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.

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