Burn Out: The Endgame for Fossil Fuels

Burn Out: The Endgame for Fossil Fuels

by Dieter Helm

Main Points:

• Immediate Challenges: Trump Executive Orders, Chinese Coal-to-Liquid, Sale of Aramco Stake, Russian Arctic Drilling, Keystone Pipeline, smart meters, etc.
• Three Big Structural Changes:
• Long run oil price
• End of the commodity super-cycle and fall of oil prices. Oil price will fall forever and $50 is a high price for oil. The price might spike, but the long-term trend is constant. Supply increases as oil prices fall.
• Decarbonization
• Unstoppable and we need to do better to make progress on climate change.
• Digitalization of the Economy
• Radical technical change (robots/AI/3D printing/ electric cars) and what is going to happen to our economies. New technologies and digitalization will impact economies. The future of energy will be about electricity.
• Two promising aspects of solar technology: (1) opening the larger extent of the solar spectrum (2) transformation of absorption to actual energy.
• Geopolitical:
• America has the largest increase in fossil fuel since the second World War. The US is on course to have rough energy independence and they have exports. 
• Implications for the Oil Companies:
• What should the companies do as a profit maximizing strategy if you believe oil prices will fall? If a barrel of oil is worth less tomorrow than it is today, then you will pump more. If you think it is a great idea to go drilling in the deep Arctic, then other investors will question you because prices fall. Doesn't make sense to borrow to pay the dividends. Big oil companies are lowly geared- they are equity bets on technology. What would you do if oil prices fell? You would harvest at exit (concentrate on low production), pay high dividends (pay cash out to investors and not invest on new oil and gas capex), and would minimize capex at the margins. This isn't what is happening, but if oil prices fall then this is what will happen.
• Implications on Electric Companies:
• Decline of wholesale market/role will mean that we are entering a zero marginal cost world. The market will be passing through fixed costs and people will buy a capacity share. Currently all electricity world depends upon is the wholesale price. Fixed price contracts are securitization of an asset. End of vertical integration. What will happen? Break up, divestment, and new business models. 

Main Points from the Helm Talks:

