Energy Economics Final Study Guide

Energy market price volatility:
Why is price volatility greater in energy markets compared to the price volatility in (most) markets for other goods?

• Many types of risk make energy markets susceptible to price volatility.

• There is very elastic demand for energy.

Energy market price volatility
Draw a simple short-term supply/demand diagram explaining the price volatility with the appropriate demand and supply curves.

• 

  Price volatility is represented by the diagram, indicating that price goes up when supply goes down.

• 

  Price volatility is represented by the diagram because when elasticity of supply changes price does not, meaning the energy market is usually stable.

Energy market price volatility
Explain the reasons for the shape of the demand and supply curves.

• The shapes of the supply and demand curves are representative of the total units available for sale. If there are a greater number of units available then the length of the supply line increases.

• The shapes of the supply and demand curves are representative of the elasticity of supply and demand. If a curve is inelastic it will have a very steep slope. Inelastic behavior of demand means it is less responsive in the short term to changes in supply.

Hotelling´s model
According to the model, how does an owner of an oil field schedule its production?

• production will be scheduled so that the asset bears its highest return

• production will be scheduled so that the price is lowest during the asset extraction, so it may be sold later at a higher price

Hotelling´s model
Put forth the equation for price development and explain it. Show on a figure how the model predicts prices over time.

• 

  Price development is based on the first order condition, where Marginal User Cost (MUC) plus Marginal Extraction Cost (MEC) is the price at time t. The resource owner must be fairly compensated for the decision to extract today and forgo the marginal value of extraction tomorrow.

• 

  Price development happens at the intersection of the shadow price and the demand in the same period, t. The resource owner must be fairly compensated for the decision to hold reserves today for the future use of national interests.

Energy efficiency. Consider a possible energy efficiency investment and answer the following:
Explain the assumptions an investor would need to make to estimate the profitability of the energy efficiency investment.

• The pricing of green power or energy efficiency have parity with a brown power investment. After the subsidies for energy efficiency investments sunset then the technological investment will remain profitable.

• The pricing of energy efficiency will be lower than an investment in brown power but the investor believes it is the right thing to do for the good of the planet. The subsidies for the energy efficiency investment are irrelevant to the benevolent financier.

Energy efficiency. Consider a possible energy efficiency investment and answer the following:
How would an investor calculate whether the investment is profitable of not?

• Using net present value. If NPV is positive, then the investment is made.

• Using loan payoff periods. If the loan payoff period is within a reasonable time frame then the project is profitable and the investment is made.

• Using the expected revenue formula. By estimating the revenue the investor determines the monthly profitability of the project then adds the expected profitability to determine when they will fill their bank accounts.

Energy efficiency. Consider a possible energy efficiency investment and answer the following:
Explain and give examples of the market failures when it comes to energy efficiency.

• Market failure is where a competitive market does not yield the socially efficient outcome. Government subsidies of green power lead to over consumption of electricity and disincentives for energy efficiency. The underlying market failure is under pricing of brown power, not overpricing of green power, artificially depressing the price of power and discouraging energy efficient consumption.

• Market failure is where a competitive market does not yield the socially efficient outcome. When the government does not subsidize energy efficiency then society losses out by not having enough power to deploy luxury lighting of their properties.

• Market failure is where a competitive market does not yield the socially efficient outcome.
  In energy efficiency the biggest market failure happens when policy makers fail to forward payments to brown power producers and there is not enough electricity to power the new generation of LED products.

Energy efficiency. Consider a possible energy efficiency investment and answer the following:
How have governments addressed these market failures?

• Subsidies, Feed-in Tariffs, command-and-control regulation, market-based credit trading schemes

• legislative quagmire, legal precedent, direct taxes on consumers, grants for economists

“Missing money” problem
Explain the “missing money” problem in electricity markets.

• Prices do not fully reflect scarcity due to wholesale price caps.

• Prices do not fully reflect scarcity due to retail price caps.

