The economic case for Net Zero - part 1: Energy

I had originally intended to make this a single blog on “the economic case for Net Zero”. The central contention I wanted to make is – a future Net Zero world is desirable on purely economic grounds, whether you care about climate change or not (and to be clear, you should and I do). As I read the public and political discourse on Net Zero, it is usually framed as a trade-off between economic cost today and an environmental benefit in the distant future. That environmental benefit is then unconvincingly translated into an economic benefit in the form of avoided costs from excessive global heating. This has always been emotionally a hard sell – “please pay more for energy now, because it will move the probability distribution of extreme weather costs for your grandchildren to be only a bit worse rather than a lot worse” is always likely to be met with a sceptical response.

This has never been the primary reason that I am excited about the transition to Net Zero. To me it is exciting also because the economic benefits – the opportunity to reduce the cost of energy, reduce the cost of transportation, reduce the cost of energy-intensive processes and raw materials. A Net Zero world can be one of near zero marginal energy costs, with that source of energy (wind, sun and other renewable sources) being widely available rather than concentrated in a small number of petrostates. On the face of it, that’s an exciting future and one we should all want (though there are myriad risks associated with such a radical change).

But this will not be a single article on this topic, because the deeper I delve into this, the more interesting and exciting it has become. So instead, this will be the first in a series that explores different aspects of the economic case for Net Zero. Today I want to focus on the cost of energy. The economic case for Net Zero hangs on the possibility that a future built around renewable energy could be one of significantly lower cost and more widely available energy than the current world economy built around fossil fuels, so we need to examine this first.

A detour into geekery – Marginal vs. Levelised cost

First, let us explore the current cost of energy provided by different sources. This will require a definition of what we mean by “cost”. In the preamble, I discussed the possibility that a Net Zero world would have near zero marginal energy costs. Marginal cost is the additional cost required to generate a unit of electricity for a power generation unit. For renewable energy, this is already close to zero (there is some cost associated with maintenance and depreciation, but otherwise no cost is incurred as a solar panel or wind turbine generates power); for fossil fuel generation the marginal cost is the cost of the fuel burnt to generate the electricity (plus also the maintenance and depreciation costs). Clearly on a marginal cost basis, then renewable power is already preferable to fossil fuel generation.

This comparison however distorts difference in the cost structures of energy production. Renewable energy has large up-front capital costs to build the generation capacity and then very low marginal costs to run, whereas for conventional energy up-front costs are a smaller proportion of the total cost. Merely comparing the marginal costs thus doesn’t tell the whole story. As such we use levelised cost as a measure of the average cost of producing a unit of power through different sources – this takes the full lifetime costs of a power generation facility (including original build costs, maintenance and fuel costs), and divides by the lifetime power generated to get to a USD/MWh comparison. It also includes a financing cost – this depends on the discount rate put on the original up-front investment (we’ll come back to this!).

Where do we stand today?

Investments in renewable energy technology and manufacturing in recent years have the effect of reducing the cost of production, increasing the efficiency with which power is generated (especially through solar panels), and increasing their lives. All of this has brought down the levelized cost of power from renewables such that even today, the most efficient sources of renewable energy are already more cost efficient than fossil fuel sources. In researching this, I spent several enjoyable hours with the IEA’s excellent interactive tool on levelized costs . This allows us to see not only the levelized cost comparison today, but also the sensitivity to multiple variables. I adjusted two – the carbon tax and the discount rate applied to investments in renewable energy. First see the results with the IEA’s default assumptions, which involves a $30 carbon tax, and a 7% discount rate on investments:

The immediate and stark conclusion is that when the best available technologies are used, renewable energy and nuclear power are the cheapest overall sources of energy. But there is a wide range – industrial scale costs are markedly lower than the large number of sub-scale technologies deployed. Rooftop solar deployed on rooftops of houses and industrial facilities are relatively expensive, but utility scale Solar plants are the cheapest source of energy. Similarly, large scale onshore Wind facilities provide cheaper energy than any source of fossil fuel power, but small scale onshore wind is amongst the most expensive sources, and offshore wind is better than many sources but more expensive than the most efficient coal and gas fired power generation.

