What Is the Real Cost of Cheap Energy?

Our public policy debate explores the extent of government’s role, and questions the fairness and transparency of mandating one form of energy over another.

By Gregory DL Morris

Fierce public debates and partisan rancor are all too common when energy policy is discussed. Within the Wharton community, we’ve uncovered a conversation that is more tactical: at what level should public policy be set, and how can the government’s role be fair and effective.

The current administration in Washington, D.C., recognizes sustainable energy as a target area of investment. The $787 billion federal stimulus program enacted in 2009 included an allocation of $27.2 billion, or 3.5 percent, for green energy initiatives. The largest portion of that, $6 billion, was designated for loan guarantees, whereby money is not spent unless the borrower defaults. This has not happened in many cases, though one notorious situation involved $545 million and solar-panel maker Solyndra, which filed for Chapter 11 at the end of August. Opponents of the stimulus pounced on that as an example of how government involvement in energy investment can go astray.

When it comes to what sections of the energy sector are the “next big thing,” and where investment dollars should go, our Wharton experts in the field believe that the rules that determine this should be clear and stable.

“The proper role of government is to set the rules under which the free market economy can operate,” says Peter Robertson, WG’71, retired executive vice chairman of Chevron Corp., who now sits on several corporate boards of directors. “The role of the government is not to pick winners and losers.”

“Free market forces should determine what energy technologies are brought to market, and how they are developed, priced and used,” agrees Bill Montgomery, WG’89, who is managing director in Houston at Quantum Energy Partners, a private-equity firm. “But if the government is bound and determined to spend $760 billion on stimulus, I would like to see at least a better distribution.”

If policymakers give loan guarantees to solar-panel makers, he argues, why not some for building compressed-natural-gas filling stations? Funding a variety of initiatives in the energy sector could result in more high-tech, well-paying jobs, meeting the public policy goal of decreasing rates of unemployment. Montgomery points to the oil and gas production generating “good jobs in previously depressed areas” in North Dakota and Pennsylvania.

“We have to accept the limitations of our own intelligence,” Montgomery adds. Business and government officials alike cannot predict which technology will generate the best returns over time. Instead, government should set fair rules and allow industries to compete. “Let the best technology flourish and win. You don’t want situations like the ethanol mandate with all its unintended consequences.”

He is referring to the current federal Renewable Fuels Standard that mandates that 35 billion gallons of ethanol-equivalent biofuels and 1 billion gallons of biomass-based diesel be consumed in the United States by 2022. A report issued in October by the National Research Council suggests that those mandates are not likely to be met. Still, 14 billion gallons are being produced, diverting enough crops, such as corn and soybean, to be blamed for increased prices for food and livestock feed.

Another energy investor, Billy Quinn, W’92, managing partner at Irving, TX-based private-equity firm Natural Gas Partners LP, argues that, in an ideal world, government involvement in the energy sector would be on a “limited basis.”

“Unfortunately, we don’t live in utopia,” Quinn says. “The economical animal in me, the skeptic, finds it difficult to believe that government can get involved in anything in a small way.”

Still, Quinn notes that the free market has successfully driven long-term energy trends.

“The economics of the energy business should dictate where to drill oil and gas wells and where to build power plants. And in most cases it has,” he says.

On the same page, Montgomery describes how the high prices of energy just a few years ago—with oil at $140 a barrel and natural gas at $13 per thousand cubic feet—resulted in increased investment in exploration and production. Oil prices have since gone down more than one-third, and gas prices dropped more than two-thirds from those peaks.

“That is the market at work,” Montgomery states.

Ravi Viswanathan, ENG’90, WG’98, general partner at venture-capital firm New Enterprise Associates in Menlo Park, CA, believes that the market ultimately will prove certain clean energy technologies a winner. For the most part now, however, it is a “nascent” field.

“Subsidies are very helpful in cleantech, particularly given how the industry is still in very early days,” he says.

Viswanathan adds that fossil fuels received subsidies for many years and that the “basic energy” industry still receives more subsidies than clean technologies do.

Clean technologies will need to stand on their own two feet eventually, without subsidies. But when?

“That’s the real challenge, and that’s one of the Holy Grail questions,” he says.

THE COSTS OF REGULATION

Public policy can impact certain energy sources not only through subsidies, but it can encourage and discourage through regulation. But the costs added by regulation aren’t something policymakers should enter into lightly, Robertson says.

“If costs are added, that should only be done transparently, and for good reasons, like environmental protection,” he says. Other valid reasons for increased costs are energy security and efficiency.

Still, he admonishes policymakers. “The question should always be if the gain is in proportion to the cost,” he says. For example, current proposals to raise taxes on domestic oil and gas production could drive users to imported fuels. Or take how billions in stimulus money was allocated to clean coal research while the natural gas industry has had to spend its own money enhancing supply and developing new markets. Where is the transparency in reasoning there, Robertson asks.

His conclusion is that some form of carbon control, possibly a form of cap-and-trade program or carbon tax, could be viable if done in an evenhanded way.

In late October, California adopted a statewide cap-and-trade program. Beginning in 2013, the largest carbon emitters in California will have to meet the caps or buy credits to account for the difference if they exceed those caps. By 2015, the program will comprise 85 percent of California’s emissions sources.

The Economic and Allocation Advisory Committee estimated in its 2010 report that California’s measures could lead to a net cost increase of $3.7 billion. This would be offset by $8.7 billion in savings from California’s initiative to reduce automobile vehicle miles by 4 percent by 2020.

