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.

Climate Change is about Conflict

In various ways during and after college, I’ve worked on climate change. In fact, it’s pretty much the defining issue of my life and career thus far. For a long time, I might have had a hard time explaining exactly why it was that I cared about it. And outside of my professional circle, many people I know have a hard time envisioning exactly what it is about climate change we should care about. Yeah, there are big hurricanes and disasters like Sandy and Katrina, and extreme weather events like cold-waves and heat-waves that seem to be more common these days and that are beginning to impact the day-to-day of people around the world, but overall it’s something that is very hard to observe. But my logic was simpler and more abstract: that humans and our economy evolved on Earth under a broad set of climatic conditions; changing those conditions at our current scale and pace just seemed like a Bad Idea, and would manifest itself in broadly lower living standards around the world.

But now, I would characterize my concerns about climate change in one word: War.

I am not an expert in human conflict, but it appears broadly true that migration and struggles over resources are two of the most important ingredients in catalyzing strife at all scales. If you have trouble thinking of examples where resource conflicts caused human conflict, look no further than the current situations in Darfur and Syria. In both cases, droughts caused shifting resources and displaced peoples, and brought two groups of people into conflict.

In Darfur, a long period of low rainfall and advancing desert pushed Arab nomads into land held by black farmers, and the result over time was a major escalation into war, political collapse, and further ecological collapse triggered by conflict that resulted in up to half a million dead and scores of violent atrocities that will scar the region for a generation, and leaves a permanently unstable situation. [more info]

In Syria, a major drought over the years 2004-2011 caused almost a million Syrian farmers to lose their livelihood, and many of them abandoned their land. As much as 85% of all livestock died and major crop failures were common. Displaced farmers moved into cities at massive scale, and these people were at the brink, with no jobs and food shortages common throughout the country. In combination with a corrupt government and ethnic tension, the scene was ripe for conflict, which exploded in 2011 and shows no signs of abating. [more info]

In both cases, exacerbating factors were present, and it would be foolish to say that climate change was the only factor behind the conflict. Rather, it was one of many ingredients, amid sectarian and racial tensions, corrupt or failed states, and poverty, that sparked the conflict, and indeed it’s because these conflicts are so complicated that they have been difficult to untangle and end. But the connection is clear: changes in local climates caused resource shifts and movements of people that, under the right (or, rather, wrong) conditions, led to major conflict.

In both cases, droughts began a fairly straightforward, and short, sequence of events that led to conflict. But it doesn’t matter how long and complex the chain is, if climate changes cause something that causes something that causes something, and so on, that causes something that causes conflict, the changes to the climate are still culpable.

So the things that really scare me about climate change are things that won’t necessarily appear to be caused by the climate, like the two examples listed above, along with broadly lower living conditions, but quite unlike news-grabbing events like the Polar Vortex, Sandy, Katrina, the 2013 European Heat Wave, and so on.

I fear that changing, and in many cases deteriorating, conditions will be manifested, and punctuated, by human conflict at scales ranging from minor to massive.

I’ll conclude with a development that I consider to be evolving into situation with violent potential: potentially massive Bangladeshi migration caused by sea level rise. But as I quoted recently:

So perhaps what scares me most are the situations that we haven’t yet envisioned. All we need to know is that we’re adding more of the wrong ingredient.

Bangladesh is the most densely populated country in the world, with 150 million people crammed into an area the size of New York State. It also lies in lowlands, and a 1 meter rise in sea levels would flood about 10% of the land. Clearly, with so many people in such a small area, this would create problems. In addition, many people don’t know that Bangladesh used to be “East Pakistan”, or the eastern of two predominantly Muslim regions of the former British colony, and it shares with modern India (Bangladesh’s neighbor) and Pakistan in their violent history. It’s not hard to imagine a scenario where sea level rises (among other negative climatic changes) cause massive displacements of people in a context that cannot support that other than violently.

Intergenerational discount rates

I’ve been idly wondering about how philanthropic behavior and the saving patterns of parents should influence our understanding of intergenerational discount rates. It seems that when people do selfless things for their progeny, or simply for posterity, they are exhibiting very low to zero intergenerational discount rates; at the very least it seems to complicate the transition between investment preferences within an agent’s life and those across human generations.

Why have I been thinking this?

These days I’m working on a project that’s being billed internally as a follow up to the highly influential Stern Report, which was commissioned by the UK government and published in 2006. In a nutshell, the Stern Report attempted to understand the scale of climate change as a market failure.

Although our understanding of the science is always evolving, climate change is often understood as a problem that has causes today, and effects later on. There is thus the immediate challenge of comparing temporal apples and oranges – how do you compare the benefits of the causes with the damages of the effects if they don’t happen at the same time?

For economists and most social scientists, the answer is discount rates. Conceptually, discount rates “discount” the future – i.e., between $1 today and $1 in a year, we’ll value the $1 today higher than the $1 in the future – for a variety of reasons: the future is uncertain, for example, we may never get that $1; there are productive investments available – if you give me a $1 today there is a good chance I can turn that into more than a dollar by investing it; and other reasons as well.

The question – the $1,000,000 question – is what the discount rate should be. A very low discount rate values the future almost as highly as the present. A high discount rate amplifies the present significantly – future payoffs or costs will barely register.

The application to an economic understanding of climate change should be immediately obvious. If the causes (the production of goods and services – good things) are today, and the effects (destructive weather and climatic effects – bad things) are tomorrow, the choice of a discount rate will completely determine whether or not we should adjust our path.

The biggest critiques of Stern Report were that they chose a very low discount rate. They had good reasons, but many economists essentially pointed out that they were begging the question. Yes – with a low discount rate, Climate Change is Bad. Their contribution was essentially to estimate the scale of the market failure at their very low discount rate.

At the same time, my own thoughts have been changing rapidly. I used to be on the carbon price everywhere train – but it appears that this is not politically feasible. Carbon prices may be possible – i.e. through things like gas taxes or permitting fees that effectively collapse to an economy-wide price on carbon. But personally, I’m now turning towards technological progress as the only feasible source of solutions to GHG emissions. That has different policy implications that I’m only beginning to grasp beyond “let’s spend a lot of money figuring it out”.