One for the skeptics

#153. One for the skeptics. Tim Morgan. Surplus Energy Economics. July 14, 2019.

THE STRICTLY ECONOMIC CASE FOR ENERGY TRANSITION

We need to be rather careful about the term “opinion is divided”.

When English league champions Manchester City were drawn to play fourth-tier minnows Newport County in the F.A. Cup, the opinions of football-watchers over the expected outcome probably were “divided” – but only in the sense that, whilst 99% expected the giants to win, only 1% hoped (in vain, as it turned out) for a miracle.

The same caution should apply to any claim that informed opinion is “divided” over the threat to the environment. Even if you’re not convinced by the concept of climate change, or of human activity as one of its main causes, you’d struggle to dismiss species extinction, water supply exhaustion, land degradation, desertification, melting glaciers or simple pollution as figments of the imagination.

We don’t, after all, have to assume that absolutely everything ever stated by ‘the establishment’ or the mainstream media is a pack of porky-pies, even if quite a lot of it is.

There’s one point, though, which really does need to be addressed. This is the widespread assumption that environmental and economic objectives are opposed, and that tackling environmental imperatives will have an economic “cost”.

This is a wholly false dichotomy. Far from ensuring ‘business as usual’, continued reliance on fossil fuel energy would have devastating economic consequences. As is explained here, the world economy is already suffering from these effects, and these have prompted the adoption of successively riskier forms of financial manipulation in a failed effort to sustain economic ‘normality’.

If you take just one point from this discussion, it should be that a transition to sustainable forms of energy is every bit as important from an economic as from an environmental imperative.

“What if?” A contrarian hypothesis 

To explain this, what follows begins from a hypothetical basis that ‘there’s no truth in the story of man-made climate damage’.

Just for the moment, I’d like you to suspend your disbelief – as, writing this, I’ve had to suspend mine – and adopt the starting position that human activity, and in particular our use of energy, isn’t threatening the planet.

If they were of this persuasion, what conclusions might be reached by decision-makers in government and business?

It’s probable that, stripped of the environmental imperative, the case for transitioning our supplies of energy, away from fossil fuels and towards renewable sources such as solar and wind power, would either be dismissed altogether, or watered down to the point of irrelevance.

Even as things stand, efforts to transition to sustainable sources of energy are faltering.

Once persuaded that we could do so safely, there would be considerable support – reinforced by the human traits of self-interest, conservatism and inertia – for taking a “business as usual” approach, in which oil, gas and coal remained, as they are now, the source of fourth-fifths of the energy that we consume.

From this start-point, a great deal of inconvenience could be prevented. We wouldn’t need to change our practices, or our way of life. We could carry on travelling in gasoline- or diesel-powered vehicles. Holidaying abroad would remain an activity with a future. We needn’t expend huge sums in plastering our countryside with wind turbines and solar panels. We’d be likely to abandon vastly-expensive, technically unproven plans to switch over almost entirely to EVs (electric vehicles), confining them instead to marginal urban use. By heading off the need for drastic increases in power supply, this in turn would make it easier for industry to keep on coming up with new products and processes (like drones and robotics) which call for increases in our use of electricity.

In short, in a purely hypothetical situation in which it could be proved that the environmental activists were wrong, there’d be a huge collective sigh of relief, from government, business and the general public alike. Few people, after all, really like change and disruption.

The energy reality of the economy

What has to be emphasized – indeed, it cannot be stressed too strongly – is that, even if it were environmentally safe to carry on relying on fossil fuels, doing so could be expected to cripple the economy within, at most, twenty-five years.

Indeed, the process of economic deterioration is already well under way.

That this is not generally understood results primarily from the mistaken view that the economy is ‘a financial system’.

It has long been traditional for us to think of the economy in this way. This, in part, is a legacy of the founders of economics, men like Adam Smith, David Ricardo and James Mill. They established what are called the “laws” of economics from a financial perspective. They demonstrated the way in which the pricing process determines supply and demand. Specifically, they contended that, if there’s a shortage of something, the solution is to raise its price, thereby encouraging increased supply. All of their work, then, was expressed in the notation of money.

