Non-renewable resources & energy Economics, management, and policy

Motivating Group Project California Renewable Energy Requirement for Electricity: Legislation requires that 20% of generation be from renewables by How can this best be achieved? Bren Group Project

Key Characterisics of Nonrenewables Fixed endowment of given quality Stock declines over time For minerals Costly process of discovery Costly process of extraction Technical change decreases costs of exploration and extraction over time Key Results Physical Stocks Decline over time Price eventually increases with time Technical change may cause prices to decrease initially

Time paths p t tc dominatesexhaust dom Production ceases; Substitutes enter t Stock

Scarcity value of non-renewables Since limited supply, non-renewable resource command a “scarcity value” Problem: You own a barrel of oil. Can sell today for $30. Should you sell today, or wait for next year? (r=.05)

Price today: p 0 (=$30) Price tomorrow: p 1 If p 1 >$31.50, wait If p 1 <$31.50, sell today In equilibrium: p 1 =p 0 (1+r) Intertemporal Arbitrage: Hotelling’s Rule

Hotelling “rent” Real Prices should rise at rate of interest. If think they won’t, firms would deplete reserves today. What about extraction costs? R t = P t – MC t implies R t+1 = R t (1+r) Also called “user cost”, “royalty”, “rent” Hotelling: It is actually rent which rises at rate of interest Present value of rents equal through time. Indifferent between selling barrel today or any point in future.

What about quantity extracted? Recall demand curve: $ Barrels of oil D If price increases through time, quantity must decrease. Confounding factors: 1.Shifts in demand 2.New discoveries 3.New extraction technology 4.Backstop technology

Prices and quantities over time time Price Quantity Produced Seek: Price path that follows Hotelling Rule, such that stock is just exhausted when quantity demanded drops to zero

Switching to a “backstop” Backstop technology: a perfect substitute for non-renewable resource that can be produced in any amount at constant (usually high) price. When price of non-renewable = price of backstop, we’ll switch.

The effect of a backstop technology MC b Price path with backstop time $ Question: If you know backstop price And stock of resource, how do you Find initial price?

Other factors that affect price path: with a backstop technology Decreasing extraction cost: Lower price initially, then rises more quickly Sudden increase in demand: Price jumps suddenly, decreases current consumption. Monopoly: Price higher but rises more slowly, but extraction is slower so extends life of the resource.

The monopoly case Time Price Time Quantity MC b Monopoly What do they mean when they say “A monopolist is a conservationist’s best friend”?

Are we running out of resources?

Physical measures of “scarcity” Reserves: known amount that can be profitably extracted. Changes with tech, discoveries, cost, price. Inventory ~ constant through time Reserves/Production: Assumes constant demand Crustal abundance: total amt in crust. Ignores cost of extraction Ultimately recoverable: total to 1 km depth Arbitrary, different for all resources, no new tech.

Economic measures of “scarcity” Marginal cost of extraction: likely to increase as stock decreases, but ignore price Price: Ignores extraction cost. Hotelling rent: Difficult to observe, but probably best measure of scarcity. Confounding factor: Technology of extraction continues to improve

Studies of Scarcity Barnett and Morse (Scarcity and Growth) Looked at natural resource prices over 100 yrs Nearly all resources getting less scarce Timber only exceptin Slade Extraction tends to drive price up Technological change tends to drive price down Eventually exhaustion overcomes tech change Simon-Ehrlich Bet Question: If we made the same bet today, who would be on Ehrlich’s side and who on Simon’s?

Subsidizing renewable energy Remember our model: Price of non- renewable rises until it reaches price of backstop. If extraction cost = 0, extract all non- renewable before switching (more likely, won’t extract all of it). If MC b decrease from subsidy, current price of oil will decrease, and consumption of oil will increase.

The effect of decreasing MC b MC b 0 MC b 1 Price path with high backstop price Price path with low backstop price time

Comparing the two policies Taxing the thing that causes damage (oil consumption) can internalize externality. Subsidizing renewables may have unintended consequence of pushing consumption of fossil fuels to the present! Principle of targeting: design regulation or policy to target (internalize) the externality.

OPEC Organization of petroleum exporting countries Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, Venezuela Controls most of world oil production. Maintain low production to keep prices (profits) high. Why would prices ever drop?

The “Prisoner’s Dilemma” Kuwait Saudi Arabia cooperate defect cooperatedefect

Maintaining cooperation An example of a “Nash Equilibrium” – both countries do what is in their best interest given what the other does. Defecting from the original agreement is a dominant strategy for both countries. Intuitively, incentive to cheat (by overproducing) is very high. Because other countries restrict output to keep prices high.

Electricity Markets – Basic Conditions Demand – energy vs. power Reliability time Power 24 hours Probability Density Power system demand (kw) Loss of load probability Area under curve is energy

Basic Questions What demand level should system be designed for? Electricity = power + energy + reliability Supply – 3 activities: Generation Transmission Distribution

Operation of Power System 100% Fraction of Year Power at Least this high Baseload Intermediate Load Peak Load Load Duration Curve: Area under LDC is energy

Regulation of Electricity Markets Historically natural monopoly Rate of Return Regulation Utilities allowed to price to achieve “fair rate of return” Problems: Gold plating Inefficient Average Cost Pricing More recently (worldwide): deregulation

The California energy crisis Pre regulated monopolies that owned and operated generation, transmission, distribution (PG&E, SCE, SDG&E) Federal Energy Regulatory Commission regulates wholesale power transactions (one utility to another) California Public Utilities Commission regulates retail prices (to consumers)

Restructuring electricity Designed competitive wholesale market Suppliers bid to supply electricity on daily basis “Grid” accepts lowest bids; price at margin Goal: more competitive California Argued it would decrease prices Could pass savings on to consumers by giving them a choice of supplier But consumer side still regulated. Didn’t work Prices skyrocketed over 500% between Utilities paying far more than consumers paid. State had to bail out industry, cost $60 billion.

From Joskow: “The wholesale prices prevailing between June and September 2000 were much higher than the fixed retail price that the utilities were permitted to charge”

Why did wholesale prices rise? Rising natural gas prices (natural gas is an input to electricity production) Large increase in demand in CA (growth) Reduced imports from other states (heat waves) Rising prices for NOx emissions credits (costs of producing electricity) Market power (in wholesale spot mkt)

Why didn’t it work & lessons Technically challenging to create competitive wholesale market Consumers were insulated from wholesale market prices (because retail market still regulated). Deregulated wholesale, failed to deregulate retail prices or to allow forward contracts. Required utilities to buy at unregulated price and sell at regulated retail price.

What next? State committed to long-term contracts at unreasonably high prices – cost $60 billion. Prices likely to remain high to pay off. Prices dropped in 2001 due to increased supply, decreased demand. SCE and PG&E effectively bankrupt. Replaced deregulated wholesale with state procurement and regulated prices