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Mind your Business - 27 February 2006

Alternative Fuels

The News

Oil has rarely been out of the news in the past two years. The oil price has climbed from $25 a barrel to over $60, and some analysts are preparing for the $100 per barrel mark being breached in the not-too-distant future. The issues and arguments surrounding oil are well rehearsed. It is clear that oil is a valuable resource and that countries are coming to rely on it as a primary source of fuel. It is equally clear that such a situation is, in the longer term, untenable for a variety of reasons, not least the fact that oil is a non-renewable resource and at some point will run out. This means that the imperative to find alternative sources of fuel to supply future generations is becoming increasingly important. The rise in the price of oil has perhaps helped to focus the mind on just how important it is to seek other fuel sources. President Bush's annual State of the Union address to Congress in January 2006 highlighted the concerns that politicians have over the future of fuel. President Bush urged the United States (US) to break its addiction to oil and look to embrace the opportunities that alternative energy sources could provide. He claimed that US researchers were close to developing a viable alternative to gasoline (petrol) within the next six years if continued research was supported. He also said that he hoped that technology could provide the key to breaking the US reliance on Middle Eastern oil in his lifetime. George W. Bush has been widely criticised over his stance at the Kyoto talks but his plea to Americans to abandon their addiction to oil is a sign that the US does recognise that the reliance on oil is not sustainable in the longer term - whatever the reason! Copyright: Oscar Dahl, stock.xchng President Bush has also held out hopes that technology is the way forward in tackling the problem of climate change - much of the blame for which is placed at the feet of the use of fossil fuels. The US has consistently refused to sign up to any agreement that imposes targets on the reduction of greenhouse gases and instead has tried to argue that it is technology that will provide the way forward in dealing with the problem. There are a number of candidates for alternative energy. The sun provides one source. You can apparently fit over 1 million Earths inside the sun. The surface temperature of this ball of burning gas is 5,500 degrees centigrade and the temperature at the core is estimated at over 15 million degrees centigrade. The sun belts out energy at the rate of 386 billion billion megawatts, which means that it generates more energy in 15 minutes than the entire planet uses in a year. The sun will eventually die, of course, but it has an expected life span of around five billion years, so we should be OK in the short term! There is also the energy that can be harnessed from the oceans. The power of the sea has long been the focus of research into energy production, but producing viable ways of channelling the sea's energy is proving quite a challenge. Hydro-electric power has, however, proved an important source of energy in many areas. More successful has been the use of wind. Throughout the world, wind is being used to generate power but the exploitation of this source of energy, producing as it does clean supplies, is still a source of controversy. The erection of large wind turbines is thought by some to be a blight on the landscape and there are complaints of the noise that these turbines produce. Energy can be harnessed from the wind, the sun and from other sources such as coal. There are costs and benefits associated with each of these methods and the others that could be utilised. Copyright: Frank van den Berg, Clara Lam, Keith Syvinski, all from stock.xchng. In recent months, Tony Blair, the British Prime Minister, has re-opened the debate about the future of nuclear fuel as an energy source. Mr Blair seems to be moving towards pushing for the construction of new nuclear reactors to help solve Britain's future energy needs. The problem here is that whilst a new generation of nuclear reactors will probably be very much more efficient than existing ones, the cost of construction and the problem of what to do with waste and the decommissioning costs when the reactors come to the end of their life present major challenges as to their economic viability. Given the explosion in the number of cars used throughout the world, finding some alternative to petrol is seen as being vital. Electricity and hydrogen are both possible candidates but are a long way off anything viable as yet, although the use of biofuels like ethanol is proving more successful. In Brazil, the extensive farming of sugar cane provided a source of bioethanol in the late 1970s, following the dramatic rise in oil prices. Brazil led the world in developing ethanol from sugar cane to power its vehicles, but as oil prices fell back the technology was largely forgotten. With the rise in fuel prices again providing a spur, Brazil has put its weight behind large scale development of ethanol. Sugar cane is one natural product that can be used to generate so-called biofuels that may be part of the solution to the reliance on oil to power our cars. Copyright: Robert Lincolne, stock.xchng. The move to invest in bioethanol technology is gathering pace. A plant to convert wheat to ethanol is being set up in the UK in Somerset and in the US, the research President Bush was talking about is gathering pace. The US is now close behind the Brazilians in generating ethanol. The research is exploring ways that other crops can be used to generate this fuel; soya beans, maize and grass are all being used to produce fuel that can be mixed with petrol to power cars. There are a number of green benefits to this technology. Ethanol does not produce the quantity of pollutants that conventional petrol does and any that it does produce is cancelled out by the planting of a new crop. It seems that President Bush is right in his assertion that technology is the only way forward in lots of ways. There are, however, a number of economic and business challenges that lie ahead before we see these technologies really providing competition for oil. In the meantime, we can expect the price of oil to continue to rise and consumers having to pay for the privilege of using these non-renewable resources.

Theory

There are a number of theories that relate to this story. The obvious one is Externalities.

Externalities can be positive or negative. Positive externalities are the benefits that a third party gains from an economic decision. In this case, the decision to invest in wind power, for example, might have positive benefits on a range of people if the effect on the environment of cleaner energy is realised.

