Until further notice, my position on the environment is similar – though not identical – to that of Professor David Goodstein of the California Institute of Technology (2004). Oil and gas are much scarcer than commonly thought, and rather than reduce their consumption of energy, and particularly motor fuel, Mr and Ms Consumer will insist on – and by one means or another obtain – the continued use of coal at the present intensity, or even higher. It is not certain, but some observers have suggested that this could mean some environmental disasters.
It would be nice to believe that along with the increasing consumption of coal, environmental considerations will be given their proper weight, however I see no signs of this taking place. This is why I welcome agitation for a direct and immediate attack on environmental dangers, which includes a Manhattan-Project type crusade in favour of better and more efficient nuclear equipment, as much wind and solar as makes economic sense, perhaps hydrogen, and in addition an expansion of the environmental type legislation that Governor Schwarzenegger is attempting to pass in California. “The debate is over,” he has said. “We know the science. We see the threat. And we know the time for action is now.”
The lovely thing about the governor’s agenda is that it is not explicitly based on fools-gold or pie-in-the-sky type initiatives such as emissions trading. One reason of course is that California is in the worst possible geographical position if global warning actually triggers some of the environmental catastrophes that have been mooted. I am referring to floods and a rise in the sea level that could obliterate some very choice real estate. According to an article by Charles Petit in Nature (2005), California is one of the places where legislators “have begun their own versions of Kyoto-like regulations”. What this apparently involves is capping carbon dioxide (CO2) from more than 600 power plants in California and the northeast, which is a grand idea, assuming that “capping” doesn’t mean tempting fate by playing trading games that involve a reliance on overblown institutions such as the Scandinavian exchange NordPool.
Some time ago I was informed that emission trading had been shown both theoretically and experimentally to be the most efficient means for ensuring a healthier environment. Like the Russian submarine commander in Tom Clancy’s ‘Hunt for Red October’, as soon as I heard this bizarre comment I knew what it meant: that gentleman was in line for a piece of the heavy research and/or travel grants that for some looney reason are being passed out to supporters of this crackpot scheme.
To get some idea of what we are dealing with here, readers should find out the kind and quantities of pollution that are associated with a typical coal-fired power plant, and in particular mull over the millions of tons of CO2 that are emitted into the atmosphere annually. Reducing or sequestering in the ground or oceans even a modest percentage of these emissions via half-baked market mechanisms is completely out of the question. No proof of that will be offered here, however for those readers who want proof let me suggest that they examine the quantities of CO2 that are involved, and then contact their local exchange to find out how much it would cost on the market for emission permits to get rid of significant quantities of CO2.. Some energy intensive firms in Sweden have performed this exercise, and concluded that if they have to accept expenditures of this magnitude, then everything under their control that is movable should be transferred to another part of the world as soon as possible. Needless to say, this would be economically ruinous for Sweden, and in particular for every part of the Swedish welfare system. Similarly, ‘carbon capture’ is probably a pipe-dream if very large quantities are involved. Another description might be ‘play for the gallery’.
Professor Eric Smith (of Tulane University) has informed me that combined cycle generation mated to coal gasification units, which could be located at a ‘mine mouth’ in the U.S., would have acceptable pollution features, though capital costs can be above the average. He also notes that at present no ‘hydrogen economy’ is possible without using nuclear to produce hydrogen. As the brilliant U.S. jurist once noted, “danger invites rescue”, however rescue in the form of a large input of nuclear would not be easy to sell.
COAL PRICES AND PRICE THEORY
One of the great mistakes of mainstream academic economics was/is the emphasis placed on Hotelling model of exhaustible resources (1931) as a valid representation of the way that an industry such as coal (or oil or bauxite or whatever) functions. Then why bother with it here? The answer is that my presentation will be extremely brief, and my explanations of what is wrong with that construction might be useful to serious students of resource economics – or for that matter persons taking the attitude of a colleague in Copenhagen a few years ago, who agreed that Hotelling’s work was meaningless, but that shouldn’t keep it from being presented to students.
What it comes down to is the expression ?p/p = r, where p is the net price – i.e. the price minus the marginal cost of the next unit that can be extracted; and r the interest rate. ?p then is the change in price between the present period and the next period. In various classrooms around the world I have derived this expression using modern versions of the calculus of variations, and also the kind of algebra taught to third year students in the considerably less than elite secondary schools I attended in Chicago. If this expression holds, it makes no difference in which period we extract the resource; but if this equality does not hold, then because marginal cost is constant, we end up extracting all the coal in either this period or the next. For instance if ?p/p < r, extraction will take place today because, the rate of growth of the net price is less than the interest rate (and thus it would not pay to extract coal now, sell it, and invest it at an interest rate of ‘r’).
