Cap & Trade: No Free Lunch

One thing I still miss about living in the New York metro area is receiving the Times on my front doorstep every morning. So instead of pouncing on Tom Friedman's latest column the morning it's published, I often don't see it for a couple of days, until I run across it on the Internet. The net effect is to raise the bar for Friedman remarks on which I feel compelled to comment, because they're usually superseded by other, more interesting topics on which to blog. Unfortunately, the theme of Mr. Friedman's column of last Saturday is likely to be with us for some time, working its way insidiously into our assessment of energy and climate policy. Cutting through its convoluted logic, it suggests that we can significantly increase the price of energy to send a signal concerning greenhouse gas emissions but somehow end up spending less on energy and becoming richer in the process. While I continue to support the basic idea of a cap & trade system for managing our emissions, touting it to the public as a free lunch seems likely to set us up for a future backlash not unlike the one the financial industry is now experiencing, after we learned that the cheap credit we've enjoyed came with a steep hidden price.

In his script for a hypothetical speech by President Obama, Mr. Friedman sets out his thesis this way: "Yes, the cost of gasoline or kilowatt hours will rise in the short term. But in the long term, your actual bills and expenses will go down because your car, appliances and factory will become steadily more productive and give you more power for less energy." This exaggeration of the basic principle that higher energy prices stimulate greater energy efficiency incorporates several basic fallacies, the most important of which is that while higher prices affect all consumers and businesses more or less immediately--some businesses may have hedged their energy purchases for a time--their capital stock of energy-consuming devices turns over slowly. It also ignores the diminishing returns to higher fuel economy. Someone buying a new, more efficient car might offset most or all of the fuel price increase via higher fuel economy, but the other 93% of car owners are stuck with higher bills for at least another year. The only means by which the remainder of the population can manage this higher expense is through reduced consumption, if not of energy then of other goods and services. We saw that effect on steroids last year, and we are still living with the hangover from it. But even the consumer who bought the frugal car might be worse off, if it cost much more than the model he would have bought otherwise. In effect, he traded some wealth for lower expenses.

The impact on businesses looks similar. While business investment is hardly a zero-sum game, higher investment in energy efficiency would come at least in part at the expense of other kinds of investment, perhaps in new computer equipment or staff hiring or training. Higher prices on energy thus promote improvements in energy productivity at the expense of other kinds of productivity. Although this certainly reduces expenses, it would take some time to reduce them in absolute, rather than merely relative terms, and without increasing top-line revenue. That might sound equivalent in terms of its impact on profits, but it often isn't. Expense improvements tend to get competed away in the marketplace, and are thus often not sustainable sources of earnings. So while business investment in energy efficiency might ultimately shield consumers from higher prices for finished goods and services, it seems unlikely to do much for corporate profits or stock valuations.

Mr. Friedman's assertion ultimately rests on an energy analogy to the experience of the electronics industry. If there is a Moore's Law for energy, it has yet to be discerned, let alone quantified. In the early phases of any new technology, "experience curve" effects can emulate Moore's Law-style improvements for a while. Then, as cumulative output grows the rate of change slows dramatically. Last year's DOE study on the feasibility of obtaining 20% of our electricity generation from wind energy included some interesting observations on cost. While the cost of new wind power fell dramatically between the 1980s and 2000, in classic experience-curve fashion, that decline appears to have bottomed out in 2002 and actually reversed somewhat since then. Moreover, when wind capacity is pushed further along its supply curve, the cost of incremental capacity is expected to go up, as prime wind locations are exhausted and new development is forced into more expensive regimes, in coastal waters or further from markets. Creating a bigger market for energy efficiency won't necessarily drive the cost of efficiency dramatically lower than it is now, or will be once the wave of efficiency investments triggered by $100 oil and $10 natural gas rolls through.

Like Mr. Friedman, I believe we should put a price on emissions of greenhouse gases--if not this year then fairly soon--in order to promote efficiency and the adoption of cleaner technologies over time. However, we shouldn't imagine this will be easy or cheap, let alone something that will create mountains of new wealth out of, literally, thin air. Haven't we all just been through something like that, to our regret? We can't suddenly start collecting fees on behalf of an environmental service--storing our waste carbon in the atmosphere--that has been free since the dawn of time and expect that this won't impose a burden on someone. More precisely, it represents a different kind of wealth transfer than the one we all complained about last year--sending our money to OPEC--in which those who use energy (most of which is still derived from fossil fuels) will send money to those who use less of it and to those who are developing new ways of producing and using it with fewer emissions--and of course to those administering these programs. That should benefit investors in green technology, but someone else will get the bill.

Dangerous Delusions

If you've read this blog for any length of time, you know that it's not my practice to single out individual officials or politicians for particular praise or criticism, preferring an even-handed and scrupulously non-partisan approach. So it is with some reluctance that I feel compelled to share my considerable alarm about the views expressed by the new Chairman of the Federal Energy Regulatory Commission (FERC), Mr. Wellinghoff. His suggestion that "baseload capacity is going to become an anachronism" and that renewable energy can meet all our future energy needs represents a dangerous delusion, at least for the next several decades. I am not dismissing the vital contribution of renewables in addressing climate change, or the potential of a smarter electricity grid to accommodate a greater share of generation from renewable sources than would be feasible today. However, while I appreciate the benefits of visionary leadership in moving the country towards those goals, that vision must be grounded in reality, and not skewed by wishful thinking or the ingrained habits of a long career spent in advocacy for renewable energy.

My first recommendation to Mr. Wellinghoff would be to read today's Washington Post op-ed by Dr. James Schlesinger, the nation's first Secretary of Energy, and Dr. James Hirsch, a former official of that department's predecessor agency. More than 30 years ago, they were responsible for the early research initiatives that helped to develop many of the renewable energy technologies that Mr. Wellinghoff promotes. Their deeply informed comments on the inherent limitations of renewable energy lead to inescapable conclusions about the need to balance these intermittent and cyclical energy sources with the stability provided by large, central generating facilities capable of producing electricity around the clock, without daily or seasonal fluctuations.

My next suggestion to him would be to invest some time analyzing the electricity statistics of Denmark, which leads the world in deriving nearly 20% of its electricity needs from wind power. These data demonstrate the dramatic seasonal variance in Denmark's wind output. In 2008 alone, the country's 3,180 MW of wind turbines generated as little as 234 gigawatt-hours (GWh) per month (May) and as much as 1,050 GWh (Jan.), resulting in monthly effective capacity factors ranging from 10% to 44% of installed capacity. The monthly stats also demonstrate how this remarkable volatility can be accommodated without causing massive disruptions to the Danish economy. This is only possible through tight integration of the Danish electricity grid with those of its neighbors via robust interconnections--big power lines. When Denmark has more wind power than it needs, it is exported to Norway, Sweden and Germany. When its wind turbines are becalmed, it draws on the enormous hydroelectric reserves of Norway and nuclear and hydropower from Sweden. Because of the variability of wind power, Denmark's electricity import/export balance fluctuates daily, monthly, seasonally, and even from year to year. But the US isn't Denmark. We have 55 times as many people, and no neighbors with bigger power grids than ours.

We can't yet know the mix of central and distributed power, or of baseload and variable power that the US will ultimately need to power our economy and meet the emissions reduction targets we will take on. Improvement of the grid and the advent of "dispatchable demand", including smarter appliances and electric vehicles that could be preferentially recharged when renewable electricity is abundant will certainly increase the amount of renewable energy that can be absorbed usefully. However, that will not entirely obviate the need for large baseload power plants, and pursuing an agenda that makes it more difficult to build at least enough new nuclear power plants by the 2020s and 2030s to maintain nuclear's present 20% share of net generation would be disastrous for both US energy security and for our ability to reduce our contribution to climate change. I can only hope that Mr. Wellinghoff is open to modifying his views, as he adapts to his new role.

The Water Behind Ethanol

US ethanol producers didn't need more bad news. Despite federal and state blending subsidies and a steadily increasing federal mandate for the use of their product, the US ethanol industry has been suffering badly from low margins in the wake of last year's oil-price collapse. A number of companies, large and small, have been forced to seek Chapter 11 bankruptcy protection. The bankrupt VeraSun, a former industry leader, recently sold seven of its plants to independent oil refiner Valero, and several others to its creditors. But while last year's "food vs. fuel" controversy has largely died down, thanks to lower corn prices, a new study from the University of Minnesota suggests that some ethanol production uses even more water than previously estimated--as much as 2,000 gallons of it for every gallon of ethanol produced in states where crops must be irrigated. This finding further undermines the environmental benefits of a fuel that saves significant amounts of oil but requires large inputs of natural gas and other fossil fuels, and thus offers only modest greenhouse gas improvements over gasoline.

