Wednesday, July 13, 2011

What impact would very low cost electricity have on the economy?

An interesting question to ask is what effect low cost electric power would have on the modern economy. In the United States, electricity rates are climbing upward, averaging 9.7 cents per kilowatt hour in the year ended February 2011, up from approximately 5.5 cents per kilowatt hour in 2000. (non-inflation adjusted, however) This is approximately a growth rate of 5.2% per year, a growth rate significantly higher than the average real GDP growth rate of the US of 1.5% per year over the same period.

Electric power is of course a prerequisite of almost every aspect of modern life, from the production and shipping of commodities (crushing reservoir rock, drilling into rock, pulverizing grains, etc) to manufacturing, to the operation of consumer products that rely on computing, lighting and/or moving parts or chemicals of any type.

The increasing cost of electric power in the United States is been driven to a large degree by higher coal and natural gas prices, which, combined, accounted for approximately 70% of electricity generation. One can certainly say that supply is failing to keep up with demand -- the reasons for the decline in supply relative to demand of coal in particular is not fully understood to my knowledge, as the supply of coal appears, on the surface, to be abundant. (I will address this topic of supply and demand in more detail below).

Alvin M. Weinberg's The First Nuclear Era: The Life and Times of a Technological Fixer captured the optimism of future low cost power -- nuclear power -- in the early 1950's until the early 1970's. Alvin Weinberg, along with the Nobel Laureate Eugene Wigner, were two scientists at the forefront of the development of nuclear power, and both theorized that fission and later fusion power would become exponentially more efficient (an electricity production version of Moore's Law) over the next few decades. As such, Weinberg describes (somewhat infamously) that nuclear power had the potential to be "too cheap to meter" which earned him and the nuclear community a significant dose of ridicule with the higher build costs experienced in the US in the 1970's.

Interestingly the potential of nuclear power was shared by other members of the scientific community in the 1950's and 1960's. One of the greatest scientists of the 20th century, John Von Neumann, wrote in 1955 that nuclear power was likely to be the source of vast amounts of energy by the late 20th century: "A few decades hence (nuclear) energy may well be free -- just like the unmetered air -- with coal and oil used mainly as raw materials for chemical synthesis, to which, experience has shown, their properties are best suited." Science Fiction movies such as "The Day the Earth Stood Still" (1951)implied that rapid technological progress in nuclear energy production was imminent (the movie showed Aliens coming to Earth due to the potential technological breakthrough from nuclear energy).

In 2011 however we are still stuck with a significant reliance on oil and coal for energy while nuclear is fading as an energy source, and energy is anything but free as the cost of energy is rising.

Estimating the Impact of Higher Energy Prices on GDP:

The most direct way to estimate higher energy prices is through treating higher energy costs as a "tax" on consumption on the residential electricity usage side and as a cost to business on the industrial and commercial usage side. Utilizing the GDP formula: GDP = Consumption + G + (X-M) + I, consumption should be reduced by the amount of the additional electricity costs on residential customers. Note that residential customers comprise approximately one third of US electricity demand, while industry comprises one-third of electrical demand and commercial (office buildings, retail, grocery, non-industrial) comprises one-third of demand.

Higher electricity costs on industrial and commercial sources will be treated as a direct tax to income in the income measure of GNI -- as GNI must approximately equal GDP then a simplifying assumption is that the higher rates pass through to consumption as well on the consumption measure of GDP. (actually I am not sure if this assumption holds, but will go with this anyway :)

The Keynesian Multiplier!

I've been informed that a higher amount of consumption would ripple through the economy through Keynes' multiplier. This is to say, that as a typical consumer has more income, they spent a percentage of this income, then the recipient of this income spends the income, etc, leading to a "ripple" effect through the economy. Keynes termed this effect "the multiplier" which actually (I believe) wasn't Keynes' original idea but one of his student's ideas (the Polish economist Michal Kalecki had a similar idea of revolving around additional stimulus impacting the economy, but did not come up with the idea of the multiplier).

With additional income that is present over all time periods -- and not during a recession (when consumers are more likely to save income to reduce debts and plan for an uncertain future) the marginal propensity to consume should be higher, towards the normal spending range for Americans, which is currently around 0.94. In times of recession, tax cuts tend to have a lower MPC, this paper argues that the MPC in the 2001 tax cuts was somewhere between 0.6 and 0.4.

