Energy policies and market forces

Energy policies and market forces

Conference report Time among market forces Energy Policies and Market Forces, Institute of Energy, London, 4 March 1987. The stated object of the semi...

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Conference report Time among market forces Energy Policies and Market Forces, Institute of Energy, London, 4 March 1987. The stated object of the seminar I was: • . .professionals to bring together legislators encrgy to examine theand way we measure cost-effectiveness: whether we should leave it to market forces, what that means and what it implies; what are the interests of the consumer (industrial, cornmcrcial or domestic) and how does he decide about energy investment; how public bodies do so; the economic justification of Government R & D on energy, and how the topics should be selected; the mechanisms available to a government to give effect to its energy policy including conservation; the timetables of implementation and their economic significance,

ly overwhelmed by orders and starved of them. Crossland went on to deplore nuclear power opponents' disregard of fossil fuels' problems. He also urged study of combined heat and power (CHP) generation for the long term and with a view to the next century.

in the light of governmental emphasis on competition, market forces and the price mechanism.

e, i,e economists' and accountants' unanimity over discounted cash flow (DCF) assessment as the only sure guide to the most profitable investment opportunity, Chesshire observed, many private UK firms do not use this technique. Most prefer the payback period as their touchstone because it is easy to understand and work out. However, it ignores the cost of capital, the timing of cash flows

The introduction of CHP in cities would be a formidable task, presenting problems for the next four or five governments. It exemplified the issues

during payback and the returns after payback, so its can lead to poor decisions. Its use is strongly discouraged in the public sector. DCF and payback criteria diverge most when

calling for energy planning and policy, Better a policy that is changed every five years, declared Crossland, than

applied to long-lasting projects. Payback methods bias judgment against protracted projects and favour

In the event the attendance list carried half a dozen names from the House of Commons (one of them that of the seminar chairman, Sir John Osborn, MP, who presided over the Parliamen-

no policy at all.

Investment criteria appraised

brief ones. Also noted by Chesshire was UK private firms' varying attitude to in-

John Chesshire, senior fellow of the

moneyVeStment'intoC°mpanieSoutput capacity,typicallYR&putD

tary Group for Energy Studies, which helped to organize the seminar), and four names from the House of Lords. The remaining five dozen names (exeluding press) were those of the presumed 'energy professionals', who therefore outnumbered the legislators six to one. Did that render the meeting a failure? Not for at least one of

Science Policy Research Unit, Sussex University, acknowledged that investment criteria might at first seem an arcane subject but he persisted with and clarified it. He pointed to the 40-50% of UK investment currently committed to major energy supply and to the growing evidence of the UK's relatively inefficient consumption. His concern was the efficiency with which investment is allocated. To illustrate

and taking market share, aiming thus to develop their business or raise their profits. To maintain their business or their profits they find capital for plant replacement, complying with regulations (eg with respect to health, safety and environmental protection) and services such as those connected with energy and its efficient utilization. All of which means, in Chesshire's

those who did turn up. Challenged from the floor on the poor legislative attendance, the chairman explained that Parliamentarians were busy in committee work, and he ended the day expressing satisfaction with the proceedings because they had given him material for a speech in the House of Commons. The absent legislators, though no doubt usefully occupied elsewhere, missed some instructive addresses and some lively questioning from the floor. The scene was set by Professor Bernard Crossland, President of the Institution of Mechanical Engineers (another of the bodies that had helped the Institution of Energy to organize the seminar). Crossland lamented the lack of an energy policy. He said that the power industries had been suffering under a stop-go regime, alternate-

