The Economics of Renewable Energy Part 2

Efficiency Policies Governments can promote energy efficiency by setting energy efficiency standards. For example, in 2022 the United States adopted light-bulb efficiency standards that effectively phased out oldstyle incandescent light bulbs (invented by Thomas Edison in 1879) and required the use of LED lighting. Other energy efficiency standards exist for buildings, appliances, electronics, and vehicles. Like renewable portfolio standards, efficiency standards are an example of government taking a direct role in regulating the efficiency of products available in the market. Efficiency labeling is a different approach that informs consumers about the energy efficiency of various products. For example, in the United States the U.S. Environmental Protection Agency and U.S. Department of Energy manage the Energy Star program. Products that meet highefficiency standards, above the minimum requirements, are entitled to receive the Energy Star label. About 75% of consumers who purchased an Energy Star product indicated that the label was an important factor in their purchase decision. Since the program inception in 1992, the savings from Energy Star products amount to over $500 billion. Even with informative labels, many consumers do not purchase high-efficiency products because the upfront costs may be higher. For example, more-efficient refrigerators cost more than lessefficient ones. However, the energy savings from efficient refrigerators means that the additional cost will be recovered in a relatively short time period. The problem is that people often have high implicit discount rates, focusing on the upfront cost while discounting the long-term savings (see Box 9). Rebates on efficient products can reduce this problem. Education and promoting a cultural change toward more long-run thinking will likely be needed to make consumer purchasing habits more consistent with energy efficiency. Economists point out that if efficiency is raised without any increase in energy prices, there is a leakage or rebound effect – since it is cheaper to use more efficient cars and appliances, people may respond by using them more, thus partly offsetting the energy reductions from greater efficiency. Gillingham et al. (2016) find that the magnitude of rebound effects estimated in different studies varies greatly, but most results fall in the range of 5%-25%, i.e. this proportion of the energy reduction from efficiency is lost due to greater usage. As mentioned earlier, from an economic theory point of view energy prices should rise to reflect the negative externalities of fossil fuel use. Higher energy prices could prevent rebound effects. Of course, higher energy prices are not popular – but from an economic point of view they are a reliable way to promote increased efficiency. BOX 9: IMPLICIT DISCOUNT RATES AND ENERGY EFFICIENCY A major problem in increasing energy efficiency of appliances arises from high implicit discount rates. Suppose that a consumer can purchase a standard refrigerator for $500, and an energyefficient model for $800. The energy efficient model will save the consumer $15 per month in energy costs. From an economic point of view, we can say that the return on the extra $300 invested in the efficient model is $15 x 12 = $180/year, which generates a 60% internal rate of return (a metric equivalent to return on a financial asset) over a 15-year refrigerator life. Anyone who was offered a stock market investment that would bring a guaranteed 60% annual return would consider this a tremendous opportunity. But it is very likely that the refrigerator buyer will turn down the chance to make this fantastic return. The reason is that they will weigh more heavily the immediate decision to spend $500 versus $800, and therefore choose the cheaper model. We could say that the consumer is implicitly using a discount rate of greater than 60% to make this judgment—a consumer behavior difficult to justify economically, yet very common. Capital Intensity and Interest Rates Most renewable energy technologies, such as wind and solar, are capital intensive. For these energy sources, annual operating costs account for only a small portion of total costs, relative to the large initial capital costs. Given this capital intensity, the levelized costs of renewable energy (see Box 7) are very sensitive to interest rates. (Exercise 4 at the end of the module asks you to calculate LCOE with low and high interest rates). Lower interest rates imply a lower cost of capital and thus lower costs for renewable energy, while higher rates have the opposite effect. Government policy affects interest rates, particularly the rates set by central banks to regulate the macroeconomy. Targeted policies can also provide lower-interest loans for specific technologies such as renewable energy to encourage adoption. Such policies are particularly important where interest rates are high, for example, in lower-income countries where interest rates can be double those found in higher-income countries. Removing Regulatory Barriers Finally, government policies can affect renewable energy adoption by addressing regulatory hurdles to deploying renewables. For example, siting wind turbines is easy in some government jurisdictions, and almost impossible in others. Permitting processes may require environmental reviews that can last for years. A process designed to allow a reasonable level of public information and participation can be abused by a small number of people who wish to block a project, regardless of its level of public support or net environmental benefits. In the United States, building new electric transmission lines—critical for the cost and reliability of a renewable energy system, as discussed above—has been particularly stymied by regulatory processes that were not designed to address the urgent