The Economics of Energy – What is the cost-effectiveness of energy and climate policies? 

In a panel debate with key European policy makers hosted by GE and organized by ScienceBusiness; I emphasized the need to more systematically internalize environmental costs, which we have enumerated in recent scientific work.

The social and economic benefits of modern energy are tremendous. While two billion people still lack access to clean cooking fuels and one billion lacks access to electricity, the number of energy-poor in Europe is small and energy is both reliable and affordable for most European consumers. The real benefits of modern energy become apparent only when we experience power outages, gas embargoes or when we see

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what fraction of the household income energy-poor are willing to pay for energy. Research on the social metabolism of societies has demonstrated that access to fossil fuels was essential to allow the growth of urban centers even before invention of the steam engine and how it has fueled the industrial revolution and economic growth ever since.

The use of fossil fuels, however, has substantial environmental costs. In a study for the International Resource Panel, we assessed the main drivers of a large set of environmental problems in terms of industry sectors, products and materials. We found that fossil fuel utilization was the number one cause of most pollution-related environmental problems, while agriculture and food production stood as the major cause for habitat change, biodiversity loss, and a significant contributor to ecotoxicity and overfertilization of the environment. Energy not only stands for 80% of the climate problem, it also causes the exposure to fine particulate matter with significant health impacts especially but not only in developing countries, the formation of smog, significant pollution associated with the extraction and transport of fossil fuels, and more. As people become wealthier, they are increasingly less willing to have their lives cut short by five years because of cheap energy supply, as we see in China today.

The environmental costs of fossil fuel use should be the deciding factor in determining our energy policy. Climate costs affect mostly future generations and the poor, which have little political clout today and cannot force decision makers to internalize these costs. Fortunately, as our recent research has shown, low-carbon power sources also lower other types of pollution which cause more immediate damages. This dual benefit provides an additional rationale for climate policies.

In the area of solar and wind energy; Europe has been at the forefront creating a market for these technologies, thereby driving costs down and making these energy sources cost-competitive in some markets, even if the environmental costs of fossil fuels are not yet fully internalized. Even if China has now taken over as a technology supplier, it would not have happened without European leadership.

Solar and wind energy are intermittent. Good resources are sometimes far from demand centers. Extending electricity grids and removing regulatory barriers to create a single energy market in Europe can overcome some of the challenges posed by intermittency and remoteness. Our research shows that transmission lines and subsea cables, while adding to the pollution impact of renewables, do not compromise the environmental edge renewables have over fossil fuels. Even with extensive transmission networks, in North Sea or across Europe, RES come out as very attractive from a pollution perspective compared to today’s system.

However, impacts on the landscape become a problem – people do not want to have all places full of windmills and transmission towers. The variability of RES may be a real challenge to effective utilization if not sufficient transmission capacity is built. We should hence also explore alternative options to address variability through energy demand reduction, peak shaving, and various forms of energy storage. Technological progress, including in smart grids and energy storage, will reduce the costs and hassle associated with these strategies and will make them more attractive. They may also have clear environmental benefits, which, however, need to be demonstrated.

Energy and climate policy, GE Europe CEO Stephan Reimelt claimed in the discussion, have become a major source of volatility for companies, providing a challenge to businesses. The way of internalizing social costs is important. Instead of imposing a carbon tax or an effective ETS with predictable carbon costs, Europe has followed a second-best strategy of protected markets, subsidies, and regulation. This strategy has been successful in stimulating necessary technology development and increasing energy efficiency, but it is not reducing emissions enough. The second-best approach has resulted in inconsistent and varying signals to companies. The system thus exposes investors to unnecessary policy risks, thereby adding to the financing costs of the energy transition. Transmission system operators call for a stable investment climate to reduce the risk to those making huge investments.

Internalizing environmental costs can provide the stable investment climate requested by industry. The EU should introduce a price floor for the emissions allowances in its emissions trading system (ETS) by charging a minimum price for handing out the allowances. Better still, it could replace the ETS by a carbon tax. A more predictable price of carbon would reduce the market volatility for energy efficiency, transmission and other energy investments and thus reduce the costs of financing the energy transition. It will also reduce the need for regulation, thus further reducing the costs to business.

Today, some electric utilities in Europe are in a difficult economic position, as the split of Germany’s EON shows. They have created an overcapacity of fossil fuel fired power plants, because they expected more demand growth and maybe did not believe the planned renewable generation would be realized. Their investment decisions were based on a higher carbon price, but their own overestimates for required emission allowances are to blame for the glut in the ETS. Utilities today complain that guaranteed feed-in tariffs for renewables are to blame for their poor return on investment, but both feed-in tariffs and EU renewable energy targets were in place when they invested in the most recent fossil capacity additions. Sure, few have predicted the shale gas revolution and its effect on the price of coal, so gas was a poor bet. Higher carbon prices improve the position of gas, but it would not go all the way making it competitive with coal today. Right now, some utilities lobby for capacity payments – a way to subsidize fossil fuel power plants in a manner comparable to the protected markets for renewable power. I am not convinced that more subsidies are the right decision.