Energy Futures: an Economic Framework and Some Policy Implications

Keywords: Environment & Resources; 


This is a response to the IPS Bio-fuels seminar series of July-August 2006. It is is both a reflection of what I learned and an attempt to put it in an economic framework.

It may be useful to begin with a little of my view of economics. At its best it offers the opportunity to think systematically about some problems (typically involving resources). Most resource debates use an economics framework. What distinguish the useful from the unhelpful is the good or bad economics. The latter arises not just because the advocates dont understand the economics they are using, but often they are pushing economics beyond what it can say, perhaps to give a policy outcome they desire. In fact economics rarely gives decisive policy conclusions. It is at its best when it eliminates the bad arguments which often riddle policy debates.

This paper is about the likely long run energy use and some policy implications. While trying to set down the framework clearly, I have had to make a number of technological assumptions and forecasts outside my competence, and which have not been entirely resolved by the seminar. Hence the analysis is riddled with caveats. But the framework is robust, I think.

The World Energy Economy

Any analysis of New Zealand starts with the state of the world. So we begin here by observing that sometime in the future (there seems little agreement of when) the production of oil will peak.

As a consequence of the peaking, the price of oil will rise too. This will encourage production from more marginal oil reserves and lead to some reductions in the demand for oil. (That is while the demand schedule remains constant, the actual amount purchased will shift up the schedule – the curve – to a point of lower consumption.)

A third important response from the higher price is that alternative transport fuels will become commercially viable. The price at which they become viable sets a sort of cap on oil prices. (I say ‘sort of’ because oil is used for a number of purposes including diesel, petrol and avgas. That the alternatives may be better at producing some fractions than other complicates the analysis.)

Evidence was given to the seminar that bio-petrol should be available in the not too distant future at a price equivalent to oil in the range from $US70 to $US80 a barrel, say $US75. (At current world prices: it will rise with inflation.) Allowing for the above mentioned caveats in relation to the fractions of oil, this sets a long run limit on the normal price of oil. ( It would be great to have some firmer consensus on the figure.)

This $US75 price is similar to the current price of oil which, at first, may seem surprising. But at the moment $US75 is not thought to be the ‘normal’ price of oil but the abnormal. On occasions the price of oil will go above the ‘normal’ price because of short term events (such as a shortage of refining capacity, a cyclical surge in world demand, or a temporary disruption to world supply). Long term planning does not base its strategy on such transient abnormal prices, but it should have plans for dealing with such emergencies (such as reserves oil stocks).

The price of oil may also run for some time above the ‘normal’ long run price if the peak oil occurs before the alternative fuels can come on supply at their long run normal cost. In this case the price of oil would, for some time, rise above the long run normal price, and then fall back to it. The policy conclusion might be that countries which were adjusting to the $US75 price would deal much better with this difficult transition period than those which were not bothering.

There is a useful simplification from this price forecast. It summarises the state of the world energy economy, fractions aside. I wont say that it is all we need to know, but it is the single biggest thing. (Those unfamiliar with economics may be astonished that all economists appear to need for long run analysis, is the ‘normal’ price of energy. However, they are not ignoring the complexities of available resources, processing technologies and consumer demand. Instead the complexities are embodied in the price, and one has had to examine them to obtain its estimate.)

It also simplifies analysis. Suppose there is a major hydrocarbon find in New Zealand. It would not require a change of the framework described here. Of course there would be differences (and regional and income effects) but none of the policy points would be markedly affected.

(I wont go into details but the policies we use to tackle global warming wont much affect this analysis either – that is the relevant price is $US75 a barrel – assuming that bio-fuels are largely carbon-emission neutral. Of course there will be an impact on the return to the carbon emitters, and the mix of fuels which are used.)

Energy Prices in New Zealand

It appears that around $US75 a barrel New Zealand will be able to supply substantial quantities of bio-fuels. Coal-sourced fuels may also be possible. (This will be even more so – it appears – if hydrogen becomes a viable source of transport power. My impression is there is little consensus on hydrogen technology, except that its commercial viability is further into the future.)

As the price of transport fuels rises, it becomes economic to use standing energy for transport. This includes in public transport, the electrification of railways, and for hybrid and battery power cars. Standing energy becoming a major source of transport would have two major implications.
First, transport and standing energy uses currently hardly overlap in New Zealand. They may in the future. That is likely to raise the price of standing energy towards the equivalent of $US75 a barrel. (But how close?)