• Prices do not fully reflect scarcity due to privatization of industry.

• Prices do not fully reflect scarcity because consumers are unwilling to pay wholesale rates above a certain price.

“Missing money” problem
Explain the two different kinds of rationing in electricity markets and how that is tied to the “missing money” problem.

• In demand response, voluntary rationing is accomplished by price incentives. Involuntary rationing, if employed, would be accomplished via rolling blackouts during peak load periods. If distributors are forced to pay distributed generators at retail rates, they are free-riding the grid and voluntary price signaling fails, leading to a higher potential for involuntary rationing.

• One kind of rationing is to curtail renewable energy supply. Another kind of rationing is to curtail distributed generators and make them pay for feeding power into the grid. This solves the missing money problem.

Assume a hydro dominated electricity system and the bathtub model when answering the following questions:
What are the socially optimal pricing rules?

• Such pricing rules serve as benchmarks when evaluating actual pricing of electricity and the value of hydropower reservoirs.
  Actual prices may not reflect the socially optimal prices, especially in the case of market power or price regulation.

  The ability to store water implies that it is optimal to use water in the highest price periods to bring down prices and create greater social surplus

• Such pricing rules serve as benchmarks when evaluating actual pricing of electricity and the value of hydropower reservoirs.
  The socially optimal pricing rules ensure that all water is used today to produce as much electricity from renewable resources over one period, as possible.

• Such pricing rules serve as benchmarks when evaluating actual pricing of electricity and the value of hydropower reservoirs.
  The socially optimal pricing scheme involves pumped storage using nuclear reactors to mitigate the effects of carbon intensive electricity production.

Assume a hydro dominated electricity system and the bathtub model when answering the following questions:
Draw a bathtub diagram for two periods and explain the assumptions. What is the price of electricity for the two periods when there is no constraint binding? How much water is used in each period?

• 

  Assumptions:
  We will assume there is unlimited transferability of water between the periods
  Water is measured in energy units, kWh, and no conversion from water to electricity is shown
  The marginal utility, measured in monetary units is the marginal willingness to pay
  This is our demand function for electricity

  The water values for period t-1 and t must be equal when no hydro-related constraint is binding. The hydro contribution is the amount of water, AB, locked in to be used in period 1 and a full reservoir BC is left for period 2. The water value for period 1 is equal to the price. It is a general result that the water value in a period is equal to the marginal cost of the partially utilized technology.

• 

  Assumptions:
  We will assume there is limited transferability of water between the periods
  Water is measured in mass units, kg, and no conversion from water to electricity is shown
  The marginal utility, measured in mass units is the marginal willingness to pay
  This is our supply function for electricity

  The water values for period t-1 and t must be unequal when no hydro-related constraint is binding. The hydro contribution is the amount of water, AB, locked in to be used in period 1 and a full reservoir BC is left for period 2. The water value for period 1 is equal to the price. It is a general result that the water value in a period is equal to the marginal cost of the fully utilized technology.

Assume a hydro dominated electricity system and the bathtub model when answering the following questions:
Show the prices of electricity for the two periods when the storage constraint is binding. How is this result consistent with the socially optimal pricing rules? How much water is used in each period?

• 

  The general effect is that the price in the period with a binding storage restriction will be higher than without such a restriction, and in the multi-period case more water has to be transferred to the period after the period with the storage capacity constraint.
  Storage capacity is BC
  In the first period, water available is equal to AC
  Second period inflow equal to CD
  The optimal allocation is to store maximal amount BC in period 1 and consume what cannot be stored (AB)
  Consume BD in period 2
  What was stored from period 1 plus the inflow in period 2=BD

• 

  The general effect is that the price in the period with a binding storage restriction will be lower than without such a restriction, and in the multi-period case more water has to be transferred to the period after the period with the storage capacity constraint.
  Storage capacity is BC
  In the first period, water available is equal to AC
  Second period inflow equal to BD
  The optimal allocation is to store maximal amount BC in period 1 and consume what cannot be stored (AB)
  Consume BD in period 1
  What was stored from period 1 plus the inflow in period 2=AC

• 

  The general effect is that the price in the period with a binding storage restriction will be equal than without such a restriction, and in the multi-period case no more water has to be transferred to the period after the period with the storage capacity constraint.