problem of climate change (though this may be changing: in early 2024, the Federal Energy Regulatory Commission approved a new rule to speed up the process of connecting new sources to the power grid, especially benefitting the considerable backlog of new wind and solar projects. Governments thus have a role to play in hastening and smoothing the adoption of renewable energy through reconsideration of its own procedures. Governments must provide the right balance of necessary regulation, appropriate public participation, and concrete action to address the crisis of climate change through transformation of the global energy system. Renewable Energy in Low and Middle-Income Countries (LMICs) The economic and policy principles governing renewable energy systems as described in this module are intended to be nearly universal, i.e. to apply to countries and regions regardless of their economic, environmental, and social characteristics. Yet several aspects of renewable energy development may differ in low- and middle-income countries (LMICs). The term “leapfrogging” is often used to describe a technology development path that uses the most current technology without ever adopting its historical antecedents. For example, countries that never installed universal landline telephone service can now move directly to mobile technology without the expense of landlines. The leapfrogging concept applies in part to renewable energy development. The most obvious example is that LMICs without fossil-fuel infrastructure can now avoid the expense of developing this, along with the potential for stranded capital assets as fossil fuels are retired to mitigate climate change. Rather than building coal, oil, and gas-fired power infrastructure, LMICs can invest in solar and wind energy along with the necessary energy storage. Similarly, buildings and transportation infrastructure can be built for electricity use initially and at appropriate levels of efficiency. On the other hand, completely avoiding the development of a hard-wired electric grid (i.e. as a parallel with communications technology) in LMIC seems unlikely. For those without electricity, small, independent energy systems can indeed provide substantial benefits at minimal cost and without an electric grid. For example, a family without electricity could add a single solar panel and battery to supply a few lights and charge phones, greatly increasing quality of life. But larger electric loads—even a refrigerator—can be less expensively supplied by an electric grid than by an independent system. Where consumers also demand electric cooking, cooling, transportation, water pumps, etc., there is no substitute for an electric grid. Even where most households supply their own solar energy, an electric grid may be a less expensive way to balance loads between households (and between commercial and industrial uses) than to have enough batteries for each household to be fully independent. But the characteristics of newly developed electric systems may be different, including initial use of smart-grid features, microgrids, two-way energy flows, and local energy storage not found in older electric grids. New electric grids can also be better positioned to access the best renewable energy production sites and for interregional electric transmission. In these ways new electric grid development represents a partial leapfrogging of earlier technologies. As described above, most renewable energy sources require substantial initial investments, and their final costs (LCOE) are thus greatly dependent on interest rates. Many LMICs face much higher costs of borrowing than higher-income countries, effectively making renewable energy more expensive in LMICs. If all countries of the world are to adopt renewable energy—as needed to avoid the worst effects of climate change—LMICs are likely to need assistance in the form of lowered interest rates for renewable energy investments. As observed above for the Bogdanov et al. (2021) study, prices for renewable energy are widely expected to decline over time, especially for the core solar and battery technologies. This expectation is based on learning that occurs as the technologies are more widely deployed and on achieving greater economies of scale in production. If prices indeed fall as expected, early adopters will thus face higher prices than later ones. A key role for higher-income countries is thus being the initial renewable energy developers, in part to mitigate climate change and in part to drive down prices, making renewable energy more affordable throughout the world. Finally, the nature of renewable energy systems may be somewhat different in LMICs. In particular, many LMICs are in regions near the equator, where solar energy is stronger than at far northern and southern latitudes. A 2020 report by the World Bank found that many of the world’s poorest countries are also those with the highest solar potential, including Namibia, Lesotho, Afghanistan, and Sudan (World Bank 2020). Year-round equal day length at the equator also removes the seasonal solar energy storage problem. Solar energy is thus expected to be more prominent in equatorial LMICs. Many LMICs also face freshwater shortages that can be mitigated with seawater desalination (at least in coastal areas). Desalination represents a large electric load that can be accomplished only when solar energy is available, with the resulting freshwater easily stored in reservoirs, effectively storing energy at low cost. Such reservoirs may also hold potential for pumped hydropower electricity storage. This energy-water nexus is thus likely to provide opportunities to reduce costs and increase benefits of renewable energy systems in LMICs. 