Non-renewable
resources & energy
Economics, management, and policy
Motivating Group Project
California Renewable Energy
Requirement for Electricity:
Legislation requires that 20% of
generation be from renewables by
2020. How can this best be
achieved?
 2003-4 Bren Group Project

Key Characterisics of Nonrenewables



Fixed endowment of given quality
Stock declines over time
For minerals




Costly process of discovery
Costly process of extraction
Technical change decreases costs of exploration and
extraction over time
Key Results



Physical Stocks Decline over time
Price eventually increases with time
Technical change may cause prices to decrease
initially
Time paths
Production ceases;
Substitutes enter
p
tc dominates
exhaust dom
t
Stock
t
Scarcity value of non-renewables

Since limited supply, non-renewable
resource command a “scarcity value”

Problem: You own a barrel of oil. Can
sell today for $30. Should you sell
today, or wait for next year? (r=.05)
Intertemporal Arbitrage:
Hotelling’s Rule
•Price
today: p0 (=$30)
•Price
tomorrow: p1
•If
p1>$31.50, wait
•If
p1<$31.50, sell today
•In
equilibrium:
•p1=p0(1+r)
Hotelling “rent”


Real Prices should rise at rate of interest. If think
they won’t, firms would deplete reserves today.
What about extraction costs?




Rt = Pt – MCt implies Rt+1 = Rt(1+r)
Also called “user cost”, “royalty”, “rent”
Hotelling: It is actually rent which rises at rate of
interest
Present value of rents equal through time.

Indifferent between selling barrel today or any point
in future.
What about quantity
extracted?

Recall demand curve:
If price increases through time,
quantity must decrease.
$
D
Barrels of oil
Confounding factors:
1. Shifts in demand
2. New discoveries
3. New extraction technology
4. Backstop technology
Prices and quantities over
time
Seek: Price path that follows Hotelling Rule, such that stock is
just exhausted when quantity demanded drops to zero
Price
Quantity
Produced
time
time
Switching to a “backstop”

Backstop technology: a perfect
substitute for non-renewable resource
that can be produced in any amount
at constant (usually high) price.

When price of non-renewable = price
of backstop, we’ll switch.
The effect of a backstop
technology
$
Question: If you know backstop price
And stock of resource, how do you
Find initial price?
MCb
Price path with
backstop
time
Other factors that affect price
path: with a backstop technology

Decreasing extraction cost:


Sudden increase in demand:


Lower price initially, then rises more quickly
Price jumps suddenly, decreases current
consumption.
Monopoly:

Price higher but rises more slowly, but extraction is
slower so extends life of the resource.
The monopoly case
Price
Quantity
Monopoly
MCb
Time
Time
What do they mean when they say “A monopolist is a conservationist’s best friend”?
Are we running out
of resources?
Physical measures of
“scarcity”

Reserves: known amount that can be profitably
extracted.


Reserves/Production:


Assumes constant demand
Crustal abundance: total amt in crust.


Changes with tech, discoveries, cost, price.
Inventory ~ constant through time
Ignores cost of extraction
Ultimately recoverable: total to 1 km depth

Arbitrary, different for all resources, no new tech.
Economic measures of
“scarcity”

Marginal cost of extraction:


Price:


Ignores extraction cost.
Hotelling rent:


likely to increase as stock decreases, but ignore price
Difficult to observe, but probably best measure of scarcity.
Confounding factor:

Technology of extraction continues to improve
Studies of Scarcity

Barnett and Morse (Scarcity and Growth)




Slade





Looked at natural resource prices over 100 yrs
Nearly all resources getting less scarce
Timber only exceptin
Extraction tends to drive price up
Technological change tends to drive price down
Eventually exhaustion overcomes tech change
Simon-Ehrlich Bet
Question: If we made the same bet today, who would
be on Ehrlich’s side and who on Simon’s?
Subsidizing renewable
energy



Remember our model: Price of nonrenewable rises until it reaches price of
backstop.
If extraction cost = 0, extract all nonrenewable before switching (more likely,
won’t extract all of it).
If MCb decrease from subsidy, current price
of oil will decrease, and consumption of oil
will increase.
The effect of decreasing
MCb
Price path with
high backstop price
MCb0
MCb1
Price path with
low backstop price
time
Comparing the two policies
Taxing the thing that causes damage (oil
consumption) can internalize externality.
 Subsidizing renewables may have
unintended consequence of pushing
consumption of fossil fuels to the present!
 Principle of targeting: design regulation or
policy to target (internalize) the externality.