During the period from the first oil price shock (in l973) until a few years ago, when people like myself were able to convince many of the great and good in resource economics that Hotelling’s logic was highly suspicious (and its study a blatant waste of time for innocent students), the equilibrium result derived above was treated with the same veneration in the learned journals of economics as shown Einstein’s E = mv2 elsewhere. However, if we take a careful look at a disequilibrium situation – e.g. ?p/p >r – we will be able to comprehend just how hopeless it is.
With this kind of disequilibrium the expected rise in net prices is greater than the rate of interest, and so no production takes place in the present period: R is removed and sold in the next period. In terms of large real world coal mines this is nonsense, because with the exception of mom-and-pop type operations, in the real world coal mining is a very capital intensive activity, and some production might have to take place in any and all circumstances in order to obtain money to pay interest and amortization costs on the equipment being used. I can also note that in case the reader is bothered by the use of only two periods, in my energy economics textbook (2000) I have extended this discussion to more than two periods, and provided a graphical analysis of the course of production. Should fixed capital be present, however, that analysis would have to be amended to show production in periods where the Hotelling result might indicate no production. (By the use of some calculus, however, it is a simple matter to go from a constant marginal cost to one that is dependent on production.)
In addition, there is a real option associated with things like producing or not producing, leaving equipment idle, dismissing employees, etc. (Note: a real option as compared to a financial option. For a long discussion of the latter the reader is referred to my finance textbook (2001).) Remember that the price in the next period is the expected price. It may happen – and often does happen – that the actual price in the next period is very different from the expected price. Given this possibility (i.e. uncertainty), and employing the assumed disequilibrium condition (?p/p > r) posited above, it could be argued that at least some production should take place in the present period until a clearer picture is obtained of what market conditions will or are liable to be in the next period. The cost of this limited production corresponds to what in finance theory is known as an option premium, where by paying this premium the manager hopes to dispel some of the uncertainty associated with the (at present) unknown future price.
It should also be recognized that there are explicit costs associated with stopping and starting production. Allowing production to continue for a while at an unchanged or slightly different level could be regarded as another (real) option for dealing with uncertainty concerning the future price. In the face of all this, I think we can conclude then that since Hotelling’s work did not take into consideration fixed capital, or real options, it is not comparable to anything Albert Einstein did in his real or fantasy life. Let me put it this way: it is virtually without any scientific value, although as explained above it might give readers some idea of what real option theory is all about.
The upshot of all this is that anyone trying to explain the movement of current coal prices with the Hotelling apparatus will not get very far. One theoretical reason of course is that the Hotelling approach is intended to explain the behaviour of individual firms in a make-believe, perfect-competition textbook world, where there is a smooth extension from the behaviour of firms to that of the relevant industry. This assumes that curious readers ignore the fact that in the coal market some firms are in possession of very rich deposits, and as a result they enjoy a (ceteris paribus) considerable advantage over their rivals. Of course, large firms with exceptional management and state-of-the-art technology can occasionally merge with firms that have superior resources, and apparently a great deal of this has been taking place the last few years.
Most coal is probably still sold on long-term contracts for reasons given in the previous section, but the spot market is not insignificant. Naturally, spot prices influence (long-term) contract prices, as many buyers have discovered. Here we have one of those pretentious puzzles of the type often considered in graduate level seminars and the more abstract learned journals, however as compared to physics what we are dealing with in this case is abstraction for its own sake, where there are all sorts of solutions that, while apparently highly attractive, are also highly forgettable.
For example, spot prices were generally lower than contract prices in 2003, and many utilities thought it in their interest to purchase coal off-contract. As bad luck would have it for some of these enterprises, spot prices began to increase at a rapid rate, and when buyers turned to the contract market, prices there had been dutifully adjusted up. A bystander unacquainted with the more elevated levels of economic theory might suggest that the spot market was mainly for risk takers, which is not only true but to my way of thinking indisputable; however as to be expected, the theory has been offered in some up-market publications and seminars that, eventually, these prices must converge.
This happens to be a piece of academic wisdom that is basically without consequence outside the alpine heights of pure theory – regardless of whether or not it occasionally true. What it comes down to for sellers with a speculative bent is being in the spot market when prices are escalating, and being heavy in contracts otherwise; while for buyers the opposite is true. This is no more than commonplace street-wisdom, although its embellishing might require long sessions in lecture and seminar rooms. Whether these sessions will produce players who can make the right moves most of the time in the real world is highly uncertain.
China has become a major operator in the world coal market, but on the selling as opposed to the buying side, where they do most of their oil business. Despite the talk about China’s growing role as a coal exporter, about 65% of China’s energy requirements are satisfied by coal (and 25% with oil), and it has been said that there is an insufficient supply of coal to satisfy the rapidly growing domestic demand, given the shortcomings of China’s rail transportation network, and the location of major coal deposits. Essentially this means that when these defects are remedied, exports might be decreased. Since in the short run the possible loss of Chinese coal from the export market cannot be compensated for by other exporters or other energy media, it appears that a steady global price escalation cannot be avoided.
