Tuesday, February 9, 2010

Cleantech Economics 101: Higher Fossil Fuel Prices; More Cleantech

With all the complexities of cleantech policy and technologies, there is only one simple thing needed for an explosion of competitive clean technologies – increased price of fossil fuels.

The amount of R&D expenditures that will need to be invested in clean technology in order for it to hurdle the bar into competitiveness is much greater with low fossil fuel prices. And, the lower those prices, the less appetite the private sector has for making such investments. This leaves a much-increased burden on the back of government through grants and subsidies– a back that is close to being broken from debt. While clean technology development is absolutely necessary, technology development takes time and, often, a long time. And technology development is fraught with uncertainty…nobody ever knows a priori whether such efforts will be successful and how long they will take. Believe me…every venture fund in the world would love to be able to know that! But they don’t. However, virtually every venture fund and researcher will tell you that significant advances usually take much more time and more money than expected. In an environment of relatively low fossil fuel prices with high price volatility, grants and subsidies for an amount of time and at a level that will make any permanent and meaningful difference are simply unsustainable. So, for all the focus on “cleantech stimulus” the most important thing that government can do is to affect change in the cost of the fossil fuel alternatives.

If we had higher fossil fuel prices or even just clearer visibility and certainty about future increases, the free market would make dramatic increases in investment in clean technology. When the free market sees an opportunity to make a profit, it moves extremely fast. Government actions that put in motion increases in the cost of fossil fuel alternatives, even if those increases are phased in over many years, can have an enormous impact on the money invested by the private sector in alternatives (and a corresponding decrease in need for government subsidies and grants). This, in turn, will further accelerate technology advances, leading to a more rapid convergence of the time when various technologies can competitively reach the mass market.

Given the reality that fossil fuels are a finite resource, it is a fait accompli that eventually alternative energy and energy efficiency technologies will become so compelling that they will dominate the market. But the future of fossil fuel prices in the relatively near term (e.g., the next decade or two) is far from certain as both general economic conditions and new discoveries such as those in Venezuela’s Orinoco Belt play a role. If we didn’t care about global warming, national security or economic security, there would be little need to do anything but let the market take its course. Unfortunately, irrespective of your personal policy hot button, most of us would agree that we do not have the luxury of the amount of time that this transition would likely take on its own.

The government has a role to ensure that externalities that are important to the public are accounted for in the market. But the government cannot subsidize our way there nor simply mandate that the market use a specific technology. Should it be surprising that the U.S. government “mandated” that 100 million gallons of cellulosic ethanol be produced this year and the EPA estimates that only 6.5 million will be produced? The government sank $150M into Range Fuels’ cellulosic ethanol plant expecting it to produce over 10 million gallons, but Range will only produce about 2.5 million gallons this year. How silly is it to try to “mandate” use of biofuels – did we not learn anything from the economic demise of the Soviet Union about government controlled economies? If oil had remained at over $100/barrel since 2008, I would suggest to you that biofuels production would be much higher this year without any government mandate.

The government does need to take action and do so in a way that does not crush our economy. There are important societal externalities associated with continued use of fossil fuels that are not accurately reflected in the price of the commodities in the market. Cap and trade is the right debate to be having… albeit likely the wrong solution. More on that in my next post.


Anonymous said...

David, There is a lot more to Range's woes here than meets the eye. And it begins with factual misrepresentation of what they were actually going to produce as an alternative fuel. Hundreds of millions invested and really nothing to show for it thus far. However this firm is not alone in cringing while taxpayers begin asking their first questions about what happened with public money. Do some far deeper homework first before writing further on this firm or others ostensibly working under a cellulosic ethanol label.

Nathan Bender

Bryan Guido Hassin said...

I couldn't agree more. Capitalism is a highly efficient system that motivates all players to work toward producing products and services that make the most economic sense--that is, they have the lowest costs and the highest prices.

This would be fine except that nowhere in the world do we capture the true costs of energy. At most we capture the true costs of generating and distributing energy (although this is heavily subsidized in most countries) but we never capture energy's full life cycle costs, including the cost of addressing environmental and social impact.

Consequently energy costs are so low that there is little motivation to develop clean technologies that would generate and distribute energy with lower full life cycle costs (but higher direct costs of generation) or reduce levels of energy consumption altogether.

Another factor contributing to unrealistically low energy prices is a myopic view of energy supply. For most of the developed world energy seems to be endless in supply and it is priced as such. If it were viewed as the finite resource that it is (under conventional methods of generation), prices would increase steadily as global demand increased and supply dwindled.

We see the same phenomenon with food in the US. Huge corporations are able to produce a fast food "meal" for incredibly low production cost. As such, millions of people choose fast food because it makes the most apparent economic sense. However, once again the full costs of unhealthy food are not captured; the long-term costs of acute healthcare for diabetes and morbid obesity far outweigh the price difference between fresh, healthy food and a Big Mac.

I'm a capitalist and I believe in the free market. However, the free market only works when costs are correctly captured: garbage in, garbage out. We do need a way to capture both the full life cycle cost of energy and to factor supply into its pricing. I don't know exactly what the solution(s) is/are but I suspect that world governments have a role to play.

Anders Carlius said...

Very good comment after an excellent post.

What I have been missing from the discussion is how much biomass that could be produced per year on a pice of land with sustainable methods.

One could see a 10x difference from nation to nation between how much biomass that could be produced per year on a set amount of land. Turn that biomass into biofuel and the difference would increase even more. With the right kind of biofuel the increase is less.

This does not lessen the need for a long term price plan where the government could be driving the long term adoption. But without the optimization of the production of biomass it could destroy valuable areas of nature.

Damien said...

In the course of doing research on cleantech VCs, I came across your interesting site.

I came to the very same conclusion you did: the rise of gas prices will fuel development in alternative energy and not until then.

The issue of risk is very complex since petroleum prices depends on supply, demand, refining capacity, and distribution besides foreign policy, regulations, monetary and fiscal policies, balance of trade, international relations, and currencies. Based on this, a company, new or seasoned, has to decide what funding they should put towards R&D with the possibility of whatever it invests can be overcome by events or another competing technology assuming there is an ROI at all.

An additional consideration is the infrastructure required to distribute energy (I’m thinking about cars). We’ll need new methods for storage and replenishment if we’re driving Tesla cars.

One commenter writes about the “myopic view,” but the difference between short-term and long-term is a crucial, risk-laden, and blurry threshold. Public companies have to manage quarterly performance, and executives are incentivized to meet their performance targets. For private companies, executives typically have annual targets, and all of this is made more difficult by the current economy. Never mind the internal difficulties a company might face by developing substitute, disruptive technologies while offering current technologies.

This is why venture capital funders are so important. They can look at promising opportunities with a longer time-frame to bring existing and new technologies to the fore. From what I’ve found so far, there is a lot of activity and funding in the alternative energies arena.

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