Facing the Risk in Fossil Fueled Electricity

I recently wrote about how our risk tolerance/aversion powerfully affects our estimation of the social cost of carbon, but obviously that’s not the only place that risk shows up in our energy systems.  Fossil fuel based electricity is also exposed to a much more prosaic kind of risk: the possibility that fuel prices will increase over time.

Building a new coal or gas plant is a wager that fuel will continue to be available at a reasonable price over the lifetime of the plant, a lifetime measured in decades.  Unfortunately, nobody has a particularly good record with long term energy system predictions so this is a fairly risky bet, unless you can get somebody to sign a long term fuel contract with a known price.  That doesn’t really get rid of the risk, it just shifts it onto your fuel supplier.  They take on the risk that they won’t make as much money as they could have, if they’d been able to sell the fuel at (higher) market rates.  If the consumer is worried about rising prices, and the producer is worried about falling prices, then sometimes this can be a mutually beneficial arrangement.  This is called “hedging”.

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The Myth of Price

Our society’s prevailing economic zeitgeist assumes that everything has a price, and that both costs and prices can be objectively calculated, or at least agreed upon by parties involved in the transaction.  There are some big problems with this proposition.

Externalized costs are involuntary transactions — those on the receiving end of the externalities have not agreed to the deal.  Putting a price on carbon can theoretically remedy this failure in the context of climate change.  In practice it’s much more complicated, because our energy markets are not particularly efficient (as we pointed out in our Colorado carbon fee proposal, and as the ACEEE has documented well), and because there are many subsidies (some explicit, others structural) that confound the integration of externalized costs into our energy prices.

The global pricing of energy and climate externalities is obviously a huge challenge that we need to address, and despite our ongoing failure to reduce emissions, there’s been a pretty robust discussion about externalities.  As our understanding of climate change and its potentially catastrophic economic consequences have matured, our estimates of these costs have been revised, usually upwards.  We acknowledge the fact that these costs exist, even if we’re politically unwilling to do much about them.

Unfortunately — and surprisingly to most people — it turns out that understanding how the climate is going to change and what the economic impacts of those changes will be is not enough information to calculate the social cost of carbon. Continue reading The Myth of Price

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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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

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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.

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.