Peak oil
Explain Hubbert´s analysis.

• Hubbert predicted in 1956 that US oil production would peak in the early 1970s
  He was right.
  Hubbert set forth two educated guesses for the amount of US oil : 150 and 200 billion barrels
  Then he made plausible estimates of future oil production rates for each of the two guesses
  Predicted a peak of US oil production in the early 1970s
  Actual peak turned out around 1969

• Hubbert predicted in 1956 that US oil production would peak in the early 1970s
  but he was wrong. Oil production continues to increase every year since that prediction

According to peak oilers, what are the implications of peak oil?

• The switch from growth to decline in oil production will almost certainly create economic and political tension.
  Market share of OPEC in the Middle East will rise rapidly.
  World production will have to fall and radical increases in oil prices.

• OPEC will increase exploration and discover new oil reserves capable of supplying the world for centuries to come.
  US energy supply will continue increasing only if the tax rates go down.

Describe the market failure in energy markets that has led to climate change.

• Market failure is where a competitive market does not yield the socially efficient outcome.
  By not reflecting the social cost of carbon energy markets became rampant fossil fuel consumers. The energy markets failed to account for circular economics and therefore are rapid increase in greenhouse gases resulted. Today:
  RES targets are not equitably allocating the cost of RD&D across all countries.
  Climate science has made a push for increased efforts to develop low-carbon technologies to reduce the emissions of GHG. The policy problem is how to transform the electricity system to introduce these new technologies and support their large scale diffusion. Innovation and technical change are at the center of climate change and energy policy debate.

• The underlying market failure in energy markets is the result of the high cost of scrubbing coal smoke stack carbon emissions. If the price of carbon scrubbing from coal fired power plants were lower than that would eliminate the energy market failure related to climate change.

Climate change economics
What is the first task of mitigation policy? Describe Pigou´s solution to the carbon emission problem.

• 

  Pigou proposed a per unit tax on a good generating negative externalities equal to the marginal externality at the socially efficiency quantity
  Example: if at the socially efficient quantity, and marginal external cost (MEC) is $1, then a $1 per unit tax would lead to the right outcome
  As a result, the new competitive equilibrium, taking account of the tax, is efficient
  The tax level need not equal the MEC at other quantities

• 

  Pigou proposed a tiered-volume tax on goods generating negative externalities equal to the marginal externality at the socially efficiency quantity
  Example: if at the socially efficient quantity, and marginal external cost (MEC) is $1, then a $1 per 1000 units tax would lead to the right outcome
  As a result, the new competitive equilibrium, taking account of the tax, is efficient
  The tax level needs to equal the MEC at all other quantities

Levelized cost of electricity (LCOE)
Explain what LCOE is and how it can be used

• LACE and LCOE can be used to determine which project provides the best net economic value.
  LCOE is an estimate of the revenue requirements for a given resource
  By definition, a project´s equivalent annual cost Cn is the product of the LCOE and the quantity of electricity generated by the system in that year, Qn
  Cn=Qn*LCOE
  Can include installation, operation and maintenance, financial costs and fees, and taxes and also account for incentives and salvage value.
  LCOE allows alternative technologies to be compared with different scales of operation, different investment and operating time periods.
  For example, the LCOE could be used to compare cost of energy generated by renewable resource with that of standard fueled generating unit.
  The LCOE is that cost that, if assigned to every unit of energy produced by the system over the analysis period will equal the Total Life-Cycle Cost (TLCC) if discounted back to the base year.
  LCOE is recommended for use when ranking alternatives given a limited budget simply because the measure will provide a proper ordering of alternatives.

