Sunday, May 23, 2021

CRYPTOS THREATEN SUSTAINABILITY. BITCOIN AS AN EASY TARGET FOR COP26?

 

Crypto-currencies are not just the latest speculative bubble.  Bitcoin (and others) may be virtual commodities but they have big real-world impacts, and are a threat to our attempts to contain climate change. Stopping their contribution to CO2 intensive emissions must surely be the simplest of credibility tests for international agreement in the forthcoming international climate negotiations, COP 26. 

Alarm over the carbon footprint of bitcoin is the latest illustration of the convergence of climate change issues with a widening range of social and economic issues. We are witnessing a collision between two of the most disruptive themes in today’s global economy - sustainability and the cryptocurrency explosion.

Cryptocurrencies were already a controversial subject, promoted by libertarians as an alternative to national currencies, a currency that would be outside the control of governments or “inflation promoting” central banks, and a means to improve on existing payments systems. They are however also seen as potentially damaging innovations, whose main application may prove to be, at best, facilitation of criminal activity, tax evasion and money laundering, and whose main product has no real function or value other than as a vehicle for speculative investment. At worst they may simply be an elaborate Ponzi scheme.

What is bitcoin, and could it replace other currencies?

The Cambridge University Judge Business School (JBS) provides useful summary descriptions[1]. Bitcoin is a virtual currency whose proponents believe it could represent the future for payments systems of all kinds – the future of money. The three main functions of money are to act as a unit of account, a medium of exchange and a store of value. Bitcoin’s price volatility militates against its future either as a unit of account – the unit in which most transactions are priced and value is measured, or a medium of exchange. As a store of value it has been compared to gold, in having a limited supply, with the potential to become more and more valuable as bitcoin use increases. This third function is, at least theoretically, a more credible possibility. After all gold has a price that is disconnected from its use in jewellery and its value in industrial applications.

However these ambitions for bitcoin seem to hinge, inter alia, on its ability to see off the competition from thousands of other crypto currencies, many of which can also promote themselves as payment systems. These include dogecoin (dog e-coin, or doggy coin?), originally a joke currency that now has holdings worth up to a nominal $ 80 billion.

Mainstream economic commentators and financial authorities have been almost universally sceptical or even scathing. The European Central Bank has compared the rise in crypto prices in recent months to “tulip mania” and the South Sea Bubble of the 1600s and 1700s.

The joke-coin makes a mockery of the idea that crypto investing should be considered a serious pursuit. Its very existence undermines the notion that bitcoin derives value from its scarcity. While bitcoin’s total supply will eventually be capped at 21m, as written into its original source code, there is no limit to the number of copycat cryptocurrencies that compete with it — there are now almost 10,000, and dogecoin itself has no hard supply cap. [Jemima Kelly, FT, 11 May 2021]

None of this will deter the bitcoin evangelists, and it is certainly true that many people will have made a great deal of money out of the gyrations in the bitcoin price. However early entrants often make money out of Ponzi schemes of all kinds, and one worry for financial stability is the destabilising effect of an eventual crash, possibly bankrupting thousands of smaller, later investors and speculators. The collapse of financial pyramid schemes in Albania in 1997 brought the country to the brink of civil war.

Bitcoin’s Extraordinary Energy Consumption

Mining bitcoin is intrinsically a highly decentralised and indeed largely anonymous activity, so direct measurement of its energy consumption is not possible. The Judge Business School have attempted to research the carbon footprint of bitcoin, highlighted by the recent pronouncements from Tesla’s Elon Musk. This reflects the huge amount of computing power absorbed in searching or “mining” new bitcoins, and its impact on fossil use in electricity generation. The numbers, and even more importantly the growth, are extraordinary.

In April 2018 some 17 million bitcoin had been mined[2], and the JBS estimate that the annualised rate of electricity consumption at that time was 36.4 TWh. In May 2021 the number of bitcoin had grown to 18.6 million, but JBS estimate the annualised rate of electricity consumption had grown to 148 TWh, an amount larger than that of a medium sized country such as Sweden or Argentina This 2021 level of power consumption, resulting in more generation from the most polluting coal-fired power stations, could be close to 150 million tonnes of CO2. The JBS consumption estimates from which this number is derived are central estimates and JBS suggest much much higher upper estimate bounds.

Other sources offer equally alarming estimates. One estimate by Chinese academics[3] published in the scientific journal Nature Communications in April found that, without policy intervention, bitcoin in China alone would generate 130m metric tonnes of CO2 emissions by 2024.