ENERGY POLICY August 1987

the importance of this emergent area of public policy he quoted from the first report of the Commons Select Committee on Energy: We were dismayed to find that, seven years after the major oil price increases, the (UK) Department of Energy has no clear idea whether investing around £1 300 million in a single nuclear plant (or a smaller but still important amount in a fossil fuel station) is as cost effective as spending a similar sum to promote energy conservation. In order to procure allocative efficiency, maintained Chesshire, investment criteria should be similar throughout the economy, but he concentrated thereafter on inconsistencies inside the relatively self-contained energy sector. He deliberately refrained from considering pricing policies but he

view, that the private sector rather frowns on energy efficiency investment (eg new boilers or energy-saving gear). He referred to researches that had shown government pricing policy, intended to promote energy efficiency, not to have been as stimulating as its advocates had hoped. The foremost reason for this unresponsiveness to price signals was seen by Chesshire as the demand for swift payback. Private-sector investment in the supply (as distinct from the efficient consumption) of energy is mostly in the "business development' category, perceived Chesshire, and he thought that supply investment would probably be less severely judged than 'discretionary' expenditure on energy efficiency, which latter would fall into the 'business maintenance' category.

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Conference report The UK's privately owned energysupply companies appeared to prefer DCF methods and were more likely to invest than were the demand-side companies in the private sector, Turning to the public sector, Chesshire paraded evidence for its misallocation of resources, particularly its under-investment in energy efficiency. He began with the policy guidelines that had been laid down in the 1967 and 1978 White Papers. National resources were to be allocated efficiently and the public sector's claims were not to distort the situation. Appraisal of individual investment projects was to be on a DCF basis. Costs and benefits were to be discounted at the test discount rate (TDR) of 8% real according to the 1967 White Paper, but in 1969 the rate was raised to 10% real. The rationale had been that, to maximize welfare, marginal rates on new investment should be the same in the public and private sectors. The 1978 White Paper demanded a 5% real rate of return (RRR), after tax, on entire investment programmes, leaving each nationalized industry otherwise free to determine its own discount rate in consultation with its sponsoring department. Broadly, the 5% figure had been based on notionally equalizing the return to be required of the public sector with the return that had actually been obtained in the private sector. These investment rules had been applied with reasonable consistency only on the energy supply side, argued Chesshire, because the 1967 and 1978 White Papers had referred to nationalized industries. 'While all the publicsector energy-supply investment has been in nationalized industries', he said 'most energy efficiency investment has not'. The Central Electricity Generating Board (CEGB), in its evidence for the public inquiry regarding a new nuclear power station at Sizewell, had emphasized the 5% discount rate recommended in the 1978 White Paper. The CEGB's 'central' case for the station envisaged a 7-8% RRR. By comparison, before British Gas (BG) had been privatized, that corporation had used a 10% discount rate for revenueearning projects, to make sure of a 5% R R R overall (some projects, eg those

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for safety, earn nothing). The National Coal Board (NCB) had used DCF in the same manner as had BG. The marginal return on proposed investment - ie the difference between a colliery's cash flows with and without the i n v e s t m e n t - h a d had to be at least 10%. Overall colliery investment (based on future cash flows for the whole colliery) had been expected to return at least 5% real. British Coal (BC) had continued on those NCB lines. 'It is thus interesting to note', commented Chesshire, 'that were the CEGB to follow BG or BC practice in the assessment of revenue-earning projects, the Sizewell PWR project would not achieve a sufficiently high rate of return to be sanctioned'. On the demand side of the public sector, however, Chesshire found much more stringent criteria than were being applied on the supply side. There was often no formal T D R / R R R system. Cash limits, driven by the public-sector borrowing requirement (PSBR), strongly influenced energy efficiency investment. Local authorities were keeping to investments showing very high returns. Health authorities were favouring measures with a five-year or shorter payback, equivalent to a minimum RRR of roughly 15%. Energy efficiency projects averaging a 1.9 year payback had not been embarked upon in 1983. 'Needless to say', said Chesshire nonetheless, 'there would appear to be prima facie grounds for suspecting a misallocation of investment resources within different parts of the public sector'. He went on to detect signs of'wider political considerations' and 'perhaps institutional bias'. As an instance he cited an Energy Efficiency Office statement that, while investment in energy conservation in buildings is generally appraised in accordance with the 1978 White Paper, and while the Government favours similar criteria for energy supply and energy use: This does not imply that all investments with a realistic prospect of earning a 5 per cent return will go ahead. In allocating resources to different activities (health, law and order, education, energy, transport and so on) Government makes judgments on priorities between them and on priorities within the programme. Particular in-

