Thursday, March 22, 2012

Energy finance in free markets: an open conundrum

A question which has occurred to me lately revolves around the oft-heard objection that, "Nuclear has always been a state enterprise." In other words, the high up-front capital cost (and attendant front-loaded risk from construction delays and potential intervenors) makes nuclear a tough pill to swallow for liberalized energy markets, despite the extremely low operating costs (and hence, low back-end risk).

This problem seems to extend well beyond nuclear energy itself; rather, it would seem to indict any capital-intensive energy projects where a given rate of return on investment is not guaranteed. It provokes the question - in a completely free market for electricity (as opposed to the admixture we have now), what would energy investment look like?

Some of the imbalance which currently exists now owes to the imbalance of externalities captured by the current regulatory environment. Sources like coal - especially older, "grandfathered" plants, are allowed to treat the atmosphere effectively as an open cesspool; at the other extreme, nuclear is expected to account (and pay for!) each last curie of waste produced, going as far as to return the site to greenfield status once the plant has closed.  Meanwhile, indictment of nuclear as uniquely a "state industry" by its detractors rings somewhat hollow, given that yet more expensive, diffuse, and less reliable sources such as wind and solar would almost certainly be pushed to the margin under the same standard.

Obviously, a balance to the regulatory playing field is called for (although don't hold your breath waiting for that one…). Yet going a step further, assuming this, what would energy investment look like in a completely liberalized energy market?

Natural gas historical prices
U.S. natural gas prices, per EIA
Essentially, what such a market would appear to produce, if the current trend is any example, is likely sources in which costs are easily externalized to others (e.g. coal and to a lesser degree natural gas) or the costs are relatively distributed throughout the lifecycle (e.g., natural gas, where costs are largely on the fuel cost). Yet one predictable consequence of this - beyond the environmental impact - would be the impact on retail electricity price volatility. Again - natural gas is far from being historically "stable" in price.

Where does this leave nuclear? Ultimately, nuclear would seem to have the ability to moderate these types of price shocks, namely by providing stable, low-cost baseload power. This ultimately is where I believe technologies such as small modular reactors (SMRs) are so vital to the future of nuclear; they provide at least some means of blunting the capital risk of nuclear in liberalized energy markets. Further, incentives clearly matter - Pigouvian measures such as a carbon tax would go a long way toward leveling the playing field (again, don't hold your breath on this one.)

Yet even beyond this however, the need for innovative mechanisms for financing large, capital-intensive energy projects remains clear. Ultimately, my expertise is in nuclear technology and not finance, and thus I am at a loss for ideas. Given my own personal predilections toward free markets, it is often disappointing to see many market-oriented advocates simply put down nuclear as "socialist" rather than seeking out new vehicles and mechanisms to finance such projects through private investment.  (Unlike many nuclear advocates such as Rod Adams, I do not share their antagonism to Wall Street, recognizing that ultimately private capital will be essential for future energy projects, especially as America's own government contemplates austerity measures in light of a growing entitlement crisis brought about by massive demographic shifts). One notable example of innovative ideas for finance comes from this excellent guest post at Idaho Samizdat, taking a lesson from the Dutch nutmeg trade. But further such ideas for innovative financing models are badly needed.

An alternative proposal is for legislative mandates such as portfolio standards - e.g., a "clean energy standard" similar to renewable energy portfolio standards which currently exist, mandating that utilities generate a certain fraction of their energy from designated sources. Beyond the obvious potential for peril of political manipulations on defining just what qualifies as "clean" (or attempts to game the standard by powerful, entrenched interests), this does nothing to solve the existing problems of financing which have ultimately precipitated the perceived need for such mandates.

Ultimately, this question goes well beyond nuclear; given the fact that liberalization in energy markets is unlikely to reverse course in the forseeable term, how can we develop new mechanisms to provide financing to capital-intensive (but lower long-term financial risk) projects, sans government intervention? This is the true long-term challenge, incumbent advocates of clean energy of all types as well as market advocates themselves. These kinds of questions are the kind whicn should form the basis of free market environmentalism (a term which need not be an oxymoron).

Unfortunately, these are questions I am ill-equipped to answer, yet they are (in my mind) vital to the future of energy markets.