Sustainablog

This blog will cover some news items related to Sustainability: Corporate Social Responsibility, Stewardship, Environmental management, etc.

8.12.06

Toward a Flexible Energy Future: When the price of fuel reflects all the costs, government and industry will know where to invest.


Toward a Flexible Energy Future
by Lord Andrew Turnbull
 
When the price of fuel reflects all the costs, government and industry will know where to invest.

Illustration by Lars Leetaru

In most of the industrialized world, there is a growing consensus that nations must reexamine and restructure their energy portfolios. A number of factors have contributed to this awareness: increasing fuel prices, the insecurity of energy supplies, and the recognition that humanity must reduce its carbon dioxide (CO2) emissions to address global climate change. Even countries that have enjoyed steady supplies of electricity, transportation fuel, and heating fuel in the past will find it much more difficult to maintain control over those supplies in the future. Any responsible government that is not thinking seriously about its country’s energy investments today — from both the public and private sectors — risks being caught cold, powerless, and immobile in the future.

But there is typically a five- to 10-year lag between an energy investment and the time the new capacity comes online. After that, countries are stuck with the facilities they have built for at least several decades. Thus, every major decision made now about energy involves a bet about the future. Because we don’t know which mix of fuels will be available or most useful in the coming years, how can investments best be allocated among natural gas, coal, oil, nuclear power, renewables, or improved energy efficiency?

The debate over these choices is contentious. In my own country, the United Kingdom, there are heated arguments over whether nuclear power should be promoted or decommissioned; whether increased use of natural gas is or is not a viable option; and whether wind farms represent an ecological breakthrough or an inefficient blight on the countryside. In any given year, new energy technologies (hybrid cars, hydrogen fuel, biofuels) emerge and add to the contention. The only way that political and business decision makers can appropriately manage these options is through a flexible portfolio: not a choice about a particular mix of fuels but through an effective and resilient marketplace that can take advantage of economic principles to help us settle on the optimal combination of investments at any given time.

In policy circles, this is coming to be known as the “modified market approach.” The government (or perhaps a regional political structure like the European Union) establishes a framework for energy prices. This framework incorporates the prices and costs of energy, as set by supply and demand, but also takes into account the social and ecological benefits and harms of each fuel source. Fuels that exacerbate climate change, for example, are made more expensive; fuels that reduce the danger cost less. An implied surcharge on carbon-based fuels reflects the desired CO2 reduction target. Once a rationale is agreed on, the government embeds the new framework in permits, surcharges, and regulations, after which the various technologies can effectively compete in the marketplace.

The modified market approach is a relatively recent innovation. Traditionally, governments have handled energy decisions in two ways: “Add it up” and “laissez-faire.” Adding it up is a time-honored approach. Government planners assess worldwide energy needs and generation capacity, make projections for the next 20 years, calculate the gap between future demand and supply, and decide which mix of fuels to subsidize, tax, or invest in.

Flexible Portfolios
Even at its best, this approach has many shortcomings. It is static; if energy technologies, supply constraints, or demand patterns change, another plan will be needed. It is also vulnerable to lobbying, with the verdict going to whichever pressure group shouts loudest that “our favorite fuel is better than yours.” And if political priorities change, the desired goals cannot be adjusted without a new plan. This makes it extremely difficult to take advantage of lower-cost opportunities, such as new technological developments, that emerge in later years.

Faced with these complexities, many governments take the “laissez-faire” approach: they leave it to the oil and power industries to govern their own investments. But this method, too, has many shortcomings. Market prices do not capture such externalities as the environmental impact of fuels, and they do not recognize the complex interdependencies among different forms of energy, the infrastructure required to maintain them, the security of supply, the needs of customers, and the uncertainties of the future.

To their credit, many governments are gravitating to the flexible portfolios of the modified market approach. In the U.K., for example, the government (controlled by the Labour Party) and the largest opposition party (the Conservative Party) agree on four basic objectives: to reduce CO2 emissions; keep the economy competitive (by reducing the price of energy); maintain security of supply; and ensure that people on all levels of society, including the poor, have heat and mobility. Both parties have encapsulated these objectives in a rationale that, when it is complete, will allow energy sources to compete and evolve, without regulators and investors having to predict in advance precisely which technologies will be adopted by the market.