We should be in no doubt that these founding fathers of economic interpretation have bequeathed us invaluable lessons, of which none is more important than the role of free, fair and uncluttered competition in promoting economic progress. The successors to the early pioneers have added new economic interpretations, of course, but almost all of these are money-based theories, which perpetuate the idea that the economy is a financial system.

But the founders of classical economics lived in a world totally different to that of today. Smith died in 1790, Ricardo in 1823, and Mill in 1836, and even Mill’s son, John Stuart passed away in 1873, which was 99 years before the publication of The Limits To Growth. In their era, there was little or no reason for anyone (other than the maverick Thomas Malthus) to think about physical limitations, still less of the environmental issues that have entered our consciousness over the last twenty-five years or so.

They were right to state that higher prices can stimulate the supply of shoes or beer – but no increase in price can conjure forth new, giant and low-cost oil fields where these do not exist.

There can be few, if any, other matters of twenty-first-century importance which are tackled on the basis of eighteenth-century precepts. Neither, logically considered, is there any reason for clinging on to monetary interpretations of the economy.

If, as in fig. 1, we look at the relationship between, on the one hand, global population numbers (and related economic activity), and, on the other, the use of energy, we can see an unanswerable case for linking the two. It’s no coincidence at all that the exponential upturn in the world’s population took off at the same time that, thanks to James Watt’s 1776 invention of the first effective heat-engine, we learned how to harness the vast energy potential contained in fossil fuels.

Not just the size of the world economy, but its prosperity and complexity, too, are products of the Prometheus unleashed by Watt and his fellow inventors.

Fig. 1.



Moreover, observation surely tells us that literally everything that constitutes the ‘real’ economy of goods and services relies entirely on energy. Without energy supplies, the economy would grind to a halt, and the society built on it would disintegrate.

After all, if you were adrift in a lifeboat in mid-Atlantic, and a passing aircraft dropped you a huge pile of banknotes, but no water or food, you’d soon realize that money has no intrinsic worth, but commands value only in terms of the things for which it can be exchanged.

Money, then, acts simply as a claim on the products of an economy which, itself, is an energy system.

The cost component

Anyone who understands the energy basis of the economy knows that the supply of energy is never cost-free, though the relevant measure of cost needs to be stated in energy rather than financial terms. Drilling a well, digging a mine, building a refinery or laying a pipeline requires the use of energy inputs, as, for that matter, does installing a wind-turbine or a solar panel, or constructing an electricity distribution grid.

This divides the aggregate of available energy into two streams – the energy which has to be consumed in providing a continuity of energy supply, and the remaining (“surplus”) energy which powers all other economic activity.

The cost component is known here as the Energy Cost of Energy (ECoE). This is the critical determinant of the ability of surplus energy to drive economic activity. Low ECoEs provide a large surplus on which to build prosperity, but rising ECoEs erode this surplus, making us poorer.

Further investigation reveals that, where fossil fuels are concerned, four factors determine the level of ECoE.

One of these is geographic reach – by extending its operations from its origins in Pennsylvania to places as far afield as the Middle East and Alaska, the oil industry lowered ECoE by finding new, low-cost sources of supply.

A second is economies of scale – a plant handling 300,000 b/d (barrels per day) of oil is a lot more cost-efficient than one handling only 30,000 b/d.

Now, though, the maturity of the oil, gas and coal industries is such that the benefits of scale and reach have arrived at their limits. This is where the third factor steps in to determine ECoE – and that factor is depletion.

What depletion means is that the lowest-cost sources of any energy resource are used first, leaving costlier alternatives for later.

The crux of our current predicament is that ‘later’ has now arrived. There are no new huge, low-cost sources of oil, gas or coal waiting to be developed.

From here on, ECoEs rise.

To be sure, advances in technology can mitigate the rise in ECoEs, but technology is limited by the physical properties of the resource. Advances in techniques have reduced the cost of shale liquids extraction to levels well below the past cost of extracting those same resources, but have not turned America’s tight sands into the economic equivalent of Saudi Arabia’s al Ghawar, or other giant discoveries of the past.

Physics does tend to have the last word.

Unraveling economic trends

Once we understand the processes involved, we can see recent economic history in a wholly new way. The narrative since the late 1990s can be summarised, very briefly, as follows.