There are also important differences within fossil fuel generation. Best available technologies – combined cycle gas turbines and ultra-super critical coal fired power plants – are relatively cost efficient. Less efficient technologies (open cycle gas and super-critical or sub-critical coal) are not really any better than mid-scale renewables.

The (slightly overstated) relevance of carbon taxes…

The obvious objection to the above analysis is that it includes a $30 carbon tax. That’s a pretty low estimate of the societal value destruction of climate change, but if the economic case hinges on the carbon tax then we are back to the “cost today for environmental benefits tomorrow” equation. Fortunately, the IEA allows you to adjust these assumptions and recut the answer. This is what the picture looks like with no carbon taxes:

The picture here is less positive, but still the same – the best available renewable technologies provide the cheapest source of power. If this is the whole picture then the conclusion is clear – any newly built power capacity should be industrial scale renewables. This economic case does not rely on carbon taxes – i.e. it does not rely on any belief about the value of avoiding costs associated with climate change, and should require no policy intervention to achieve.

…And the under-appreciated significance of discount rates

Eagle-eyed readers will notice that there are two factors listed in the analyses above. Let us now turn our attention to discount rates. This is important because the discount rate (the opportunity cost or financing cost of the original investment) is proportionately a much more significant factor for renewable energy than it is for fossil fuel energy. Because, as we noted earlier, the cost structure of renewable energy is almost entirely up-front, whereas for fossil fuel generation it is a balanced mix of up-front capex and fossil fuel costs through the life of the plant. Consequently, lower discount rates will make the economic case for renewable energy more compelling, whereas high discount rates will do the opposite. See below the same charts side by side with no carbon taxes and discount rates at 3% (a reasonable proxy for “risk free” USD financing through the cycle, though lower than today’s prevailing interest rates) and 15% (the highest level possible in the IEA tool, and a reasonable proxy for commercial expectations of return on a risky or equity investment).

These are intentionally put side by side, and with the y-axes fixed to the same scale. Because it allows both of the key factors to immediately jump out – that a low discount rate favours renewable energy, whereas at high discount rates Gas and Coal become cheaper; and that the discount rate is a critical factor in the levelized cost of energy across all sources. This has some pretty wide-ranging implications:

• Lower cost of financing will accelerate the energy transition, even if that is not differentiated between Green and Brown sources of energy
• The incentive to build renewable energy will be higher in countries with low interest rates and low risk (i.e. developed countries) than those with high interest rates and high risk (i.e. developing countries). As much of the incremental power supply that is added will be in high discount rate countries, finding a way to lower the cost of financing is a clear priority
• De-risking renewable energy is essential to its economics. Renewable energy has been a risky investment, exposed to construction risks, policy changes, further technological changes, and environmental factors (it is one of the world’s great ironies that an affect of climate change in recent years has been more frequent and severe droughts with a direct effect on hydro and nuclear power generation). Rational investors demand a higher return for higher risk, and this has an outsized impact on the relative attractiveness of renewable vs. conventional energy
• This derisking is especially important because fossil fuel generation is typically owned by large existing companies with strong balance sheets and existing commercial agreements; whereas a lot of renewable generation is created by newer, smaller companies. This balance sheet difference creates a difference in risk and leads to lower discount rates for fossil fuel generation vs. renewables – precisely the opposite of what is needed to incentivise positive developments

What this means, and what’s coming in future parts

To go back to where we started, what all this means is that the economic case for the energy transition is (with some very important caveats) already strong. Rational investors building new capacity (or replacing retiring old capacity) would invest in industrial scale renewables rather than additional fossil fuel generation. They would do that without any policy interventions, but carbon taxes and (especially) support to lower financing costs and reduce risk make this case more compelling. The energy transition should eventually lead to lower energy costs, and is an economically desirable outcome independent of your views on climate change.

This is not the whole story, which is why this is not just one article. Coming soon:

• Infrastructure, intermittency and impairments – complications in the economic case for the energy transition
• Electric vehicles – behaviour changing, thinking four dimensionally, and the “price does not equal marginal cost” paradox
• The geopolitics of the energy transition (or why we should all be scared of Net Zero)
• Implications of cheap renewable energy for “hard to abate” sectors
• Supply chain constraints on the transition to Net Zero