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Market failure in the Energy Transition

The energy sector is facing challenging times in which it has to balance short-term returns with its long-term license to operate. Shell, one of the largest oil and gas companies in the world, started a massive reorganization as they expect a permanent decline in the price of oil and gas due to the corona crisis. On top of this, the speed of the energy transition from fossil fuels to sustainable energy puts the old business model of the sector at risk.

The CEO of Shell was recently asked about the future of the company in relation to climate change. What struck me was that his answers were both logical and intriguing at the same time. Since 2016, Shell has invested around $2 billion in building a low-carbon energy and electricity generation business. However, investments in developing fossil fuel projects during this period were more than $120 billion. There are even plans set out to increase spending on fossil fuel projects to $30 billion a year in the early 2020s. This would surprise many of us, especially with the uncertain future of the energy sector.

Last month, Shell and BP wrote down the value of their assets by $22 billion and $17.5 billion, respectively, in line with the uncertain future of the industry. This directly links to the term stranded assets: assets that quickly lose their value because of necessary write-downs. Why are these large oil and gas companies still betting on their old “money-maker”, and why are they not investing more in renewable energy? It is not as simple as it sounds, as also pointed out by the CEO of Shell.

The need for an energy transition

Energy systems around the world have to be transformed. The European energy system accounts for 75% of the EU’s emissions and is thus under enormous pressure to reduce its greenhouse gas emissions. A global transition to low-carbon energy is necessary to lower the carbon emissions, where fossil fuels are replaced by renewables. If the emissions are not reduced quickly enough, the transition to a low-carbon economy will occur more abruptly. This is the too late, too sudden scenario, mentioned in a report by the European Systemic Risk Board in 2016 (!). Slowly but surely, this scenario becomes the most likely scenario we will be facing. Governments will have to implement constraints on the use of carbon-intensive energy sources abruptly. A sudden transition will be more costly compared to a gradual transition to a low-carbon economy.

This abrupt transition becomes more likely because we are coming close to using up the carbon budget for limiting global warming to 1.5°C above pre-industrial levels. The carbon budget here refers to the amount of greenhouse gas emissions that we can emit over a period of time. According to the Emissions Gap Report 2019 of the UN Environment Programme, the 1.5°C goal of the Paris Agreement “will slip out of reach” if we do not reduce the global greenhouse gas emissions rapidly. Furthermore, Carbon Brief shows that if the emissions do not drop in the coming years, the 1.5°C carbon budget will be used up within eight years. This means that we only have eight years of current emissions remaining that can be emitted before the world passes the 1.5°C global warming goal. This is very much in contrast to the pledge made by nearly every country in the Paris Agreement: keeping global temperatures well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5°C.

The two figures below show pathways to global warming scenarios of 1.5°C and 2°C, respectively. Figure 1 shows that limiting global warming to 1.5°C is very challenging. If we follow the 2019 pathway in Figure 1, emissions would have to fall 15% a year until 2040 to stay below 1.5°C without negative emissions from carbon capture. This is an insanely large amount to reduce, given that the corona crisis led to an estimated decline of emissions of around 7% this year. Figure 2 shows the emission reduction trajectories to keep temperatures below 2°C for different starting years. Every year that goes by, the line becomes steeper and makes the task more difficult. If the emission reductions would start after 2019, emissions will have to decline 4% a year to limit global warming below 2°C by 2100.

Figure 1: Emission reduction pathways to limit global warming to 1.5°C for different starting years. Source: Carbon Brief

Figure 2: Emission reduction pathways to limit global warming to 2°C for different starting years. Source: Carbon Brief

Low carbon technologies

The two figures clearly show that we have to hurry with reducing emissions to keep the global temperature below 1.5°C or even 2°C. As the European energy system accounts for 75% of the EU’s emissions, it is crucial that low-carbon solutions are ready to be implemented in this sector.

There are many techniques to produce energy without using fossil fuels. Solar panels and wind parks, for instance, are by far the greatest drivers behind the generation of renewable energy electricity. However, these energy sources are heavily reliant on the weather. Techniques to store the generated energy are necessary for times when there is neither sunlight nor wind.

