the fundamental cashflow time series of renewables too. Even if these different energy investments all add up to the same dollar value, the time distribution matters, because capital often just cares about net present value. (See Dave Roberts’ famous Discount Rates: A Boring Thing You Should Know About With Otters!)
From an extractor’s point of view, pushing the reclamation costs into the future makes them unimportant, because they’re discounted to the present. By the time they loom large, the true remaining value of the well or mine is already negative, with cleanup costs included. And the only rational thing to do at that point is to walk away. That’s what bankruptcy is for. But in this case, the counterparty is the public, and we have no upside risk.
The public takes on the environmental or cleanup costs of the mine or well at the outset, rather than internalizing those costs within the business decision. To put energy investments without those environmental or cleanup costs on equal footing, you’d need to give them up front or ongoing subsidies. And here we’re just talking about the traditional “environmental” costs — not the climate costs.
Half of finance and capital markets is just smuggling money through time. We can pull piles of it back from the future. Or we can exile our debts to the future. From and to those people we don’t think are us. The other half of finance seems to do the same thing with risks, extracting certainty from others, pushing uncertainty onto others, moving uncertainty through time. Trying to keep upside uncertainty, and lose downside uncertainty.

Now We’re Hedging With Wind

Price is not the only economic variable to consider in deciding what kind of generation a utility should build.  Different kinds of power have different risks associated with them.  This is important even if we set aside for the moment the climate risk associated with fossil fuels (e.g. the risk that Miami is going to sink beneath the waves forever within the lifetime of some people now reading this).  It’s true even if we ignore the public health consequences of extracting and burning coal and natural gas.  As former Colorado PUC chair Ron Binz has pointed out, risk should be an important variable in our planning decisions even within a purely financial, capitalistic framing of the utility resource planning process.

Utility financial risk comes largely from future fuel price uncertainty.  Most utility resource planning decisions are made on the basis of expected future prices, without too much thought given to how well constrained those prices are.  This is problematic, because building a new power plant is a long-term commitment to buying fuel, and while the guaranteed profits from building the plant go to the utility, the fuel bill goes to the customers.  There’s a split incentive between a utility making a long-term commitment to buying fuel, and the customers that end up actually paying for it.  Most PUCs also seem to assume that utility customers are pretty risk-tolerant — that we don’t have much desire to insulate ourselves from future fuel price fluctuations.  It’s not clear to me how they justify this assumption.

What would happen if we forced the utilities to internalize fuel price risks?  The textbook approach to managing financial risk from variable commodity prices is hedging, often with futures contracts (for an intro to futures check out this series on Khan Academy), but they only work as long as there are parties willing to take both sides of the bet.  In theory producers want to protect themselves from falling prices, and consumers want to protect themselves from rising prices.  Mark Bolinger at Lawrence Berkeley National Labs took a look at all this in a paper I just came across, entitled Wind Power as a Cost-effective Long-term Hedge Against Natural Gas Prices.  He found that more than a couple of years into the future and the liquidity of the natural gas futures market dries up.  In theory you could hedge 10 years out on the NYMEX exchange, but basically nobody does.  Even at 2 years it’s slim!

Average Volume and Open Interest in NYMEX Gas Futures Contracts

Continue reading Now We’re Hedging With Wind

Doing the Math on Climate Divestment

I just got back from the 350.org Do The Math event in Boulder.  The touring show is an outgrowth of Bill McKibben’s piece in Rolling Stone this summer, Global Warming’s Terrifying New Math.  The argument is elegant and horrifying: if we want to keep global temperature from rising more than 2°C, we can emit at most 565 more gigatons of CO2, ever.  Currently, the global fossil fuel industry’s reserves total nearly 2800 gigatons.  That carbon accounts for a substantial fraction of their overall market value, and at least 80% of it must never be extracted.  Ergo, we must necessarily bankrupt pretty much all of them, and soon.  At our present burn rate, we’ll have used up the 565 Gt allowance in about 15 years, taking us well into that part of the map where, as they say, there be dragons.

