Ask the Expert: Understanding Energy

from:

http://www.ft.com/cms/s/2/a0d87696-a0e5-11dd-82fd-000077b07658.html

The energy infastructure industry faces mounting pressures. Amid fierce competition to secure supplies and to meet demand, spending on energy infastructure is set to rise sharply over the coming years. The International Energy Agency has estimated this could total $22,000bn by 2030.

But issues are emerging that make investment in infastructure projects more difficult. One is the global financial crisis, which is hitting funding of new projects, while the other is the growing pressure to build an energy system that will reduce carbon dioxide emissions to address the threat of climate change.

So will the global financial crisis hit the investment required to upgrade the world’s crumbling energy infastructure?

To coincide with the publication of the Financial Times Understanding the Energy Challenge special report, Ed Crooks, FT energy editor, and William Ramsay, former deputy executive director of the International Energy Agency and now senior fellow at the Paris-based Institut Français des Relations Internationales, took your questions on the challenges facing the energy infastructure industry. The pick of the question are answered below.

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Does the European Union have a co-ordinated energy strategy? If so, is it working? If not, why not?

Johanna Pickering, London

Ed Crooks: The good news is it does, up to a point. The bad news is that the parts that are unco-ordinated are very important, and even the co-ordinated parts are showing signs of strain. What has been co-ordinated remarkably effectively is climate change strategy, with a working emissions trading scheme and a well-developed trading market. EU governments have also agreed on some very ambitious targets for cutting emissions and boosting renewable energy. On the other hand, energy security policy is still a free-for-all, with no common stance on negotiations with Russia and other energy suppliers. And the climate change strategy is under considerable strain as the economic downturn bites, with countries such as Italy and Poland looking to lift the burden of compliance.

William Ramsay: The EU has a strategic energy strategy composed of many moving parts. The objectives are broadly to move quickly to a secure high-efficiency, low-carbon energy system. The sub-strategies of these overarching goals become quite specific. Targets have been established for greater energy efficiency, carbon reductions and the contribution of renewables to the energy mix all at 20 per cent by the year 2020 - ”20-20-20 by 2020”. These targets are reinforced by a number of directives to promote the integration of the internal EU markets for energy commodities - in gas, power, transportation, storage, etc.

Perhaps declaring the objectives will prove to be the easy part as the political challenges of dividing the burden among the 27 countries will prove more difficult. These difficult negotiations have been addressed by the third package of proposals on the internal energy market that will establish legally binding targets by country and set our many concrete measures to achieve energy efficiencies.

This programme is under discussion at a time when a great deal of new uncertainty has been introduced in global energy market by the financial crisis sweeping across all economies and by the economic slow down. While commodity prices may be falling, this has considerable downside risks for future supply, plus the lack of credit is making investments in more energy efficient equipment and new capital stock that much more difficult even if many of these investments have a short payback.

The EU has a strategy, well-enunciated and with political commitments. Implementing that strategy, already difficult has only gotten more difficult in the past few months. The October Council discussion of these issues deferred the most difficult. The French presidency has its work cut out for it.

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Could you please define the main challenges in the energy [infastructure] industry and formulate the new strategy, which, in your opinion, has to be executed to overcome the obstacles and establish the sustainable development in the global energy sector in 2009?

Viktor O. Ledenyov, Ukraine

EC: The challenges are the same as they have been for years: to put in place an infrastructure that delivers reliable energy supplies at affordable prices but does not leave the planet partially or wholly uninhabitable. The problem is that our ability to rise to that challenge is less than at any time for decades because of the economic downturn and the financial turmoil we are experiencing. The important thing will be for governments and businesses to keep their eyes on the long-term objectives, and not take too many decisions that will compromise those aims. In particular, I think there is a real leadership role for government here. Businesses can only respond to the incentives they are set, and it will be up to government to make sure that the right sorts of incentives, such as a price for carbon dioxide emissions, are in place.