vestment must be justifiable in all the circumstances and the balance between different objectives must be held. Chesshire was expressively dismissive after reading the quotation. 'To me', he said, 'that's just Yes Minister yah yah'. Was no uniform discount rate appropriate for public-sector energy industries? Should the private sector be followed by considering different discount rates for the larger and riskier projects? Chesshire thought it preferable to judge their "robustness' by detailed sensitivity and probability analysis, applied more comprehensively, rigorously and openly than it had been hitherto. Capital rationing in the public sector is not helped by the RRR or T D R test when it passes more projects than resources can cover. The 1978 White Paper ignored this problem, with what Chesshire called 'particularly crucial' effect because it 'effectively halved the real discount rate from 10 to 5%'. The choice of 5% worsened the aggregate constraints: RRR did not either steer or dimension capital investment in the public sector. Not only did different investment criteria ensue for the nationalized energy industries but PSBR priority often deflected capital expenditure. Energy efficiency projects had too frequently suffered. Measures such as the recent appointment of energy managers in every government department might 'raise consciousness' but were not enough. The least problematic corrective action would be to raise the RRR from 5%. To help make capital allocation efficient the RRR had to reflect the private sector's ex ante and not expost returns, but Chesshire saw no hint of such thoughts in Treasury minds. In the circumstances he deemed it better to revive the T D R of 1967-78, properly applying and enforcing it, at 8-10%. Energy supply investment criteria in the public sector would then approach those on the demand side, and would also be brought nearer private-sector criteria. While restricting some investments this would fail to stimulate others, though, so Chesshire advocated changed rules for public-sector demand-side investment. 'It is clearly absurd', asserted Chesshire, 'that public supply projects can spend £1 billion

ENERGY POLICY August 1987

Conf~,rence report or more with a 7.5% expected return, while many efficiency projects, which are perhaps three times as profitable, are regularly shelved'. He opined further that tile private sector had to be encouraged to invest more in energy efficiency, Summing up, Chesshire condemned debate over whether demand and supply investment streams are alternative or complementary. Supply-side assets had to be replaced and could, in the process, bring better fuel efficiency. In both the public and the private sector, the streams were "essentially' complementary. He could not expect decline in total public-sector investment, at least in the medium term, if the discount rate were lifted from 5 to 8-10%. Rather did he observe much, highly cost-effective, public-sector investment held back by cash limits, even when 20-40% RRR looked likely. A higher discount rate for publicsector appraisal would shift the balance between competing claims for scarce capital, especially those of supply and efficiency. Public-sector procedures would be improved, limited investment resources would be more effectively used and conspicuous waste of energy would be avoided,

T i m e as a m a r k e t f o r c e Nothing happens instantaneously, Northern Engineering Industries' corporate engineering director, Philip Warner, a former president of the Institute of Energy, gave some physical illustrations of this 'law' before he turned to its implications for energy policy. He split 'energy policy" time into three: time taken to decide, to promulgate decision and to put decision into effect. The possible protraction of time-scales could be seen in such cases as those of the Belvoir coal and Sizewell PWR projects. Seminarists would be deluding themselves, however, if they thought time mattered less if small projects were preferred. The smaller the units the more numerous they had to be and the longer it might take for cumulative effect to signify. The obvious merits of better thermal insulation for houses, for example, did not include a negligible time factor,