For a modified market approach to succeed, there must first be a clear set of targets for the reduction of CO2 emissions. In setting the formulas that determine a nation’s energy portfolio, we should favor not merely the cheapest fuels, but the optimal fuel mix that adjusts over time, operates effectively during scarcities and surpluses, produces energy when the wind blows and when it doesn’t, and is independent of the vagaries of international oil politics (it must be viable whether or not a nation is on good terms with Russia, Nigeria, Saudi Arabia, Iran, or Venezuela). To accomplish this, three elements, in particular, must be reflected: the ecological impact of carbon, the variability of fuel supply, and the costs of energy security. If we understand how to factor in those elements, then all available energy sources — oil, gas, coal, alternative fuels, hydrogen, nuclear power, hydropower, and renewables — can compete on an equal footing.

Environmental Shadow Prices
In the coming years, faced with general climate change and more extreme weather patterns, every government will have to make a decision: To what levels must carbon fuel emissions be reduced to affect the rate of global warming, and by what year? No government can ignore this imperative for long. There is a growing body of opinion which (drawing on conclusions from such groups as the International Intergovernmental Panel on Climate Change and the American Association for the Advancement of Science) recognizes that human activities are contributing significantly to the dangers of global warming. Already, serious efforts to mitigate climate change are moving forward, with those political leaders who refuse to participate finding themselves marginalized; for example, a July 2006 greenhouse gas reduction agreement between U.K. Prime Minister Tony Blair and California Governor Arnold Schwarzenegger bypassed Washington completely.

The effective modified market approach must reflect the real environmental costs of different fuels. Having set a CO2 reduction target — taking into account the estimated effects of global warming on sea levels, crops, and the weather, and the destruction such effects could cause — governments must engineer a “shadow price of carbon” that delivers that target. The new framework would, in effect, modify the price of every fuel and technology, reflecting the increased risks caused by its CO2 emissions, while exempting fuels and technologies that emit little or no CO2.

The process for setting a shadow price must be transparent enough to draw open criticism from both environmental and economic experts, and robust enough to meet or incorporate that criticism without losing scientific credibility. It must also be consistent enough to enable suppliers to make informed predictions about costs and to set prices with confidence. Documentation would be required for each estimated cost — and costs would be revisited periodically to take into account changes in technology, practices, and damage assessment techniques. Priorities could no longer be determined by pressure groups demanding, for example, expansions of natural gas lines, bans on nuclear power, or restrictions on windmills.

In its approach to climate change, the E.U. has adopted a modified market system, at least in principle. The Emissions Trading Scheme (ETS), introduced in 2005, is still (as of late 2006) in the first phase of implementation. Each member country proposes a cap on greenhouse gases emitted by power plants and other major industrial sites; the E.U. approves the caps; and then companies are granted permits to operate within those caps. Carbon-profligate companies can buy more emissions rights from carbon-frugal companies, giving everyone more incentives for lowering emissions and building efficiencies.

But the ETS is an imperfect work in progress, in which political horse-trading overrides the best scientific judgment. The caps were so generous in the first year that no countries were forced to reduce total CO2 emissions — which (as many observers noted) undercut the entire purpose of the initiative. In the end, it is not clear whether the ETS will have the political will to overcome bargaining on the part of special interest groups, but only a tough stand will allow it to deliver a true shadow price for carbon that genuinely leads to the CO2 reductions required to mitigate climate change.

Because the ETS is still embryonic, most countries in the E.U. are retaining a national carbon or energy tax. This represents a significant structural difference: Trading systems, which fix the level of permitted emissions and allow the price to vary, tend to be more effective at capping emissions than tax systems, which fix the price and allow the amount of pollution to vary. Tax systems are also more prone to the arbitrariness of top-down control; the U.K.’s Climate Change Levy, for example, is a confused mixture of energy and carbon tax, levying on nuclear power, even though it is a low source of CO2.

The Price of Volatility
Emissions trading programs represent a valuable first step, but because they don’t take the other uncertainties of the sector into account, they alone are not an adequate means of guiding energy investment. Volatility adds cost to any portfolio. Investors know this well; they diversify across a variety of assets, balancing their requirements for growth and security. A good modified market energy portfolio should do the same, taking into account the volatility of the availability and price of different fuels.