WR: If you look at the probable evolution of global energy consumption, you find a world continuing to draw heavily on fossil fuels to meet its energy needs. The International Energy Agency projects that fossil fuels will continue to meet 80 per cent of energy requirements in 2030 unless we do something fairly dramatic to change that. We should not be misled by what appear to be easy solutions - e.g. biofuels or deep penetration of renewables to solve our problems. These are both valuable, but their potential contributions have to be kept in perspective.

Aside from the cyclical mismatch of supply and demand for energy, which we see reflected in high prices and geopolitical shocks to energy systems as we are seeing in Iraq or Nigeria, the real longer term challenge we confront is that we cannot afford to continue burning fossil fuels without abating their carbon emissions. That means much greater attention to prosaic things like energy efficiency - perhaps not very sexy but efficiency can provide up to 40 per cent of the solution in the next 25 years. The next most important thing is to decarbonise power generation. That means pressing forward with renewables that could supply up to 50 per cent of power by 2050, and demonstrating carbon capture and storage (CCS) to remove carbon dioxide from power plants, oil and gas production and other major stationary sources of carbon dioxide. This will require huge investments in demonstration facilities. This is doubly important because even though oil prices have come down, they are still above traditional levels. This is forcing many countries to use greater amounts of coal - which will be a major source of incremental CO2 for the next 40 years.

For the longer term, governments must reverse the decline in energy R&D spending that has collapsed from its highs in the early 1980s. Technological solutions will be needed to decarbonise the transport sector through new fuels such as second generation biofuels and hydrogen and through better equipment such as plug-in hybrid cars.

Everyone has a responsibility in meeting this challenge. The search for a post-Kyoto framework for carbon abatement offers the right opportunity to define a common strategy where everyone can shoulder their share of the burden.

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Is the lack of energy infrastructure in developing countries, such as India, not something of a blessing in that it allows them to leapfrog outdated fossil fuel energy distribution and develop a renewable grid from the start?

Glyn Jenkins, Vancouver, BC, Canada

EC: Certainly that is an argument it is possible to make. My concern would be that given the huge pressure to deliver electricity to poorer people and rural areas, the temptation will inevitably be to come up with the lowest-cost solution, which is unlikely to be at the cutting edge of technology. Building a ”smart grid” instead of a dumb one, for example, is a more attractive option when you are starting from scratch, rather than replacing an existing infrastructure. But it is still likely to be more expensive.

WR: I don’t think the Indians view it as a blessing at all and would be quite happy to have a reliable kilo-watt hour at their fuse box even at some incremental environmental cost. The strategy for India and other developing countries is how to mobilise the capital necessary to bring new power generation capacity on stream to meet their growth requirements, without aggravating the planet’s chances of survival. It is not an option to deny Indians or others the right to growth.

But how do you create the market conditions necessary to draw in the foreign capital? Some 60 per cent of the total required investment for energy infrastructure is for electricity and a very large piece of that is in the developing world. In nearly all developing countries, electricity rates are too low to attract capital, regulatory regimes are too frail, transmission capacity and grids do not allow wheeling of power around countries - and governments do not have the budgets necessary to carry this capital burden.

The solutions reside largely in foreign direct investment. And if that is not bad enough, slower economic growth, higher food prices, general inflation are all making it more difficult for governments in these countries to ask populations to shoulder higher electricity prices. Not to put too much of a burden on one mechanism, but putting a price on the ton of carbon through a cap and trade system broadly adopted could become an important source of capital for this transformation of developing country electricity markets. This would only provide part of the answer. Incremental sources of private finance will have to come from somewhere, but in today’s financial markets, risk is going to be more closely assessed. That will not make energy project lending any easier.

All solutions will be necessary to help developing countries choose better technologies - concessional financing, development assistance, market differentiation, carbon trading, supplier credits will all need to play. But every power plant decision made anywhere for carbon dioxide intensive coal-fired capacity means a time horizon of 60 years for that technology choice.

As to a renewable grid, I refer the questioner to an earlier response about keeping the potential for renewable energy in perspective. It can definitely be part of the solution, but the problem is vastly bigger than available or affordable renewable responses.