According to SEEDS – the Surplus Energy Economics Data System – world trend ECoE rose from 2.9% in 1990 to 4.1% in 2000. This increase was more than enough to stop Western prosperity growth in its tracks.

Unfortunately, a policy establishment accustomed to seeing all economic developments in purely financial terms was at a loss to explain this phenomenon, though it did give it a name – “secular stagnation”.

Predictably, in the absence of an understanding of the energy basis of the economy, recourse was made to financial policies in order to ‘fix’ this slowdown in growth.

The first such initiative was credit adventurism. It involved making debt easier to obtain than ever before. This approach was congenial to a contemporary mind-set which saw ‘deregulation’ as a cure for all ills.

The results, of course, were predictable enough. Expressed in PPP-converted dollars at constant 2018 values, the world economy grew by 36% between 2000 and 2008, adding $26.8 trillion to recorded GDP. Unfortunately, though, debt escalated by $61.5tn over the same period, meaning that $2.30 had been borrowed for each $1 of “growth”. At the same time, risk proliferated, and became progressively more opaque. Excessive debt and diffuse risk led directly to the 2008 global financial crisis (GFC).

With depressing inevitability, the authorities once again responded financially, this time adding monetary adventurism to the credit variety that had created the GFC. In defiance of a minority who favoured letting market forces work through to their natural conclusions (and who probably were right), the authorities opted for ZIRP (zero interest rate policy). They implemented it by slashing policy rates to all-but-zero, simultaneously driving market rates down by using newly-created money to buy up the prices of bonds.

This policy bailed out reckless borrowers and rescued imprudent lenders, but did so at a horrendous price. Since 2008, we’ve been adding debt at the rate of $3.10 for each $1 of “growth”. The proper functioning of the market economy has been crippled by the distortions of monetary manipulation. The essential regenerative process of ‘creative destruction’ has been stopped in its tracks by policies which have allowed ‘zombie’ companies to stay afloat. Asset prices have soared to stratospheric levels, supported by a tide of debt which can never be repaid, and can be serviced only on the assumption of perpetual injections of negatively-priced credit. The collapse in returns on invested capital has blown a gigantic hole in pension provision. As the Federal Reserve is in the process of discovering, no route exists for a restoration of monetary normality. We are, in short, stuck with monetary adventurism until it reaches its point of termination.

The relentless rise of ECoE

Back in the real economy, meanwhile, ECoEs keep rising. SEEDS calculates that global trend ECoE has risen from 4.1% in 2000, and 5.6% in 2008 (the year of the GFC), to 8.1% now. Critically, the upwards trajectory of ECoE has become exponential, with each incremental increase bigger than the one before.

As this trend has progressed, prosperity has turned downwards, initially in the advanced economies of the West.

To understand this process, we need first to look behind GDP figures which have been inflated by the simple spending of borrowed money. In the decade since 2008, an increase of $34tn in world GDP has been accompanied by a $106tn surge in debt. What this means is that most of the reported “growth” in GDP has been bogus. Rates of apparent “growth” would slump to, at best, 1.5% if we stopped pouring in new credit, and would go into reverse if we ever tried to deleverage the world’s balance sheet.

Once we’ve established the underlying rate of growth – as a “clean” measure of GDP which excludes the effects of credit injection – we can apply ECoE to see what’s really been happening to prosperity.

In the West, people have been getting poorer over an extended period. Prosperity per capita has fallen by 7.2% in the United States since 2005, and by 11.3% in Britain since 2003. Deterioration in most Euro Area economies has been happening for even longer. Not even resource-rich countries like Canada or Australia have been exempt. As an aside, this process of impoverishment, often exacerbated by taxation, can be linked directly to the rise of insurgent political movements sometimes labelled “populist”.

The process which links rising ECoE to falling prosperity is illustrated in figs. 2 and 3. In America, prosperity per person turned down when ECoE hit 5.5%, whereas the weaker British economy started to deteriorate at an ECoE of just 3.4%.

Fig. 2 & 3.