ENERGY POLICY August 1987

Having brushed aside the 'small is beautiful' argument (without using that phrasing), Warner felt free to focus on large supply-side projects, The energy investment cycle involved consumers, suppliers and manufacturers, he said. The consumers chose between electricity, gas and coal, and they chose how much of each to consume, thus influencing the suppliers. The consumers also equipped themselves to utilize each form of energy and they thus influenced manufacturers. Consumers' decisions, why ever made, had a fuel-choice influence on energy suppliers and an equipment-choice influence on manufacturing industry, The more obvious investment decisions of fuel suppliers were exploration, production and R & D. These decisions affected manufacturing industry. Warner illustrated the principies by elaborating on electricity generation. For some ten years, he said, the electricity supply industry lESt) in England and Wales had been publishing formal mid-term development plans for seven years ahead. Similar assessments were being made in Scotland and Northern Ireland. The formal planning horizon, seven years, was a measure of power-station building-time but construction could take longer and in practice the industry looked further ahead. Capacity had to be provided to meet peak demand because electricity could not be stored. Peak demand varied over the years, much of its fluctuation caused by the weather, and as unpredictably. Two major determinants of demand were price (relative to other fuels) and industrial activity. Prices were not much more predictable than the weather. Industrial activity could be measured by GNP, which economists did try to predict. Industrial output affected demand directly but relative prices did not: consumers could not switch to a cheaper fuel unless equipped to do so, and few consumers were. Interestingly, the ESI was, for it had to meet the annual peak and therefore possessed spare capacity at all other times. So it could choose to run oil- or coal-fired stations according to fuel price, Cutting production costs was a good reason for building power stations,

The case for the Sizewell PWR had originally been cheaper production. Only the long delay had turned it into a capacity investment case. Building for cheaper production could be timed for convenience. When building for capacity, though, time was of the essence. Less time might be taken where thetechnologywaswellknown. Thus the second of two 2 I)00 MW coal-fired stations at Drax (actually a trio of turbogenerators) had taken some eight and a half years from design contract to full load. The Sizewell PWR, on the other hand, had taken a purely "policy" time, so far, of nine years - more than enough for the industry to prepare itself in. The total time expected for construction was seven and a half years. Warner showed graphically how supply capacity and maximum demand in England and Wales had varied from 1960, and how they were predicted to vary until 2010. tte pointed out that forecasting uncertainties (brought about by weather, plant mishaps, construction overruns etc) were allowed for by lifting the demand curve to give the so-called 'planning margin'. Subtraction of the demand curve from the supply curve gave the amount of new capacity required, but with a tendency to compound forecasting inaccuracies. Research and development also took their toll of time. 'For any new system', averred Warner, 'there is a sequencey through physical concept, engineering feasibility, research and development, prototypes and demonstration plants, taking 30 to 5(J years altogether'. He gave as examples nuclear and tidal power. Nuclear had not contributed much to UK needs until the mid-1960s although it had been shown to be possible decades earlier. The Severn's tidal power had been under consideration since early this century. Warner went on to say that manufacturers (including not only those providing energy suppliers with systerns and equipment but also those supplying the domestic, commercial and industrial consumer) respond classically to market need: they try to fit their products to it and to compete with each other more keenly on price, quality and delivery. To these ends

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Conference report manufacturers invest, inter alia, in design and development of new products and in manufacturing facilities, Such investment might be intended to meet either steady or intermittent demand, and time affects both but the latter more fundamentally. Steady demand might arise from a worldwide market or from a home customer with long-term plans (such as those for nuclear power in France and Canada). Under steady conditions manufacturers can invest steadily too, with progressive benefit all round. If demand is intermittent, as it has been in the UK, the story is different, 'You can hold a team of engineers for a while', Warner sighed, 'but high-grade people are dedicated to what they call "real work", not paper studies'. Without 'real work' those people moved on. Teams could take two or three years to form again, Projects could be delayed, even abandoned. Control of the timetable could almost be lost, as on Sizewell. The uncertainties, and their costs, were not easy to plan for. 'The surest way of driving up manufacturing and construction costs is to keep making changes or delaying decisions', remarked Warner with the timbre of experience in his voice. 'To be cornpetitive, industry must take a long view: recruit and train its people, develop its products, work up its production and quality processes, renew and update its facilities. It is a controlled evolution. Arbitrary changes are expensive and, in the limit, there is a degree of haphazardness which the manufacturer cannot deal with: he cannot hold his skilled resources, he runs the risk of poor performance, and he has great difficulty in carrying through productive investment.' Warner advised administrations to recognize that, if they wanted to enjoy the customer's privilege of irregular ordering, they should admit and take account of the cost of such irregularity. Better still would be for them to avoid sharp fluctuations altogether. The one-year interval for decisions fitted the Parliamentary cycle but was much too short for industry. What was wanted was a steady ordering policy, and that did not mean ordering possibly superfluous plant. The principle