Battery storage systems are one way to effectively store solar and wind energy, and this technology is expected to grow significantly in the coming years. Utility-scale batteries can enable the storage of excess energy generation from solar panels, which can later directly feed back into the grid. Another solution to “store” energy is hydrogen. Frans Timmermans, First Vice-President of the European Commission, recently announced the hydrogen plans of the European Commission. They believe that hydrogen will play a crucial role in Europe’s energy transition. There are different types of hydrogen, however, and each has very different emission levels during the production process.

Renewable hydrogen is the type that can be produced with near-zero emissions, as it is produced using electricity from renewable sources such as solar and wind energy. However, this type is currently three times as expensive compared to producing fossil-based hydrogen. This second type uses fossil fuels in the production process and the emissions are much higher than when producing renewable hydrogen. A third type of hydrogen is fossil-based hydrogen with carbon capture (‘blue hydrogen’). The greenhouse gas emissions that are emitted during its production process are captured and stored. Producing blue hydrogen is roughly 30% more expensive than without carbon capture, which makes it a more viable option for the energy industry. There are mixed opinions about this type, as opponents are saying that it holds back the development of renewable hydrogen. Timmermans from the European Commission, however, says that we need blue hydrogen while renewable hydrogen is in development.

How the market fails in the energy transition

Given the available low-carbon energy technologies and the urgency to cut emissions, you would say that this is a good business to invest in. However, here lies the problem. The CEO of Shell, Ben van Beurden, shared his thoughts on accelerating the energy transition in a recent interview. He said that he could not just stop with producing gasoline and invest heavily in, for instance, biofuels and carbon capture. He will not be able to sell a story to Shell’s shareholders that they can be proud of fulfilling their social responsibility through large scale investments in renewables if these investments are not yet cost-competitive. These low-carbon technologies are still much more expensive than the energy produced through fossil fuels. He is entirely correct in saying this, but it shows that the problem is fundamental. Shareholders are the owners of the firm, and many of them will not agree with Shell behaving anti-economically with projects that will not have great, if any, returns in the short term. Van Beurden had a nice term for how Shell should be behaving: “economically sustainable”.

How can we fix this issue in the market, where energy companies will only choose the most profitable investments and not invest more in low-carbon technologies, which cost (much) more? We can look at this situation from a simple economic equilibrium theorem.

Pareto efficiency

We are in an economic equilibrium where the producers of energy choose the most profitable investments, and the consumers are paying the price that follows from a competitive energy market. You could introduce Pareto efficiency here: producers of energy will keep investing in the most profitable (fossil-fuel) projects to produce energy, while consumers have the option to choose their energy supplier and choose what fits their preferences best. Once producers and consumers are in equilibrium, neither will have the intention to move.

If the producer invests in more costly low-carbon technologies, either the consumer will be charged more, or the producer will end up with more costs. At least one party will be worse off. The consumer will not move either, as he has the free choice to choose its energy supplier in the first place. Moving means a less optimal choice, given the equilibrium where the consumer already made his optimal choice. The energy producer will not be affected by the consumer switching energy supplier.

Although the Pareto efficiency does have some assumptions built in, it does not matter for the point here. If we introduce government intervention in this economic optimum, we can create a new equilibrium where it is beneficial for producers to choose the low-carbon technology investments over fossil-fuel projects. By introducing a CO2-tax, companies are nudged into investing in low-carbon technology. These low-carbon investments will be cheaper than the fossil-fuel projects, as the CO2-tax increases the cost of the fossil-fuel projects. The tax could itself be used to pay out a CO2-subsidy to companies investing in low-carbon technologies, nudging preferences even more towards this direction. This should be done on an international level until the low-carbon technologies are cheaper and are sufficiently developed. In the end, it would make investing in low-carbon technologies the new economic optimum.

Solving the market failure

Some sort of intervention is needed to break the fossil-fuel equilibrium in the energy sector and to lower the global emissions. The Dutch Central Bank already published an article saying that pricing carbon emissions remains the economically most effective means to reduce them. This carbon tax already exists in the form of the ETS system, but it can also be used effectively to nudge investments in the energy sector to low-carbon technologies. Without any intervention, the economic equilibrium will not change and investments in low-carbon technologies will stay on a low scale, with all its consequences for our carbon budget and our planet.


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