World average prosperity per capita has declined only marginally since 2007, essentially because deterioration in the West has been offset by continued progress in the emerging market (EM) economies. This, though, is nearing its point of inflexion, with clear evidence now showing that the Chinese economy, in particular, is in very big trouble.

As you’d expect, these trends in underlying prosperity have started showing up in ‘real world’ indicators, with trade in goods, and sales of everything from cars and smartphones to computer chips and industrial components, now turning down. As the economy of “stuff” weakens, a logical consequence is likely to be a deterioration in demand for the energy and other commodities used in the supply of “stuff”.

Simply stated, the economy has now started to shrink, and there are limits to how long we can hide this from ourselves by spending ever larger amounts of borrowed money.

Safe to continue?

Let’s revert now to our hypothetical situation in which, unconcerned about the environment, we remain resolutely committed to an economy powered by fossil fuels.

The critical question becomes that of what then happens to the economy moving forwards.

Unfortunately, the ECoEs of fossil fuels will keep rising. SEEDS puts the combined ECoE of fossil fuels today at 10.7%, a far cry from the level in 2008 (6.5%), let alone 1998 (4.2%). Projections show fossil fuel ECoEs hitting 12.5% by 2024, and 14.5% by 2030.

For context, SEEDS studies indicate that, in the advanced economies of the West, prosperity turns down once ECoEs reach a range between 3.5% and 5.5%. Because of their lesser complexity, EM countries enjoy greater ability to cope with rising ECoEs, but even they have their limits. SEEDS analysis identifies an ECoE band of between 8% and 10% within which EM prosperity turns down. Sure enough, China’s current travails coincide with an ECoE which hit 8.7% last year, and is projected to rise from 9.0% in 2019 to 10.0% by 2025. A similar climacteric looms for South Korea (see figs. 4 & 5).

Figs. 4 & 5



In short, then, continued reliance on fossil fuels would condemn the world economy to levels of ECoE which would destroy prosperity.

Hidden behind increasingly desperate (and dangerous) financial manipulation, the world as a whole has been getting poorer since ECoE hit 5.5% in 2007. As more of the EM economies hit the “downturn zone” (ECoEs of 8-10%), the so-far-gradual impoverishment of the average person worldwide can be expected to accelerate.

After that, various adverse consequences start to impact the system. The financial structure cannot be expected to cope with much more of the strain induced by denial-driven manipulation. The political and geopolitical consequences of worsening prosperity, exacerbated perhaps by competition for resources, can be left to the imagination. Economic systems dependent on high rates of capacity utilization can be expected to fail.

This, then, is the grim outlook for a world continuing to rely on fossil fuels. Even if this continued reliance on oil, gas and coal won’t destroy the environment, it can be expected, with very high levels of probability, to wreck the economy.

Even as things stand today, the energy industries seem almost to have stopped trying to keep up. Capital investment in energy, stated at constant 2018 values, was 20% lower last year (at $1.59tn) than it was back in 2014 ($2tn), and is not remotely sufficient to provide continuity of supply. Even shale investment only keeps going courtesy of investors and lenders who are prepared to support “cash-burning” companies.

Critically, what this means is that the supposed conflict between environmental imperatives, on the one hand, and economic (“cost”) considerations, on the other, is a wholly false dichotomy.

For the economy, no less than for the environment, there is a compelling case for transition. But the implications of the future trend in ECoEs go a lot further than that.

As the ECoEs of fossil fuels have risen inexorably, those of renewable alternatives have fallen steadily. It is projected by SEEDS that these will intersect within the next two to three years, after which renewables will be “cheaper” (in ECoE terms) than their fossil alternatives.

At this point, it would be comforting to assume that, as the ECoEs of renewables keep falling, and the extent of their use increases, we can make a relatively painless transition.

Unfortunately, there are at least three factors which make any such assumption dangerously complacent.

First, we need to guard against the extrapolatory fallacy which says that, because the ECoE of renewables has declined by x% over y number of years, it will fall by a further x% over the next y. The problem with this is that it ignores the limits imposed by the laws of physics.

Second, renewable sources of energy remain substantially derivative of fossil fuels inputs. At present, we can only construct wind turbines, solar panels and their associated infrastructure by using energy sourced from fossil fuels. Until and unless this can be overcome, sources termed ‘renewable’ might better be described as ‘secondary applications of primary energy from fossil fuels’.