5. SUMMARY Addressing climate change requires that carbon emissions eventually approach zero, so most remaining fossil fuels must be left in the ground. A number of renewable energy technologies are available to replace fossil fuels, with many of the needed technologies being well established and cost-effective, and others, such as battery storage, rapidly improving in efficiency and capability. A renewable energy economy is technically and economically feasible. A general plan for energy decarbonization is to use energy in the form of electricity, and then make electricity from renewable sources. In this renewable energy economy, many applications that previously used fossil fuels, e.g. transportation and home heating, can most cost effectively be powered by electricity. An essential goal for society is minimizing the cost of a renewable energy system—a system that provides for society’s energy needs at all times. Costs can be considered broadly, including any externalities of energy production. There is now much evidence that least-cost, fully renewable energy systems should include a diversity of renewable energy sources as well as energy storage in different forms. This energy diversity includes both variable sources (wind and solar) and dispatchable sources (hydropower, biomass, geothermal, storage), taking advantage of source complementarity and making provision for occasions when variable sources are unavailable. Long-distance electricity transmission lines are also important to increase reliability and decrease cost, since wind and solar energy are more consistent over larger areas, and long-distance transmission allows generation to take place in the best (e.g. windiest, sunniest) and least expensive locations. In addition to energy production, energy efficiency must play a central role in achieving the shift to renewable energy systems, since it can significantly reduce overall energy demand. Energy conservation (doing without energy for some purposes, at least temporarily) at critical times can also reduce the cost of a renewable energy system. Climate change is a major externality of economic activity. As such, economic theory indicates that an unregulated free market will not respond adequately to this problem. Some level of government policy to limit fossil fuel use and promote renewable energy and energy efficiency is needed. Potential policies range from direct controls (e.g. requiring use of renewable energy) to various incentives (e.g. taxes, subsidies) to promote a transition away from fossil fuels. While climate change is a formidable problem, technically and economically feasible solutions already exist. The challenge for our society is to organize ourselves around renewable energy use with all possible speed. Economic analysis is essential to indicate the most effective choices. 34 6. DISCUSSION QUESTIONS 1. What are the main reasons for promoting a transition away from fossil fuels? What are the characteristics of renewable energy sources that distinguish them, and an economic system based on renewables from fossil fuels? 2. What are some of the problems and limitations of renewable energy sources? What major solutions are available, or can be developed, to respond to these? 3. Compared to fossil fuels, biomass fuels might appear to be the easiest substitute, since in most cases biomass fuels can easily replace fossil fuels, using similar technology. Also, like fossil fuels, biomass fuels are dispatchable on demand. But what are some potential problems with moving to a more biomass-based economy? 4. Hydropower is currently the largest source of renewably generated electricity in the world, and there is potential for expansion. In a few countries, a renewable energy portfolio could be based on hydropower and energy efficiency alone. Yet hydropower is also controversial, chiefly because of associated negative externalities. Describe some of these. Do you think more hydropower should be developed in the world? What criteria would affect a decision on whether to develop a particular hydro project? 5. In this module, we have stressed a systems approach to the renewable energy transition. Rather than considering only individual energy sources, we should consider the set of production and consumption technologies as a whole. What are some of the motivations for a systems approach, and some examples of this? 6. Why is public policy essential to promoting renewable energy use, and in accelerating the transition to renewable energy? What public policy approaches do you think will be most effective? 7. EXERCISES 1. Energy use can be expressed in an annoying number of different units, but fortunately any energy unit can be converted to any other unit. To compare real energy costs, search the web to get typical prices, energy content, and conversion factors, and express the following costs in gross $/kWh (to get net $/kWh we would also need to consider efficiency, which would vary by application): • • • • • electricity bought from a utility in your home region natural gas home heating oil (#2 fuel oil) gasoline in the United States gasoline in some European country (Hints: See Box 1 on units above. You may need to find the energy content of the fuels in Btu, then convert Btu to kWh. 2. Hydropower availability can be calculated as: kW = 9.8ηQH where Q is flow in m3/sec, H is head in meters, and η is overall system efficiency. Also, Annual kWh = kW x annual operating hours If a waterfall has an average flow of 5 m3/sec, a head of 10 meters, and overall system efficiency (η) is 0.8, how much power is available from the falls (in kW)? If the capacity factor is 0.7, how much energy can be generated in a year (in kWh)? (Hints: See Box 5 on power and energy and Box 6 on capacity factor above.) 