As with its other environmental liabilities, most of ethanol's water impact occurs upstream of the ethanol plant. Process water for slurrying corn and boiling, fermenting and distilling fuel ethanol only accounted for 3% of the total water consumption analyzed by Chiu, Walseth and Suh in their paper, "Water Embodied in Bioethanol in the United States". They also reported a remarkably wide range for the ratio of total water consumption (irrigation and process) per unit of produced ethanol by state: under 10:1 in Iowa, Kentucky and Ohio, and over 1000:1 in California, Colorado, New Mexico and Wyoming. Fortunately the latter states contributed just 3% of the 2007 ethanol production tallied in the study, resulting in a national average of 142 gallons of water per gallon of ethanol. However, two significant ethanol-producing states, Kansas and Nebraska, accounted for 14% of ethanol production but more than half of all US water consumed for ethanol, with ratios above 500:1. A useful chart in MIT's Technology Review illustrates these variations from state to state.

These findings add to an already daunting list of concerns about the long-term sustainability of an alternative energy policy that has so far relied mainly on biofuel produced from a food crop requiring extremely high inputs of water and natural-gas-derived fertilizer. The water dependency of corn ethanol looks even more unsustainable under various scenarios of climate change, which ironically this fuel is intended to help mitigate. Simply put, if water in the West and Southwest is likely to be in even tighter supply in the future, the last thing we should be doing with it is to divert it to the production of such a water-intensive oil substitute. The urgency of converting biofuel production to cellulosic feedstocks requiring little or no irrigation is high, at least for those states with water:ethanol ratios above the national average, but unfortunately urgency and bigger research budgets don't guarantee making today's demonstration-scale cellulosic ethanol technologies economical at larger scales. Breakthroughs don't arrive on demand.

The results of Chiu, Walseth and Suh provide further support for a thorough reevaluation of US biofuel policies. Rather than trying to squeeze ever more ethanol into gasoline, with uncertain consequences for motorists, and stretching our agricultural resources by expanding unsustainable crop-based biofuels of questionable value for reducing greenhouse gas emissions, the administration should ask the Congress for authority to freeze the conventional ethanol portion of the Renewable Fuel Standard at its current level of 10.5 billion gallons for 2009. That still represents a 9% increase over 2008's consumption of 9.6 billion gallons, which took well over a trillion gallons of water to produce. Further increases should await either economic cellulose-based biofuel, or the imposition of prudent standards limiting the embodied water and fossil-energy content of this fuel. That won't help today's overbuilt ethanol industry, but it would ensure that its survivors enjoy a more viable, sustainable future.

Time to Choose

Last week's finding by the US Environmental Protection Agency that greenhouse gas emissions "threaten the public health and welfare of current and future generations" should not have come as a surprise. It has been virtually inevitable since the Supreme Court decision in Massachusetts v. EPA two years ago, and it was rendered imminent by the election last November of Barack Obama, who made responding to climate change a centerpiece of his presidential campaign. Whatever you might believe about the risks of climate change, we no longer have a choice between addressing them or ignoring them. Representative Edward Markey (D-Mass.), who chairs the Select Committee on Energy Security and Global Warming, responded to the finding by saying, "It is now a choice between regulation and legislation." I don't think that's quite accurate, particularly since his own proposed climate legislation includes many strong regulatory features. Instead, I believe the choice lies between relying primarily on an explicit price for emissions to nudge consumers and businesses away from emissions-intensive activities, and employing a more prescriptive approach using mandates, "standards", and air pollution-style rules on smokestacks and tailpipes. Long-time readers won't need to infer my position on this matter from the way I've described that choice.

I've argued the case for cap & trade numerous times on this blog and in front of various audiences, corporate and public. I've also expressed my misgivings about the imposition of a strict cap & trade system in the middle of a recession, particularly if the government intends to use the revenues from cap & trade to fund a dog's breakfast of non-energy programs, rather than returning the bulk of it to taxpayers. I've even suggested that under some circumstances a simple carbon tax might be preferable to cap & trade, since both serve the purpose of establishing a price for emissions, to which our market economy must respond by shrinking emissions-intensive sectors and growing low-emissions ones, including the renewable energy sector with its vaunted "green jobs." I've spent less time, however, examining the regulatory approach, perhaps because I regarded it as self-evidently inferior, particularly if it looks more constraining than the version of cap & trade that might accompany it. It is abundantly clear that many others do not share that view.

The main appeal of the regulatory path is that it would build on long experience in managing other environmental impacts--including many from energy systems--under existing federal and state air and water quality regulations, the federal Renewable Fuel Standard (RFS), and numerous state-level renewable electricity standards (RPSs) and other regulations. But these programs also illustrate some of the severest drawbacks of this approach, in the complexity and overlapping nature of these rules. Regulating emissions that are not incidental to, but rather a fundamental consequence of the use of our principal energy sources would add further layers of complexity without subtracting any, as cap & trade might eventually be expected to. We already have trading in Renewable Energy Certificates (RECs) for state RPS compliance, Renewable Identification Numbers for compliance with the federal RFS, and sulfur and nitrogen credits for compliance with the Clean Air Act's rules for criteria pollutants. And because the GHG emissions from motor vehicles are determined largely by how much fuel they consume, efforts at regulating tailpipe emissions become de facto fuel economy regulations, in conflict with the federal Corporate Average Fuel Economy regs. (This is the matter on which California eagerly awaits a waiver from the administration to pursue its legislated Low-Carbon Fuel Standard.) With all due respect to the dedicated professionals at the EPA, anyone contemplating leaving the regulation of greenhouse gas emissions to that agency should be required to pass a test demonstrating that they understand the EPA's notice implementing the RFS for 2009, which involves the comparatively much simpler task of setting the required ethanol percentage in gasoline for the year.

We are now at the point that I have long feared we would be, if we mislabeled carbon dioxide as a pollutant. While the consequences of excess CO2 and other naturally-occurring greenhouse gases certainly live up to the terms the EPA has applied in its finding, unleashing a pollution mentality to solve climate change will be counter-productive and unnecessarily expensive, when dealing with a phenomenon for which a ton of CO2 emitted, captured or avoided in Boston is exactly equivalent in its climate impact to a ton emitted, captured or avoided in Beijing. We would have been much better served if the Supreme Court had paraphrased the Hitchhikers Guide to the Galaxy and found that CO2 was "almost, but not quite, entirely unlike" pollution, yet here we are.

By next year's Earth Day, the 40th anniversary of the first one, I expect that we will have made our choice between these competing approaches. We see signs of this in the apparent determination of the administration to arrive at the Copenhagen climate conference this December having taken concrete steps here, and in the competing cap & trade bills making their way through the Congress. I can understand that opponents of strict legislation on climate change might regard the EPA's endangerment finding as a high-stakes game of chicken. But whether it serves as an implicit threat or merely an insurance policy against protracted legislative delay, it--rather than inaction--represents the new baseline. Anyone who has been sitting on the fence must now decide which approach is likely to be more effective in dealing with the US contribution to global warming, while simultaneously doing less harm to our economy. After long and careful scrutiny of the options, and after spending a career in an industry that has already been regulated to the gills, I find pricing emissions by far the most attractive solution. This is anything but a trivial decision, though it is one that must be made, and soon, before the default option becomes as inevitable as the endangerment finding was.

Paying $300 for Oil

Predicting the future price of oil has always been something of a sucker bet. Although the fundamentals of the moment are relatively transparent, they are subject to interpretation, and future fundamentals--and thus prices--are affected by diverse and daunting uncertainties. I've seen oil-price forecasts ranging from $20 to $200 per barrel, while the market consensus reflected in the forward pricing curve of the futures market hovers around $70 past 2010. But there's at least one market that values oil much higher, with practically no uncertainty. I'm referring to the oil price implicit in US government incentives for some hybrid cars and alternative fuels. While these programs doubtless offer benefits beyond simply displacing imported energy, including stimulating new jobs and reducing emissions, the effective price paid for the avoided energy or emissions is still relevant, because it contributes to the federal deficit and determines how much of these benefits we can afford to buy.

In a well-known mystery story Sherlock Holmes points out "the curious incident of the dog in the night-time", referring to a dog that didn't bark when it would have been expected to. In the context of energy, the dog that didn't bark is the energy we didn't consume, but might have. In particular, if we avoided consuming a gallon of gas or kilowatt-hour of electricity as a result of investing in more efficient technology, then the cost of that investment puts an implicit price on the energy we saved. When it's lower than the going rate, we get an economic return on our investment. When we pay more than a market price, the premium paid comes at the expense of other things we could have bought with the extra money. That's true at either at the personal or national level.