The implication of the JBS trend growth, or of this alarming estimate for China, is that we could easily see bitcoin mining exceed 1% of global CO2 emissions in a few years. This may sound small but global GHG is an aggregation of individually small issues. Aviation, for example, to which far more attention is paid, accounts for only about 2.5 % of CO2.

This accelerating rate of energy use is intrinsic to the bitcoin process as mining becomes increasingly difficult. Inefficiency is a necessary consequence of its security requirement. Higher energy use is also encouraged by a rising bitcoin price, and by the fact that much of bitcoin mining takes place in jurisdictions with high coal based power and where electricity is subsidised or seriously under-priced. The increasing “inefficiency” of bitcoin mining implied by these numbers is not remediable; it is intrinsic to the bitcoin design, and indeed to that of other cryptocurrencies.

The Carbon Footprint and Implications for the Global Climate Challenge

The carbon footprint of bitcoin, and other similar cryptocurrencies depends on how the electricity is generated. Crypto promoters attempt to argue that this is or can be from renewable resources and therefore that the carbon footprint should not be an issue. This is a nonsense argument. Low or zero running cost renewables will always be used in power systems before fossil plant is brought into play, so any additional power demand will normally result in extra production from the generating plant at the margin. In almost all geographies this will be fossil plant for the next few decades, and all the extra CO2 emissions attributable to bitcoin will reduce the available carbon budget.

Two particular concentrations of bitcoin mining have been in highly fossil dependent Iran, where illegal use of subsidised power for crypto mining is believed to resulted in major city blackouts, and China, which relies very largely on coal generation.  The current growth of mining in China is of increasing concern to the Chinese authorities on environmental grounds, and the FT reported[4] that the government of Inner Mongolia, which is particularly reliant on coal generation, has come under particular pressure to crack down on bitcoin mining.

Implications for COP 26 and Global Agreement

The clearest possible priority in the global effort to reduce GHG emissions is to seize, with urgency, the “low hanging fruit”; these are the easy measures which have little or no real economic or social cost and deliver immediate savings. Since CO2 in the atmosphere is cumulative we know that immediate emissions prevented are more valuable than the same saving in 20 years time.

Stopping or severely discouraging emissions attributable to crypto currencies falls in this category. There is little or no real cost in economic terms, and perhaps economic and social positives if the world has one fewer set of Ponzi schemes and speculative bubbles. Reduced subsidies to fossil fuel is one of the instruments to discourage mining, and will also help reduce emissions and fund low carbon alternatives. No major physical investments or disruptive lifestyle changes are required to dispense with cryptos, and the carbon saving is immediate and substantial.

It does however need concerted international agreement. What better simple “win” with which to start COP 26 negotiations than a general agreement to apply measures which will discourage any use  of cryptocurrencies dependent on high energy input[5].

The Chinese approach of criminalising bitcoin mining may not be universally acceptable, although most countries have plenty of laws and regulations prohibiting the release of other dangerous substances.  Bitcoin was designed to “escape” any such central control from authoritarian regimes or central banks, and mining is highly decentralised. However there are plenty of other effective measures that governments can take to minimise the attractions of crypto currencies. These include wide restrictions on the use of cryptos as a means of payment (Turkey, Morocco, and India), and controls over the holding of bitcoin by pension funds or other regulated investment vehicles.

For COP 26 a declaration of intent to eliminate the crypto emissions threat might be a small step, but a useful one that sends a powerful message..

 



[1] https://cbeci.org/  “Bitcoin is a software protocol and peer-to-peer (P2P) network that enables the digital transfer of value across borders without relying on trusted intermediaries. … an open and permissionless system: anyone can participate in the network, as well as send, store, and receive payments. Bitcoin has its own cryptocurrency called bitcoin (BTC), as the universal unit of value within the network. New bitcoins are issued … through a process called mining.“ It is a virtual currency, and the Bitcoin protocol specifies that a maximum of 21 million bitcoins will ever be created. Of this 21 million, it is estimated 17 million have been create to date, of which some 4 million have simply been “lost”. It is intrinsic to this virtual currency that, once lost, they can never be found.

 

[3] Policy assessments for the carbon emission flows and sustainability of Bitcoin blockchain operation in China.  Jiang, S., Li, Y., Lu, Q. et al. Nature Communications, April 2021.

