Renewable Energy Faces the European Debt Crisis

With all the bad economic news and political turbulence in the US, it's been easy to lose track of the sovereign debt crisis in Europe, which appears to be spreading from smaller, peripheral countries like Greece to affect the banking systems of core European Union members like Italy and France. To read Paul Krugman's column in last Sunday's New York Times, Europe could be on the verge of another financial crisis on the scale of the one triggered by the collapse of Lehman Brothers in 2008. Aside from the global economic consequences of such an event, it would send ripples throughout the energy sector, affecting both conventional and renewable energy markets and participants. While such an outcome is far from certain, it's a worrying scenario to contemplate.

The 2008 financial crisis is a good place to begin looking for the implications of a potential 2011 credit crunch in Europe. Start with oil, which in the fall of 2008 slid from around $100 per barrel to below $40 by mid-December of that year. Of course oil prices had already retreated from a high of $145 that summer, as the weakening US economy and collapsing housing market slowed US demand for oil. Yet it's worth noting that despite their generally more efficient use of energy and higher consumer energy prices, the countries of Europe together import slightly more crude oil and petroleum products than the US does. And as I've noted before, the economies of the EU's Euro area have been partially sheltered from high oil prices by the strength of the Euro relative to the US dollar, in which most oil transactions are settled. Even without a full-blown financial crisis, a sharp drop in the Euro/dollar exchange rate resulting from sovereign debt worries would create a regional energy price spike that could further hamper the EU's growth and reduce its energy demand. OPEC appears to be preparing to trim output for just such an eventuality.

Next consider what happened to renewables, such as wind and solar power. Lending to renewable energy projects in the US dried up in late 2008, as credit became harder to obtain in general, and participants in "tax equity swaps" retreated. Without the generous renewable energy supports in the 2009 stimulus, wind turbine installations might have ground to a halt, and the expansion of solar manufacturing that has recently hit a rocky patch might never have occurred. European projects and suppliers weren't affected to the same degree, thanks to a combination of higher direct subsidies for renewables and robust lending from EU agencies such as the European Bank for Reconstruction and Development.

Those protections look less dependable in a new crisis. European governments have been busily cutting renewable energy subsidies, and growth is already slowing, squeezing local firms like Germany's Q-Cells between a weaker domestic market and low-cost import competition from China and elsewhere. It's anyone's guess whether commercial lending to the renewable energy sector and loans from groups like the EBRD could be sustained in another financial crisis focused on the Eurozone.

A sudden contraction in European funding for renewable energy projects would be felt around the world. Suppliers in the US and Asia have relied on European sales of wind turbines, solar panels and components for much of their planned growth, and the further decline in equipment prices that would follow a big demand drop would leave all but the best-capitalized, lowest-cost competitors scrambling. And even as renewable energy growth has shifted in recent years toward developing countries and away from North America and Europe, Europe has remained the most important market for many of these technologies--particularly for solar PV and offshore wind power--just as Europe has retained the strongest focus globally on reducing the greenhouse gas emissions implicated in climate change. Every aspect of the global energy business has a big stake in the success of Europe's leaders in navigating through the current crisis, but none more than the renewable energy sector.

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Energy Crisis Prices Persist

Watching oil prices is a hard habit to break, once formed. They're always moving up and down, sometimes for obvious reasons and sometimes not. It has probably escaped most observers' notice that the magnitude of this year's price moves has exceeded the total nominal price of oil that prevailed not many years ago, yet without the sort of apocalyptic events that one might expect such volatility would require. Perhaps that's because we seem to be stuck in the middle of an ongoing, slow-boil oil crisis from which the financial crisis and the demand contraction that accompanied the global recession only provided a brief respite. In fact, when you glance at the oil price trend in real dollars over the last 40 years, it's apparent that prices are back at the level associated with the peak of the oil crisis of the late 1970s and early 1980s:


One reason I've been paying extra attention to oil prices lately is that I've been observing the impact of the coordinated release from the US Strategic Petroleum Reserve (SPR) and strategic reserves of other members of the International Energy Agency. So far, my initial assessment that it would have little lasting effect seems to have been validated, though I'll reserve judgment until the oil is actually delivered during August, when we might see the market respond to the increase in commercial oil inventories that should result. Robert Rapier had an excellent posting yesterday on the folly of this decision. My view is, if anything, less flattering. Not only was this choice unwise, but it also appears to have been ineffective, which in the current economic climate is an even more damning assessment.