Consider a typical hybrid car tax credit from the IRS's list of those available in 2009, noting that the tax credits for all of Toyota's popular hybrids have expired. The Ford Escape small SUV qualifies for a $3,000 credit on the front-wheel-drive version. Based on its EPA fuel economy estimate of 32 mpg, the Escape hybrid would save 1,223 gallons of gasoline over a 100,000-mile life, compared to the 23 mpg non-hybrid 4-cylinder Escape. On an undiscounted basis that equates to $2.45/gal. for the avoided fuel. That's a little higher than current pump prices but seems reasonable enough. Still, after you factor in the $0.184/gal. federal excise tax not collected and convert to barrels, Uncle Sam is paying the purchaser of that Escape Hybrid the equivalent of $110/bbl for the fuel it won't use. Some of the other hybrids on the list look a bit better on this metric. For example, the Dodge Durango Hybrid qualifies for a $2,200 tax credit. At 21 mpg, compared to 16 mpg for the non-hybrid Durango, the same calculation yields an effective price of $70/bbl of fuel avoided.

Of course the key to this comparison is the tricky assessment of what a consumer would have bought if the tax credit weren't available. Perhaps instead of comparing the Escape Hybrid to its non-hybrid version, we should assume that the combination of $3k and the allure of a "green" hybrid might divert someone from buying a larger SUV, such as the 17 mpg Explorer. In that case, the effective price of avoided petroleum consumption would be closer to $50/bbl and a smart buy for the government and consumers alike. Unfortunately, this logic can cut both ways. A new federal tax credit offers buyers up to $7,500 toward the purchase of plug-in hybrid electric vehicles (PHEVs). Even if a future buyer of the widely-publicized 100 mpg Chevrolet Volt were lured away from buying an 18 mpg gas guzzler, the cost of avoided fuel would equate to around $75/bbl, while on the much likelier comparison to a Toyota Prius it would rise to a whopping $322/bbl, due to the diminishing returns of higher fuel economy. And that completely ignores the energy that goes into the grid electricity inputs needed to reach the notional 100 mpg estimates for a typical PHEV.

Similar comparisons are possible for other federal energy incentives, such as the $0.45/gal federal blending credit for ethanol. On the surface, this looks pretty good, at least in oil displacement terms. After adjusting for ethanol's lower energy content relative to oil, the direct cost works out to $0.68/gal. of avoided gasoline, or less than $30/bbl. However, that's before accounting for the significant inputs of oil and natural gas required to produce the corn-based ethanol that dominates the US market. With an average net energy input of 77 BTUs of fossil energy--mainly in the form of natural gas and gas-derived fertilizer--required for every 100 BTUs of corn ethanol produced, a more realistic assessment of the effective cost of the net oil-equivalent energy ethanol contributes would be around $120/bbl.

These figures are all ballpark estimates and they ignore the value of the emissions reductions that accompany the energy savings or gains involved. Nevertheless, they highlight an important, under-appreciated aspect of US energy policy that has been accepted with little dissent. I can only imagine the outcry if the Congress granted US oil producers a guaranteed price ranging from $100-300 per barrel. Yet although hybrid cars and alternative fuels have acquired an enviable "motherhood and apple pie" aura, we should be equally cautious about subsidizing them to such an extent that they embed high implicit energy costs into our economy. Just as paying over $100 per barrel for imported oil last year was rightly viewed as an unsustainable drain on our financial resources, paying over $100 per barrel to avoid those imports might prove equally unsustainable, if these subsidies are continued beyond their present expiration dates or phase-out limits.

China's Oil Strategy

I was intrigued by a couple of items I ran across in the morning papers concerning China's pursuit of new oil sources. The Chinese National Petroleum Corp. is apparently in talks with the Venezuelan state oil company, PdVSA, and Total for a heavy oil producing and upgrading concession in the Orinoco heavy oil zone, as well as discussing a partnership with Shell to bid on new oil projects in Iraq. China may still lag the US in oil imports, but it is catching up fast, and the efforts of state-controlled CNPC suggest that China has a strong sense of the importance of future oil supplies in supporting the country's economic growth. Perhaps we should take a page out of their book.

I'm not suggesting that the US consider setting up state-owned oil companies or pursuing the kind of government-to-government deals that would take large quantities of oil off the global market for years to come. Not only is that unnecessary for us but counterproductive, as well, considering the inflexibility it locks in. At the same time, it seems clear that China regards oil as a key strategic resource--a pillar industry--and that ensuring access to it remains essential for economic and national security, even in a world increasingly focused on renewable energy. Although our environmental priorities are quite different from those of China, our economic priorities have more in common. Oil represents energy diversification for China, while it is a mainstay of our own energy economy; however, both countries will consume many billions of barrels more oil before either of us reaches the point at which some combination of energy efficiency and alternative energy renders it passé.

The common thread here is access. In the case of China, it is to oil reserves around the world, as its oil industry outgrows its domestic roots. For the US, the task is more complicated. Falling oil prices have created a great opportunity to reverse the tide of resource nationalism that accompanied the rapid rise of oil prices from the $20s to nearly $150 per barrel. Countries that built their budgets on soaring oil revenues are straining, and some astute diplomacy by our government could help open some doors that had swung shut in recent years. But just as we are keen to set the right example on climate change policy, going into December's talks in Copenhagen, it is bootless to plead for access to other countries' oil fields when we restrict access to our own untapped resources so tightly.

A new report by the Department of the Interior indicates a mean estimate of "undiscovered technically recoverable resources" under the US Outer Continental Shelf of 86 billion barrels of oil and a similar quantity of natural gas, including significant quantities off the Pacific coast. To put that in perspective, the cumulative volume of the federal Renewable Fuel Standard between now and 2022--including large quantities of cellulosic ethanol that is still at least as speculative as the undiscovered oil resources highlighted by the Interior Dept.--sums to 308 billion gallons of ethanol, the energy equivalent of a little over 4 billion barrels of oil. In other words, there's potentially 40 times more energy in the oil and gas that remains to be found in our own waters than in all the ethanol and biodiesel we're required to burn over the next 14 years.

Once again, I should emphasize that this is not an either-or proposition. For all the faults and limitations of our present biofuel strategy--and they are numerous--the potential of non-food-based biofuels looks significant and too good to pass up. However, the same is also true for the opportunity represented by our own undiscovered potential oil and gas resources, which at least one study suggests could contribute over a trillion dollars in new royalties and taxes to the Treasury, if developed. Whether or not China would be as reticent as we have been about such a resource off their shores, we must recognize that the global oil game is changing in response to new players, and that it is a game we cannot yet afford to opt out of, because renewable energy is not yet ready to fill the gap that would be left, nor will it be for at least another decade or two.

Fuel of the Past?

Today's Wall St. Journal features a front-page article sounding the death-knell for the growth of US gasoline demand. The combination of recession, stricter fuel economy standards, and the hangover from last year's high gas prices, together with growing biofuels consumption, appears to herald a peak in gasoline sales. The Journal cites a forecast from ExxonMobil in support of its conclusions. However, to assess the full implications of such a shift, it's important to differentiate between a decline in the requirement for the petroleum-based components that gave gasoline its name and the demand for the fuel generically referred to as "gasoline", which in most of the country already includes up to 10% ethanol, and is likely to include a more diverse mix of non-oil constituents in the future.

According to data from the Energy Information Agency of the DOE, US average daily gasoline consumption peaked in 2007 at 9.29 million barrels per day (MBD), declining by 3.5% last year. However, if we back out the blended ethanol volumes included in that tally, petroleum-based gasoline demand peaked a year earlier at 8.93 MBD and has fallen by 5.3% since then. With a federal renewable fuel standard (RFS) that mandates ever-higher volumes of biofuels, and with the apparent breakdown of many of the trends that have been driving gasoline consumption up since the end of the energy crisis of the 1970s and early 1980s, including annual vehicle miles traveled, that 2006 figure could prove to be the high-water mark for petroleum gasoline. However, the Journal's analysis also ignored or downplayed several factors that could soften its decline, particularly for the oil-and-biofuel blend that "gasoline" has become.

The most obvious of these is low fuel prices. Since monthly gasoline demand bottomed out at around 8.5 MBD last August, we've seen demand rebound somewhat, in response to the dramatic drop in gasoline pump prices. But while this factor might be self-correcting, since higher demand will tend to push up prices, which will retard further demand growth, another factor is creating a new source of steady underlying demand growth: As the RFS ratchets higher, the energy content of gasoline falls, and it takes more gallons to travel the same distance. With 8 billion gallons of ethanol included in last year's gasoline sales, the average gallon of gas delivered 112,700 BTUs to your car in 2008. At the 13.2 billion gallons of ethanol required in 2012, that figure would fall by 1.2%, requiring a corresponding increase in volume to compensate for its lower energy content. In fact, unless sales of biodiesel ramp up significantly, relieving the pressure to blend more and more ethanol into gasoline to satisfy the RFS, the current car fleet would require 7% more of 2022's "gasoline" to drive the same total miles as last year.