[4] Chinese province sets up hotline to report suspected crypto miners. [FT. 20 May 2021]

 

[5] Not all such currencies do. Restrictions on bitcoin, and likely subsequent collapse of the bitcoin bubble, would however send a significant warning to future cryptos, even those with much lower energy implications.

 


Tuesday, April 20, 2021

STAKEHOLDER DECISION-MAKING: UNDERSTANDING SIERRA LEONE'S ENERGY SECTOR

 

The Sierra Leone power sector suffers multiple problems of inadequate capacity and finance. Most of the population does not have access to electricity, and supply is often unreliable. At the same time the country has been trying to implement significant structural and economic reforms, aimed both at government policy objectives and more market-driven operation. The focus of the paper is to achieve a better understanding of current decision making processes and issues, in terms of their impact on inception, planning, and implementation of projects and on operations. This should assist consideration of organisation and governance for the sector. Key findings relate to the conflicting frameworks of market driven pressures and government or policy driven objectives, and lack of a clear pathway for change. Resulting problems include misaligned goals, un-clear or inconsistent communication channels and ambiguous responsibilities.

The final open access version of a recent article by Malcolm McCullough’s Oxford team on this subject is now available online. See link below. 

Stakeholder decision-making: Understanding Sierra Leone's energy sector 


https://authors.elsevier.com/sd/article/S1364-0321(21)00381-6

THE IPAT EQUATION AND THE KAYA IDENTITY. A CONVENIENT MEASURE FOR UNDERSTANDING CLIMATE ISSUES?

 

What Matters Most?  Population, GDP Growth or Technology.

A common theme in popular discussion of climate change, or rather of whether mitigation is feasible, is its attribution to different factors, notably population growth or economic growth, and the reliance of solutions on technology. This also affects any discussion of historic responsibility for CO2 emissions. It is a highly emotive subject, particularly in relation to population control or the limitation of growth, so it is at least worth a cursory look at what the hard statistics tell us.

The so-called IPAT equation represents a general description of human influence on the environment: IMPACT (of CO2) = [POPULATION] X [AFFLUENCE] X [TECHNOLOGY]. A popular and useful way of interpreting this for CO2 emissions for the energy sector is the so-called Kaya Decomposition. Affluence is measured as GDP per capita and technology is further decomposed as energy per unit of GDP, and CO2 emitted per unit of energy. The Kaya identity[1] is:

Global Picture. The IPCC Fifth Assessment Report (2014) provided a useful breakdown of changes in global CO2 emissions over several decades, based on this identity:



In the three decades from 1970 to 2000, population growth and increasing incomes contributed similar amounts to the rise in emissions, but the energy intensity of GDP fell quite sharply contributing a significant saving to the level of emissions that might otherwise have been expected.

The energy intensity of GDP was a significant offsetting factor, whose importance rose in 1990-2000, possibly reflecting the longer term impact of higher energy prices and uncertainties in the 1970s and 1980s. However efforts to reduce the carbon emissions associated with energy use played only a limited role in reducing emissions. This is unfortunate since reduction of dependence on fossil fuels  this is a key component of emissions reduction hopes, and this factor actually moved in the wrong direction from 2000-2010, again reflecting in part the Chinese dependence on coal.

From 2000 to 2010 the importance of rising incomes rose relative to population factors, reflecting inter alia the rapid growth of the Chinese economy. The overall outcome was particularly depressing as the decade showed a sharp increase in emissions and lessening impact of the mitigating factors.

Major regional and temporal differences

But this decomposition can change significantly over time. Global averages also conceal major differences  between countries, and there are some optimistic signals. A similar but more recent chart for China (Safonov reference below) shows overall reductions (to 2016), and significantly more reductions attributable to less energy intensive GDP and less carbon intensive energy. For China, population growth has not been a significant factor over this period, but income growth continues to be so.

China recent emissions

Similarly more optimistic trends have been observed in the USA to 2015, but with higher influence from population, less from economic growth, and significant reductions attributable to less energy intensive GDP and less carbon intensive energy consumption. 


An interesting comparison of country by country decomposition for periods before and after the financial crash of 2008 is given in a fairly recent paper by Sadorsky, referenced below. It shows huge diversity in findings between countries, exemplified in the following chart for four countries:

NB. This chart has a rather more complex interpretation, as it represents the changes between two very distinct periods. The reader is referred to the Sadorsky article

Kaya factors. The future.