Sea levels have been predicted to rise by as much as 11 metres in the next thousand years if our production of greenhouse gases are not reduced. Using sources of energy such as wind does not generate greenhouse gases and so would help to reduce the impact on the environment if significant investment is made in wind power. The positive externalities in this case might not be felt by the third party in any obvious way and possibly not for many years. This adds to the difficulties of factoring in such things, making the decision more difficult.

Negative externalities are the costs to a third party of economic decision making. These costs are also referred to as social costs. In the case of nuclear fuel, the private cost of building a nuclear power station can be estimated. Critics argue that this is very difficult because no new nuclear power stations have been built for some years but in theory it is certainly possible to estimate the materials and inputs needed to construct one. In the diagram below, this is shown by the supply curve MPC which stands for the marginal private cost. The bigger the amount of power generated, the more expensive it is to build a power station to generate that power, hence the upward sloping supply curve.

Let us assume that the demand for energy is given by the demand curve MSB in the diagram, with MSB standing for marginal social benefit. The marginal social benefit represents the value of the additional benefit to society derived from one extra unit of consumption - in this case, of energy developed from nuclear sources.

Where the two curves cross is a point of equilibrium. At this point, consumers value the consumption of one extra unit of energy the same as the cost of generating that extra unit of output. However, what this does not take into account is the external or social cost of generating electricity through nuclear power. These social costs might include the cost of disposing of waste material, the impact on the environment of building the power station in the first place (the damage to ecosystems etc.), the cost of any potential leakage of radioactive material or the cost of solving the problems caused by some Chernobyl-like explosion.

When we add in these costs, the true costs of generating fuel through nuclear power is given by the curve MSC+MPC. At the previous equilibrium level of output of 400, the value placed by consumers on that 400th unit of output is now less than the cost of generating that output. The socially efficient output would therefore be where the social benefit of generating power through nuclear is equal to the social costs of generating power. In our diagram, this equilibrium output is less than previously and the price paid by consumers greater than before.

The Sizewell B nuclear power station in Suffolk. Local residents are surprisingly upbeat and positive about living next to a nuclear power station. Is this the way forward for energy supplies in the UK or are the social costs too great to embark on investment in this type of fuel? Copyright: Les Powell, stock.xchng.

To make decisions about the future of energy supplies, therefore, it is important to ensure that all costs are considered. Consumers and producers must have good information about the true cost of whatever type of energy source the government decides is the way forward. For consumers, it is important that the external costs are internalised. This means that consumers are aware of, and contribute to, the social costs of any economic decision.

There are a number of methods of internalising externalities. These can be summarised as:

Internalising the externalities is not necessarily that easy. How do you calculate the social costs for one thing? In the diagram above, we drew a new curve to represent the social costs and assumed that the social cost of producing 400 million KwH of power was the difference between the two supply curves - 35p in this example.

But how do we know for sure that this is accurate? In short, it is almost impossible to estimate some of these costs. If a new nuclear power station was built, it is likely it would have to be near the coast somewhere. The coastline is not only a thing of natural beauty, it also provides a delicate ecosystem that houses thousands of plants, animals and birds. How do we measure the effect of the construction on this, and then place a value on it? How can we place a value on the loss of the aesthetic value of a piece of coastline?

This sort of task is what is carried out through cost-benefit analysis - sometimes also referred to as economic appraisal. Cost-benefit analysis is used to help make decisions by seeking to estimate all the costs and benefits of some proposed investment. This helps decision makers to make choices between alternative policy directions. For example, if a cost-benefit analysis was undertaken of the investment in nuclear power and in solar energy, the outcome would provide a transparent means of making the decision. If the value of the net benefits of solar energy was found to be greater than that of nuclear power, a decision could be made to pursue the solar energy option.

The use of cost-benefit analysis might be one way of assessing the UK's future energy needs and determining where the investment should be made. Copyright: Fernando Fazzane, stock.xchng.

The problems of calculating the costs and benefits, however, are no less using this method. Economists have devised some techniques for estimating such intangible costs and benefits, but the emphasis is still on the word 'estimate'. It is considered better to have gone through the process of estimating than not doing it at all!

One way of measuring the impact on an area of natural beauty of building a nuclear power station would be to assume that consumers would value the area as a place to visit. If this is the case, a price can be put on what consumers would be prepared to pay to see the area. From such information, a demand curve can be drawn up showing the number of people willing and able to visit this place of beauty and from this, an estimate of the value of consumer surplus can be calculated. By building on the land, the value of the lost consumer surplus can be built into the calculation of the cost and benefit. (For further information about consumer and producer surplus, see Biz/ed's Consumer and Producer Surplus PowerPoint presentation). (http://www.bized.co.uk/educators/16-19/economics/markets/presentation/surplus.ppt)

Whatever the government's eventual decision about the future of energy supplies in the UK, it will not be an easy one. The costs and benefits are not just going to affect people today but for many years in the future. This makes the decision extremely difficult and even more contentious. Economics could provide some pointers to how such decisions could be made but ultimately, it will be a case of judgement!