3. Switchgrass grown in the United States can produce about 7.5 tons of biomass per acre per year, yielding about 80 gallons of ethanol per ton, and each gallon of ethanol has about 67% of the energy in a gallon of gasoline. Find total annual U.S. gasoline consumption and the farmland area of the United States, and calculate the percentage of U.S. farmland needed to grow switchgrass to completely replace gasoline with ethanol. What economic effects might there be from getting a large portion of the U.S. fuel supply from switchgrass ethanol? (Hint: it may be easiest to work this problem in millions of gallons and millions of acres) 4a. Find the levelized cost of electricity (LCOE) for a 5 kW capacity solar electric system if the system capital cost is $3,000 per kW of capacity, the interest rate is 5%, the system lasts 30 years, and the capacity factor is 0.15, and for simplicity we assume no operating costs (solar PV operating costs are typically low, but greater than zero) (Hints: See Box 7 on LCOE and Box 6 on capacity factor above.) b. Repeat problem 4a. using an interest rate of 10%. How much does this change in interest rate affect the LCOE? 5. Find the system LCOES for the simplified (but realistic) renewable energy system shown below, if the interest rate is 8.0%. source Wind Solar Hydropower capacity, kW 100 200 150 fixed capital useful life, operating cost/kW years cost/kW 1400 25 35 1000 30 10 3000 50 60 Total system supply and demand, kWh: energy generated, kWh 210,000 240,000 150,000 600,000 (Hint: See Box 7 on LCOE above.) 6. A study of energy efficiency options for a Vermont apartment building estimated the additional capital cost of heat-recovery ventilation to be $16,000 (as compared to ventilation without heat recovery). If the heat-recovery ventilation saves 9,000 kWh per year, the equipment has a useful life of 20 years, and the discount rate is 4%, what is the cost of conserved energy (CCE)? GLOSSARY biomass energy: energy derived from biological sources such as trees, crops, and animal waste, which may be used for heating, for conversion to liquid fuels, or for generating electricity. capacity factor: for an electricity generating plant or device, the ratio of actual energy produced in a period of time to maximum energy production potential in that time period. A capacity factor is usually less than one, since most electricity generating plants do not operate at full power continuously. cap and trade: an emissions control system where the government issues permits for a target emissions level (the cap), requires polluters to hold permits for their emissions, and allows polluters to buy and sell permits in a market. capital and operating costs: costs of supply (for energy or other products), with capital costs being the initial costs of constructing facilities, and operating costs extending over the life of the facility. capital intensive: requiring a relatively higher level of investment cost for initial establishment as compared to ongoing cost for operation. carbon capture and storage: technology that captures carbon dioxide from an emissions stream or the atmosphere and sequesters the carbon dioxide underground in liquid form or chemically through reaction with bedrock. clean electricity standard: a requirement that some or all of a utility’s electricity sales come from sources defined as clean, for example, from sources having low or zero carbon dioxide emissions. climate change: changes in global climate, including temperature, precipitation, and storm frequency and intensity, that arise from changes in the concentrations of greenhouse gases in the atmosphere. constrained optimization: an economic method to identify a best solution subject to one or more limits or constraints. For example, constrained optimization for a renewable energy system might seek the lowest cost subject to the availability of wind and solar resources over time and to having enough generation to meet demand. curtailment: limiting supply of energy to the grid from sources such as solar, to avoid overloading the grid at specific times direct air capture: a version of carbon capture and storage that removes carbon dioxide from the atmosphere at normal atmospheric concentration (as opposed to capturing concentrated carbon dioxide in an emissions stream). discount rate: the annual rate at which future benefits or costs are discounted (or reduced) relative to benefits or costs in the present. A discount rate reflects the difference in value between getting something now and having to wait to get the same thing in the future. dispatchable: an electricity generation source that can be started or increased when needed (not including sources like wind and solar, where the output depends on weather conditions). dynamic problem: a problem in which conditions change over time, i.e. where time is an important variable in the problem. ecosystem services: beneficial services provided freely by nature such as flood protection, water purification, and soil formation. efficiency label: a product label that indicates energy efficiency relative to similar products, such as a label on a home appliance showing annual energy use. electric grid: the network of electric cables, transformers, controls, and other equipment that provides long-distance electricity transmission and local electricity distribution to users. energy efficiency standard: an environmental regulation approach that sets a minimum standard for efficiency, such electricity use for a household appliance or fuel use for a vehicle. energy transition: an overall change in the energy sources used by society, for example in the past from wood to fossil fuels, and now from fossil fuels to renewable energy sources. environmental externalities: effects of market transactions on the environment, usually not considered by market participants feed-in tariff: a policy to provide renewable energy producers with long-term contracts to purchase energy at a set price, normally based on the cost of production plus an additional incentive. flow: in a hydropower context, the quantity of water in a river or stream moving past a given point