Natural gas, as the world has witnessed, can fluctuate enormously. In the U.K., the spot price of natural gas doubled between 2004 and 2006. Even more damaging were two price spikes, in which U.K. gas prices briefly rose about 400 percent. Importing nations, in particular, have little recourse if suppliers raise prices suddenly (as Russia’s Gazprom has done) or supplies approach a natural peak (as has been predicted for oil). Other fuels are relatively stable; once reactors are built, the price of nuclear power remains relatively constant. Nuclear power can therefore take the role that bonds play in a pension fund: not necessarily the highest-yielding asset, but one that reduces volatility.

Another source of uncertainty that needs to be addressed arises from the protracted and uncertain nature of planning and licensing regulations. These are particularly damaging to highly capital-intensive options, such as the building of new liquid natural gas (LNG) or nuclear power facilities, or the recovery of heat from waste incineration. The U.K. government is proposing to address this uncertainty by allowing licensing of technologies to run in parallel with the planning process. Any resumption of nuclear construction should be preceded by agreement on a strategy for disposal of nuclear wastes (though those energy sources emitting CO2 as a waste are not required to meet an equivalent constraint). We should also insist that enough funds be allocated for waste disposal and decommissioning of plants, lodged outside the producer’s balance sheet.

If nuclear power can compete with the benefit of the carbon adjustment while meeting its waste and decommissioning costs in full, then it should find a place in the energy mix. Conversely, if it is still uneconomical, it should not. And the same logic should apply to other technologies, including renewables. There is no reason why established renewable energy technologies such as wind power should receive both the preference of the CO2 adjustment and a guaranteed market share (as is currently the case in the U.K.).

Recent analysis conducted by the U.K. government shows that nuclear power would be viable over a wide range of scenarios. It would struggle to compete only if gas prices and the shadow price of carbon were both low. That combination is inherently implausible, however; it would almost certainly lead to a higher shadow price for carbon, bringing nuclear power back into contention.

During my tenure as Cabinet secretary, I saw the shortcomings of addressing the energy supply in piecemeal fashion. Although there were two attempts to write an energy policy paper, at the time no one wanted to challenge prevailing assumptions — for example, the assumption that greater energy efficiency, renewables (such as wind power), and natural gas would provide enough carbon reduction in and of themselves. Such assumptions were undermined when the price of energy shot up, and the Russians and others reminded us of the vulnerabilities of natural gas.

But as I write, a consensus is building in Europe and North America with respect to global climate change and energy security, and it is coupled with a growing sense of urgency. We now have a moment of opportunity to create a framework that enables the essential energy choices to be made — not by dictating them, but by providing open competition and building all the relevant factors into the marketplace where choices are made.

Reprint No. 06404

One Billion New Automobiles


One Billion New Automobiles
by Bill Jackson and Vikas Sehgal
 

Imagine how the world would be transformed if the number of people who owned cars doubled in a decade. In fact, as the rate of personal vehicle ownership soars in Asia, a new kind of global automotive manufacturing industry is emerging to capitalize on this new customer base. Automakers (and the financial markets and supply chains that support them) already know their world is going to change; the media are beginning to pay attention to fledgling motor vehicle companies such as Chery (in China) and Mahindra and Mahindra (M&M, in India). But few people realize the full implications. If the auto markets of developing nations evolve on a par with established markets by, say, 2020, that development could upend today’s prevailing notions of what a car costs, how it is produced, and how it is used.

The trends that will shape this future — from automobile production to environmental impact to changes in working patterns — are proceeding at different speeds. But they are all interrelated, and their impact will be cumulative. These trends include:

• Social Mobility. In emerging markets, especially if the building of roads and fuel infrastructure continues, individual mobility and job opportunities will increase. This in turn will accelerate both the democratization and the industrialization of China and India.

We can assume that no emerging nation will become an automotive society on the U.S. model, with its suburban sprawl, subsidized fuel, and demand for large cars. Countries like India and China will likely impose strict regulations on vehicle size, fuel economy, emissions, and driving rights — and they will cut back or eliminate their current fuel subsidies. Excise taxes on larger engines and vehicles are also likely. The Shanghai government has already implemented a Singapore-style license-fee system that effectively rations drive time at peak periods in high-congestion areas.

As a result, people in relatively wealthy urban centers — such as Beijing, Guangzhou, Hyderabad, and Bangalore — will continue to rely on public transportation, since daily driving is impractical in dense cities without major highways. Rather than providing mobility during the week, cars in such locales will be used by residents to leave town on weekends, and they will also serve as status symbols.