Given the pace of reduction required to reach net zero by 2050, the Kaya emphasis will have to shift to much greater emphasis on decarbonising energy. Population cannot be subject to substantial percentage reduction, and the drive for higher incomes is unlikely to stop. There is some scope for further weakening of the link between affluence and energy use, but the heavy lifting will depend very substantially on decarbonisation of energy, starting with the power sector and expanding the power sector into transport and heating.

References:

IPCC Fifth Assessment Report.

George Safonov's Lab. National Research University Higher School of Economics, Moscow. Long-term, Low-emission Pathways in Australia, Brazil, Canada, China, EU, India, Indonesia, Japan, Republic of Korea, Russian Federation, and the United States. December 2018.

Sadorsky, P. Energy Related CO2 Emissions before and after the Financial Crisis. Sustainability 202012, 3867. https://doi.org/10.3390/su12093867

Dr Ajay Gambhir, Neil Grant, Dr Alexandre Koberle, Dr Tamaryn Napp. The UK’s contribution to a Paris-consistent global emissions reduction pathway. Grantham Institute. Imperial College. 2 May 2019.

Public Utilities Fortnightly. First Look at 2015 CO2 Emission Trends for the U.S.

For a fuller “actuarial explanation and justification for the Kaya identity, this reference may help  Kaya identity_JC Final 050219.pdf (actuaries.org.uk)




[1] Since the identity is multiplicative, a logarithmic transformation is usually used in the calculation of the factor contributions.

Monday, April 12, 2021

THE AFFORDABILITY OF A UK ZERO CARBON TARGET

 Here are some back of the envelope calculations that demonstrate the credibility of the assertion that action to mitigate climate change, and progress to a low carbon economy, can be achieved at a containable cost. It aims to provide a simple intuitive defence of conventional estimates for the general reader, but serious students of the subject are invited to delve deeper into some of the excellent material produced under the aegis of the Committee on Climate Change[1].

One of the arguments mounted against taking effective action on climate is that the economic cost is unaffordable. The obvious response is that this has to be compared with the cost of not taking action, the costs of adaptation, and the possibility of existential climate threats on an unimaginable scale. However rather than engage with the occasionally hysterical accusations of alarmism from those in denial on the climate science, it is worth trying to get a sense of the scale of what may be involved in meeting a UK zero carbon target by 2050. Some sense of proportion should start to defuse the issue and calm any fears of national bankruptcy.[2]

This can be a confusing exercise, not least because estimates (of mitigation costs) tend to get tossed around in very different contexts. For example, it’s most common for costs to be discussed in very broad terms as a percentage of GDP. The Stern Review indicated costs of up to 2.0 % of GDP per annum, and some people have argued that this would be a very damaging and unsustainable burden in macro-economic terms.  The Committee on Climate Change currently makes a similar estimate (of 1-2 % of GDP). Others argue that Green investment can actually be used to boost economic growth and domestic employment[3]. There can be at least a partial truth in this argument, even if it can be misrepresented as arguing that the low carbon economy pays for itself. It is not an argument I intend to deploy here.

Some will be more concerned with the public expenditure implications, although that issue should be seen much more in terms of more political questions of how we choose to fund transformational change. For example, much of the cost of transition to low carbon may be carried by private consumers, in their utility bills or more expensive motoring choices, or it may include publicly funded infrastructure investment and extensive grants and subsidies.

Macro-economic shocks and UK GDP numbers

2019 GDP (last year before pandemic)                                                              £ 2170 billion pa

Estimated permanent loss of GDP due to 2008 financial crisis                          £  300 billion pa
The economy is 16%, or £300 billion, smaller than it would have
been had it followed the pre-crisis trend. (IFS 2018[4])

Typical impact of an oil price shock[5] in 1970s, 1980s and 1990s.                   £ 100 billion pa
(an order of magnitude estimate, based on spikes and falls in
the oil price of $100/ bbl, UK consumption of 100 mn tonnes pa,
and scaling up to an equivalent percentage of 2019 GDP)

Assumption of a 2% of 2019 UK GDP devoted to GHG reduction                      £ 43 billion pa
and low carbon transition.

I have not included the significantly larger shifts in resources associated with different government priorities on taxation and spending. Even so, the conclusion we might draw here is that the expenditure on a low carbon economy, while substantial, is far from catastrophic and unmanageable when viewed in macro-economic terms. We have coped with much larger and less predictable economic shocks than what we now face in eliminating emissions.