The impact will be calculated according to the simplified MPC impact on GDP formula: Change in GDP = 1/(1-MPC)

So, a calculating the increase in GDP from electricity costs at a variety of rates per KWh verses the average rate of 9.7 cents in 2011:

Total Electricity Usage (thousand MegaWh) (2009): 3950331

Cost per KWh (cents) 9.7 8 7 6 5 4 3 2 1 0
Total Cost $383,182,107,000.00 $316,026,480,000.00 $276,523,170,000.00 $237,019,860,000.00 $197,516,550,000.00 $158,013,240,000.00 $118,509,930,000.00 $79,006,620,000.00 $39,503,310,000.00 $0.00
$ Savings (verses $0.097) $0.00 $67,155,627,000.00 $106,658,937,000.00 $146,162,247,000.00 $185,665,557,000.00 $225,168,867,000.00 $264,672,177,000.00 $304,175,487,000.00 $343,678,797,000.00 $383,182,107,000.00
GDP 2009 $12,832,600,000,000.00

Percentage Increase in GDP 0.52% 0.83% 1.14% 1.45% 1.75% 2.06% 2.37% 2.68% 2.99%

With a Marginal Propensity to Consumer of 0.94 for additional consumption from additional income, increase in GDP:8.72% 13.85% 18.98% 24.11% 29.24% 34.37% 39.51% 44.64% 49.77%

With a Marginal Propensity to Consumer of 0.5: 1.05% 1.66% 2.28% 2.89% 3.51% 4.12% 4.74% 5.36% 5.97%

Results: At first glance, with electricity at ZERO cost, the increase in GDP is appears to be only 2.99% from current levels, as a total, not in growth terms. (meaning that the savings from electricity are equivalent to about one year of additional GDP growth, as the US economy can easily grow about 3% in real terms during a good year).

However this result does not take into account the effects of the multiplier. With a normal multiplier of 0.94 -- meaning that consumers spend 94% and save 6% of their income -- the increase in GDP with free energy is nearly 50%. With a multiplier more in line with stimulus/tax break spending of 0.5, the increase in GDP from zero cost energy is only about 6%.

The 50% increase in GDP sounds more in line with what one should expect from zero cost energy, in a very unscientific way, mainly by being be more in line with the optimistic comments from the great scientists of the 1950's, referenced above:). Nevertheless, it is likely that the increase in GDP from very low cost energy would be even higher, for several reasons.

Reasons for likely higher GDP from Low electricity costs than implied by the multiplier:

First of all, low cost energy would likely translate to lower cost commodity prices across all sectors, in so far that cheap and abundant energy can be used to produce and extract commodities at a lower cost, leading to higher returns for oil, mining and agricultural firms. For oil refining, for example, electricity costs are approximately 10% of total costs. Lower costs would encourage higher supply, lowering prices relative to demand.

Low Cost Electrical Power as a Signal to the Market That an Energy Shortage is Not Foreseeable:

One aspect of very low electricity costs is that it would signal that a shortage in other energy commodities -- oil, natural gas and coal -- is not imminent over the medium term. There has been a lot of speculation on why the prices of commodities have risen over the past decade, for example this discussion forum at the Economist Magazine presents a wide variety of reasons for rising commodity prices, from Federal Reserve monetary policies, to demand from China. Financial speculation has also been blamed in some circles. One reason for higher prices is that an impending shortage may be anticipated relative to supply.

Adam Smith once asked, "Why is it that diamonds, although frivolous, are expensive, while water, while necessary for life, is free?" This question led decades later to the concept of supply and demand (invented by the economist Alfred Marshall, in (incredibly for such a core concept) the late 1800's. One can say, if water was in shortage, it certainly would be expensive -- the last remaining volume of water would be "bid" upon by millions of individuals (one can think of the movie "Mad Max" -- absolute chaos if water was in shortage relative to demand (although in that movie it was gasoline that was in shortage)(perhaps this mental picture is a bit silly but does illustrate the basic concept :). There is a lot of evidence that many key commodities, from oil to copper to even grains, have been getting close to shortage levels (the subject of this is lengthy, and for another post). For example, the additional supply of iron ore in late 2009 were bid upon by the European Union and China, with the only additional supply coming from three companies (BHP, Rio Tinto and Vale), causing the price to increase from around $80 per tonne to over $200 per ton. China, in particular, in late 2009 was desperate for iron ore as a key input into in construction-heavy stimulus program passed in 2008 -- the economic livelihood of China was at stake in obtaining iron ore as as such demand outstripped supply, causing prices to skyrocket.

Figure 1: The Historical Price of Iron Ore:

I would argue that a proper calculation of GDP savings would calculate additional price declines across energy as well as metal and food related commodities, stemming from low cost electricity. As this post is getting lengthy, I will calculate this GDP increase in the next post.


Sasuke Uciha said...

Good Article, thanks for your article. :)

Uzumaki Naruto said...

Good Article, thanks for your article. :)