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was that change should not be sought without taking account of the speed at which the system was capable of responding. Warner raised laughter with an analogy: If you are navigating a supertanker down a narrow channel, you adjust its speed to the width and the shape of the curves. You do not ask that it should sail for ever at the same speed. But nor do you expect someone to stop surprise youand with sharp call corners, call to dead, another to geta

problem. To essay a view on future market forces, to project prices and costs probabilistically, was to risk one's reputation for wisdom. 'The discrediting of forecasters, a kind of corporate bearbaiting', as Parker put it, 'has become a favourite sport in the energy policy underworld'. Forecasters conferred under such titles as Planning for uncertainty to escape further ridicule. Another defence was

started after all, and quickly. Least of all do you expect the marker buoys to have been removed and kept hidden away, to be dropped just ahead of the supertanker at unexpected times and in random positions,

'the agnostic practice of "scenario" building'. Thus were people encouraged to say that, as the future was unknown, 'the market' should be left to decide: and most meant by this that

Warner's conclusion, however, was direct and free of parable. 'When you contemplate a decision, you must ask how soon or how slowly it can take effect. Otherwise, you cannot know if it is the right decision. If you want to change your mind, take care also of the time factor. Ignore it then, and it will cost you money'.

all decisions should be based on the current week's prices and costs, or that payback must be very fast. 'But', said Parker, 'you cannot conduct energy policy based on a mixture of Rotterdam spot prices and two-year paybacks'. A school of thought sceptical over 'resource cost' calculations, or attempts to do the 'total sum', also favoured leaving everything to the market, in other words disregarding all such factors as national security, regional unemployment and balance of payments and concentrating solely on future prices. But governments' preferences had to be decided and reflected in the discount rate on public investment, in capital rationing for PSBR reasons and in weighting of non-commercial factors. These highly political choices varied with governments and, because political forecasting was even harder than energy forecasting, exacerbated uncertainty particularly in the public sector. Moreover, the market might sometimes be distorted covertly or unintentionally, rather than perhaps partly as a matter of policy. In Parker's view - and here he endorsed Chesshire's - a major distortion arose from the very large differences in the effective RRR sought in the different parts of the energy sector. Market forces were crucial in the public sector but, as Parker chose to define them, they were not 'merely blind and instant reaction to shortterm price and cost movements' and he allowed 'the influence of noncommercial factors or market distortions in energy policy'. Market forces were not just a 'hidden hand' in the

The uncertainty principle BC's director of economics and statistics, M.J. Parker, simultaneously the chairman of the British Institute of Energy Economics (another of the seminar's organizers), began by declaring his views his own and not necessarily those of his organizations, But he called on the experience of the publicly owned coal industry as evidence that 'market forces are the decisive factor in determining the strategies lying behind energy policy', A fine, definite affirmation, but Parker went on to concede 'that there is great uncertainty both as to how those market forces will operate, and the extent to which other influences will be brought to bear on public policies', Politics undoubtedly contributed to public sector uncertainty but Parker thought that this contribution had figured too strongly in debate on energy planning and policy. Market forces' role, on the other hand, had been seriously neglected, Parker found market forces hard to define relevantly to business decisions beyond immediate ones. Strategy demanded projections of costs and prices and these were highly uncertain. No large organization in the energy sector, public or private, could avoid this

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Conference report long-leadtimed, panoramic, energy sector but involved the activities of governments and energy industries, all of them looking to the future, Hitherto the strategy of publicly owned energy industries had reflected the current government's view of energy prospects: other factors had been taken as constraints rather than as policy determinants. Parker traced the last forty years' events in Britain's coal industry by way of illustration. When the NCB had been formed (in 1947) the country had depended largely on coal and had been desperate for more. Cross-subsidization, with average cost-plus pricing, had therefore been approved and 'efficiency' had meant raising labour productivity and overcoming manpower shortages by technical improvement. In the 1960s cheap Middle Eastern oil had eroded markets and the UK coal industry had shrunk fast. It had been assumed that oil would always be cheap and abundant - the 1967 White Paper on Fuel Policy had said so. The primary objective had become to run down the coal industry as quickly as socially possible while reducing production costs in surviving mines. After OPEC's 'revolution' in 1973-74, O E C D governments had placed overriding collective priority on reduction of oil dependence, and they had strengthened their efforts after the further price rises of 1979-80. UK coal had been seen as a major contributor, and a large coal industry had been deemed entirely compatible with nuclear development and energy conservation. In our own time there was too much oil - indeed, too much energy generally - in the world. 'The present wisdom', said Parker, 'is that this situation will persist for the foreseeable future' and that market competition should therefore be relied upon to minimize use of real resources. In the Government's own words to BC, 'the justification for coal production, like any other business, lies in the ability of those engaged in it to earn a satisfactory return