Public expenditure choices

Expenditure budget 2021:                                                                          £ 908 bn.

Defence                                                                                                      £  54 bn pa

Defence in 1951 (Korean War) accounted for 
10% of GDP. Equivalent percentage of 2019 GDP                                    £ 217 bn pa

Overseas aid (0.7% of GDP target)                                                           £   15 bn pa

Overseas aid (after current cuts)                                                               £  10.85 bn pa

Reported cost of UK Track and Trace system[6]                                       £   37 bn
(spread over two years but seems to be essentially
a 12 month figure). Minimal identified benefit.

Assumption of a 2% of 2019 GDP devoted to GHG                                  £ 43 bn pa
reduction and low carbon transition. (as above)

But what can you buy for 2% of GDP?

It turns out you can do quite a lot for decarbonisation with around £ 40 billion a year. Here is one allocation of that money:

Decarbonising the power sector.                                                               £ 18 bn pa

Retrofitting UK housing stock. 28 million households                                £ 20 bn pa
Grant of £ 20,000 per household for retrofitting, at one million
households a year for 28 years

Charging infrastructure for electric vehicles (EVs)                                    £ 2.5 bn pa

Total                                                                                                           £ 40.5 bn pa

This covers the three main sources of UK emissions, and the main areas for investment to achieve net zero by 2050. Assumptions to justify the plausibility of these numbers are as follows

Power Sector

Sizewell C has an estimated capital cost of around £ 18 billion for 3.2 GW of capacity. Nuclear is currently regarded as one of the more expensive options for low carbon capacity, and Sizewell is “first of a kind” but this at least gives us an order of magnitude. The equivalent of one Sizewell a year for 25 years delivers around 80 GW of capacity and more than 600 TWh pa of energy, more than enough, even after allowing for significant growth, to effectively decarbonise a power sector which already has a significant proportion of renewable low carbon energy. [Current UK annual consumption less than 350 TWh]

Alternative renewable sources are also widely seen as likely to be much cheaper than this, although there will be other major costs associated with energy storage. However we might interpret this as at least a first approximation, or an upper limit to the capital cost for low carbon generation. A great deal of new investment would of course be required in any case, so much of this will not be a truly incremental cost.

Heating of buildings

Retro-fitting of buildings, especially residential property, for energy efficiency and low carbon heat pumps or heat network solutions, is one of the biggest problems for achieving zero carbon. The cost of air or ground source heat pump installations are currently advertised at around £ 6000-8000 and up to £ 16000 respectively, while heat networks are collective typically municipal investments which can also be quite costly. But even adding on a substantial allowance for insulation improvement, £ 20000 per household would look like an extremely generous grant to a householder, especially as there would be a continuing benefit in lower running costs.

Electric vehicles

“The UK by 2040 needs 1-2.5 million new charging points. An average public charging point costs 25-30,000 euros so it would need to invest 33-87bn euros from now until 2040,” said Wood Mackenzie’s Wetzel. Interpreting this as two million over twenty years and assuming a cost per installation of £ 25000, this implies an annual investment of £ 2.5 billion.

The price of EVs is likely to fall dramatically with increasing scale, so we should not need to worry unduly about the capital costs of fleet replacement, which will be borne by motorists as they retire their existing vehicles.

Conclusions

Current estimates of expenditure required for a zero-carbon economy are plausible. In no sense can they be considered unattainable or damaging in macro-economic terms, as the sums are smaller and more predictable than the much bigger economic shocks we have endured in recent decades from other sources. Viewed as public expenditure choices the sums are commensurate with other choices we make and have made, such as the unfortunate “test and trace” scheme. An it is quite easy to hypothesise major elements in the composition of that expenditure.

Caveat. Sharp-eyed readers will have noticed that I have omitted some of the notoriously difficult, but smaller, sectors, such as aviation and shipping. But I believe the biggest additional issue will be the funds that high income countries will need to find in order to support low carbon strategies in the developing world.  That is a different story, and one that I have addressed in earlier posts this year.



[2] This post concentrates on UK statistics but the same arguments, and similar orders of magnitude, will apply to most developed economies.

[3] Retrofitting the UK housing stock, and many other infrastructure investments, will be labour intensive.

[5] The UK became a net oil exporter during this period, so the macro-economic consequences for the UK relate both to price shocks and significant changes in production.