The modest response to this move tells us something about the fundamentals of the market. In the past, an SPR release on this scale would have crushed prices--not just for a few days, but for months at least. Consider the release that accompanied the start of the first Gulf War in 1991. Only about half of the nearly 34 million bbls authorized was eventually sold, but the price of oil dropped by 33% overnight and took 13 years to recover to the peak it had reached during the lead-up to Desert Storm. By comparison, the announced release of 30 million bbls from the US SPR--the sale of which was fully-subscribed--and another 30 million bbls from other IEA members managed to depress the price of oil by only around 5% for a week or so. As of this morning Brent crude, the global marker, is $4/bbl higher than it was on June 22nd. And as of this Monday's survey, the average pump price of unleaded regular in the US was also higher than before the President announced the release.

The market's tepid reaction to the SPR release suggests that oil prices have been driven up by more than just speculators. Speculation may be playing a role, but it's more like the head on a glass of beer. Beneath that froth lies the robust demand growth in the developing world, which has pushed global oil consumption to a record level of 89 million bbl/day this year. On the supply side, some point to incipient Peak Oil, but characterizing the crisis we're in doesn't require a grand theory. In addition to the curtailment of production from places like Libya and Yemen, and OPEC's desire to keep a lid on output to preserve their revenues, there's a fundamental mismatch between the companies that have the capital and the desire to invest in new production, and the willingness of some governments to grant access to the resources, whether in the Middle East or the US. All of this is compounded by the inherent time lags in resource development, which can range from 5-10 years, depending on the technology and permits required.

As different as the causes and symptoms of this crisis are from those of the 1970s, the broad outline of solutions remains quite similar: Reduce demand, increase supplies, and diversify our sources of energy. We have more and better options than in 1979, but still no miracle cures.

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Mark to Market

The practice of requiring banks and other businesses to mark their investments to market has drawn increasing criticism in the last several weeks from pundits and high-profile investors who would like to see it at least relaxed, if not rescinded. When I traded commodities in Texaco's international oil trading operation in London in the early 1990s I acquired some first-hand experience with "mark to market." Although I wasn't dealing with multi-billion dollar investments in exotic credit derivatives, the principles are sufficiently similar for me to offer some thoughts on the benefits and risks of this methodology, which appears to be feeding a vicious cycle of asset deflation in the financial sector.

The other night while watching our favorite TV cop show, "Life", my wife and I got a laugh out of the bumbled attempts of several of the characters to explain a derivative, and the confusion that greeted the accurate definition when it was finally given. I suspect the writers were reminding us how few people truly understand some of the financial instruments and regulations at the heart of the current crisis. Mark-to-market accounting likely falls into this category.

In the case of the futures market and physical oil market deals in which I was involved in London, the mark to market (MTM) provided a way to issue a daily report card on each of the trading positions we had taken on behalf of the company. This removed much of the element of surprise, if the value of something we had bought or sold changed significantly before the deal was ultimately completed. It entailed assigning a market-based price to each component of the deal at the end of every trading day, as if the product had been delivered or the position unwound that day, even though that might not actually happen for weeks. When the commodities in which we were dealing were ones for which there was an active, liquid market at all times, this accounting was relatively easy to perform. For some of the more unusual things we dealt in, for which there was no futures market and only occasional, sometimes unreliable reports of recent transactions, it generated uncertainty and anxiety.

The purpose of undertaking this effort, which consumed valuable time and was not exactly popular with the trading team, was to promote accountability and action. If the MTM on a particular trade showed a steady negative trend--particularly if it had moved from an expected profit to a loss--this triggered a discussion with management about why it was happening and what should be done. When handled well, this sometimes led to new insights about the market that we had failed to recognize. It normally resulted in a decision on whether to hang in there a bit longer, because we could justify our view that things would turn our way, or to modify or unravel the position--even at a loss--and regroup. Of course, that wasn't always possible; sometimes the cargo was on the water, bought and paid for, and there was nothing we could do but watch the red ink swell. That gets at the essence of my concern with the application of MTM to the big banks and institutions that the government has been forced to assist, for fear of "systemic risk"--the chance of the whole financial system crashing like the Blue Screen of Death on your PC.

Crucially, the reliability of mark to market depends on the ability to obtain an accurate reading of the value of what you are holding. That requires credible reporting of current transactions--preferably many of them--in something that, if not identical, at least looks enough like your asset to serve as a good proxy. If the only deals reported are distressed sales by desperate firms, you must write down your position to that level, even if you would never willingly sell it for so little. In the worst case a series of such write-downs causes a large enough deterioration in the balance sheet of the firm that it is compelled to sell some of these assets, driving their market value even lower and triggering a cascade of further sales by depressing the MTMs of other institutions.

Throughout the financial crisis, the practice of MTM has been defended as an unpleasant but necessary discipline to prevent an outcome such as was seen in Japan after its property bubble collapsed, with numerous "zombie banks" that were effectively insolvent but kept alive by the fictitious value of assets that were worth only a fraction of the level at which they were carried on the books. That argument still has some merit. However, it seems equally possible to destroy investor (and ultimately depositor) confidence in otherwise profitable, solvent institutions through the steady mechanical deflation of their illiquid assets, the potential buyers for which understand clearly that time is on their side.

