The Economics of Renewable Energy

In this analysis of renewable energy policy in the U.S. the author proposes the adoption of a more economic decision-making method for investments that goes beyond environmental considerations and focuses on financial returns.

While electricity costs from renewable energy sources have dropped significantly over the past 25 years, these costs are still greater than wholesale electricity prices. Despite growing evidence for environmental damages caused by fossil fuel sources, the damages are extremely difficult to quantify, and as a result, the evidence for these effects has not been universally accepted. Because the evidence has not been accepted, funding for renewable energies remains stagnant. The problem with support levels for renewable energy is the criteria used to decide those levels. Currently, “two of the criteria for evaluating the effectiveness of incentives and mandates such as PURPA are renewable energy capacity and generation growth.” (Source: Energy Information Agency, Incentives, Mandates, and Government Programs for Promoting Renewable Energy, February, 2001) While capacity and growth are excellent metrics for reductions of greenhouse gases and other pollutants, they do not capture any measurable economic value, and cannot effectively be used as arguments for capital investments. Proper investment decisions should be made based on financial returns. Fortunately, we are approaching an amazing transition from “cheap power equals more polluting” to “cheap power equals less polluting”. For this reason we can start arguing for the economic benefits of renewable energy, especially now that we have a fossil fuel friendly President in the White House with a MBA degree who has been educated to make decisions based on economic and not environmental reasons. Investments in renewables will eventually drive electricity prices produced from clean sources to be cheaper or as cheap as other forms of power production. When this occurs environmental benefits will only be secondary arguments. But now, in financial terms, investments in R&D and incentives for renewable energies should be treated as capital expenditures which will result in cost savings in the future that will provide a positive net present benefit to all parties involved. This is not a new idea. According to the ACEEE, the “DOE [US Department of Energy] recently documented that twenty of its most successful energy efficiency projects have, over the past twenty years, saved the nation 5.5 quadrillion BTUs of energy, worth about $30 billion in avoided energy costs. The cost to taxpayers for those activities over the past decade was $712 million, less than three percent of the savings, and the savings are increasing every year.” (source: ACEEE) Renewable energy has historically been promoted for the direct and indirect benefits of reducing our dependency on fossil fuels. Traditional arguments include: minimizing climate change, reduction on dependency on oil imports, local air pollution reduction, and increased productivity of the overall economy. All of these arguments are valid is a general sense in their support of renewable energy. Each of these arguments faces a range of contradictory “scientific evidence” or quantification difficulties. At this point in time, only penalties for carbon emissions exist to “value” clean energy. As important as these penalties are, there still needs to be additional qualities that can be quantified and can garner universal support. Renewable energy benefits need to be quantified to be able to attract investors, both public and private. The value of an investment that includes the multi-year future economic benefits is called net present value. The net present value solution is exactly in line with the United States market-driven economy. Our country has grown to be an economic world leader because decisions have been made that attempt to optimize a limited set of existing resources to create additional resources at some point the future. This mentality should translate to the renewable energy industry. Current investments in renewable energy should be decided based on future economic benefits, but as mentioned above, most benefits are extremely difficult to quantify. For example, the Office of Management and Budget “estimates the net benefits from Federal health, safety and environmental regulations at between $30 billion and $3.3 trillion annually”. (source: Energy Information Agency, Incentives, Mandates & Government Programs for Promoting Renewable Energy, February, 2001) That is quite a large range, and does not lend tangible support to understanding those benefits. One important aspect of renewable energy that can be quantified is the future cost savings that will occur once electricity prices from renewable energy sources drops below those of wholesale electricity. This is will be a benefit to all parties involved. For the government, when electricity costs decrease, capital is available to be spent on other expenditures, which is good for the economy. For the renewable energy industry, lower prices equate to greater demand, which will increase sales and economies of scale. Wind power will most likely be the first renewable energy source to become less expensive per kilowatt-hour than electricity produced from fossil fuel sources. Both solar and wind power costs are declining at decreasing rates, which means that the ‘per kWh’ rate is reduced each year by a smaller amount. This may lead one to believe returns on renewable investments would also be declining. On the contrary, because production volumes are increasing, the net result is increasing returns to renewable investments. The returns are defined by the reduction in electricity costs from the previous year. For example, the average manufacturing cost of photovoltaics is decreasing as capacity increases. Even though the costs should decrease slightly less in 2000-2005 than they did in 1992-1999, in 2000-2005 the capacity should increasing 2-3 times than in 1992-1999. Meaning, investments are generating larger returns than before in the form of total cost savings. The net present value, or NPV, of an investment is the difference between the initial investment and the discounted value of the future benefit of the investment. The information needed to find a NPV includes the initial investment amount, accurate predictions of the future economic benefit, and a fair discount rate, which represents the equivalent return of similar investments. First of all, initial investments cannot be determined unless the incentive money spent each year is identified. Government investments in renewable energy are divided into two major categories: research and development (R&D) and incentives. Fortunately, R&D investments are tracked. Unfortunately, the always-popular Internal Revenue Service is unwilling to share information regarding tax credits and rebates. The most obvious step is to require the IRS, states and local governments to share tax credit, rebate, and other incentives granted. The Energy Information Agency of the Department of Energy attempted to estimate the annual costs of Federal energy subsidies in 1990, and ended up with a range of $5 billion to $10 billion. (source: EIA, Incentives, Mandates & Government Programs for Promoting Renewable Energy, February, 2001) A $5 billion range is not helpful for making investment decisions. Secondly, to be able to accurately predict the future value of the renewable investments, the drivers of renewable energy costs must be understood. Five such drivers are research and development, incentives, production volumes, earnings from other industries, and the cost of carbon emissions (models exist to determine carbon emissions, such as EIA’s National Energy Modeling System and the Pacific Northwest National Laboratory’s Second Generation Model). Finally, renewable energy projects are considered risky, and hence receive higher discount rates than other energy-related projects. As renewable energies build a solid track record, the discount rates should come down to other energy-related levels. This point in time is very crucial because prices are becoming competitive with wholesale electricity prices, and future benefits are not that far in the future anymore. There exist numerous factors that can be modeled that will drive the future value of renewable energy investments. Only after these models are constructed can we begin to project the future benefits, and lay the foundation for a sound economic argument for renewable energy investments. — Matt Coleman Anderson School of Management at UCLA.
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