Public Sector Perspectives On Renewable Energy Economics

Tim McDaniels McDanieis Research Vancouver, British Columbia

Introduction

The objective of this paper is to discuss public sector perspectives on renewable energy economics and to outline methods for analyzing the economics of renewable energy options from the public perspective. A key focus of the paper is to point out the differences between private financial analysis and social benefit-cost analysis, particularly in the context of analyzing renewable energy options. Examples are given of differences between these two approaches, and public policy implications are discussed.

As energy economists, most of us can provide answers to the questions about why energy is an important public policy issue. Certainly energy is crucial to the workings of national economies, and our experience in the 1970s demonstrated our vulnerability to drastic changes in energy supplies and alerted us to uncertainty in energy prices. But perhaps the most important reason that energy, and particularly renewable energy, is an important public policy question is that prices do not always reflect all relevant social concerns for decision makers. We, as economists, would typically urge reliance on the marketplace, and information conveyed by prices, to make resource allocation decisions. The experience with energy tells us that prices and private sector decisions may not always work effectively as a guide to social decision making. Thus, public decision makers and energy analysts are increasingly concerned with providing public sector perspectives on energy economics.

Some examples of situations in which renewable energy prices may not completely reflect the values that are important to public decision makers include:

1. If subsidies or incentives exist for conventional energy development, such as drilliny incentives, then the relative prices of conventional and renewable resources are likely to undervalue renewables, providing disincentives to the use of renewables.

2. The prices of conventional energy resources do not completely reflect the full costs of the risks of relying on imports. Again, this would provide a disincentive to renewables.

3. The costs of conventional energy resources do not reflect the environmental costs associated with their development.

4. The prices of renewables may not reflect social preferences for low-impact, decentralised renewable resources.

The implication is that we need public sector analysis that considers these broader issues in trying to determine the appropriate role for renewable energy.

Social Benefit-Cost Analysis: A Tool for the Public Sector

How should a government go about taking this broader perspective? Social benefit-cost analysis (SBCA) is the obvious choice; SBCA is an analytical tool to determine the merits of a given project, program, policy, regulatory change, or similar option from the public or government perspective.

Benefit-cost analysis is superficially similar to private sector financial analysis, in that both involve analysis of revenue (or benefit) and cost streams over time, but the two differ in many fundamental respects. Table 1 gives a comparison of specific differences between financial and social benefit-cost perspectives, in terms of factors important in analyzing renewable energy projects.

Perhaps the fundamental difference is that in social benefit-cost analysis, costs and benefits are assessed from the viewpoint of society as a whole, while private financial analysis is conducted from the viewpoint of a private investor. As you might expect, this difference shows up in measures of benefits, measures of costs, decision criteria, and many other aspects of the analysis.

Briefly, measures of benefits in social benefit-cost analysis generally reflect society's willingnoee to pay for incremental supply of a given quantity. A conceptually-similar benefit measure is based on social opportunity costs, or the values that could be obtained by using the same resources in other markets. In Canada, for example, the potential value of natural gas in U.S. export markets has long been used as a measure of the social value of saving domestic consumption of gas through renewable projects.

Costs are measured on the basis ot benefits foregone, hor example, the costs ot building a small-scale hydro project are based on the alternative uses of the resources that are needed for the project, including the labour, capital, and environmental resources.

All relevant resource values should be considered in a benefit-cost analysis, even if they involve resources that are not normally traded in conventional markets. Common examples are non-market resources such as environmental quality or health. These non-market considerations could be dealt with through imputed shadow prices, or they could be tallied in multiple accounts (separate tallies, for example, of environmental effects of projects that cannot be measured in dollar terms).

When calculating the costs of projects, taxes are generally iynored, because they du nut represent real resource costs needed to develop a project. However, when discussing taxes, we should distinguish between distributive and allocative taxes. Distributive taxes are, essentially, ways that governments appropriate part ot the rents ot a given project; that is, they simply distribute rents from one group to another. Allocative taxes, on the other hand, could be viewed as payments for government services. An example might be property taxes that pay for water supply. When doing a benefit-cost analysis, it is important to distinguish between these two types of taxes because the latter group, allocative taxes, actually are payments for real resource inputs often called social infrastructure.

Now, we turn to differences in key parameters of these analyses. Table 1 shows that most private investments typically involve a decision criterion such as payback period or internal rate of return above a given rate which is set by the firm. The public decision criterion would normally be a positive net present value at the given social discount rate. The time frame is relatively short-term in private analysis, related to the decision criterion, while in SBCA, the time frame Is the whole project life cycle. Finally, discount rates are typically lower for social benefit-cost analysis.