Having run this experiment in its pure form until now, I'd like to see the administration test the opposite hypothesis for a few months: suspend MTM for bank capital purposes and restore the "uptick rule" on short-selling, while they're at it. We'd quickly find out whether these steps helped to stabilize the system. If they made things worse, they could quickly be reversed. It wouldn't be the first course correction we've seen during this crisis.

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The Road to Copenhagen

The road to Copenhagen goes through Poland. If you know what that geographically-dubious statement refers to, then you must follow the news relating to climate change pretty closely. This week and next, the UN Framework Convention on Climate Change (UNFCCC) is holding its fourteenth Conference of the Parties (COP-14) in Poznan, Poland. Along with conducting the ongoing business of the UNFCCC, the main goal of the meeting is to table a first draft of the replacement for the Kyoto Protocol, which expires in 2012. A new agreement is meant to be finalized in a year's time, at COP-15 in Copenhagen, Denmark. While this is all consistent with the "road map" agreed at last year's conference in Bali, the current conference is taking place in a remarkably different context, with financial uncertainties that were never contemplated in Bali.

Two changes, in particular, will affect the effort to develop a new set of international commitments on the emissions contributing to climate change, and for addressing the consequences of further warming. The election of a US President with a very different approach to climate change alters the negotiating dynamic, even though he has not yet taken office. The official US delegation is accompanied by a Congressional delegation headed by Senator John Kerry (D-MA.) Although Sen. Kerry does not officially represent the President-Elect, he certainly brings a point of view much closer to that of the incoming US administration than to the outgoing one, reflecting a shift back toward greater harmony with the positions of the EU members, Japan and other countries that adopted the Kyoto targets. Considering the views on climate change of Senator McCain, however, this change since Bali is not nearly as surprising as the one that ultimately may overwhelm it: the evolution of a US housing slump and already-nascent recession into a global financial and economic crisis.

We don't know what lies ahead, but we can make some reasonable guesses. Unemployment will continue to increase in the US and EU, and even if the recession in Asia proves less severe than the one in the late 1990s, as a recent article in the Economist suggested, China and India will face the prospect of millions of people falling back into poverty, after having risen close to middle class status. That will make it harder for their governments to devote resources to reducing CO2 or to be seen to sacrifice future economic growth to slow emissions. Nor will it be easy for Western governments to agree to terms on delayed targets and generous technology transfers benefiting countries that many of their citizens worry are competing for their jobs.

It was always going to be tricky for the delegates following the Bali road map to design an agreement that would reconcile the divergent emissions histories and economic growth rates of the developed and developing countries in a way that left all parties feeling fairly-treated, while still making meaningful progress on stabilizing and ultimately reducing global greenhouse gas emissions. Attempting this against the backdrop of a major global recession complicates matters greatly, going beyond the question of whether economic priorities will trump environmental challenges for the next few years. Depending on the ultimate duration of the current crisis and the manner in which it is resolved, the future mechanisms of our international system might look quite different, and the scope for a global response to climate change could alter significantly. Simply put, the delegates to Poznan cannot assume that the world in which a Copenhagen Protocol would be implemented will resemble the one in which the process for negotiating its terms was outlined a year ago.

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Slowing Growth and Lower Emissions

Even before the global economy began to stumble, 2009 was set to be a milestone year for climate change policy. A new US administration will take office with a decidedly more pro-active attitude toward addressing climate change, and international negotiations are expected to culminate in a new agreement to replace the Kyoto Protocol, which expires in 2012. But while efforts to address climate change have always had to contend with their possible impact on the economy, we are receiving a vivid reminder that this relationship also works in reverse: a slowing economy will emit fewer greenhouse gases than if growth continued at previous rates, and the financial burden of emergency fiscal stimulus and capital injections will hamper governments' ability to dedicate large sums to addressing climate change.

This morning I was looking at the most recent oil market estimates from the International Energy Agency in Paris. In January the IEA had expected global oil demand for 2008 to average 1.7 million barrels per day (MBD) higher than in 2007, or +2%, exceeding the 1.5% growth in 2007 that had helped to push oil prices from the $50s into the $90s per barrel. As of October 10, however, their estimate for 2008 has fallen to 86.5 MBD, a scant 0.5% increase over last year. Nor do they expect growth to pick up much next year. Their current 2009 forecast is for an average of 87.2 MBD, down from 87.7 MBD in July, and growth will almost certainly fall further--perhaps below zero. We see the tangible echoes of these expectations in falling oil prices and in the 1.5 MBD production cut announced by OPEC on Friday.