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Is it not the case that the energy companies - and other utilities, water companies for example - have been making huge profits for years while watching the infastructure crumble? Surely the short term concerns of shareholders will always be at odds with the huge amounts of capital needs to build a 21st century infastructure?

Callum Johnston, Edinburgh, Scotland

EC: The energy companies have indeed been making big profits but they have been investing vast sums as well: $20bn-plus a year in the case of BP, Shell and Exxon.

It is also true that much of the developed world’s energy infrastructure has been crumbling, but it is hard to see that the energy companies have been doing particularly well as a consequence. Ask any BP shareholder. The truth, of course, is that if we want this investment, someone has to pay for it, and ultimately that ”someone” is us, through higher energy costs.

The short-termism of shareholders is a fair point but it is one of those problems that is always with us. What is the alternative, I wonder. No one really thought the Soviet Union did a great job of investing in infrastructure. It comes back to a point I made earlier, I think: there is an important role for governments in setting incentives for long-term investment decisions that businesses will respond to.

WR: There is definitely a tension here. We have for the past two decades put great confidence in two criteria to guide the reform of our utilities. In the case of energy, to get governments out of the business of electricity and gas - to privatise them. The two criteria were to let competitive forces operate and to seek economic efficiency. You may have heard former Federal Reserve chairman Alan Greenspan in recent congressional testimony allow as how he had put more faith in institutions’ instincts to pursue these principles that has proven to be the case. In the gas or power business, money is made in transmission, generation or distribution - all regulated by governments at multiple levels. If the regulators get the regulatory framework right, the businesses will adapt to doing what needs to be done.

Unfortunately, the early years of deregulation were protected/masked by the large excess capacities put in by government utilities to ensure security of supply. State utilities were more governed by the social contract with the customers than they were to profitability to divide among shareholders expecting dividends. Now, the surplus capacity has been absorbed.

Countries lack transmission lines, gas storage, generating capacity etc because it is not in any private sector operator’s interest to build capacity it won’t use. Nor is it utilities’ interest to invest in more environmentally sensitive equipment than necessary if they can’t get repaid.

The issue, then, is for governments to decide what policies they want implemented concerning security of supply, environmental standards, equity and distributional effects. Governments pass these policies to regulators who embody them in regulations such that the necessary incentives are in place. We will come a lot closer to achieving theses policy goals once companies know what is expected of them. One obvious example of rational company behaviour running counter to public policy is the predisposition to turn always to gas for power generation when more environmentally secure options are available, because the regulatory framework does not put sufficient emphasis on low carbon options.

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The global financial crisis and the looming recession will hit spending in all sectors of the economy - corporate and government. What effect will it have on the energy infastructure sector?

Bobby Seiler, New York, USA

EC: A very significant one, is my guess, and I think we have not seen anything like the full extent of it yet. There is a ”double whammy” here, with falling oil and gas prices compounded by the drying up of debt and equity finance. There are a few stray anecdotes already of projects being delayed or cancelled - the Canadian oil sands, a notoriously high-cost area, seems to be one of the worst hit - and I suspect we will see plenty more, as well as corporate failures and many smaller companies looking to bigger players to rescue them.

WR: The full effects of the financial crisis are hard to anticipate, but there is little doubt they will have an impact on the energy sector. Energy investments rely heavily on borrowing and the combination of reduced credit availability and lower prices for energy will chill current planning for major infrastructure. This will accentuate supply demand tensions in conventional energy markets, possibly aggravating price volatility and security of supply. How that evolves will depend on how soon confidence is restored in major lending institutions. Depending on how long the economic slowdown and credit crunch last, efforts to address carbon abatement and probably costly alternatives to conventional energy may push these concerns towards a back burner. That would be unfortunate and will have to be resisted.

