Energy Follies (continued)

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

We’ve written in this column before about the folly of having government select certain alternative energy technologies over others for favorable treatment. In the case of ethanol, government mandates, tax incentives and tax credits at various levels from the farm to the gas pump have created an environmental fiasco. Moreover, economists have shown that these expensive efforts have not so far actually led to reduction in the use of fossil fuels, when all inputs (including fertilizer, planting and harvesting fuel usage, refining and transportation of the refined product) are considered.

Incentives for wind power are also leading to distortions. One such incentive is the federal tax credit of 2.1 cents per kilowatt hour for production of wind energy. An article in the Forbes Magazine (“Take My Juice,” 9/7/2009, p. 29) gives a striking example of the unanticipated consequences of such policies. In many areas where large scale wind farms are being developed, the wholesale price of energy is falling to zero for a portion of the daily energy cycle.

Energy usage is generally heaviest in the daytime. But prevailing winds typically are higher at night. Therefore, wind farms tend to produce peak power when grid demand is low. This would be fine if other forms of energy production could be stepped down when wind power is peaking. With natural gas powered generators, this is feasible. However, with coal fired generators, and with nuclear power, this is not practical. Moreover, as it is expensive to store energy (in batteries, capacitors, reservoirs of water, or otherwise), some utilities have an incentive to dump wind energy at night.

In West Texas, according to Forbes, electricity prices dropped to zero 11% of the time in the year beginning May 2008. What’s wrong with free power? In the short-run, this is dandy for consumers. In the long wrong, though, it undercuts private market incentives for energy investment. It can also deprive utilities of a reasonable rate of return on existing investments.

Over time, such inefficiencies might resolve themselves. For example, more factories could operate at night. Solar power during the day could be used to balance wind power that is generated more at night.

However, we would be better off letting markets make such allocation decisions, setting broad government policies that markets can respond to. For example, there is a growing consensus that we must reduce use of fossil fuels in order to combat global warming. There is also a widespread feeling that we should seek to reduce our dependence on imported oil. A tax on carbon based fuels would help to accomplish this. To keep a level playing field among carbon based fuels, the tax could be geared to energy content, as measured by BTU’s.

If reduction of air pollution is another key policy objective, there could be a second tax on pollution emissions. Such a pollution tax could be justified based on the problem of “externalities”; individual polluters can reap a higher rate of return by using cheap fuels, while imposing the costs of air pollution on everyone. The so-called “cap and trade” system for carbon emissions much more cumbersome and less effective than these tax measures.

However, taxes on carbon-based fuels are politically unpopular. Instead, we grasp around, favoring one energy technology and then another, based on fallible hunches made in Congress or the Executive branch. In such legislation, there lots of pork to go around. In this way, we deal with some of the most important problems of our time by old fashioned log-rolling, wasting precious resources and time.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.