[6] “Chancellor Rishi Sunak’s Budget last week included an additional £15bn for test and trace, taking the total bill to more than £37bn over two years.” [Independent. 10 March 2021]

 


Tuesday, March 23, 2021

Principles for the effective integration of renewable or low carbon energies into national or regional power systems.

This is the substance of a recent talk I was asked to give at a recent COP26 roundtable in Turkmenistan. It is an attempt to summarise, for policy makers, some of the general principles we have learned in the course of the Oxford Martin School Integrate project.

…………………………………………………………………….

First, the context. A low carbon power sector has a central role in reducing CO2 emissions and making progress towards zero carbon. This is not just because fossil-based power has high emissions and we already have numerous technologies for low carbon generation. A low or zero carbon power sector means we can progressively use electricity solutions to reduce CO2 emissions in other major categories, notably transport and heat.

The task then is developing and integrating renewable and other low carbon energy resources into power systems that deliver what we need and expect. The main factors that have to be respected and reconciled are the following:

·         Power systems require flexible responses to balance real time supply and demand.

·         Low carbon sources (mostly) lack the flexibility of traditional thermal generation plant using coal oil or gas.

·         Renewables output can be intermittent and unpredictable

Today I am going to summarise some of the general principles we have learned in the Oxford Martin School. The principles apply not just to the UK but in virtually all power systems. However, lesson one is that every country and every network is different, in terms of its available resources, its climate, weather and seasonal effects, and the needs of its consumers. So the best choices for the future will also be different.

Framing the Policy Choices


We have used this diagram to represent the task, and the large number of questions that need to be addressed. The potential resources and activities that we can manage, the options available to the power sector, are shown in the top row - generation, storage, networks and consumption. Costs are generally coming down.

The policy instruments that we have to manage these options can be categorised, in the left-hand column, in terms of technology and innovation, the wise use of markets and price signals, social engagement in the process of change, and finally the whole framework of law, organisation, policy, regulation and governance on which the sector depends.

There are 16 cells in this 4x4 matrix, and there will be important questions in almost all of them.


Starting with the resources, choices involve selection from a long menu, much of which I am showing on this slide. Virtually all the items here feature in the UK as part of our likely solutions, and they are all potentially important. I will just comment on a few highlights.

·         When we look ahead to planning the power sector, we have to look not only at the current use and applications of electricity but also at its substitution for other fuels in new applications, especially transport and the provision of heat. This implies coordination across sectors.

·         Electric vehicles especially have the potential to play a huge part in the operations of the power sector.

·         Interconnection. The recent power crisis in Texas has highlighted the importance of interconnection and the risk of isolation.

·         Solving the storage problem is one of the most challenging parts of the exercise, at least from a technical and economic perspective.

·         Consumers are also a vital part of the system, technically, economically, and politically. They merit a separate conference on their own.

Technical and technology choices

The choices have to be complementary rather than exclusive. This will involve substantial computer modelling of alternative combinations to find out what works best.

So the balance, getting the right mixture, of solar, wind, biomass and other sources is essential. For the UK, for example, meeting seasonal variations is very important, implying a higher ratio of wind to solar.

Storage is going to be important everywhere. Battery technology and pumped hydro, possibly some interconnection, combined with the ability to make use of more time-flexibility in consumer demands, will mostly be more than adequate for smoothing daily variations. But inter-seasonal storage is potentially a much bigger problem, unless the capital cost per unit of energy stored can be greatly reduced. The most promising answer appears to be conversion of renewables output into high energy forms which can be stored more cheaply. Hydrogen may be the preferred long term storage option at the present time, but there are other contenders.

In the UK, a bigger issue than seasonal storage may turn out to be risk of prolonged periods of low wind. Some modelling has simulated the effects using weather data over the last 40 years, and this has proved a useful exercise.

Markets and prices

These issues have related to technical planning, and available innovations, but there are also major implications for markets, governance, and the management and control of the sector. Turkmenistan and the UK have very different starting positions. Turkmenistan starts from a position of government ownership and control of the power sector, and supply to many consumers has been free. The UK has private ownership and some market structures but also has increasing government involvement in underwriting new low carbon investments, and in ensuring coordination within the sector. Despite these differences, I believe that there are some important common principles.

