The Low-Growth Scenario

Who would have guessed as recently as two years ago that the story that finally pushed the energy crisis off the front page would turn out to be a major global financial crisis? Of course, energy--specifically its environmental consequences, along with high oil prices--remains just as important as it was, but it must now be viewed in an entirely different economic context, the ultimate shape of which remains to be seen. The slowing of global economic growth has already resulted in lower oil prices. But if that slowdown becomes a recession, particularly one triggered by a significant tightening of credit, the expansion of both conventional and alternative energy supplies could be affected, along with investments in improved energy efficiency, including more fuel-efficient automobiles.

I've led a number of scenario projects in the last decade, many of them examining various aspects of the future of energy. One of the key steps in developing scenarios involves the identification and ranking of the main uncertainties affecting the outcome of the proposition in question. Participants will often highlight economic conditions such as growth rates and inflation, but in my experience, these have usually been trumped by other factors, including environmental regulations, energy prices, and technology. As fundamental as economic growth is to demand for energy and the capital to invest in new forms of energy, the prospect of a protracted period of low growth and tight capital simply didn't seem credible to most people, even though the last major slowdown in energy investment followed the collapse of oil prices in the late 1990s, which was triggered in part by the Asian Economic Crisis.

There are numerous ways in which a credit crunch would affect energy investment, though the notion that I keep hearing, that it would enforce an either/or choice between investing in traditional energy sources--oil, gas and coal--versus renewables is almost certainly wrong. If oil investment slows, it likely won't be because oil companies can't borrow for projects, but because falling demand and resulting lower prices make marginal projects unattractive. Particularly for the largest oil companies, who after several years of high prices have lots of cash and little remaining debt, decisions will boil down to hurdle rates and forecasts of future oil, natural gas, and refined product prices--and to their effective tax rate on profits, which is already around 40%. Most alternative energy companies are in a very different position, with large recent investments and much smaller cash flows, a significant fraction of which depend on government subsidies and mandates. A credit crunch could slow their expansion dramatically.

Nor would this effect be confined to companies and large alternative energy projects. If consumers can't obtain attractive financing for more efficient appliances, heating systems, or rooftop solar power installations, the markets for those products will languish, and their aggregate impact on energy consumption and greenhouse gas emissions will be less than hoped, at least for the next few years. That also applies to more efficient cars, especially those involving technologies that add significant up-front costs. Lavish tax credits for plug-ins and other hybrids might not help their sales much, if buyers can't qualify for the loans to buy them. Getting up to $5,000 off your taxes the following April--assuming that doesn't exceed your net tax liability--may seem very attractive, but only if you can float that amount in the interim, or reduce your withholding accordingly. (Based on recent effective average federal income tax rates, anyone earning less than about $80,000 per year might not qualify for the full credit.) As US new car sales fall, it will take longer for the fleet to turn over, and for overall fuel economy to improve.

It's still not certain that we'll be living the low-growth scenario. Much depends on the success of the emergency measures developed by the Treasury and Federal Reserve Bank and now under urgent consideration by the Congress. But even if a $700 billion "bailout" shores up the value of weak assets, the deterioration of which has sickened both the firms that lent against them and the other firms that entered into derivative contracts tied to them--the formerly-obscure but now infamous Credit Default Obligations (CDOs)--it is unlikely that everything will rapidly revert to the status quo ante normal. Confidence may be restored, but our financial sector will end up smaller, and that will mean less availability of easy credit. Unless energy prices spike much higher, again, that would work against measures to overturn the energy status quo. I think we're going to hear a lot more about this in the weeks and months ahead.