Under the federal fuel economy regulations enacted in 2007, the increased demand for less-energetic fuel should eventually be overwhelmed by the energy-efficient cars expected to make up a sizable fraction of the US car fleet by 2022. If anything, those standards will become even stricter, as the administration seeks to align fuel-economy rules with California's pending tailpipe standard for greenhouse gas emissions. As with everything else, though, there's no free lunch for CAFE standards. The same weak economy that is constraining gasoline demand is depressing car sales to an even larger extent. I haven't seen any credible forecast suggesting those sales will bounce back to their pre-2008 level of roughly 16-17 million vehicles per year any time soon. At 12 million cars per year, which would represent a nice rebound from today's levels, it would take an extra 5 years to turn over the existing US fleet of 245 million light-duty vehicles (ignoring motorcycles.) That assumes no net growth in the fleet, despite US population growth of roughly 1% per year. It also remains to be seen whether fuel prices and/or tax policy will effectively nudge Americans into the more efficient cars that the government wants us to drive.

On balance I think the Journal is right to conclude that the heyday of US gasoline has passed. However, much as with Peak Oil, anyone expecting a prompt and precipitous sustained drop in US gasoline demand is likely to be disappointed by the structural inertia of an enormous, slowly-changing vehicle fleet, a growing population, and alternative fuel regulations that are steadily diluting the energy content of the fuel. That means that while oil companies can't count on gasoline sales growth here to drive future profits, the mature US gasoline sector could still serve as a cash cow for their other business lines, including the search for more oil to meet the growing energy needs of large developing countries. Every first-time car buyer in China and India adds another increment of net global demand, and the industry will have its hands full satisfying that demand, once the global economy gets back on track.

The Candy Bar Energy Diet

After becoming increasingly frustrated with insubstantial US network evening news shows, larded with equal helpings of “pessimism porn” and “feel good” stories, my wife and I recently switched back to BBC America. Last night’s news included a clever segment called, “The Ethical Man Reborn in the USA.” This featured a sardonically humorous reporter making his way across the country on public transportation to drum up concern about climate change. Yesterday’s program focused on a town hall meeting in Muskegon, Michigan, in which Mr. Rowlatt demonstrated America’s energy profligacy by converting our average daily energy consumption to its equivalent in candy bars. But while the unsubtle message of gluttony was delivered with a smile, my take-away was quite different from the intended one.

Before I could draw any serious conclusions from this little demonstration, I felt obliged to check his math. The most recent figures on per capita energy consumption from the Energy Information Agency reveal that the average American uses 337 million BTUs, or British Thermal Units, of energy in all forms per year. (That excludes the energy content of food consumed.) This works out to 233,000 kilocalories, or food Calorie equivalents, per day. Dividing by the 271 Calories in a Snickers bar gets us to 860, roughly the number of candy bars that Mr. Rowlatt showered on his audience by way of comparing our energy consumption to a daily food diet equivalent to 8-10 candy bars per person. In other words, Americans consume something like 100 times as much energy as food, thus contributing enormously—and more than most other countries—to climate change. He then swept all but a few of the bars off the table, suggesting that the heap on the floor represented the national energy diet we must go on to achieve an 80% reduction in greenhouse gas emissions by 2050.

As clever as this symbolism was--I admit I had never thought about our energy use in quite these terms before--there are a few problems with the logic, although the basic math is sound. For one thing, while our present energy mix, heavy in fossil fuels, makes energy and emissions largely synonymous, that would presumably no longer be the case in our low-emissions future. An 80% emissions cut can’t depend on an 80% energy cut, or we’ll all be starving in the dark, or at least leading lifestyles that most modern Americans would find pretty unappealing. As important as efficiency improvements are to achieving large emissions reductions, particularly early on, the long-term trend of civilization is increasing energy use, and sooner or later that will overcome efficiency. The key to achieving that 80% emissions reduction is a massive transition to low-emission energy sources. As we envision this today, that means renewables and nuclear power, with some proportion of lower-emission fossil fuels, presumably natural gas and carbon-sequestered coal. When that shift is complete, sometime later this century, we’ll still be energy gluttons in world-historical terms, but presumably cleaner ones.

OK, it’s a semi-humorous news segment and I shouldn’t scrutinize its message too deeply, right? But aside from its somewhat misleading conclusion, I found that the candy bar demonstration made tangible one of the main themes of this blog since I started it in 2004: The scale of our present energy economy greatly constrains the ease and speed of its transition to other forms. Consider biofuels. Thanks to the Green Revolution, a large continental land mass, and plenty of energy-intensive fertilizer, the US produces a substantial food surplus. We can feed ourselves abundantly and still have food left over to export to other countries. However, even the most optimistic estimate of future agricultural productivity must fall well short of assuming that we can produce energy crops equivalent to 100 times our food consumption, or even 50 times, allowing for an eventual doubling of our current energy efficiency. Even if we’re just looking at replacing our per-capita gasoline consumption, that would still require the equivalent of 36,000 Calories per day, or about 14X our food intake.

That comparison reinforces my conclusion that we cannot hope to rely solely on energy sources derived from photosynthesis—or with conversion efficiencies little higher than photosynthesis—to solve our energy and emissions problems. Advanced biofuels such as cellulosic ethanol still have the potential to be an important element of our future energy mix, but they can’t replace the concentrated energy we get from fossil fuels, and they may be no more than a bridge to a long-term energy economy based mostly on electricity derived from the atom, advanced solar and geothermal power, and augmented by intermittent power from wind, wave and tidal energy. After all, as I’m sure your mother told you years ago, we can’t live on candy bars.

Hybrid Choices

Having just returned from a brief family vacation, I spent much of the last few days driving. That afforded much time to ponder the mix of cars on our roads and the product-line choices the administration may soon be imposing as it attempts to restructure the ailing US auto industry. The conventional wisdom appears to favor building lots of hybrids, though that leaves open the question of which vehicles or vehicle types to hybridize first. It also ignores the potential of clean diesels, for which there is already more than adequate refueling infrastructure. In any case, I hope the government avoids the trap of focusing the industry's hybrid efforts mainly on small cars. That's not just because sales of small cars are suffering under current low fuel prices, but because the potential to save fuel in larger cars is much greater. Our national energy goal ought not to be hybridizing cars, but saving as much imported petroleum as possible. That means putting hybrid and other advanced powertrains where they'll do the most good.

I was surprised by the number of questions I received from friends about hybrids on this trip, including one couple who asked whether they should buy a Prius. Although hybrids' share of US car sales remains quite low, their "share of mind" appears to be much higher than those figures would suggest. However, unless the administration intends to impose high enough taxes on gasoline to drive consumers towards hybrids and smaller cars, hybrid economics look shaky at $2 gasoline, particularly for those models for which the tax credits have already phased out. Although I continue to believe that oil prices will rebound strongly once the economy recovers, I would sympathize with a consumer who is worried that the $8,000 premium for the 2010 Ford Fusion Hybrid over a base-model Fusion (or $3,300 over the best-equipped non-hybrid four-cylinder Fusion) appears hard to justify, even after the $1,700 federal tax credit now available. After all, the base Fusion is hardly a gas hog, at 20 city/28 highway. As appealing as the hybrid seems, typical annual fuel savings would be around 200 gallons--less if you do a lot of highway driving. That's pretty good, compared to the Toyota Camry Hybrid, which would only save around 130 gallons/year over the non-hybrid 4-cylinder Camry, but it only translates to $33 per month.

If we can't hybridize every car at once--and it's clear we can't and probably shouldn't even try--which ones should get the highest priority, particularly if the government, rather than the market, is calling the shots? The clear answer seems to be intensively-used urban vehicles such as taxis, delivery vans, and police patrol cars. If hybrid economics look shaky for the next few years, go where those economics look strongest, even with low fuel prices. Take that same Camry Hybrid or its Detroit counterpart and put it into taxi service, driving 20,000 miles or more per year, all in the city, and the fuel savings expand to nearly 600 gallons. Even at $2/gal, the hybrid model would pay out its higher cost in less than 6 years, and that would drop to less than 4 years with gas at $3, or 3 years at $4. Similar calculations apply to clean diesels. Although their fuel savings are somewhat lower than for hybrids, even with diesel fuel and gasoline again close to price parity, the up-front premium is also typically lower.