• Fossil Fuels:
• Shaped the 20th century
• Population growth from 2 billion to 7 billion
• Steam/horse transport changed to diesel/petrol transport
• Railways were replaced by cars/lorries
• Horse power in agriculture and tractors/farm machinery
• Travel by land/sea to Aviation
• Gas Lighting replaced by Electric lighting
• US Pennsylvania, Baku, Anglo-Iranian Oil industry growth
• Long Run Price of Oil
• Beginning of the age of oil (kerosene w/ limited supplies) the prices were high, but then the prices drop (1870-1970). The price in oil was constant because supply and demand are met, the cost even drops. Two periods when prices went up without an immediate supply response: (1) 1970's two OPEC spikes made production outside of the Middle East attractive and (2) after 2000 super-cycle with fiscal stimuli.
• OPEC's fleeting market power
• 2000-2014 super-cycle for commodities
• 1999 the Economists ran an article that the oil companies wouldn't survive with falling oil prices. 
• Why did oil prices go up after 2000? (1) Increase in consumer demand in US and Europe. Assets bubbles crash- the response was to drop interest rates, engage in massive fiscal expansion (Bush tax cuts/ Gordon Brown's expenditure in UK). This created a demand boom and signal to spend. The US sucked in imports.  (2) China was developing their east coast as a carbon intensive/industry-intensive area. This is why China has $1 trillion in US debt and growing at 10% an hour. 
• By 2010, China went from being a net exporter of coal to becoming half of the toal world coal trade. A massive transformation (doubling every 7 years and growing at 10% every year).
• The End of High Prices
• Why did oil prices fall off the cliff at the end of 2014? (1) The Shale Revolution that was the combination of horizontal drilling, seismic information, hydraulic fracturing (2) transition to gas. Gas has cut into oil. Until 1990, gas was required as a scarce premium fuel in the US to be kept as a petrochemical, high-value part. It was illegal to burn gas in power stations until 1990. Now gas is the preferred fuel for electricity, it is cleaner than coal. Gas has also started to cut into transport, gas-to-electricity transport. In the US, shale gas has facilitated a resurgence of the petrochemical industry- gas is the feeder fuel for naphtha to ethane.  Demand Side: China has slowed down in GDP growth after the 2008 crisis and environmental damage has refocused Chinese policy. 
• Impact on Russia: Putin came to power in 2000 after the country went bankrupt due to low prices the year before. Oil prices continued to rise every single year after that. So Putin could pay off the pensions, finance the military, and help the economy keep going.
• Impact on Saudi: the country had a coup where a 30 year old prince has seized control and believes the country will ween itself off of oil. Half of the sovereign wealth fund has been spent and will cut public expenditure. The average age is below 18 years old in Saudi Arabia. It faces an existential crisis from the low oil prices. 
• Electricity
• 19th century was the beginning of steam power and the use of fossil fuels that displaced horses and manpower. The translation of steam engine to help the coal power station in the late 19th century became the backbone of the electricity sector. 
• By the time of the second World War, the UK had nationalized and had central planning of the national grid. There were two principles: state ownership and statutory monopoly. This allowed for a 3% economic growth and a 7% increase in energy year after year.
• Only France pursued a centralized process. 
• In most of Europe their municipalities stayed in charge and frowned upon centralization.
• Vertically Integrated Monopolies: coal was mined and sold to the CEGB, which generated electricity and sold to the boards on the bulk supply tariff (energy charges and standard charges). The nationalized period allowed for the state to build more power stations. 
• Thatcher believed that private was better than a monopoly and set about privatizing the gas industry before the electric one. She thought the CEGB had spent too much and she faced two strikes in 1981 and 1985. When it came to privatization Lord Marshall who had ran the CEGB thought that the monopoly was important and were concerned with the need to have a secure base to plan future power stations. Competition undermined the ability to meet the capacity margin. 
• All renewable technologies are zero marginal costs (eliminate concept of wholesale market), and make the electricity system a capacity system. Storage is going to happen through our transport system, an increasingly important part of a decentralized electric system . Demand side is becoming active because of smart systems, broadband hubs, smart charging, and other appliances enable big data. 
• Digital World
• Electricity industry based on wholesale market, lack of storage, and passive demand. 
• Today we now have radical change: zero marginal costs, storage, & active demand
• Why? The 21st century is a digitalized century- almost everything can communicate with one another which becomes the service basis of our economy. 
• Robots and 3D Printing- robots have taken over manual functions, allowing us to track everything in real time. 3D printing has changed scale and location- customization and reduced labor costs.
• Artificial Intelligence: the mining of large data. Large impacts for autonomous vehicles.
• Smart Systems: Car changing, smart meter/broadband hubs/ smart local networks/ smart grids/ off peaking management/ system operators/ demand management and appliance management.
• Distributed Energy Resources- enormous potential in solar, but it is about extracting the maximum from the light spectrum and applying that captured energy into usable electricity. 