Second, New Zealand will be able to export standing energy (sort of) by substituting it for transport fuels and exporting (or not importing) the transport fuels. (On a per capita basis New Zealand seems well endowed in coal and solar energy (transformed by hydro, bio, wind and sea as well as directly) – even if there are no further hydrocarbon finds. One might therefore expect the economy to reduce its imports of oil, while shipping fuel overseas . It may be already export more energy than import it, if the energy embodied in our other exports are allowed for. While some energy exports may be raw energy, New Zealand should aim to value-add on the energy – embodied in other goods and services – as much as possible.)

How will energy-users respond to this higher normal price regime? There is plenty of anecdotal evidence that there has been a response to the current high prices of oil, with less car use, more use of public transport, and purchases of less fuel using new cars. To analyse the response systematically, we need to classify adjustments by different time horizons.

This is my list if there is a hike in the price of fuel (which is unanticipated).
            Fewer car trips
            More use of public transport subject to the capacity limits
Medium Term (say about ten years)
            The majority of the stock of cars becomes more fuel efficient
            Increased capacity on existing public transport routes
            Some improvements in domestic energy use (assuming standing energy prices rise too)
                                                Adjustment of workplace-home relationship (to minimise commuting, including more homework based on broadband access)
                                                Fall in house (land) prices on outer city fringes relative those in CBDs and close to places of employment.
Long term (thirty and more years)
            New public transport routes
            The majority of houses becomes more energy efficient
                                                Intensification of city centre residences (although there may be an increase in holiday homes for weekend residence).

The list represents no more than an assessment of how long it takes to adjust capital stock. The list also broadly applies to small businesses, whose energy use in the totality of their decisions is similar to households. However, large businesses will adapt much more quickly.

What is important here is that I do not believe that people will at first react substantially to significantly higher energy prices, and then lapse back into their old energy intensive ways once they believe the energy price hike is permanent. What I do not know, however, is how big an adjustment they will make. And I also fear they may not think the energy price hike is permanent.

The market signals may not be strong in some activities until it is too late. There is little voluntary incentive for a builder to design a house for energy prices thirty years out, and the four or so owners in the interim will not have the expertise to know how well the builder has. When the price hike becomes painful, it may be too late for houses built years before: retrofitting is very expensive. The implication is, therefore, there is a case for some limited intervention in energy markets especially in regard to the long run capital stock.

(There have been too many energy experts crying wolf, especially extrapolating recent cyclical trends – as for instance, for the current surge – to quite unrealistic levels. This may scare the public today, but when tomorrow the bubble bursts, such projections turn in the other direction. The public rightly discounts the past hysteria, but then concludes that energy prices are not going to rise in the long run. The $US75 figure is not based on extrapolation of recent prices trends, but on technological trends: that should be stressed.)

Policy Directions

I have been working on the ‘Economic Transformation’ which is the Government’s core economic policy. Energy is a part of its infrastructural concerns, for it is an enabling sector which impacts on the costs of all other sectors. However, the above adds is that energy is also ‘transformational sector’, that is one that is going to experience major change over the next few decades. The following policy remarks are directed at that aspect of the sector.

1. We need to build into the nation’s thinking that the normal energy price, some years out, will be equivalent to $US75 a barrel of oil, say. Obviously there is a need to determine the price more systematically than I have been able to do, and it will also be necessary to turn it into more understandable level (say petrol at $2 a litre).

2. The Government should publish its assessment of the long run normal price, both as a guide to the public and to its own advisers.

3. The public should be made very aware of this assessment. But it would be an indicative price not an enforced one and that no one in the private sector would be required to use it in their own decision making.

4. There appears little consensus when oil production will peak, so it is not possible to forecast the ‘normal’ price path of oil, let alone the variations around it. However, I would be astonished if the $US75 was not normal (or below normal) in 25 years (i.e. 2030).
            Notice there is no policy recommendation for cars for most bought in the next ten years will be scrapped by then. It is up to individuals to make their decisions. The State need not do it for them. Rather than guessing the peak, or interpreting cycles, the State can best contribute by firmly emphasising the expectation of high energy prices.