• LACE and LCOE can be used to determine which project provides the best profit value.
  LCOE is an estimate of the profit requirements for a given resource
  By definition, a project´s equivalent annual profit Pn is the product of the LCOE and the quantity of electricity generated by the system in that year, Qn
  Pn=Qn*LCOE
  Can include installation, operation and maintenance, financial profits and fees, and taxes and also account for incentives and salvage value.
  LCOE does not allow alternative technologies to be compared with different scales of operation, or the same investment and operating time periods.
  For example, the LCOE could be used to compare profit of energy generated by renewable resource with that of standard fueled generating unit.
  The LCOE is that cost that, if assigned to every unit of energy produced by the system over the analysis period will equal the Total Life-Cycle Cost (TLCC) if discounted back to the base year.
  LCOE is not recommended for use when ranking alternatives given a limited budget simply because the measure will provide an improper ordering of alternatives.

Levelized cost of electricity (LCOE)
Explain the key inputs for LCOE and how they vary among different technologies. What are the main differences in LCOE for renewables and depletable resources?

• Key inputs to calculating LCOE include capital costs, fuel costs, fixed and variable operations and maintenance (O&M) costs, financing costs, and an assumed utilization rate for each plant type.For technologies with no fuel costs and relatively small variable O&M costs, such as solar and wind electric generating technologies, LCOE changes nearly in proportion to the estimated capital cost of the technology. For technologies with significant fuel cost, both fuel cost and capital cost estimates significantly affect LCOE.

• Key inputs to calculating LCOE include policy, environmental rule making procedure, administrative oversight, bank regulation, and an assumed payback period for each plant type. For technologies with fuel costs and relatively small variable O&M costs, such as solar and wind electric generating technologies, LCOE changes nearly in proportion to the estimated capital cost of the technology. For technologies with no fuel cost, both fuel cost and capital cost estimates significantly affect LCOE.

LCOE is usually presented as the private costs. In terms of climate change, how can you include social costs into LCOE? What is the advantage of doing that?

• In the first best economic world:
  Pricing externalities is likely to be the best way to move behavior towards efficiency
  Pollution rights would be an input to the production of electricity
  Automatically included in the levelized cost calculation
  Most levelized costs do not include the costs of emissions directly
  LCOE generally include the costs of technology that must be installed in order to meet the command and control regulations
  Implications of the social LCOE:
  no need for anti-competitive subsidies
  example - LCOE for fossil fuel: $45/MWh LSCOE for fossil fuel: $ 55/MWh
  LCOE for renewables: $50/MWh, then renewables could compete with fossil fuels.

• In the first best economic world:

  Price of carbon is a regulatory mandate that is controlled outside of the marketplace to prevent corruption.
  There is little incentive to include the social cost if there is no command-and-control regulation.

Renewable energy policy
What are the main arguments for supporting renewable energy? What are the main long-term assumptions behind this support?

• lower environmental impact Impact
  energy security
  green jobs
  Primary public policy argument for renewable electricity generation is externalities from burning fossil fuels.
  The main arguments, though problematic, favor subsidies for renewable energy. The truth of the matter is that the market failure of emissions is the underpricing of brown power, not the overpricing of green power.

• higher environmental impact Impact
  energy security
  green jobs
  Primary public policy argument for renewable electricity generation is externalities from job automation in the oil industry.
  The main arguments, though problematic, favor subsidies for renewable energy. The truth of the matter is that the market failure of emissions is the overpricing of brown power, not the underpricing of green power.

Describe the structure of feed-in tariffs.