Targeting light-duty and heavy-duty urban vehicles would provide additional benefits, both for air quality and vehicle performance. Hybrids emit less pollution and most give at least a few miles of electric-only driving with zero local emissions. You also need a much bigger gasoline engine--with even higher fuel consumption--to deliver the same torque as an electric motor or a diesel. If the administration intends to dictate the future product mix to car companies that accept government assistance, it should base its choices on tangible benefits such as these, not just on a vague preference for "green".

Zombie Project?

A year ago, the FutureGen partnership to build a prototype low-emissions coal power plant incorporating gasification and carbon capture and sequestration (CCS) technology looked dead in the water. Now, according to Technology Review, it may be on the verge of revival. A cynic would point out that a project sited in the home state of the new President might be a little harder to kill than most. It also can't hurt that Illinois's senior Senator stands high in the leadership of the majority party. However, there may be objective reasons to carry on with the project, particularly if the cost assessments that led to its "restructuring" were flawed, as suggested in a report issued recently by the General Accounting Office. Moreover, although major R&D projects ought to be carried out as efficiently as possible, I'm not sure that project costs should be the primary criterion for evaluating a one-off proof of concept, especially for such a crucial technology.

At its estimated cost of $1.8 billion for a 275 MW power plant, FutureGen must be the most expensive coal-fired power plant project in the world, for its size. That equates to $6500/kW of capacity, roughly triple the cost of a conventional coal plant and six times the cost of the combined-cycle gas-turbine unit that its core power block resembles. In normal utility service it could never compete with the cost of power from other technologies. If the project is successful, it should produce reliable power for many years, but as a byproduct of its principal purpose, which is to demonstrate a fully-integrated process for reducing the greenhouse gases and criteria pollutants from fossil-fuel power plants to the maximum extent possible. While all of the elements of this system, involving the gasification of coal to produce hydrogen, combustion of hydrogen in a gas turbine, and the capture and sequestration of CO2 from flue gas have all been demonstrated separately, with some of these elements in routine industrial and oil-industry service, integrating them at scale and running them together to determine the suitability of such a system for wider deployment has not.

As I described recently, CCS is a key technology for addressing climate change and for holding down the cost of large-scale reductions of emissions, once we've harvested the low-hanging fruit of energy efficiency and methane destruction. That doesn't mean FutureGen should be given a blank check, unless the new management at the Department of Energy can convince themselves that, particularly in light of all the work already done on this project, it represents the quickest and most effective next step in proving the technology. In particular, they should assess whether FutureGen includes outcomes beyond a proven prototype CCS power plant, such as opportunities to transfer technology elements to improve the efficiency or cost of other new and existing facilities. For example, could it improve existing integrated gasification combined cycle (IGCC) designs to increase their efficiency advantage over supercritical pulverized coal and other conventional coal technology, and thus reduce emissions even without full CCS? Could it advance our knowledge concerning the retro-fitting of CCS to existing power plants? If the answers to these questions look promising, then FutureGen deserves reviving, even if that creates the appearance of home-state favoritism.

Note: Energy Outlook will be on vacation for a few days. New postings should resume next Wednesday or Thursday.

Perfect Energy

The recent start-up of the latest large-scale nuclear fusion experiment, the National Ignition Facility at the Lawrence Livermore National Laboratory, was greeted with the customary mix of fanfare and skepticism that has accompanied the quest for practical fusion power for as long as I have followed it, starting as a seriously nerdy child. MIT's Technology Review does a good job of describing the new facility, which will use high-powered lasers to attempt to create useful amounts of nuclear energy. But rather than focusing on the stupendous potential of fusion energy and whether this device might finally be the one to deliver on it, I'm more interested in what our dogged pursuit of this technology through decades of frustratingly slow progress says about our collective view of our current energy sources. How much of the search for fusion springs from its inherent value, and how much from our dissatisfaction with every other long-term energy option we possess?

The answer may lie in the generally-assumed characteristics of a successful commercial nuclear fusion reactor technology, providing cheap, reliable and concentrated energy from a fuel that is as ubiquitous as it is limitless, using a process that creates large amounts of power but essentially no harmful waste. Is that a realistic expectation, or merely the aggregated antonyms of the shortcomings of every existing energy source? Consider the alternatives:

• Fossil fuels are finite, and their production and use release a variety of unwanted byproducts, including greenhouse gases implicated in climate change. Their reserves are also unevenly distributed, giving rise to worrying levels of rent-seeking, resource nationalism, and geopolitical instability and insecurity.
  
• Wind power is intermittent, unpredictable and unsightly, requiring extensive adaptation of the power grid, ample fossil-fueled back-up, expensive energy storage or all of these to contribute reliably on a large scale.
  
• Solar power is more predictable than wind but still expensive, inefficient and cyclical, delivering less than a quarter of a day's peak output even in optimum locations. It takes well over 3,000 MW of solar installations to generate the same amount of energy as one 1,000 MW coal-fired power plant.
  
• Geothermal power is reliable and relatively cheap. However, the "hydrothermal" reservoirs--natural deposits of steam and very hot water--that it taps are unevenly distributed and often far from markets. Enhanced, or "dry rock" geothermal offers greater promise and flexibility, though it is still in its infancy and might also cause earthquakes.
  
• Ocean power taps waves, tides or temperature gradients, offering enormous potential while sharing many of the drawbacks of wind, solar and geothermal. It is also decades behind them in development.
  
• Biofuels' necessary shift away from unsustainable food-based feedstocks depends on unproven or expensive technology. Truly large-scale biofuel production entails harvesting and hauling vast quantities of bulky materials with low energy densities, raising serious questions about whether it can ever create a sufficient energy surplus for the rest of the economy. This limitation also applies to electricity generated from biomass.
  
• Perhaps fusion's first cousin, fission, comes closest to its ideal, providing large amounts of cheap kWhs on demand, around the clock and with very low emissions. Unfortunately, it's hobbled by the high construction cost of new reactors and concerns about safety, security, proliferation, and waste. Some of these are legitimate while others seem overblown, but the technology is no one's free lunch.

Don't get me wrong; I have always loved big science, and nothing would please me more than if the NIF performed exactly as advertised and heralded the dawn of a new era of energy abundance. However, given the long history of drawbacks and unintended consequences from all other energy sources, it seems unrealistic to suppose that any new source, including fusion, is capable of living up to all of its pre-deployment expectations. Fusion is perfect on paper, but then so is my favorite long-term energy option, space-based solar power--until the public becomes anxious about beaming megawatts of power to earth from space, or rogue nations develop anti-satellite capabilities that could hold our orbital energy supplies hostage.

I don't know what form fusion's unexpected drawbacks will take, should the NIF testing pave the way for commercial fusion power plants a decade or two from now. I do know we need a serious debate about the sorts of trade-offs we're willing to accept from any energy source we promote as part of the solution to our dual challenges of climate change and energy insecurity. At a minimum, we must move beyond the mindset in which no current technology can compete with the presumed perfection of those that are still on the drawing board or have yet to be deployed on a scale at which their flaws might become apparent. Our future energy diet will most probably be a messy mix of "all of the above", just as our current one is. Perfect energy remains an April Fool's story.

The Wrong Enemy

While reading an article on oil company taxation in the Wall Street Journal, I ran across a quote from Treasury Secretary Geithner that crystallized my growing impression that the administration has misinterpreted its own mantra on energy and is training its "friend or foe" radar on the wrong enemy. I would paraphrase the Obama energy strategy as seeking to reduce US oil imports and greenhouse gas emissions by strongly promoting renewable energy and energy efficiency. Unfortunately, the administration's actions risk putting the domestic oil and gas industry on the wrong side of the divide that creates. Absent the steady output from our oil & gas producers, improved energy security--let alone energy independence--would become simply unattainable no matter how many wind turbines and solar panels we build in the next few years. Domestic oil & gas is not the enemy; it is a natural ally in the administration's quest to wean the US from our harmful over-reliance on foreign oil.

Policy makers must have a clear understanding of the country's energy balance and the relative contributions of our different sources. I looked at these "Big Chunks" in some detail in January. Domestic oil and gas production covers 34% of the nation's energy needs. Imported oil provides another 28%, and that's the chunk we need to focus on, along with the emissions from coal-fired power plants. When Secretary Geithner said, "We don't believe it makes sense to significantly subsidize the production and use of sources of energy that are dramatically going to add to our climate change," he was implicitly lumping oil and gas from all sources together with coal. Although he was correct to the extent that domestic oil and gas--just like the imported varieties--emit CO2 and other greenhouse gases, there is simply no way to keep the US economy running in the near-to-medium term without them, emissions or not.