I get all of the above, and am enthusiastically in support.  However, I’m confused by the logic of McKibben’s suggested first salvo against the industry.  He is promoting a divestment campaign, along the lines of the one aimed at apartheid South Africa in the 1980s.  In this campaign, institutional investors susceptible to moral or public relations arguments — like pension funds, church congregations and university endowments — are being encouraged to purge their portfolios of fossil fuel related securities.  There seems to be widespread confusion as to what this would mean in a purely financial sense to the targeted companies.  Certainly the audience was confused, but I couldn’t tell what McKibben and the other folks on stage really thought.

So, what would happen if a major swath of the world’s institutional investors dumped their fossil fuel stocks?  Presumably, this would depress the industry’s stock prices, by reducing demand.  But would this actually hurt the companies in any way?  The simple answer is no.  Most people I talked to seemed to think that by selling stock, they’d somehow be taking money away from these companies.  That’s just not how stock works.  The only time you’re buying stock from the company itself, and giving it funding, is at the initial public offering (IPO), or, occasionally, in subsequent public financing rounds, where new shares are issued, diluting existing shares.  Institutional investors owning shares of publicly traded companies are trading with other investors, not the company itself.  You can’t go to a company and say “I want my money back” after they’ve issued the stock.  Sometimes companies that are sitting on a mountain of cash will voluntarily buy back their own stock, but this results in the value of remaining outstanding shares appreciating — you’re sharing ownership of the same business over fewer shareholders.  Buybacks are often used as a tax efficient way to return earnings to investors, since dividends are taxed as income, but share price appreciation is taxed as capital gains, and those taxes can be deferred indefinitely.

The stock price of a company that’s in financial trouble goes down, reflecting that financial trouble.  Artificially depressing that company’s stock price doesn’t induce financial trouble.  What would it do?  It would lower the price to earnings (P/E) ratio, which would increase the dividend rate.  It would make the companies with stable underlying businesses more attractive stock purchases, and in a purely financial world, other less morally encumbered investors would buy up all the dumped shares, probably severely limiting any depression of the stock price.

The fact that climate divestment won’t starve the fossil fuels industry of capital doesn’t necessarily make it a bad idea.  So what are the other potential consequences of a successful divestment campaign?

Getting churches, universities, pension funds and other institutional investors to divest would decouple their financial interests from those of the fossil fuels industry.  This might make it easier for divested institutions to take strong political stances on climate change.  At the same time, as an individual, unless you have a lot of money invested, or live in a very efficient house and refuse to drive and fly, you’re more tightly bound to the financial interests of these companies via the prices of the fossil fuels you consume, than by the prices of the stocks of the companies that produce them.

If you’re feeling optimistic, getting institutions you care about (or depend on) to divest from the carbon industry might be seen as self-interested.  If we succeed in keeping 80% of the world’s booked fossil fuel reserves in the ground, then all these companies are the walking dead.  Like the hordes of zombie banks created in the financial collapse a few years ago, in a world that rises to meet the climate challenge, they are already bankrupt — they just don’t know it yet.  If you really believe we’re going to succeed, divesting is clearly the right thing to do financially in the medium to long run.

Probably most importantly, the campaign is aimed at branding fossil fuels as a morally repugnant investment, both explicitly and by analogy with the apartheid divestment movement.  In the case of South Africa, it was successfully argued that companies taking advantage of apartheid were benefiting from a form of legalized slavery, and anybody sharing in those profits was, in some part, morally equivalent to a slaveholder.  In the case of the Carbon Lobby we’re not slaveholders, we’re waging a war on the future.  This is particularly ironic in the case of university endowments, which support the education of young people, who will live further into that war-torn future than the rest of us, and pension funds that ostensibly work to ensure we are supported in our old age, as much as 50 years hence.

Morally repugnant industries are often allowed to operate, but their political influence becomes diminished and expensive.  Unless you’re actually representing a tobacco growing district, it’s tough to stand up publicly these days as a politician and rub shoulders with tobacco companies.  Their veneer of respectability has been peeled away.  This has made advertizing restrictions and smoking bans and hefty sin taxes politically possible.  If fossil fuel extraction were broadly accepted as a repugnant transaction, would it remain politically feasible to continue spending  five times as much on fossil fuel subsidies as we do on climate mitigation?