The earliest improvements in energy systems will come from greater efficiency and as I said earlier, they will deliver some 40 per cent of early carbon abatement results. But improving energy efficiency also requires investment and while ultimately the payback can be short, decisions to invest in new capital will be deferred in times of uncertainty. Up to now my focus has been on industrialised countries. The impact of a credit squeeze will be even greater in developing countries where risks are higher and payback generally longer.

Perhaps some flexibility will be apparent in energy commodity markets at the outset of lower economic growth as demand slips off, but this signal to the upstream to go slower, will only create tensions later in supply as economic activity recovers.

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It seems that the US in particular has a problem with infrastructure. Have the US authorities fully understood the scale of the challenge?

Kirin Mattu, unknown

EC: The US does have big problems, particularly in power because of the age of much of its infrastructure. But it would be completely wrong to say its position is uniquely bad. Europe also needs massive investment, and in India, 400m people still have no access to electricity. The US also has scored some important successes. The reversal of the decline in its natural gas production is an important achievement, which is bringing real benefits to consumers in terms of lower prices.

WR: I don’t think the US has a particularly difficult problem with infrastructure. Much capacity in power generation will need to be renewed over the next years, in particular older coal plants and the first wave of nuclear retirements, but the task is not beyond the capability of the sector if the sector knows what the rules of the game are and that the rules will not be changing. The greatest impediments to infrastructure investment are regulatory uncertainty and policy ambiguity - in particular in relation to promoting lower carbon options. These uncertainties combined with a popular aversion to energy infrastructure (”NIMBY”) it is indeed the case that infrastructure investment is running behind requirements.

Many years ago US vice-president Dick Cheney warned that the US had used up all the surplus capacity inherited from the days of public utilities and overbuilt oil and gas infrastructure. He was right then, and he would still be right now. The next administration will need to identify a concrete set of energy policy priorities designed to respond to the twin challenges of security of supply and sustainability, not by seeking to achieve ”energy independence” which is impossible, but sending clear instructions to the private sector via the regulators.

The US challenge does not exist in isolation. Collaboration with other countries around the world will be essential to meeting global energy requirements in a safe and sustainable way. The first major challenge for the next administration will be to define how it plans to address climate change and greehouse gas abatement. The world is expecting a significant shift in US policy, but no one should underestimate how difficult it will be to achieve a consensus amongst those who have been proclaiming their commitment to robust policies in the expectation that they would not have to inplement them.

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Your special report today suggested that nuclear power was a solution to the energy problem. But in a post 9/11 world, surely nuclear power poses more risks - in terms of security - than it solves?

Neil Menzies, Vietnam, Thailand

EC: You are absolutely right: along with waste disposal, proliferation and security are the most serious drawbacks of nuclear power. The point about nuclear power, in my opinion, is that it is one of the ”least worst” options. If the alternatives are gas, which creates carbon dioxide emissions and belongs mainly to Russia and Iran, or coal, which has even higher emissions, then nuclear does not look so unappealing. Wind power is intrinsically unreliable, and no other renewables can yet be delivered at scale. As Winston Churchill said - approximately - about democracy: ”It is the worst possible option, except for all the others”.

WR: Nuclear power is part of the solution to energy security and sustainability. It has been demonstrated through thousands of years of reactor operation to be a safe source of electricity. In light of recent increases in the cost of gas linked to oil prices, the economics of nuclear power have improved substantially. Nuclear is still expensive up front in its capital costs, but the fuel costs during the life of the reactor are very small compared with fossil fuels. The decline of oil from $147.27 in July to today’s prices does not change this assessment. Added to the improving economics of nuclear is the fact that it is virtually carbon-free in its operations. This could become an even more important feature as carbon takes on a meaningful/tradable market price.

Nuclear power is not appropriate everywhere depending on the nature of electricity demand, the preparedness of the institutions to safely oversee nuclear power, the maturity of the electricity market and the geological circumstances of the location for a nuclear power plant. Governments deciding to build nuclear power plants need to understand the responsibilities that come with the decision. They need to ensure independent regulatory and safety oversite of nuclear installations including their adequate protection from terrorist activities. The fact of 9/11 cannot serve as a rationale for abandoning nuclear power, but it is certainly a fair warning that a terrorist threat exists and must be anticipated in design and operation.