One is how to choose the most efficient plant to operate. In the UK we call this the merit order. As we progress towards low carbon economies, this will normally imply the plant with lowest CO2 emissions per kWh. In the UK and Europe this means that a price has to be attached to emissions and that must impact on the economic choices made for the sector. But it is also true that the task of managing power systems effectively with high renewables presents new challenges. In the UK we are also having to re-examine the methods that we use to get the most efficient operation of the system. The optimisation methods designed for a world of coal and gas generation are not necessarily the right ones for a low carbon system.

Consumer tariffs are very important. They are central to the ecology of the power sector as the primary means of communication between production and consumption. The priority attaching to reduced emissions is such that this should be reflected in cost reflective pricing. Tariffs are even more important if we need to promote more flexible demand. We expect to see some profound changes in the nature of the services provided by electric power in meeting consumer needs.

Finance and Governance

My last big economic issue is financing. It is widely held that collectively the world has a glut of savings waiting to be invested in useful projects. Also, the cost of capital is at historically low levels. But to access that capital, for any country or industry dependent on external or private finance, it will be essential to demonstrate that the investment is going to be well managed. The institutional structure is important for that and also for successful implementation.

This means ensuring a good and stable legal and institutional framework within which low carbon investments can be delivered, and one that banks, the World Bank and others, or other investors, can rely on. That of course depends on the commitment of governments, in the UK as much as anywhere, to low carbon objectives.

Saturday, February 20, 2021

TEXAS POWER CRISIS. MARKET OR REGULATORY FAILURES?

 

Viewed as independent countries California and Texas would both rank among the ten largest economies in the world. One Democrat and the other Republican, the feature they now have in common is failure to prevent extensive and disruptive interruptions to power supply – California in 2001 and Texas in February 2021. In both states near-catastrophic failures raise questions as to the viability of highly market-driven power systems, which contrast with the stability of more integrated models of the East Coast of the US, and internationally. The answers matter, not just for Texas, but for developed and developing economies everywhere.

In California, the new market structures had only recently been introduced. California had copied many features of the UK 1990 model, which had worked successfully, or at least without major mishap, for ten years. With the benefit of hindsight and a lot of analysis, there seems to be a reasonable consensus that the failures resulted from a combination of factors:

·         Weaknesses in the design of the new market structures

·         State regulatory authorities’ imposition of a price cap, which prevented the market working as it should, to reduce demand and increase supply.

·         Market abuse by Enron, notoriously exploiting the rules to gain large economic rents. Enron went on to become a major corporate scandal, but California was the setting for some of its most egregious wrongdoings.

The recent failures in Texas, celebrated as an example of liberalised market reform, are harder to explain. Unusual weather conditions may be a proximate cause but are hardly an adequate excuse for one of the wealthiest advanced economies in the world, in a liberalised power sector that has appeared to operate without serious mishap since the late 1990s. The other factor cited, the intermittency of wind, can be dismissed as a credible explanation; if relevant at all, it is a known risk that should have been easily managed in a well-functioning sector. We need to look further for adequate explanations of failure to provide reserve capacity.

Creating incentives for private operators to provide the level of reliability that the public want has always been a potential weakness of market-driven systems, usually resolved by the imposition of reserve margins, and financial incentives or penalties. Peter Cramton[1]  is Vice-Chair of ERCOT, the body that has coordinated the Texas power sector over this period, and has described[2] the approach taken to this problem in Texas. It is an administered scarcity price similar to that used in the 1990 UK reforms, which operated successfully up to the introduction of further changes in 2000.

A market in reliability

The Texas model, according to Cramton, sets out the rules to determine an administered scarcity price, in periods when there may be very high or peak demand or low supply.  In theory this should incentivise sufficient capacity (Q) at all times. The administered price aims to reflect the value of lost load (VOLL), and a high VOLL should in consequence result in high reserve margins for generating capacity. Texas sets a high value for VOLL. [3] Simple economics suggests high rewards will bring forward more than adequate supply.

One possible explanation for the current failure is simply that this scheme lacks credibility. If we look at these incentives for investors in potential reserve capacity, then the return on investment – the future revenue stream – may depend on achieving ultra-high prices in periods with an ultra-low probability of occurrence. This probabilistic estimate may indicate good “expected value” returns, but the very high chance of zero revenue is not attractive as a basis for large scale investments. Paradoxically the higher the value of VOLL, the rarer the occurrence of periods of scarcity and the less credible the projected revenue becomes. 

Closely linked is the matter of regulatory credibility: if prices need to go that high, as they must do to validate the investment in reserve capacity, and particularly if the price spikes impact on consumers, will the regulatory or political authorities really stand aside and let them happen? The 2001 California experience, at least as suggested in many accounts of that event, suggests otherwise.