Before leaving this section some remarks need to be added about the optimal deployment of coal-based power plants. The theory associated with this topic is presented at considerable length in both my textbook and book on coal, but even so teachers of economics often fail to get the message. The essential point here is that peaky, short duration loads should be carried by equipment with low fixed costs, since this equipment might be idle a large part of the time. Prior to the development of combined cycle gas-based equipment, the so-called ‘merit order’ called for natural gas to perform this function, but later it became conceivable that natural gas could compete with coal, nuclear and hydro for carrying the base load – which is the load that is always on the line. Accordingly, as long as the price of gas was low, it was perhaps the most versatile member of the merit order.
When I deal with the subject of an ideal electricity generating system, I of course cite Sweden, where the base load is traditionally produced by nuclear and hydro. Hydro also carries most of the peak load, because it can be easily switched on and off, or output raised or lowered. Naturally, it also produces a large part of the base load, and together nuclear and hydro almost divide evenly the total electricity output of the country. For what it is worth, Sweden has often had the lowest electricity generating costs in the world, and is one of the lowest producers of CO2 from its electricity sector.
Norway is the other winner in the low-cost league, and in that country almost all electricity production is hydro based. Accordingly, for many of us who remember our secondary school mathematics, this means that since electricity costs in the two countries are almost equal, nuclear based electricity is very inexpensive. I have unfortunately had to entertain arguments that nuclear is in reality very expensive for Sweden, and furthermore I have been assured that this will continue to be the case, however to my way of thinking, if someone does not understand why this belief is incorrect, they would hardly be able to comprehend a simple argument to the contrary.
A good example here would be the so-called ‘energy professor’, Gordon McKerron. In a recent article in the Observer (November 4, 2005) he wants to know “who puts up the cash” for a new generation of nuclear power stations. The answer to that question is that it should be the persons who benefit from these facilities – whether they know it or not – and that means just about everybody. In the case of Sweden one of the highest living standards in the world was created on the basis of the inexpensive power supplied by nuclear. Like McKerron, however, this fact is largely unknown to the present Swedish government, or the electorate, who have foolishly tied their economic future to the fortunes of the European Union.
Something that should be emphasized is that some of the logic being employed above is different from that provided in your microeconomics textbooks. Nuclear has a lower marginal cost than e.g. gas, but if you construct a conventional supply curve and attempt to justify the use of nuclear to produce the peak load, you would be wrong: obviously, it doesn’t make sense to construct a nuclear plant that might be idle for a considerable period.
In the film mentioned earlier, ‘The Formula’, Marlon Brando says to a Swiss colleague, “Today it’s coal. In ten years it will be gold”. As owner of a large part of the hard coal deposits in the U.S., as well as a superior process for producing synthetic oil, the Brando character may well have known what he was talking about. Of course his time frame was very wrong: it wouldn’t be ten years, but thirty or forty years, or longer, before the billions of dollars started to roll in, but in terms of historical time it hardly makes a difference. Besides, in showing that they know more about the future importance and use of coal, the writers, directors, producers, and maybe even the actors involved with this film gave the impression that they were better informed about coal than many academic energy economists.
I’m sure that my opinion of Hollywood is similar to that often expressed by Mr Brando in his more articulate moments, but one thing the movie-men must be given credit for, they understand the way that some movers-and-shakers take care of real business: hypocrisy, public relations, bribes and taking advantage of the naiveté of the drowsy voters. Thus it might be possible to produce an interesting film about emissions trading, with a Gordon Gekko type character at the helm of an organization like NordPool, but unfortunately there would probably be fewer customers for this effort then for my unpublished coal book – whose title I unfortunately do not remember.
What I do remember is that the largest Swedish utility, Vattenfall, is building a pilot coal-burning installation in Germany in which CO2 emissions into the atmosphere are supposedly close to zero. This facility of 30 megawatts – as compared to a thousand megawatts for most new installations – will be ready for evaluation in ten years. If the news is good, a 250 megawatt demonstration plant will be constructed. In other words, the financing of these new, quantitatively inconsequential, installations will not interfere with the bonus program initiated a few years ago by Vattenfall, and even more important will not interfere with the flow of cash to the owners of Vattenfall – the Swedish Government – who need this money to pay their dues to perhaps the most grandiose parasitical organization in the industrial world, which is the European Union. Exactly what contribution all of this will have to the reduction of ‘greenhouse gases’ remains to be seen – although, in all fairness, it may turn out to have a great deal.
In economics, as compared to physics, there are many trivialities, and I am afraid that our students our too occupied with them to get the word. The crucial thing here is that (1) there is going to be a huge increase in the use of coal, and (2) most of this coal will be an extremely large contributor to greenhouse gases. What happens as a result of this situation is left for interested readers of contributions like this to think about and/or investigate.
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