Consider the latest figures from the Energy Information Agency of the Department of Energy. In 2008 "other renewables", excluding hydropower, generated 3% of the US electricity supply. Wind, solar and geothermal power--the non-hydro renewables that the President has targeted for doubling in the next three years--contributed just over half of that, or 1.6% of the total. That's up from 1.2% last year, for an impressive growth rate of 36%. If the renewable energy sector can maintain that growth for three years, helped by the stimulus package, it should easily double to 3.2% of our electricity supply. That might push the broader "other renewables" category close to 5%, and total renewables including hydropower to 10 or 11%--but all without displacing more than a tiny amount of oil, because oil (including petroleum coke) accounted for just 1.1% of net electricity generation last year, and plug-in vehicles aren't yet a measurable fraction of our vehicle fleet. Oil-burning power plants consumed 165,000 bbl/day, a paltry 0.8% of US petroleum demand. Even if the output of every new wind turbine and solar panel were devoted to backing out oil-fired power--a practical impossibility, given the geographical and time-of-use patterns involved--it wouldn't make a dent in our oil imports.

Increasing the tax burden on the oil and gas industry, by contrast, would most assuredly make a dent in our oil imports--by expanding them. Despite a recent uptick in oil prices, oil companies have seen their cash flows decline significantly in the last nine months. Under pressure to support dividends, those that can still borrow to maintain their capital investment programs are doing so; others have had to defer projects or sell off assets. Increasing their tax burden by revoking long-standing oil & gas tax breaks and singling the industry out for exclusion from a tax benefit offered to all US manufacturers, even with the logic of leveling the playing field for energy sources that emit greenhouse gases relative to those that don't, would be ill-timed, at best.

When the industry argued against higher taxes last year, some suggested that we were entitled to raise taxes on oil companies because political risk was lower in the US than elsewhere, while companies were denied access to key resources overseas. Those comparisons have shifted noticeably, as producing countries have become more receptive to foreign investment in their oil industries, thanks to the rigors of lower oil revenues. At the same time, political risk here has increased, as described in a provocative op-ed by Ian Bremmer of the Eurasia Group. The energy industry has already seen signs of this, in a proposal for an excise tax targeting companies that refuse to renegotiate the royalty relief provisions of certain Gulf of Mexico deepwater lease contracts, which were recently upheld in court. No business leader can watch the current spectacle of "outrage" and fail to wonder when he or she will sit in the hot seat.

This isn't a question of seeking sympathy for companies that have just come off a streak of record-setting profits, most of which were plowed back into the business or returned to shareholders. That would be as fruitless as soliciting aid for AIG's financial products employees. Rather, we need to look to our self-interest, here. When an oil company drills in the US, its production backs out imports directly, barrel for barrel. It pays US salaries--attractive ones--and it pays hefty taxes: income taxes at a 40% effective rate, along with billions of dollars in royalties, rents and bonus bids collected by the government. When a US oil company drills elsewhere, much of the benefit is captured by foreign governments, and when the oil we import comes from a non-US supplier, our trade deficit swells and the federal government only gets to tax the profits on refining & marketing, which are often pretty thin.

In the future, when we've cracked the code for producing liquid fuels cheaply from abundant non-food biomass, covered our hills and shorelines with wind farms and our deserts and roofs with solar arrays, and have sufficient domestic energy supplies--used efficiently--to back out the last of our oil imports, then the time will be ripe to talk about winding down the domestic oil industry, along with the emissions from the remaining petroleum products. Until then, rather than penalizing them on the basis of fractured logic suggesting this will somehow reduce our oil consumption, it is very much in the public interest for the government to treat the domestic oil industry as a partner, not a foe, and refrain from making it less attractive to drill in the US.

It's the Economy

Yesterday afternoon I attended a panel discussion in the Capitol building, featuring one Senator, two Members of the House of Representatives, the new CEO of API and two senior journalists from Newsweek, which hosted the event. The discussion covered a wide array of energy topics, including offshore drilling, taxation, renewables, and climate change. Although there weren't many surprises, I was not expecting to hear such uniform skepticism on the prospects for passage this year of a cap & trade bill regulating emissions in the manner proposed by President Obama. With the exception of the Honorable Doc Hastings (R, WA), who questioned the contribution of anthropogenic CO2 to climate change, the common theme appeared to be that the dire state of the economy and the need for sensible energy policy take precedence over stronger action targeting greenhouse gas emissions. In this regard, these elected representatives are attuned to the views reflected in a new national Gallup poll. For the first time since at least the mid-1980s, a majority of Americans place a higher priority on the economy than on protecting the environment. As much as that shift might disappoint environmentalists, a sound economy is the logical precondition for building a sustainable national policy to address climate change.

All three Congressional participants on yesterday's panel were from states or districts with a vested interest in energy. If anything, I would have been more surprised if this group had indicated unwavering support for the immediate imposition of cap & trade. Senator Landrieu (D, LA) represents a state that ranks fourth in US oil production, without counting the contribution from federal waters offshore Louisiana. Representative Rahall (D, WV) chairs the House Natural Resources Committee and hails from a major coal state. And while Washington might not be top of mind as an energy state, Congressman Hastings's 4th District encompasses Columbia River hydroelectric dams, a nuclear power plant, and the DOE's Hanford nuclear site. Still, the concerns expressed by both Democrats suggest that the President cannot count on a party line vote to deliver cap & trade, if it is seen as threatening vital industries and the health of the economy as a whole.

A few weeks ago, I examined the President's proposed budget and the levels of cap & trade permit revenue it included. Since then, the non-partisan Congressional Budget Office has analyzed the budget and concluded that its estimates of the ten-year federal deficit relied on overly-optimistic assumptions of future economic growth and would likely be $2.3 trillion worse than forecast. At the same time, it appears that the original estimate of $646 billion in revenue from cap & trade was highly conservative, with likely proceeds in the range of $1.3-1.9 trillion. Those figures are certainly more in line with the level of carbon prices necessary to stimulate large emissions reduction. $12/ton of CO2 wouldn't cover even the lowest-cost estimate for carbon capture and sequestration, let alone make solar power competitive with natural gas. The roughly $35/ton consistent with $1.9 trillion in permit revenue from 2012-2019 comes much closer to the mark. However, unless the Congress goes along with the President's plan to refund most of the proceeds to taxpayers, that more realistic outcome would result in a much bigger net tax on a weaker economy than the President's staff assumed.

This creates a terrible dilemma. From the perspective of those most concerned about the risks of climate change, we are very late in putting a price on emissions of CO2 and other greenhouse gases, in order to accelerate the transition to greener energy sources and bolster the existing incentives for renewable energy and efficiency investments. Yet it is also apparent from both the Gallup poll and long experience in observing developing countries that unless the economy returns to healthy growth, the wherewithal to pay such a price--and perhaps more importantly the political will to impose it--won't be sufficient. Poor countries, or those that feel poor, are understandably reluctant to pay for environmental protection, particularly when the consequences of not paying are deferred for years or decades. Anyone questioning that logic should spend a moment revisiting Maslow's Hierarchy of Needs.

Any cap & trade bill introduced this year must take into account the dramatic changes since last year's Boxer-Lieberman-Warner bill was debated. It must be structured to minimize the impact on the struggling economy. In practical terms, that means deferring the onset of emissions caps until a recovery is confirmed to be well underway and diverting no more than the President's target of $15 billion per year for energy R&D from the refund of all proceeds to taxpayers, including the businesses that will be burdened with buying trillions of dollars worth of emissions permits. Failure to do so would jeopardize the recovery and doom cap & trade. That's crucial, because mitigating climate change won't be accomplished within the term of one President; it requires commitments that must be sustained for decades. If those commitments are pitted against the public's aspirations for prosperity, they are unlikely to be sustained long enough to do any good.

Assessing Trade-Offs

Today's posting serves in lieu of a letter to the editors of the New York Times, in response to the misleading comparisons drawn in today's editorial concerning the "Lessons of the Exxon Valdez." The editorial characterizes oil development as "an inherently risky, dirty business — especially so in the forbidding waters of the Arctic." It goes on to draw a comparison between the $2 billion per year Alaskan fishing business in Bristol Bay and the presumed value of future oil and gas production from this area, concluding that the trade-off is not worth the risk. It suggests that the new Secretary of the Interior focus on promoting wind and tidal energy, instead. Unfortunately, their assessment of the trade-offs involved is undermined by the use of a resource estimate that appears to have been misinterpreted from its original source.