Table 1

DIFFERENCES BETWEEN PRIVATE (FINANCIAL) AND PUBLIC (SBCA) SECTOR ANALYSIS

PRIVATE

PUBLIC

Viewpoint

Investor

Overall society

Energy Prices (Benefits)

Prevailing

Social values reflect willingness-to-pay; alternative uses.

CoGtG

Private, prevailing

Social valuco roflcct opportunities foregone

External Effeutis

lynoied

Analysed as much as possible

Taxes

Considered

Ignored

Social Infrastructure

Ignored

Considered

Discount Rate

Reflects cost of borrowing, desired returns, (often >10-15%)

Reflects social preferences and other factors (often 5-10%)

Decision Criteria

Payback or IRR above a given rate

Positive NPV at the Social Discount Rate

Time Frame

Short term

Life cycle

Example: Industrial Cogeneration Project

Table 2 summarises an example Lliat illustrates the importance of differences between private and public sector analyses. The example is a hypothetical industrial cogeneration project, although the assumptions reflect cost data provided in a biomass energy systems example developed for Canada as background for the IEA workshop. The comparison is intended to illustrate some of the differences between perspectives; it does not purport to reflect the economic viability of a specific technology.

An important source of difference between the private and social perspectives is in the value of benefits or electricity produced. The private value of the electricity produced is based on the avoided cost of purchasing electricity from the utility and on the price at which the utility will buy electricity from the cogeneration project. The social costs are higher and are based on a more complex set of factors. The social values should reflect the facility's avoided cost of power production from its marginal projects. In this case, the utility is postponing an expensive coal-fired power plant and the cost of electricity from that plant assumed to be 6 cents/kwh as opposed to 4.5 cents/kwh for the market values in the private case. This is an illustration of a common occurrence: utilities often price electricity on the basis of average cost, rather than the higher marginal cost of generation.

Table 2

HYPOTHETICAL EXAMPLE: INDUSTRIAL COGENERATION

Table 2

HYPOTHETICAL EXAMPLE: INDUSTRIAL COGENERATION

PRIVATE

PUBLIC

Benefits

$.045/kwh

$.06/kwh

Capital Costs

$8.5 million

$7.5 million

Public Infrastructure Costs

ignored

$300,000

Annual Operating Costs

$940,000

$940,000

Time Frame

5 years

Life cycle

Discount Rate

10% real

7% real

Decision Criterion

discounted cash flow: 5 year payback

NPV

Environmental Effects

Ignored

Helps postpone a major new central power plant (coal, nuclear)

Results

Unattractive

Positive NPV and positive environmental effects

Differences in Uie approach lo capital cost are llial costs are lower from the public perspective because taxes should be netted out of the capital cost for the analysis. On the other hand, public infrastructure costs for energy , say the cost of building a new electricity transmission line to the facility, are a cost from the social perspective even though these costs might be paid by the electric utility and don't show up as costs from the private viewpoint.

Annual operating costs are equivalent in the two cases. Major differences arise in the time frame. In the private analysis, the time frame is, say. five years, while from the social perspective, the project should be evaluated over its total life cycle. The discount rate is higher for the private sector analysis, reflecting the cost of borrowing. The decision criterion is more stringent, since it considers a shorter time period. Finally, when considering environmental effects, the social analysis should consider that the project helps postpone a new coal-fired power plant and, in that sense, creates positive environmental benefit.

To summarise, in this hypothetical example, the project may be unattractive from the private sector viewpoint, but could have a positive net present value from the public sector viewpoint.

Policy Implications

The previous sections have demonstrated that major differences may occur between private and public sector analyses of renewable energy projects. What are the public policy implications of these differences?

1. Projects may be viable from the social perspective and not from the private perspective.

2. It Is unlikely that the reverse is true. It's more likely that private sector analysis would undervalue rather than overvalue the social benefits of renewable energy projects.

3. The foregoing two points suggest there may be a good rationale for public sector research arid development In renewable energy, because "market railure" considerations exist, and therefore private investors may not receive the proper incentives to do research into renewable energy.

4. There may also be a rationale for public incentives for renewable energy projects in certain cases. Canada has, over the last decade, had a number of major Incentive programs to encourage renewable energy. As Canada has moved to energy prices based on world prices, the role of such programs has declined sharply.

5. Renewable energy should be viewed as an issue that involves multiple objectives, such as maximising social income, as well as objectives such as maximising environmental quality or maximising regional development and local self-reliance. The multiple objective approach may ultimately prove to be the most informative way to structure public sector analyses of renewable energy projects.

6. Probably the chief policy implication is that decision makers need to be apprised of the fact that renewable energy may be an attractive investment from the overall perspective of society even though individual Investors may not perceive these benefits.

References

Mishan, E.J., 1983. Benefit-Cost Analysis. Praeger. 2nd Edition,

Canada. Treasury Board, 1986, Benefit-Cost Analysis Guide. Queen's Printer. Ottawa.

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