5. The main policy intervention should be aimed to get the majority of the relevant capital stock largely adjusted to this higher long run price. This applies particularly to is housing (including its location) and the public transport infrastructure which take a long time to change.

6. At this stage I am not sure what policy instruments should use to improve the energy efficiency of housing. My guess it will be a mix of direction, subsidisation and certification. Government leadership can be important. Apparently the Canadian government embarked on a retrofit of its own building stock
            (I was struck by the remark that New Zealand tradesmen have not been properly trained in constructing energy efficient buildings. There will be no public commitment to energy conservation if skilled artisans are not involved, which suggests there is a role for a (voluntary) retraining and certification program.)

7. A standard evaluation of the infrastructure for public transport often concludes against proceeding with the investment. From the retrospection of 2030 that cannot always be true. We need to review the evaluation principles for strategic investments. (That includes the discount rate, the behavioural assumptions and the impact on location, as well as the price of fuel.)
            The aim should be a long term (say 25 year) program which leads to a more intensive public transport system in urban centres. Its application may have to be opportunistic. (For instance the 2011 World Cup may provider a justification for the acceleration of the public transport link between Auckland International Airport and the CBD.)

8. The government should avoid getting involved in determining the balance between energy sources, since that requires detailed assessments of future technological possibilities. That is something market risk-takers do best. Their average judgements may be no better than the government’s, but they are more dispersed, and those that get it wrong take the loss themselves. The additional complication is that the political pressures for assistance to each energy type is such is that the country will end up with a plethora of assistance to each, and nobody will have the foggiest idea what the net effect of the assistance is, or even whether it is positive (a situation familiar to those who have studied the pre-1984 economy, or the current US energy system).
            However, whatever the outcome of the current industrial assistance review, energy should have the same entitlements to that assistance. The argument here is against additional assistance for energy suppliers. (A corollary is that New Zealand’s global warming responsibilities should be pursued primarily by market means such as taxes and transferable quotas.)

9. Of course there will be research, science and technology funding. It should not reinvent the wheel. New Zealand cannot and should not compete against work being done overseas. The effort should be about transferring overseas research to New Zealand, including adapting their findings to the peculiarities of local circumstances.

10. I cannot see any logic to New Zealand aiming for self-sufficiency in energy (whatever that means). The earlier remarks about New Zealand becoming a net energy exporter are relevant here, although it may be an energy importer for certain fractions (bio-diesel and avgas).
            (If New Zealand is to become self-sufficient in this economic activity why not every activity, and why should not every country try to become self-sufficient in everything. Anyone can make a case for self-sufficiency in their particular interest. But that anyone can do it for any product tells us something about the strength of the argument.)

11. Certainly there should be measures to deal with major temporary disruptions (where a price mechanism adjustment would be punitive). The IEA arrangements and the oil stock reserve are intended to cover a breakdown in the world supply of oil.
            Other potential disruptions need also be considered: a breakdown in the electricity transmission grid – what happens if the Cook Strait cables go, the gas transmission system, the Whangarei to Auckland oil pipe line … ? The evolving energy configuration raises new issues. If New Zealand tallow is to be processed by the Australians into bio-diesel, a CER deal needs to be negotiated for when there is disruption in world diesel supplies.

12. The government’s energy policy advice structure seems fragmented, with a lead advice agency in the MED, numerous other public agencies, and another ring of private sector agencies and consultants. The result is a myriad of views and opinions (as evident in the seminar papers) with some massive gaps in our knowledge of key features (some of which were hi-lighted by resorting to overseas studies to fill them). Normally I am reluctant to advocate reorganisation (‘re-dis-organisation’ is the grumblers’ term), but in this case there may be a case for reviewing the advice strictures, particularly strengthening the Ministry of Energy within the MED, and paying more attention to getting a common data base and understandings and coordination.

Apology: I am acutely aware that I have made a number of assumptions about technology and related facts, and am likely to have made some errors while doing so. Sometimes it arises by the disagreement among energy experts. However, insofar as I have made errors – and am grateful for their correction – it is a humbling reminder of the limitations of the expertise of an economist. But it also a reminder that we all make errors when we move into a foreign territory – including energy experts when they apply economics to their areas of expertise.

Acknowledgements: There would have been even more errors had I not shown an early draft to Geoff Bertram who, however, may is not responsible for the ones left.

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