• Feed-in tariff is an energy supply policy focused on supporting the development of new renewable energy projects by offering long-term purchase agreements for the sale of RE electricity (10-25 years)
  It has 3 key provisions:
  1. Guaranteed access to the grid
  2. Stable, long-term purchase agreements (10-25 years)
  3. payment levels based on the costs of RE generation

• Feed-in tariff is an energy supply policy focused on supporting the development of new renewable energy projects by offering short-term purchase agreements for the sale of RE electricity (10-25 months)
  It has 3 key provisions:
  1. provisional grid access when available
  2. Stable, short-term purchase agreements (10-25 months)
  3. payment levels based on the costs of fuel

Define Cartel

• an association of firms that explicitly coordinates its pricing or output activities

• a collaboration of renewable energy generators

• benevolent dictators that seek to maximize output of oil to a socially efficient level

• government program to funnel public dollars into the oil industry to increase tax revenue

Define NPV

• net present value involves a conversion of all benefits and cost streams occurring at different points in time to their present value equivalent

• net present value involves a division of all benefits and cost streams occurring at the same point in a year to their real dollar equivalents

• net present value involves a division of all benefits and cost streams occurring at the same point in a year to determine the payback period in weeks

Bathtub model:
What is the objective of the bathtub model?

• Determine water allocation and the development of the electricity price over time. Provides a graphic illustration of multi-period water allocation using a hydropower reservoir. Plus the standard objective - that is to maximize consumer plus producer surplus with the quantities produced as endogenous variables .

• Determine price allocation when water is used over one period. Provides a graphic illustration of price as a function of the nuclear power baseload.

Draw a graph with a learning curve (make sure you label the axes correctly). Explain in words the learning curve.

• 

  The cost per unit decreases with an increasing production rate. The rule of thumb is that unit cost reductions of 20% associated with doubling of capacity has been typical for energy generation technologies, with the exception of nuclear power

• 

  The cost per unit increases with a decreasing production rate. The rule of thumb is that unit cost reductions of 50% are associated with a tripling of the capacity, typical of energy generation technologies, with the exception of nuclear power.

What has been many economists´ critique of Hubbert´s analysis? What do many economists believe is missing from the analysis?

• Relatively simply calculations
  Hubbert assumed that the US had been comprehensively surveyed then modeled particular field depletion, extrapolated to the US as a whole
  US production has not followed the path dictated by the Hubbert´s curve
  The peak is only one statistical parameter. The tail of the production is what matters
  The point is to emphasize the uncertainty and to highlight the extent to which the constraints are technical and economic, rather than about physical limits.
  No practical physical limit

• The Hubbert analysis did not go far enough in defining the peak oil scenario. Physical peak oil is more readily measured with modern data and the threat is larger than Hubbert predicted. The analysis is missing more quantitative data on the now decreasing reservoir recovery factors.

Describe the economic first best solution to climate change

• Pricing externalities is likely to be the best way to move behavior towards efficiency
  Pollution rights would be an input to the production of electricity
  Automatically included in the levelized cost calculation
  Most levelized costs do not include the costs of emissions directly
  LCOE generally include the costs of technology that must be installed in order to meet the command and control regulations

• Pricing externalities is likely to be the best way to move behavior towards inefficiency
  Pollution rights would be an output to the production of electricity
  Automatically included in the levelized avoided cost calculation
  Most levelized avoided costs do not include the costs of emissions directly
  LACE generally include the costs of technology that must be installed in order to meet the command and control regulations

Explain the feed-in tariffs energy supply policy.

• Feed-in tariff is an energy supply policy focused on supporting the development of new renewable energy projects by offering long-term purchase agreements for the sale of RE electricity (10-25 years)
  It is a support mechanism
  There are three key provisions of FITs:
  Guaranteed Access to the grid
  Stable, long-term purchase agreements (10-25 years)
  payment levels based on the cost of RE generation

  There are 4 different calculation approaches:
  1 based on actual levelized cost of renewable energy generation
  2. based on the "value" of renewable energy generation - avoided costs
  3. offered as a fixed-price incentive
  4. based on the results of an auction or bidding process

  FITs are adjusted over time according to market trends and evolving political priorities and increased installation.
  Today there are more differentiations in the tariff amounts based on technology type, project size, and project location.

• Feed-in tariffs are taxes on cattle feed. The higher the taxes on cattle feed the lower the greenhouse gas emissions.

