The risk dividend of renewable energy

Avoiding catastrophic climate change will require a transition of our energy system. Policymakers around the world spend their time look at different options for how this might be effected. They look at the rate of technological progress and the lessons of different policy experiments that have been tried around the world. The most important thing they care about is cost, or how much in goods and services we’ll have to give up in order to make this transition.

One emerging point is that renewable energy has a largely-hidden, but potentially huge, benefit. It is much lower risk than fossil fuel based power, and at a systemic level this could be a huge benefit to the economy. I’ll explain both below. (This is a very rough draft intended mostly to get my own thoughts in order).

First, we have to go on a tangent and discuss the role of risk and price in an economy. It is a truism that risk and return go together (i.e., with high returns comes high risk), so it is often stated that risk is a good thing, but this is a misleading conclusion. Risk is not good per se. In fact, thinking of high returns as coming with high risk is actually a complete reversal of the process that leads to that fact: what happens is that for an investment that promises returns at low risk, the price will get bid up until the returns are low as well. Investors are paying to avoid risk. Therefore, with all of the low risk investments promising low returns, the investments that offer high returns must therefore also have high risk. While risk itself is not a good thing (it comes with good things, namely high returns), it’s clear that the ability to take risks is a good thing, as you can more easily go after high return investments.

So what does this have to do with fossil fuels and renewable energy? Fossil fuel investments are very high risk. It’s not uncommon for an upstream oil and gas company to sink multiple billions of dollars into a well and have it not produce. There’s also a huge amount of geopolitical risk; Venezuela, Nigeria, Russia, Iraq, and Iran are major energy power. Finally, there’s simple market risk, which has to do with the highly complex interplay between investment and demand, leading to periods of over- and under-supply. This is part of the reason that fossil-fuel concerns generally make high profits – they are in a high risk business, so the profits have to be high to keep them in business.

Coal or natural-gas fired power plants are exposed to these risks through volatile input prices for the fuel, which they must absorb. Renewable energy, by contrast, does not have to absorb this risk or anything like it. The input risks for wind- and solar-powered electricity are very small. They exist only in the initial estimation of the resource, and our techniques here have gotten quite good. When an investor plunks down her money for a solar-generation project, she has almost complete knowledge of how much it will produce over the the life of the project. And since financing costs make up 90% of the costs of this investment (since operating costs are minimal, as there are no fuel purchases), the entire cost structure of the investment is known beforehand. There is qualitatively less risk for renewable energy relative to fossil-fuel-powered generation, as renewable energy does not have input price risk. Financing costs for renewable energy are declining as investors become comfortable with the asset class, and business models emerge to allow more leverage in these investments.

What would be the benefit of taking this risk out of the system? Concretely, it would mean that all of the “risk capital” in the energy system – capital that investors put up, knowing they might lose it all – would be freed up and able to put to other uses. Instead of investors looking to the global energy system to take on risk and hopefully make a large return, they’d reallocate their ability to take risk to other sectors of the economy.

So in the first order, reduction of risk for renewable energy investments should lead to lower capital costs, which will help them compete with fossil fuel generation. In the second order, risk reallocation should have some sort of positive dynamic effect in the economy, where the ability to take risk is freed up and put to use elsewhere.