Whether the Times drew its estimate of $8 billion of potential hydrocarbon revenue for Bristol Bay from a 2008 World Wildlife Fund report citing a US Minerals Management Service (MMS) estimate of 230 million barrels of oil and 6.79 trillion cubic feet (TCF) of natural gas, or merely draws on the same ultimate source, I found a rather different estimate in the official report of the MMS to the Congress, as mandated under the Energy Policy Act of 2005 . It reflected a range for the North Aleutian Basin, encompassing Bristol Bay, of 20 million to 2.5 billion barrels of oil and 0.04-23.3 TCF of gas, with a mean estimate of 750 million barrels and 8.62 TCF. At $70/bbl for oil and $6/MCF for natural gas, reflecting current long-dated futures prices, the mean expected value of the "undiscovered, technically recoverable resources" around Bristol Bay would be on the order of $100 billion, rather than $8 billion.

But even that assessment provides a poor basis for comparison, because of the economic criteria that would be applied to any oil or gas discoveries in Bristol Bay. No one can know how much oil and gas is actually under the waters of the North Aleutian Basin, without at least performing a seismic survey and interpreting the results, which would then have to be confirmed with the drill bit. Nor would a positive result from such tests guarantee development, even at the prices cited above. As the Times notes, Alaska is a hostile environment. That raises the costs of exploration and extraction. The minimum resource size required to justify building a production platform would generally be higher than in the Gulf Coast. Oil finds much below that 750 million barrel mean estimate would be unlikely to be pursued, and the outlook is even tougher for gas, for which there is insufficient local demand.

In light of these facts, the balance of risks from allowing lease sales in Bristol Bay looks quite different from the one indicated by the Times, in which we might jeopardize a world-class fishery resource for an inconsequential amount of oil and gas. In reality, whatever risks hydrocarbon development entails would only arise in the eventuality that a world-class oil or gas resource were found there. Otherwise, the government would pocket the bid premiums and rental fees, the local economy would get some welcome revenue during the assessment process, and that would probably be the end of it. It's also high time for the editors of a paper that likes to be thought of as the nation's newspaper of record to recognize that renewable electricity does not function as an oil substitute and won't be in a position to do so until there are millions of electric vehicles on the road. We're going to need billions of barrels of new oil discoveries as we make the long transition to greener energy sources.

Rebound or Dead Cat?

US light sweet crude oil closed above $50 per barrel yesterday for the first time since late November. The financial press appears to attribute this mainly to the weakening of the dollar and inflationary expectations triggered by the Federal Reserve's decision to purchase over a trillion dollars of securities, in a bid to reduce longer-term interest rates. Although I don't discount these concerns, a review of oil's fundamentals suggests there are other factors at work, as well. The recovery in oil prices from the mid-$30s has involved more than a one-day rally, nearly a dollar of which had abated as of this morning. It is hardly the kind of rebound we might expect once the recession eases, but if it is sustained it should remind consumers that the current price relief on petroleum products is temporary, while sending producers a positive signal on the need for continued resource development.

Yesterday's weekly statistics from the Energy Information Agency showed that US inventories of crude oil and its two main fuel products, gasoline and distillate (diesel/heating oil), continue to build. But while distillate demand remains very weak, reflecting the decline in goods movement that accompanies a slowdown in economic activity, calculated gasoline demand has returned to within a percent or so of its year-ago level. Gasoline imports are running at a million barrels per day. All of this provides refiners some welcome headroom for their traditional spring-time switch into maximum-gasoline mode, after having optimized on distillate production during the winter. If demand were still as weak as it was a few months ago with gasoline inventories this high, any rally in oil prices would quickly extinguish itself.

Weakness in the dollar relative to other key currencies can also drive crude prices higher. This effect contributed to the extraordinary spike in oil prices from mid-2007 to mid-2008. But many of the factors that fed the resulting "oil-dollar price loop" look too anemic now to create a sustaining pattern of this type, amid the global recession and credit crunch. A slight decline in the Euro or Yen price of oil seems unlikely to stimulate much demand. Unless the dollar continued to weaken progressively, turning its recent 8% slide against the Euro into something more serious, it's hard to see this sustaining higher oil prices against the fundamentals.

The notion of oil as an inflation hedge is another matter. Traders aren't the only ones who get the jitters at the thought of the US government printing money to buy its way out of our current problems. However, inflation worries seem premature when deflation remains a serious risk. The latest report on seasonally-adjusted US consumer prices showed "core inflation"--excluding food and energy--rising at a sub-2% clip, while the three-month and twelve-month averages for the prices of all items are still in negative territory. The whole point of the stimulus bill was to soak up the enormous slack capacity in the economy, and until that begins to bite, the idea of too much money chasing too few goods seems a remote prospect. Nor did oil work out very well as an inflation hedge last summer, when the CPI was growing at more than 5% per year.

And that brings me back to oil's fundamentals. The fact that the market didn't swoon when OPEC met and decided to defer further cuts suggests that they have reduced output sufficiently--and are living up to their lower quotas well enough--to create an environment in which events such as the Fed's move can be seen as bullish. It wasn't long ago that it seemed nothing could drive up oil prices for more than a day or two. At the same time, oil's recent moves haven't flattened out the remarkable degree of "contango" that I observed in December. Oil futures for delivery twelve months from now are $10/bbl higher than the front-month price. That suggests the market is still weighed down by high inventories and tight credit, impeding the obvious arbitrage opportunity such wide spreads create. A more dramatic rebound in oil prices must still wait for the global economy to begin to turn around and draw down that overhang. In the meantime, though, the 50% appreciation of oil from its low on February 12th looks like rather more than the proverbial bounce of a dead cat.

Zero Emissions?

The other day I ran across reports of a curious event, in which the Attorney General of the state of Vermont convinced Entergy, which owns or operates 11 of the nation's 104 active nuclear power plants, to back away from characterizing nuclear power as having zero emissions. Technically, of course, the AG was correct. However, as a reader reminded me, it is equally true that such unambiguously "green" energy sources as wind and solar power also entail emissions greater than zero--a fact that appeared not to trouble Mr. Sorrell. This situation highlights another important gap in the public debate over energy and the environment. The solution lies in better public education and clearer reporting of absolute and relative emissions, based on numerous studies detailing the lifecycle emissions of our various energy sources. We might also apply some common sense to this complex technical issue. Unfortunately, the resolution of the Vermont dispute leaves the public with the mistaken impression that, at least in terms of greenhouse gas emissions, nuclear power is not in the same league as our favored renewables.

The misunderstanding in the Green Mountain State reflects a common inconsistency in the way that we look at the emissions of energy sources. In the last few years it has become pretty routine, at least in the better-informed media, to report the emissions from fuels and the vehicles and stationary facilities that consume them on the basis not just of what comes out of a tailpipe or smoke stack, but by tallying all emissions from extraction and production through to end-use: a technique referred to as "well-to-wheels" analysis, or more generically as "lifecycle" analysis when no actual wheels are involved. Energy sources that don't burn fuels have often escaped this level of rigor and tended to be clumped together as zero-emission sources. That includes nuclear power, wind, solar, geothermal, and hydropower. All of these entail a modest level of "embodied" emissions associated with their construction or manufacture, including the direct and indirect emissions from the conversion of raw materials, machining and assembly of components, and transportation to their operating sites. Nuclear power is different in one respect, in that it also consumes a fuel, the production of which--though not its use--results in some emissions. That hardly justifies lumping nuclear power in with coal, oil and natural gas burners, and drawing a misleading distinction from the embodied emissions of other low-GHG energy.

A web search turned up numerous references that quantify the lifecycle emissions from all these electricity sources. A recent report to the International Energy Agency on electricity in Japan, for example, cited cradle-to-grave GHG emissions from nuclear power at 29 grams of CO2 per generated kWh, equal to those from wind power and roughly double those from geothermal and hydropower, but half the emissions from solar photovoltaic power (PV). By comparison, the lowest fossil fuel emissions in Japan come from combined-cycle gas turbine plants running on imported LNG. Those averaged 519 g/kWh. Then there's the study from the University of Wisconsin, which shows nuclear at 17 g/kWh, beaten only by wind and geothermal, but exceeded by every other renewable source. Finally, I was amused to find the website of the Windham Regional Commission in Vermont hosting a report from the Nuclear Energy Institute bracketing nuclear power between hydro and geothermal and lower than PV and biomass power.

Rather than seeking to highlight the inconsistency of a government official--cue Captain Renault, here--I'd like to propose the common-sense application of a two-tier standard to this problem. All energy and environmental decisions involving comparisons of different energy sources and devices, particularly when they result in money changing hands, should certainly be made on the basis of full and careful lifecycle analysis. For general discussion purposes, however--most likely including the ads that offended the group that appealed to the Attorney General of Vermont--the emissions from wind, solar, geothermal, hydroelectric and nuclear power are all so much lower than those from coal, oil and natural gas that it seems entirely reasonable to treat them as effectively zero. Perhaps Entergy should reconsider its retraction on this basis.