• Market Design
• Conventional wholesale market
• Price of producing electricity at the margin (each minute of the day) that signals the wholesale prices and the investments that people make.'
• A spike in demand can ask for capacity standing by. 
• Gas sets the marginal price after 1990. Power stations have their short run marginal cost (SRMC), but they get paid not by their marginal cost but by the system marginal cost (SMP) which is the cost for the very last speaker at the time. SMP is low at night when demand is low. Integral (SMP-SRMC)= contribution to your capital costs. 
• Bulk supply tariff composed of the fixed and variable costs. 
• 1990's onwards: renewables have come onto the grid. Now there are two peaks and the SMP might not be good to pay back your capital and renewables will drive down the wholesale price. 
• ROC's and FiT's
• ROC or FiT or CfD= a guaranteed fixed price that renewables get paid for the electricity that they produce and spill onto the grid at anytime in the day.
• The system had to buy a certain amount of renewables. Setup a separation between the renewables and the rest of the market. The governments banded the renewable obligation certificates (ROC's) and each renewable technology would get its own ROC- thus planning the amount of renewables and how much in the total each one would contribute. Created lobbying and chaos- choosing winners. The governments moved towards auctions or "feed-in tariffs" to prevent the renewables from getting paid twice (wholesale and special deal). 
• Nuclear and CfD's
• Nuclear power is zero marginal cost, so it will always be reaping the SMP not the SRMC during the day through the wholesale market because it is not the majority.
• Nuclear has to be a government investment decision because of the lumpy capital problem. Takes 5-10 years to build. Don't work to plan. 
• Dungeon SB took 22 years to build. EPR that EDF have been building has been plagued with construction problems in Finland and France. 
• If the wholesale power price is going away, there is not enough money on the system marginal price to recover the capital costs. So nuclear will need a special deal where there is a guaranteed price (CfD). 
• British market: offer a fixed price contract for 35 years called a contract for difference (CfD). Sets a strike price and if the wholesale price goes below that level or above that level then the nuclear power station will get 92.5 pounds/mWh. 
• Capacity auctions- a zero marginal price world is a capacity world not an energy world
• Missing Money Problem
• Renewables cannibalize the wholesale market
• Gas un-investable
• Capacity contracts 
• A bit on top to make sure you have sufficient capacity and investment. 
• Need to focus on capacity markets, not on wholesale markets. Needs to be sufficient low carbon investment to meet the demand. 
• Equivalent Firm Power Auctions
• In Burn Out, Dieter says that a single market should be called an "Equivalent Firm Power Market" and it should be open to all and system operators. It is a capacity auction for an amount of capacity that is required in the future to meet future expected peak demand. How is this delivered? As the demand goes up, you cut demand. Use energy services to manage demand down. Or bring storage into the system (cars or grid-scale). Or Baseload plant or peaking plant could help the capacity add up. Allow all of those options bid into the market. Main problem: intermittency if a specific renewable energy wins the bid (wind power). Here is where the word "equivalent" comes in. We need to look at the contribution to the security of the capacity of the total system at a future date. De-rate or reducing the weighting of intermittent systems. Solar's intermittency is predictable and they bid for a lower value to the other alternatives. A wind bid could ensure it has a backup (battery supplier) to firm up their supply. Goal: Solve intermittency through market design. Specifications: Merge FiT's, CfD's, and capacity auctions. Need a carbon price. Incentivize storage/demand side. Subsidy free renewables. R&D financing.
• System Operators
• Capacity Problem
• CEGB- Central Electricity Generating Board contracted the private sector to build the power stations and they were overwhelmingly coal/nuclear. 
• System Properties
• Private market system- how do you make a contract-based system to make it work? Original idea was that electricity would be a commodity market and that would make up prices. The problem with this is that it disaggregates electricity into a series of discrete individual decisions. The electricity has system properties- need an integrated grid system to bring all power supplies to the customer. After privatization, the idea was that the monopoly elements would be opened up to competition. SMRC adding things to the system, but what matter is the long run marginal cost. 
• System Operators
• A system operator- responsibility that everything fits together coherently. Accomplished for national grid in an incremental way- grafted in system auctions into the operator function but the operator embedded in the national grid. (1) Coherence of the system and (2) day to day operations. 
• Day to day operations- dispatch of plants, response of power. 
• Ownership of assets = private manner. 
• A private company planning the system as a whole is making public choices and has private interests (not a good idea). Private interest is dangerous for being responsible for public decisions. 
• Conflict of Interest
• Networks and generation/ networks and demand/ networks and storage/ potential risks and private returns/ short and long run/ public not private activities.
• Choice between grid extension and demand-side management. Your customers might have a strong view. 
• If you are demand side provider you want an auction to go a particular way, same for storage and generation sides. 