For rural areas, however, motorization will open new horizons, and not just for car owners. For the first time, residents of remote villages will be able to reach urban centers in a half-day’s travel. Economic activity, be it agriculture, industrial production, or retail sales or distribution, will no longer be logistically isolated in rural regions. China’s automotive and steel sectors were once geographically segmented, with small clusters of suppliers and manufacturers duplicated in each major region. Now, the new highway system allows major players to consolidate in centralized locations, increasing their scale advantages.

• Environmental Impact. It’s still not clear whether emerging-country policymakers will take energy availability and environmental concerns into account as they promote growth. Why should they, since environmental concerns are a secondary issue in most developing countries? To date, many leaders in these nations have argued that they cannot afford the luxury of environmental accountability (particularly for greenhouse gas emissions and their impact on global climate change). This is a source of worry for many experts. China is already second only to the United States as a consumer of energy and producer of greenhouse gases. If driving habits in China, India, and other emerging nations duplicated those in the U.S., the environmental impact could be catastrophic.

But history suggests that rising economic growth leads to greater environmental awareness sooner or later, and this change may already be happening in the East. For example, China has just raised its fuel economy standards, and India’s metropolitan governments are beginning to tighten environmental regulations. “The challenge for developing countries,” says Dilip Chenoy, director general of the Society of Indian Automobile Manufacturers, “is whether to converge with European standards in the next few years, or just to maintain a one- or two-year gap behind Europe.” The latter option, he said, “may allow us to develop indigenous technologies at lower cost, making the cars more affordable but still meeting emission norms.”

• An Expanding Lower-End Auto Market. India’s best-selling small car is currently the Maruti Alto, which sells for less than 210,000 rupees (about US$4,500), and manufacturers there are aggressively developing automobiles that will sell for about half that amount. The cars that become popular in emerging markets will deliver necessities rather than creature comforts: A typical car manufactured in India or China may have a plastic shell, a rudimentary motor, good brakes, and a stout suspension to handle unpaved roads, but no airbags. In adapting vehicles for the narrow streets of emerging nations, manufacturers could change the world’s conception of what a car looks like, down to whether it must even have four wheels. Even today, in countries such as Thailand, it’s possible to see a family of seven balanced on the back of a motorbike; to such families, a three-wheeled, three-seated vehicle would seem positively luxurious.

• New Pressures on the Auto Industry. As manufacturers develop in emerging markets to serve the millions of new vehicle owners there, they could follow the path that Japanese and Korean carmakers have paved to bring their products to established markets. The basic vehicle model of the emerging economies could be adapted for other nations, offering fuel efficiency and unprecedented low prices, with a few extra tweaks like the additional safety features that established markets require.

China and India are already exporting cars to the Middle East, Africa, and Eastern Europe; these markets can act as testing grounds for penetration into North America and Western Europe. Eventually, China and India could become the world’s leading producers of small cars and of vehicles that use alternative fuels. India’s motor vehicle industry may, in particular, surprise the rest of the world. It benefits from access to a large population of skilled engineers, a 60-year history, and the world’s fastest-growing major automotive market. Indian manufacturers such as Bajaj and TVS currently produce more two-wheeled vehicles (such as motorcycles and motor scooters) than those of any other nation except Japan. Indian automakers, including M&M, Maruti, Hindustan Motors, and Tata, currently make about 1 million automobiles per year, of which about 80 percent are small, fuel-efficient cars well suited to relatively low-income consumers living in relatively dense urban areas anywhere in the world.

Recent history suggests that many Western automakers will fail to respond effectively. U.S. manufacturers have focused on large cars and trucks, and European car companies have focused on performance. Both groups have thus missed opportunities to develop economical cars with high fuel efficiency and the selling point of reducing dependence on foreign oil.

If all the current automotive trends accelerate, many companies will see their value chains overhauled, not just in the auto industry but in every sector. Nations around the world will suffer the consequences of increased pollution and greater global competition for fuel. And the automobile as a product will be transformed. Those manufacturers and suppliers that start planning now for a new wave of upstart competition will be the most likely to thrive in the next automotive environment.

Author Profiles:


Bill Jackson (jackson_bill@bah.com) is a senior vice president with Booz Allen Hamilton in Chicago. He works on major organizational change programs, including restructurings, post-merger integrations, and growth, for a variety of industrial clients, especially in the global automotive industry.

Vikas Sehgal (sehgal_vikas@bah.com), a principal with Booz Allen Hamilton in Chicago, works with clients on strategies for innovation and emerging markets.