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Shouldn’t investment in green energy infrastructure actually increase as governments move to raise spending in today’s environment?

Nick G, London

EC: Indeed it should. There is potentially a huge investment demand for clean energy infrastructure. The uncertainties, however, are very important. Exactly what kind of spending will be needed and how will it be delivered? We don’t know. In fact, we have only the vaguest idea of the answer.

WR: Well, it is not yet clear that governments will necessarily move to increase spending. Their first impulse will be to increase availability of credit to put the private sector back to work creating jobs and investing in productive capacity. The risk of the current crisis is that a shortage of capital and tougher lending conditions will put pressure on investors to cut costs they don’t need to incur. Many efforts to address environmental concerns are still on a voluntary basis or to bolster corporate image and may be sacrificed in a tighter environment.

Another factor could operate against some green investments. Many governments are strongly supporting renewables technologies to help them through their initial phases of market penetration. But until grids are smarter and transmission more agile, much of the renewable capacity has be backed up by conventional power. A government or utility strapped for cash is likely to go with the cheapest option for adding capacity and defer the renewables projects to later.

It may be that an economic slowdown will take some pressure off the need for large increments of energy infrastructure - in the short term. That would provide a bit of policy breathing space for identifying the best options for new capacity that address both the security of energy and its sustainability. Frankly, I think there is a risk just now that a number of public policy priorities will be subordinated to getting people back to work. It will be important during this period not to lose sight of longer term public policy objectives in an effort to meet the exigencies of shorter term political pressure.

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We have witnessed, in the past month, the results of mispricing and misunderstanding risk in the financial markets. Are energy regulators and energy companies any better equipped to assess risk and make the forecasts needed for ongoing capital investment?

Roy Wares, Vancouver, Canada

EC: A very good point. Anyone who committed to big plans on the basis of $140 oil or even $100 oil is in trouble now. Even more so if they believed the forecasts of $200 and $250. But on the other hand, energy companies are at least investing in real assets. If you build a power station or a pipeline, you are inevitably taking a bet on future market conditions, because the assets will be around for decades, and sometimes those bets go wrong. But if you can wait long enough, assets that seem worthless can turn out to be very valuable. The UK’s nuclear industry had to be rescued by the government in 2003; this year it sold for £12bn. People will always need heat and light. They will not always need collateralised debt obligations on sub-prime mortgages.

WR: The short answer may appear to be ”no”. The long answer is more likely, ”I think so”. But the events in credit markets have only added to the awareness already building in energy and power markets that there needs to be a recalibration of regulatory instructions to markets and substantially greater transparency. Let me focus on the latter because much of the mischief we have discovered in credit markets would not have happened if transactions had been more visible to regulators and to other market participants to ensure more of the general populations’ interests. Again, I refer to Alan Greenspan’ s comments in Congressional hearings about the failure of self-regulation by the trade.

In oil markets, we have only in the past few years been able to generate a universal system for reporting a limited set of oil statistics - the so-called Joint Oil Data Initiative. It is only a first step gathering over 90 per cent of both world oil supply and demand data, but it is a first step more than has been take in gas markets. In trading, oil and gas transactions are measured/recorded by a number of authorities, but only certain categories of trade must be recorded. More needs to be done here to improve reporting and transparency and market awareness of what is going on.

One further area I think could benefit from some institutional change would be the evaluation of how oil and gas companies assess upstream risk. They should be allowed to assess that risk in terms of the politics of the resource holding government at federal and sub-federal levels, regional stability and geologic factors. And yet, their risk assessment in their core business is reassessed by share evaluation analysts whose criteria for success are short term/quarterly profits statements or annual dividends to share holders. A primary commodity company can only be successful if it plans over a 25 year horizon.

Hopefully the lessons we should derive from out-of-control commodity markets and the sub-prime exposure of cowboy banking will not be ignored as time goes by and other crises arise.

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