Building the Low-Emissions Future

Last week The Economist published a detailed assessment of the state of play for capturing and storing the carbon dioxide emitted by power plants and factories. Although it skirted the assertion of many environmentalists that "clean coal" is inherently an oxymoron, the article's tone was generally skeptical concerning the cost and ultimate efficacy of the technology. Coincidentally, Greenpeace released a study featuring an ultra-low-carbon scenario created in conjunction with the European Renewable Energy Council. It proposes that by 2050 the US could shed all coal-fired power generation, as well as all nuclear power and most natural gas-fired power, along with nearly 80% of the petroleum used in transportation--all replaced by renewable electricity and biofuels. If the Economist regards carbon capture and sequestration (CCS) as "expensive and unproven", I can only imagine the terms it might use to describe the extraordinary transformation required to achieve the outcome Greenpeace envisions. The necessity of reducing greenhouse gas emissions dramatically by mid-century and the serious obstacles to replacing our entire energy economy with renewable energy sources in that time frame reinforce the importance of continuing to pursue CCS, in spite of its uncertainties.

I've been following CCS for a long time, and I've written about it many times on this blog. Without diminishing the technical challenges involved, I see them as being manageable with existing and foreseeable engineering know-how, without a scientific breakthrough. I attribute the prolonged absence of a large-scale demonstration of fully-integrated CCS on energy sources more carbon-intensive than natural gas to the mismatch between its costs and current monetary benefits. Whether the cost proves to be closer to the low or high end of the range of estimates included in the article, from roughly $40-115 per ton of captured CO2, it's hard to imagine a utility or oil company taking on the investment and operating expenses involved without the incentive of a transparent and fairly predictable price on carbon emissions. Whatever the cost of CCS might be, it can't be considered in a vacuum, and that is the biggest shortcoming of the Economist's otherwise thorough analysis.

As the US Congress prepares to embark on its latest effort to enact a greenhouse gas cap and trade bill, it's important to think about where its enormous pool of emissions savings will be found, and at what cost. CCS is only one option among many. Happily, a fair amount of work has been done in this regard, including a study by McKinsey & Co. for the Conference Board a little more than a year ago. A key chart from their report portrays a potential medium-term supply curve for emissions reductions. It indicates that while there might be a number of ways to cut CO2 at low or even negative cost--changes that would pay for themselves--achieving deeper cuts would require the contribution of costlier solutions, including CCS.

It's also worth noting that the current cost per ton of CO2 reductions from some of our current climate change strategies exceeds most estimates for CCS. In my recent posting on the application of energy storage to solar power, I calculated an effective cost of power for a couple of utility-scale solar projects in Florida at around $0.25/kWh. That's a premium of at least $0.20/kWh compared to a coal-fired power plant (without sequestration.) Based on typical emissions of 2.1 lb. of CO2 per kWh generated from coal, that implies an abatement cost of $190/ton of avoided CO2. In the likelier event that the power backed out by solar was generated from natural gas, the effective abatement cost could be even higher, because of the smaller emissions savings involved, despite the higher cost of gas-fired power compared to coal.

That comparison doesn't imply that solar power will always be a high-cost source of emissions reductions, or that CCS represents some kind of silver bullet for climate change. At the same time, coal now accounts for 23% of US primary energy consumption, 49% of our electricity generation, and nearly two-thirds of our baseload-capable generation. The difficulty of replacing baseload power with cyclical or intermittent sources makes me very skeptical of any low-emissions scenario that ignores CCS or assumes we can jettison coal entirely, not to mention forgoing nuclear power, the second-largest baseload power source in the US and by far our largest source of low-CO2 power. My specific comments on the Greenpeace scenario are posted elsewhere. At a minimum, any claims that it proves we can achieve the administration's 2050 emissions goals with only "green" energy options and efficiency gains are unwarranted. As useful as they are, scenarios can only point the way to possible futures. They can't provide firm proof of anything.

That leaves us with the hard work of cobbling together a broad set of climate solutions, in response to a price signal on emissions. In my assessment, that mix is very likely to include awkward elements such as CCS, along with deeply unglamorous things like improved farming and ranching practices. Contrary to the conclusions of the editorial accompanying the article on CCS, the technology is worth pursuing for reasons that have nothing to do with "placating the coal lobby." Nor does the cost of proving its feasibility look so high as to "deprive potentially cheaper methods of cutting emissions of cash and attention," particularly when the administration expects to carve out $120 billion for energy R&D from the proceeds of cap & trade over the next ten years. And even if it did, it's one of the few options that could be applied to reduce directly the emissions from the fossil fuels that still account for 85% of the energy we consume. That could make the difference between a manageable transition to a low-emissions world and an upheaval as bad as the current financial crisis.

Mark to Market

The practice of requiring banks and other businesses to mark their investments to market has drawn increasing criticism in the last several weeks from pundits and high-profile investors who would like to see it at least relaxed, if not rescinded. When I traded commodities in Texaco's international oil trading operation in London in the early 1990s I acquired some first-hand experience with "mark to market." Although I wasn't dealing with multi-billion dollar investments in exotic credit derivatives, the principles are sufficiently similar for me to offer some thoughts on the benefits and risks of this methodology, which appears to be feeding a vicious cycle of asset deflation in the financial sector.

The other night while watching our favorite TV cop show, "Life", my wife and I got a laugh out of the bumbled attempts of several of the characters to explain a derivative, and the confusion that greeted the accurate definition when it was finally given. I suspect the writers were reminding us how few people truly understand some of the financial instruments and regulations at the heart of the current crisis. Mark-to-market accounting likely falls into this category.

In the case of the futures market and physical oil market deals in which I was involved in London, the mark to market (MTM) provided a way to issue a daily report card on each of the trading positions we had taken on behalf of the company. This removed much of the element of surprise, if the value of something we had bought or sold changed significantly before the deal was ultimately completed. It entailed assigning a market-based price to each component of the deal at the end of every trading day, as if the product had been delivered or the position unwound that day, even though that might not actually happen for weeks. When the commodities in which we were dealing were ones for which there was an active, liquid market at all times, this accounting was relatively easy to perform. For some of the more unusual things we dealt in, for which there was no futures market and only occasional, sometimes unreliable reports of recent transactions, it generated uncertainty and anxiety.

The purpose of undertaking this effort, which consumed valuable time and was not exactly popular with the trading team, was to promote accountability and action. If the MTM on a particular trade showed a steady negative trend--particularly if it had moved from an expected profit to a loss--this triggered a discussion with management about why it was happening and what should be done. When handled well, this sometimes led to new insights about the market that we had failed to recognize. It normally resulted in a decision on whether to hang in there a bit longer, because we could justify our view that things would turn our way, or to modify or unravel the position--even at a loss--and regroup. Of course, that wasn't always possible; sometimes the cargo was on the water, bought and paid for, and there was nothing we could do but watch the red ink swell. That gets at the essence of my concern with the application of MTM to the big banks and institutions that the government has been forced to assist, for fear of "systemic risk"--the chance of the whole financial system crashing like the Blue Screen of Death on your PC.

Crucially, the reliability of mark to market depends on the ability to obtain an accurate reading of the value of what you are holding. That requires credible reporting of current transactions--preferably many of them--in something that, if not identical, at least looks enough like your asset to serve as a good proxy. If the only deals reported are distressed sales by desperate firms, you must write down your position to that level, even if you would never willingly sell it for so little. In the worst case a series of such write-downs causes a large enough deterioration in the balance sheet of the firm that it is compelled to sell some of these assets, driving their market value even lower and triggering a cascade of further sales by depressing the MTMs of other institutions.

Throughout the financial crisis, the practice of MTM has been defended as an unpleasant but necessary discipline to prevent an outcome such as was seen in Japan after its property bubble collapsed, with numerous "zombie banks" that were effectively insolvent but kept alive by the fictitious value of assets that were worth only a fraction of the level at which they were carried on the books. That argument still has some merit. However, it seems equally possible to destroy investor (and ultimately depositor) confidence in otherwise profitable, solvent institutions through the steady mechanical deflation of their illiquid assets, the potential buyers for which understand clearly that time is on their side.

Having run this experiment in its pure form until now, I'd like to see the administration test the opposite hypothesis for a few months: suspend MTM for bank capital purposes and restore the "uptick rule" on short-selling, while they're at it. We'd quickly find out whether these steps helped to stabilize the system. If they made things worse, they could quickly be reversed. It wouldn't be the first course correction we've seen during this crisis.