Each million barrels per day of global oil demand equates to about 160 million metric tons of greenhouse gas emissions per year. The consequences of high oil prices and slowing economic growth have thus reduced 2008 emissions by around 200 million tons of CO2, and the OPEC cuts should take a comparable slice out of next year's emissions, with the total slashed by even more, when consumption of other fossil fuels is taken into account. Of course, this represents only about 0.5% of global GHG emissions, and it falls far short of the kind of reductions that climate experts have called for.

What can we conclude from this simple observation? First, it shouldn't surprise anyone that the relationship between economic growth and energy consumption--and hence emissions--should work in both directions. But simply cutting growth can't be a desirable way to tackle climate change, not least because the reduction in growth necessary to achieve the desired emissions levels would be catastrophic for both developed and developing countries. Nor are countries in deep recession likely to spend as much on environmental protection, notwithstanding all the recent euphoria about "green jobs." And if the pessimists are right, merely slowing our emissions growth won't even buy us time for improving our responses, because we've already passed the sustainable level of atmospheric CO2 concentration. If that's true, then no realistically-achievable climate treaty is going to solve the problem before it gets much worse.

Because I still view climate change in terms of risks and trade-offs, however, I see one bright spot in the current economic difficulties. With their governments and trans-national institutions such as the G-8, IMF and World Bank scrambling to forestall a global financial and economic collapse, the negotiators following the Bali Roadmap towards a new climate agreement to be announced in Copenhagen next December must focus on approaches that deliver the largest emissions reductions at the least cost, with the least damage to an already fragile economy. That seems likely to produce the most sustainable result, in any case, and thus the response that is best suited to endure the financial instability that the further progress of climate change, itself, could still deliver, on top of the boom-bust cycles of markets.

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The Hinge of Fate

We seem to be accumulating crises at an alarming rate, lately, between the financial crisis, energy crisis, and climate crisis, along with incipient crises about which experts have been warning us, such as the government debt crisis and the looming Social Security and Medicare crises. Combine all of these and factor in the natural tendency for exaggerated predictions of disaster in an election year, and it is a wonder that we don't have more people dropping out of society to join survivalist communities in the hills. Are things really as bad as they appear, or have the aggregated uncertainties merely grown so large that our confidence in a recognizable future has been shaken?

Consider the economic crisis. Not long ago, there was still disagreement about whether the US was in a recession. Now, from media and politicians alike, we hear daily warnings about another Depression, and the tension is between those who view 2008 as 1929 or as 1932. Yet as Robert Samuelson's op-ed in today's Washington Post points out, the current situation has some ways to go before it rivals even the most serious post-war recessions, let alone the Great Depression, nor does it share the same mix of factors that made the Depression so intractable. A year ago, it seemed to many that we were headed for a repeat of 1970s-style stagflation. Given the complexity of interacting trends and events, however, I find it at least as probable that we are moving into a future for which these precedents won't prepare us very well. That could be true for energy, as well.

We've had energy crises before, too, but never one for which our responses faced a constraint such as climate change. If greenhouse gas emissions weren't an issue, we could deploy coal liquefaction on a crash basis and buy ourselves a decade or two of greatly reduced dependence on foreign energy suppliers. But the collision between coal and climate change now looms so large that a former Vice President of the United States has shockingly called for civil disobedience to stop the construction of coal plants that don't capture and sequester CO2--which today includes essentially all of them. Nuclear power, a proven large-scale alternative, faces other hurdles, including permitting problems and disagreements over waste management.

The preferred solution involves a dramatic shift to renewable energy, even though renewables have not yet reached the scale at which they are ready to take up the burden of supplying the economy with enough energy to grow. They are ramping up rapidly, and the tax credits that were extended last week will help. However, the net contribution of even the most advanced of these is still modest. Wind power is expected to grow by 7,500 MW this year, adding the equivalent of only 0.5% of net power generation. The 2.5 billion gallons per year of new ethanol capacity under construction would displace only 0.6% of US oil consumption--before factoring in the oil consumed to produce it. So while the combined energy/climate problem looks enormous, our currently-deployed options offer only incremental, not revolutionary change.

Perhaps our challenges look as big as they do because our faith in the tools available for tackling them is so limited. Every one of these problems is serious, and ignoring them would be a recipe for disaster. But unless we are truly within a few years of a climate change tipping point, they all look manageable over a longer timeframe. The economy will contract and eventually recover, as it has after every recession. Ten years from now, we won't all be driving electric cars recharged by wind and solar power--if anything, a recession will slow that transition--yet the ongoing shifts in our patterns of energy consumption and production will accumulate. Our energy diet will begin to look quite different from today's, and it will emit less CO2, per unit of economic output and in aggregate. The ultimate outcome might be less dramatic than we sense at this pre-election moment that feels like the Hinge of Fate, but we will get there, and I have a hunch that new fortunes will be made along the way.

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