OPEC

Organization of petroleum exporting
countries

Algeria, Indonesia, Iran, Iraq, Kuwait, Libya,
Nigeria, Qatar, Saudi Arabia, United Arab
Emirates, Venezuela
Controls most of world oil production.
 Maintain low production to keep prices
(profits) high.
 Why would prices ever drop?

The “Prisoner’s Dilemma”
Saudi Arabia
cooperate
cooperate
defect
30
30
40
5
Kuwait
5
defect
40
10
10
Maintaining cooperation
An example of a “Nash Equilibrium” – both
countries do what is in their best interest
given what the other does.
 Defecting from the original agreement is a
dominant strategy for both countries.
 Intuitively, incentive to cheat (by
overproducing) is very high.


Because other countries restrict output to
keep prices high.
Electricity Markets –
Basic Conditions

Demand – energy vs. power
Area under curve is
energy
Power
24 hours

Reliability
Probability
Density
time
Loss of load probability
Power system demand (kw)
Basic Questions
What demand level should system be
designed for?
 Electricity = power + energy +
reliability
 Supply – 3 activities:

Generation
 Transmission
 Distribution

Operation of Power System
Peak Load
Power at
Least this
high
Load Duration Curve:
Area under LDC is energy
Intermediate Load
Baseload
100%
Fraction of Year
Regulation of Electricity
Markets

Historically natural monopoly
Rate of Return Regulation
 Utilities allowed to price to achieve
“fair rate of return”
 Problems:

• Gold plating
• Inefficient
• Average Cost Pricing

More recently (worldwide):
deregulation
The California energy crisis

Pre-1999
3 regulated monopolies that owned and
operated generation, transmission,
distribution (PG&E, SCE, SDG&E)
 Federal Energy Regulatory Commission
regulates wholesale power transactions
(one utility to another)
 California Public Utilities Commission
regulates retail prices (to consumers)

Restructuring electricity




Designed competitive wholesale market
 Suppliers bid to supply electricity on daily basis
 “Grid” accepts lowest bids; price at margin
Goal: more competitive California
 Argued it would decrease prices
 Could pass savings on to consumers by giving them a choice of
supplier
But consumer side still regulated.
Didn’t work
 Prices skyrocketed over 500% between 1999-2000.
 Utilities paying far more than consumers paid.
 State had to bail out industry, cost $60 billion.
From Joskow:
“The wholesale prices prevailing between June and
September 2000 were much higher than the fixed
retail price that the utilities were permitted to charge”
Price
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Ap 9
r- 9
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Ap 0
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Ap 1
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450
400
350
300
250
200
150
100
50
0
Why did wholesale prices
rise?
Rising natural gas prices (natural gas is an
input to electricity production)
 Large increase in demand in CA (growth)
 Reduced imports from other states (heat
waves)
 Rising prices for NOx emissions credits
(costs of producing electricity)
 Market power (in wholesale spot mkt)

Why didn’t it work & lessons
Technically challenging to create
competitive wholesale market
 Consumers were insulated from
wholesale market prices (because
retail market still regulated).

Deregulated wholesale, failed to
deregulate retail prices or to allow
forward contracts.
 Required utilities to buy at unregulated
price and sell at regulated retail price.

What next?
State committed to long-term contracts at
unreasonably high prices – cost $60 billion.
 Prices likely to remain high to pay off.
 Prices dropped in 2001 due to increased
supply, decreased demand.
 SCE and PG&E effectively bankrupt.
 Replaced deregulated wholesale with state
procurement and regulated prices