over a specific period of time, usually measured in cubic meters per second or cubic feet per second. geothermal energy: energy derived from heat in the earth, which may be used for heating or electricity production. greenhouse gas: a gas whose accumulation in the atmosphere heats up the planet, just as the glass in a greenhouse heats its interior by trapping solar energy. head: in a hydropower context, the vertical distance that water falls, usually measured in meters or feet. heat pump: a device that uses mechanical energy and refrigeration technology to move heat from a colder area to a warmer area (the opposite of natural heat flow), usually for heating buildings and domestic water. hydropower: energy derived from falling water, usually in the form of electricity. intermittency: a characteristic of energy sources such as wind and solar, which are available in different amounts at different times. kilowatt (kW): an energy flow of 1000 watts or 1000 Joules per second. kilowatt hour (kWh): an energy quantity equal to a flow of 1 kilowatt (kW) for 1 hour, or 2 kW for ½ hour, or 0.5 kW for 2 hours, etc. law of demand: the economic principle that when the price of a good or service rises, the quantity demanded falls. The law of demand is observed for most goods and services in most markets. leakage: (in the context of energy use) the effect of improved efficiency in promoting higher energy use because of lower costs, thereby cancelling out some of the reduction in energy use from the original efficiency increase. See also rebound effect. levelized cost of energy (LCOE): the average cost of producing energy (usually electricity) from a source over the life of the source, including capital cost, fuel cost (if any), and all other operating costs. linear programming: a method for finding the best solution to a problem with a linear objective function and linear constraints. marginal benefit: the benefit of consuming one more unit of a good or service. marginal cost: the cost of producing one more unit of a good or service. negative externality: negative impact of a market transaction affecting people not involved in the transaction. nuclear energy: atomic energy that produces heat from fission, the splitting of atoms in radioactive materials, producing steam used to generate electricity with a steam turbine. Nuclear fusion would make use of heat from combining atoms, but in 2024, nuclear fusion does not yet exist as an electricity generation technology. ocean thermal energy conversion (OTEC): a system that uses the temperature difference between relatively warm water at the surface of the ocean and cold water at great ocean depths to drive a turbine that generates electricity. offshore wind power: wind power derived from wind turbines placed in the ocean or another large body of water. opportunity cost: an economic term for the value of the best alternative given up in order to get something. photovoltaic energy (PV): one form of solar energy, where electricity is produced by sunlight falling on silicon semiconductor cells. Pigovian tax: a per-unit tax set equal to the external damage caused by an activity, such as a tax per ton of pollution emitted equal to the external damage of a ton of pollution. positive externality: positive impact of a market transaction affecting people not involved in the transaction. power-to-X: converting electricity into energy forms such as fuels or latent heat that are needed in some applications and/or more easily stored. prosumer: a consumer who produces all or part of the product consumed, for example, an electricity consumer who produces part of their electricity from home solar panels. pumped hydroelectric storage: a method of storing energy where energy is first used to pump water to a higher elevation (for example in a high lake) and the energy is later recovered when the water is allowed to fall to its original level. Pumped water storage is based on hydropower technology. rebound effect: the tendency of demand for a resource such as energy to increase when increased efficiency reduces costs, thereby cancelling out some of the reduction in energy use from the original efficiency increase. renewable energy: any energy that comes from an inexhaustible source. The main examples are solar, wind, hydropower, geothermal, and biomass energy. renewable portfolio standards: regulations that set minimum percentages of energy to be obtained from renewable energy sources. smart electric meters: electricity measurement devices that record total electricity usage and collect data like electricity usage over time. Smart electric meters may also have communication capabilities and can control loads, i.e. turn off low-priority electric appliances when electricity is expensive or unavailable. solar energy: energy derived from the sun directly or indirectly (e.g. through production of plant biomass), usually as heat or electricity. stranded capital asset: productive infrastructure that must be abandoned before the end of its useful life, for example, oil wells that may be retired to mitigate climate change. subsidy: financial support provided usually by the government to encourage an action, sometimes in the form of reduced taxes or direct payments. tidal power: energy derived from incoming and outgoing tidal water flows, usually in the form of electricity. variability: a characteristic common to most renewable energy sources, meaning that they are more or less available at different times; variability is particularly challenging with wind energy, given the extent to which available energy varies with wind speed. wave energy: technology that uses the rising and falling action of waves to generate energy, usually in the form of electricity. wind power: energy derived from moving air. Wind power is often in the form of electricity, though it may also be used to pump water or generate heat.