with substituting coal for oil and in the early 1980s with the surplus of coal capacity. In other words, successive governments' coal policies had largely stemmed from apparently 'overwhelmingly sensible' contemporary judgmerits of the energy future. Parallels could be found in the other energy industries. Everywhere, public policy had reflected primarily expectations of market forces, Parker stressed that in such cases the future was judged in degree too (eg differentiating between 'oil will be cheap' and 'oil will be very cheap'), and that the rate of innovation or obsolescence would depend on the degreeofbenefitperceived. Hence the thrice greater progress of natural gas in fifteen years than of nuclear power in thirty. He noted, also, the increasing internationality of energy market forces: as it had been with oil, so now it was with coal and (to an extent) natural gas. Technology was becoming more international, as were environmental policy considerations. International energy market forces, and collective informed opinion about their future development, were more powerful than individual energy industries or governments. The factors did not require full description of their uncertainty - Parker had but to list them. They included the future international prices of oil and coal, the relationship between economic activity and energy demand, the long-term exchange rate and the ultimately recoverable amount of North Sea oil and gas. Nobody in the energy business, public or private, could escape views on these. Neither could the Government. Parker denied that he had shown 'a spectacular degree of naivety' by giving market forces primacy in the practical determination of energy policy. Governments could indeed direct publicly owned industries in different ways (political polarity on nuclear power was an obvious contemporary example), but even here the political

on capital while competing in the market place.' Despite important political factors, on Parker's assessment any govern-

uncertainty could be exaggerated. Enlarging on this, Parker pointed to the serious mismatch between the time scales of governments and of the

ment would have been preoccupied in 1947 with raising coal output, in 1965 with lowering coal output, in 1974

energy industries. Most of the latter's economic structure was the result of history and even for the next five years

E N E R G Y P O L I C Y A u g u s t 1987

was 90% inherited: every government was imprisoned by its predecessors' decisions. 'The real battles', as Parker phrased it, 'are around the margin, and will be concerned as much with timing as direction'. Finally, he found 'major similarities' between public and private corporate planning. In both sectors the planners had to come to terms with inevitable uncertainty, devise 'robust' strategies and decide actually at the margin. Admittedly, the public sector had often suffered from unclear, conflicting or radically changing objectives. Singleness of purpose - essential to commercial success - had therefore been hard to display. In Parker's opinion, though, this difficulty was not big enough to stop nationalized industries doing their duty by drawing up sensible strategies and carrying them out as far as allowed. So the more 'businesslike' the behaviour of the public energy industries became, the likelier was economic deployment of resources in the long run. These industries had to cope with business uncertainty as everybody else had. Political uncertainty had also to be coped with, 'although hopefully more stable criteria and reasonable continuity of objectives might make the task less difficult'. The private sector, too, faced difficulties in formulating strategies '"robust" to uncertainty'. Most commentators had sought to contrast the public and private sectors, concluded Parker. What he had done was to indicate 'the large elements of common difficulty' as they all wrestled with uncertain market forces.

Arthur Conway Harrow

Middlesex, UK

1This meeting, the Institute of Energy's second seminar with Parliamentarians, was organized by the Institute in association with the Parliamentary Group for Energy Studies, The Institution of Mechanical Engineers, The Institution of Electrical Engineers, The British Institute of Energy Economics and The Watt Committee on Energy. The proceedings of the seminar, including discussion, will be published by the Institute of Energy, 18 Devonshire Street, London WlN 2AU, UK. 383