Explain two different structures of feed-in tariffs and show them on a graph

• 

  Two structural types of feed-in tariffs are: 1. percentage of retail price; 2. fixed-price FIT model

• 

  Two structural types of feed-in tariffs are: 1. make-up period price; 2 fixed-payback period FIT model

Where a competitive market does not yield the socially efficient outcome

• market failure

• externality

• socially efficient quantity

The value of the next best alternative

• Opportunity Cost

• Market equilibrium

• externality

• Marginal cost

The percentage change in the quantity demanded of a good or service divided by the percentage change in the price.

• Price elasticity of demand

• Price elasticity of supply

• Marginal change in revenue

• Incremental cost function

The resource price will rise until it reaches some alternative. This price establishes the terminal value, or the long-run price at which demand for the depletable resource goes to zero.

• The backstop price

• The equilibrium price

• The market failure price

One firm produces all of the output in a market.

• Cartel

• Government

• Monopoly

• Dictator

Assume a monopoly. The inverse market demand function is P(Q)=12-Q and the Marginal revenue function is MR(Q)=12-2Q. Market supply function is MC(Q)=2Q
Calculate the price and quantity the monopoly will set in order to maximize its profits.

• P= 9 Q= 3

• P=3 Q=9

• P=4 Q=8

Assume a monopoly. The inverse market demand function is P(Q)=12-Q and the Marginal revenue function is MR(Q)=12-2Q. Market supply function is MC(Q)=2Q
Draw the demand function, marginal revenue function and market supply. Also draw the consumer surplus, producer surplus and the deadweight loss.

Assume a monopoly. The inverse market demand function is P(Q)=12-Q and the Marginal revenue function is MR(Q)=12-2Q. Market supply function is MC(Q)=2Q
Calculate the competitive market outcome given the demand and supply functions. Compare the market outcome in the competitive case and the monopoly case.

• P=8 Q=4
  Price is higher in the monopoly scenario
  Quantity supplied is higher in competitive market

• P=9 Q=3
  Price is higher in the monopoly scenario
  Quantity supplied is higher in competitive market

• P=9 Q=4
  Price is higher in the monopoly scenario
  Quantity supplied is higher in competitive market

• P=8 Q=3
  Price is higher in the monopoly scenario
  Quantity supplied is higher in competitive market

Define a water value in the economics of hydropower context. What is the water value when there is overflow in the reservoir?

• It is a general result that the water value in a period is equal to the marginal cost of the partially utilized technology. Value of water when there is overflow = 0

• It is a general result that the water value in a period is equal to the marginal cost of the fully utilized technology. Value of water when there is overflow = 0

Draw a diagram for a negative externality. Include private marginal cost and marginal social cost in the diagram. Show the Pigouvian tax on the diagram.

Define futures contracts and explain how they are different from forward contracts

• Derivative contracts are financial instruments which derive their value from an underlying asset. Futures contracts and forward contracts are both derivatives. Forward contracts are a simple extension of a cash transaction where delivery of commodity takes place in the future. Forward contracts are between two parties. In futures contracts, unlike forward contracts, buyers and sellers of futures contracts deal with an exchange, not with each other. Futures contracts are standardized, which enables traders to focus on one variable, price.

• Futures and forward contracts are both derivatives. Futures contracts are between two parties. Forward contracts are exchanged on a market, unlike futures contracts, buyers and sellers deal with the exchange, not each other. Forward contracts are standardized, which enables traders to focus on one variable, price.

Explain the importance of physical delivery for futures contracts. What implications does this have for the futures prices and spot prices at maturity (delivery date)?

• Delivery ties the price of the expiring futures to the price of the physical commodity at delivery.
  In a cash-settled contract, at expiration the buyer pays the seller the difference between the fixed price established in the contract and the reference price prevailing on payment.

• Physical delivery ensures that all parties comply with the terms of the contract. If the product on contract is not delivered, the buyer has the right to sue the seller, given a futures contract.