In the case of the technology driven oil and gas development and exploration, one might hope that a successful re-branding of the carbon industries as repugnant dinosaurs waging a war on the future would make it more difficult for these companies to recruit young technologically savvy talent, at any price.  Will petroleum and coal mining engineers one day feel unable to mention their work, for fear of public shaming?

This shift in our cultural norms about whether releasing geologically sequestered carbon is morally defensible is necessary, I think, but like virtually all climate campaigns it is not alone sufficient.  Especially in the energy-intensive developed economies, shaming and shunning the fossil fuel industry must also involve some amount of self-flagellation today.  It runs the risk of guilt-tripping people whenever they buy gas or fly, or leave the coal-fired lights on in the kitchen overnight.  That guilt can induce people to tune out, if they don’t feel like they have any alternative to their “bad” behavior.

We need to aggressively create those alternatives by creating paths to high-renewable penetration electricity, building cities for people that don’t depend on cars, inter-city high-speed rail that doesn’t suck, re-solarizing our agricultural systems, requiring the highest possible building energy efficiency, and mandating closed-loop zero-waste materials systems whenever they’re possible.  We also need to make sure we brand the fossil fuel industry as other.  We need a Them.  They take hundreds of billions of dollars in subsidies every year.  They fund disinformation campaigns on climate.  They spend half a million dollars a day lobbying congress.  They are the problem, preventing necessary change, preventing us from adopting systems that don’t wage war on the future.  This otherness can forestall that feeling of short-term guilt.

This may sound like irresponsible heresy in the face of a tidal wave of consumer green marketing.  However, the vast majority of our emissions and resource utilization are systemically determined, and are not susceptible to significant change through personal choices alone.  Those necessary systemic changes are being blocked in large part by industry lobbying and disinformation.  In that arena of systemic change, which is what matters most, it really is Us vs. Them.

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.

Continue reading Could utility ratepayers be paid to accept fuel price risk?

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.

Global Warming’s Terrifying New Math

Bill McKibben looks at Global Warming’s Terrifying New Math via three numbers.  The problem at hand: if we want to limit warming to 2°C, we can only (globally) put about 565 more gigatons of CO2 into the atmosphere.  Unfortunately the fossil fuel industry already has about 2800 gigatons worth of reserves on their balance sheets.  If we are to avoid profound alteration of the climate, all those reserves will have to be written off and taken as a loss.  This will, of course, bankrupt the entire industry.  That’s the goal.  It’s them, or the atmosphere.

Colorado to preempt local regulation of oil and gas industries

Fracking site close to Platteville, Colorado

(Fracking site close to Platteville, Colorado by Senator Mark Udall on Flickr)

With the introduction of the Halliburton Loophole in 2005 the Federal government largely abdicated its role in regulating the water quality impacts of oil and gas extraction. Local governments have been forced to step up, and communities in Colorado has been at the forefront of that effort. Routt County now requires stringent baseline water quality testing (PDF) before development can begin, and monthly re-testing during operations. The city of Longmont has banned all surface pits (PDF). The oil and gas industry is striking back against these efforts, with Colorado Senate Bill SB12-088 (PDF) which would preclude local governments from regulating oil and gas operations. If passed, this bill would slam the door on any potential regulation of fracking on our county open space lands.

A messy patchwork of different regulations in every little jurisdiction would be costly and legally dangerous for the oil and gas industry. The credible threat of such a patchwork is one of the few points of leverage we have, to get them to accept reasonable regulations at the state or national level.

If you’d like to retain the right to regulate — locally — the activities of these industries then please call and write the Senate Local Government Committee listed below. You may also attend and testify at the public hearing on the bill if you wish: Thursday, Feb. 16th at the Capitol Building, Senate Committee, Room 353, likely between 9:15 and 9:45am.

Capitol Phone: 303-866-4875
E-Mail: joyce.foster.senate@state.co.us

Capitol Phone: 303-866-4873
E-Mail: jeanne.nicholson.senate@state.co.us

Capitol Phone: 303-866-4852
E-Mail: irene.aguilar.senate@state.co.us

Tim Neville
Capitol Phone: 303-866-4859
E-Mail: tim@nevilleforcolorado.com

Capitol Phone: 303-866-4884
E-Mail: ellen.roberts.senate@state.co.us

(h/t NRDC Switchboard and Colorado 350, also posted at The Boulder Blue Line)