What do UK market models tell us?

The UK used its own version of an administered scarcity price from 1990 up to 2000. Fortunately, this was a period with a legacy of surplus capacity, so the method was not subject to severe stress tests. It worked well but was also criticised for potentially allowing larger generators to exploit their market power. It was replaced in 2000 by trading arrangements which had no formal mechanism for capacity. It rapidly became apparent, however, that these would not incentivise new capacity, and would pose an increasing risk to reliability of supply. The UK moved gradually towards the establishment of capacity markets to supplement the new arrangements.

In practice this means that investment in new capacity does not depend on investors responding to market price signals and guessing future prices in the “energy only” electricity market.  Virtually all new UK generating capacity results either from government choices, long term contracts (nuclear plant), from feed in tariffs, or from capacity auctions.

If fixing prices (P) doesn’t work, try fixing quantities (Q)? P or Q?

Economists will be familiar with markets where the choice is to use price or quantity as the appropriate instrument of policy. A good illustration is the energy policy choice between a carbon tax (P) and setting emissions quotas (Q) which can traded. It is possible for the price and quantity outcomes to be the same under either regime, but the choice is important and is usually made on an empirical or pragmatic basis, of what is likely to work best or be more politically and socially acceptable. The UK approach, de facto, for reliability, is to concentrate on fixing Q.

In this context, capacity markets can fix Q if a central authority – government, regulator or utility – decides on the reserve margin and the reliability standard, and invites tenders to provide that capacity. This has the advantage of much more certainty that the reserve will be provided, but it places the onus on the central authority, not just to decide how much capacity but also, in practice, to determine the right technology mix, and to monitor delivery. It represents the abandonment of most of the tenets of a market fundamentalist approach to the power sector.

Regulation and Governance for the Power Sector

It is always tempting to read too much into a single event, when there will inevitably be multiple interpretations of what has happened, and rarely one simple explanation. Another focus will no doubt be on the general governance and regulatory arrangements in Texas, and the role of ERCOT (see below). However, the “standard model” of unbundled utilities, wholesale and retail competition, independent regulation and excessive reliance on markets, however flawed, must come under more scrutiny. Pioneered in the UK, promoted by the World Bank, the European Commission and others, it looks increasingly incapable of responding to today’s policy challenges, of which the climate emergency is just one.



[1] Cramton is an academic economist, who has described and indeed promoted market-driven models for the power sector. He described the role of ERCOT and the power sector in Texas in a paper - Electricity Market Design - in the Oxford Review of Economic Policy.

[2] Oxford Review of Economic Policy, Volume 33, Issue 4, Winter 2017, Pages 589–612

[3] In Texas VOLL was set administratively at $9,000/MWh—367 times higher than the average energy price of $24.62/MWh in 2016.

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Additional Notes.

A regulatory issue. There is another feature of the power sector in Texas which is at odds with the “standard model” of liberalised markets and independent regulation. The Electric Reliability Council of Texas (ERCOT) effectively controls the functioning, in operational terms, of the Texas power system. It is an umbrella organisation, whose membership includes the utilities, generators and other stakeholders in the sector. It implicitly assumes responsibility for reliability and by its nature provides scope for formal or informal coordination within the sector. This might be interpreted as a quasi-regulatory role, violating one of the conventional principles of sound regulation, namely that the regulator should be independent of ownership and management.  There is an additional oversight from a Texas Public Utilities Commission, but it is unlikely this will have had the knowledge or expertise to probe ERCOT too closely, especially on technical issues

It is possible to argue that ERCOT also provides a vehicle for informal planning or informal guarantees for future investment, and that coordination and more rigorous planning disciplines, plus technical monitoring of capacity, should have been applied.  I would argue in this instance that it was reliance on a “market” mechanism that is the more likely prime cause of the failure.

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California. See for example Weare, Christopher (2003) The California Electricity Crisis: Causes and Policy Options  ISBN 1-58213-064-7;

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There is another important alternative to administered scarcity prices. It is to allow scarcity prices to be set in a market by consumer choices and consumer valuation of reliability, but that is generally seen as currently impractical, because consumers lack the technical capability to respond quickly to price or crisis signals. However increasing digitalisation, and concepts like differential reliability and supplier managed loads- see my tariffs paper - will take us in that direction in the future.