• RSOs and NSOs
• NSO= national system operators
• RSO= regional system operators- coordinate between distribution areas
• needed for decentralizing energy systems. Deals with DNO's, Supply, Embedded Generation, storage and batteries. 
• RSO's conduct auctions for DNO operations, capital maintenance, enhancement investment, and demand side aspects. 
• Regulatory Consequences
• Government has to deal with capacity margins
• NSO & RSO need to deal with the public sector (no assets)
• NSO/RSO auctions have to enable competition law and discretion
• Supply generation need to allow for single licenses for DNOs. 
• Decarbonization
• Global Initiatives- Kyoto, Paris
• Failure for a credible climate change framework.
• Started in 1980's when politicians like Margaret Thatcher said they need to do something about climate change. 1992, UN framework for climate change was the first step for the international community recognizing action must be taken. 
• Since then we have had at the global level 2 broad agreements: (1) Kyoto Protocol and (2) Paris Agreement in place. Kyoto was not an ambitious agenda and targets would be given to several countries- no penalty for not meeting them. Several nations dropped out and China was not included. The goal of Paris was a global legally binding, 1 degree, comprehensive deal. The outcome was no legally binding outcome such that the US was outside, the targets don't add up to the 2 degrees, and the only substantive outcome was continuous process to renew the pledges that the countries would meet. 
• EU Climate Change Packages
• Europeans decided to lead the world on climate change. Round 1 plan was 20-20-2020 which meant 20 % renewables, 20% energy efficiency by 2020. Round 2 plan was 27-27-40-2030, which meant 27% renewables, 27% energy efficiency and 40% target by 2030. "If you think that the Paris Agreement..are putting us on a road to keep global warming at 2 degrees...then I think you are wildly optimistic or you haven't read the facts properly. Doesn't look like those high level initiatives are going to be promising." 
• UK Climate Change and Carbon Budgets
• Multiple Interventions
• Answer lies with technology: switch to electric cars, light spectrum improvement in solar cells, development of batteries, new materials. Becoming cost competitive.
• Impact of Renewables on the Energy Markets
• wind power- offshore wind might be subsidy free. 
• Solar and wind- they are becoming a new conventional of the energy system.
• Chinese are addressing coal is to solve the problem of air pollution- help with particulate matter. In developed countries (Paris and Oslo) need to solve air quality problems. 
• Carbon Prices and Border Adjustments
• Central Role of Carbon Prices
• Taking externalities and internalizing it= role of an efficient market
• Efficient marginal arbitrations scattered across economy
• Setting the Carbon Price
• Social cost or marginal cost of carbon is determined by technology, innovation, lobbying/interests. Start with the target and unpack it into chunks. UK's unilateral target in the climate change act will determine the carbon price. Don't guess the carbon price in advance, but instead set a price and put in adjustment mechanisms to move it with respect to the target. In order for the price to work at the cheapest cost economy, it must be credible that we adjust the price. An arms length body or institution must manipulate this price. Should not be directly elected. Make it independent. Adjust to the target. Repeat.
• Targets and permits: need to address agriculture. Wouldn't impact much in damaged economic output. It's not the carbon intensive fertilizers but because the soil has a huge amount of carbon.
• Carbon taxes vs. carbon trading
• Allow for permits and have the permits diminish so that they fit with the targets that you want to achieve. 40% bundled into permits that people are allowed to trade. The price of those permits is the marginal abatement costs. Doesn't require policy makers to impact the price, but it achieves the target.
• EUTS was implemented- the prices were low and they have been volatile. But you would expect them to be stable and rising. EUTS forced renewables out of the framework .
• Point of the permit is to set the permit to the target and keep your hand off. Politicians have tried to intervene afterwards though. Commission has been tiring to manipulate the number of permits to manipulate the price. 
• Multiple prices vs. harmonization
• Carbon prices are more effective than the carbon permits.
• Intermittent context and border tax adjustments
• How do you have a domestic price? Must adjust at the border. Your carbon price applies to things no matter whether it is domestic or across the border. How would you work out the math for a can of yogurt: You don't have to be right about the answer, just need to be roughly right, not precisely wrong. 5 industries (steel, fertilizer, aluminum, etc.) are responsible for most of the carbon consumption. Look at proportion of electricity production from coal, but if it comes from France you will apply a lower rate (because it comes from nuclear power).
•  Incentive to have a carbon tax is high if you have a border adjustment tax. Because if you are China you are paying the tax to UK if you don't have tax. you would much rather have that money going to your own country.
• Conclusions
• Without a carbon price, decarbonization will not happen
• Setting Taxes like interest rates and inflation targets
• Credibility requires institutional embedding
• EUETS and permits has been an expensive mistake
• Border taxes are the way to incentivize cooperation rather than top down agreements
• Governments need the money from these carbon taxes.

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