Third, and perhaps most disturbing of all, there can be no assurance that the ECoE of a renewables-based energy system can ever be low enough to sustain prosperity. Back in the ‘golden age’ of prosperity growth (in the decades immediately following 1945), global ECoE was between 1% and 2%. With renewables, the best that we can hope for might be an ECoE stable at perhaps 8%, far above the levels at which prosperity deteriorates in the West, and ceases growing in the emerging economies.

Policy, reality and the false dichotomy

These cautions do not, it must be stressed, undermine the case for transitioning from fossil fuels to renewables. After all, once we understand the energy processes which drive the economy, we know where continued dependency on ever-costlier fossil fuels would lead.

There can, of course, be no guarantees around a successful transition to renewable forms of energy. The slogan “sustainable development” has been adopted by the policy establishment because it seems to promise the public that we can tackle environmental risk without inflicting economic hardship, or even significant inconvenience.

It is, therefore, far more a matter of assumption than of verifiable practicality.

Even within the limited scope of declared plans for “sustainable development”, efforts at transition are faltering. Here are some examples of this disturbing insufficiency of effort:

– According to the International Energy Agency (IEA), additions of new renewable generating capacity have stalled, with 177 GW added last year, unchanged from 2017. Moreover, the IEA has stated that additions last year needed to be at least 300 GW to stay on track with objectives set out in the Paris Agreement on climate change.

– The IEA has also said that capital investment in renewables, expressed at constant values, was lower last year (at $304bn) than it was back in 2011 ($314bn). Even allowing for reductions in unit cost, this reinforces the observation that renewables capacity simply isn’t growing rapidly enough.

– In 2018, output of electricity generated from renewable sources increased by 314 TWH (terawatt hours), but total energy consumption grew by 938 TWH, with 457 TWH of that increase – a bigger increment than delivered by renewables – sourced from fossil fuels.

The latter observation is perhaps the most worrying of all. Far from replacing the use of fossil fuels in electricity supply, additional output from renewables is failing even to keep pace with growth in demand. Where power generation is concerned, this has worrying implications for our ability to transition road transport to EVs without having to burn a lot more oil, gas and coal in order to do so.

The deceleration in the rate at which renewables capacity and output are being added seems to be linked to decreases in subsidies. These, though affordable enough at very low rates of take-up, have been scaled back as the magnitude of the challenge has increased.

This calls for a thoroughgoing review of energy policy, and it seems bizarre that a system which can provide financial support for the banking system cannot do the same for the far more important matter of energy. Even within the fossil fuels arena, the continued growth of American shale production has relied on cheap capital, channeled into loss-making shale producers by optimistic investors and seemingly-complacent lenders.

We need to understand that, when an individual pays for electricity, or puts fuel in a car’s tank, this represents only a small fraction of what he or she spends on energy. The vast majority of energy expenditure isn’t undertaken as direct purchasing by the consumer, but is embedded in literally all of his or her outlays on goods and services. The scope for direct purchasing is determined by the scale of embedded use.

As prosperity deteriorates, then, the ability of the consumer to purchase energy is reduced. There is every likelihood that energy suppliers could find themselves trapped between the Scylla of rising costs and the Charybdis of impoverished customers.

We should, accordingly, be prepared for the failure of a system which relies almost entirely on commercial enterprise for the supply of energy. Far from prices soaring in response to tightening supplies, it’s likely that the impoverishment of consumers keeps prices below costs, resulting in a shrinkage of energy supply as part of a broader deterioration in economic activity.

As the situation develops, we may need to think outside the “comfort zone” of current policy parameters. For instance, the promise that the public can exchange their current vehicles for EVs may prove not to be capable of fulfillment, forcing us to evaluate alternatives, including electric trams and rail.

For now, though, one imperative predominates. It is that we must stop believing in the false dichotomy in which the environmental need for a transition to renewables is “moderated” by wholly false considerations of “cost”.

Simply put, we’re likely to pay a quite extraordinarily high price for a continuation of the assumption that the economy, demonstrably an energy system, is characterised by, and can be managed using, purely financial interpretation.