There have been efforts to limit greenhouse gas emissions by groups of states in the Northeast, but they were voluntary; meanwhile, numerous federal cap-and-trade bills have been advanced, but none have been adopted.

“There is a need to address the carbon issue, and that overwhelming reason is climate change. … If we as a country do decide to limit carbon in some way, then the rules should be clear and simple and allow for free-market competition,” Robertson says.

Montgomery sees positive regulatory trends and acknowledges that it is “entirely appropriate” for public policy to “make companies bear the burden of the costs they are imposing on the communities around them that they would not otherwise have to bear without taxes, or regulations, or remediation mandates.”

As an example of a balanced approach to regulation, Montgomery points to initial EPA efforts to regulate carbon as a pollutant, which would have taken many coal-fired power plants out of service without any ready replacement. Regulators appear to have lengthened the timetable for that type of regulation, which will allow power plant owners and operators more time to prepare and allocate capital accordingly.

“The challenge is to ensure that forms of energy compete head-to-head with their true costs reflected,” he says, adding that regulators must do that in such a way that is not overly disruptive or punitive.

Conceptually, Quinn agrees with the idea that the full development, production and remediation costs of energy should be part of the price. But he warns that “the full lifecycle cost of anything” is challenging to measure. Nuclear power generation doesn’t emit pollutants, he explains, but the costs for its facilities and fuel processing and disposal are huge. Wind power also emits nothing and its source is free, yet it requires acreage and weather is unreliable.

“What is the cost of not having power when you need it because the wind isn’t blowing? Shouldn’t that be included in the cost of electricity generated by wind?” Quinn asks.

Whatever costs are incorporated into delivered energy, they have to be done incrementally and intelligently, Quinn stresses.

“With any form of energy, you can always spend more money to get it cleaner. But you have to ask, how much more money to get how much cleaner? Does that make economic sense?” he says.

ARGUING AGAINST THE MARKET

Clean energy is a misnomer, counters Robert Giegengack, professor emeritus of earth and environmental science at the University of Pennsylvania. “No energy extraction is clean and beautiful. They all have an environmental and economic and social cost,” he says.

Particularly, Giegengack takes issue with the supply-side solution to energy policy. The only way to make energy green, he says in essence, is to use less of it.

“Having markets controlling these questions has not worked well, especially if we are concerned with preserving economic quality, because the market solution is always to produce more energy, not to use less. Access to energy at close to zero cost is not a rational policy.”

That said, Giegengack does not have much to say for government control to date either. “We have a very long history of regulation, but that has not given us an energy policy that is at all coherent or viable in the long term. Officials will pay lip service to environmental protection, but they are just trying to balance the economic interests of their constituencies.”

An unapologetic redistributionist, Giegengack would impose a federal energy tax that would increase 1 percent every month, so that the price of energy doubles in a little more than eight years. The proceeds would go to fund mass transit and renewable energy.

“People always scream at any increase in gasoline taxes because they say it hurts people who drive to work. But there is no right to drive. Individual mobility is a choice, and one with costs to the environment and to society. Those costs should be borne by the users,” he says.

Giegengack’s fundamental tenet is that “the scarcity in our economy is not money, it is energy. Our unit of currency should be the BTU. We started to see this in the oil shocks of the ’70s when people were trading goods and services for fuel. But then the energy industry started to produce more, and the Arab embargo was lifted. But the future will lead us to value energy as the fundamental unit of exchange.”

Perhaps not, as long as market forces drive energy policy. A focus on short-term gains can lead to exactly the kind of inconsistent and inefficient policy that everyone decries, says Howard Kunreuther, the James G. Dinan Professor at the Wharton School.

“People shy away from high up-front costs, be that installing solar panels or a high-efficiency furnace or even a compact fluorescent light bulb. That myopia makes it a real challenge to support new technology and to achieve any meaningful conservation,” he says.

Viswanathan counters that clean technologies will be cheaper or as cheap as fossil fuels in the long term and that, in the short term, up-front costs are already decreasing in technologies like wind and solar. Within the next one to three years, he foresees multiple clean-tech IPOs—with fundamentals to back up their feel-good stories.

As the discussion returns to the topic of the market, Quinn is willing to ask the tough question.

“If land has been farmed for generations, and now it can generate much better returns by producing oil and gas, or generating wind or solar energy, why not? Ultimately, the economic best use wins out,” he says.

  • Anonymous

    In September 1964 I lived in Denver.  I bought a new Mustang for $2450.  Gas cost about $0.42/gallon for regular.  I could buy a similar Mustang today for about $26,000.  Regular gas here in Virginia is running $3.87/gallon.  Given the changes in technology, the 2012 Mustang is probably a better buy than was the 1965 model.  Gas, on the other hand, hasn’t changed all that much in quality.  So, how much of the whining we are doing about the cost of gasoline really about the fall in value of the dollar rather than about the Administration’s fumble finger handling of the economy?  QE3, anyone? 

  • Usercdj2

    Until someone reports the actual cost to taxpayers of the solyndra loan guarantee, I am going to assume to press is corrupt or stupid. It is continually said or implied that the government and thus the taxpayer lost over 500 million dollars in the solyndra case. However, this was a loan guarantee, not a loan, and not a grant and solyndra was not without equity. So I’ll ask the question: how much did the tax payer actually lose in the solyndra project? Please support with analysis of the facts.

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