The second most important concept in economics, behind scarcity, is the idea of marginal analysis. Humans make decisions based on increments, not absolutes.
We do not ask at the outset of a meal, ‘How many slices of pie should I eat?’ We ask, ‘Should I eat another slice of pie?’ At least, that’s how we make the actual decision.
That’s because each additional slice has slightly less benefit and slightly more cost each time. We continue to eat until the cost of another slice outweighs the benefits…in the case of pies, literally.
Renewable energy upends how this idea of marginal change is applied to our electricity system. That’s because there is almost no marginal cost to producing energy for wind and solar. Almost all the cost is upfront in the initial manufacture and setup. This risks a sunk cost — a solar or wind farm that cost a lot of money to build, but which produces unneeded electricity.
Contrast renewables with a power system that uses fossil fuels, and the issue becomes more obvious. Fossil fuel power requires applying more or less fuel to produce more or less energy. The marginal cost and the marginal benefit have a direct relationship with each other. This encourages efficiency and stable production.
It also keeps power prices stable over time. If less energy is needed, less fuel is used. So, the cost of fuel supply and the revenue earned from demand are inextricably linked. They balance.
Power producers conduct a marginal analysis each time they consider producing more or less power. Should I add another tonne of coal or Btu of gas? What does it cost me and what revenue does it earn me?
As the cost of resources rises with demand, the price of electricity falls with rising supply, until the twain shall meet at the mythical equilibrium of supply and demand.
It is unlikely too much electricity will be produced in a fossil fuel system because it costs someone something — they make a loss. Also, resources are not wasted because demand and supply can be matched easily by adjusting how much fuel is used.
But we are increasingly moving to a solar and wind system that does not bear the same link between cost and revenue, in a variety of ways. And precisely the consequences a marginal analysis economist would expect are emerging…
The Australian Financial Review sums it up:
‘Power prices surged to their second-highest March quarter in 18 years, despite a glut of solar and wind production that sent prices into the negative during the middle of the day, according to a new report.’
Second most expensive while negative for much of the day!? What a combination. A glut of power and high prices — something only a government could achieve.
In SA, which is ‘at the vanguard of the global energy transition,’ wholesale power prices were negative for 17% of the time, and 29% of the time between 9:00am–5:00pm.
Of course, Australia is far from alone. The UK’s National Grid spent £4.2 billion on balancing payments in 2022 because of the intermittency of wind and solar, for example. Ironically, paying wind farms to cut such excess energy production is expensive. And this cost rises as the use of renewables goes up.
How do you think paying solar and wind farms to not produce energy impacts marginal analysis for solar and wind farm builders? Does it discourage building too many wind and solar farms, or does it incentivise it?
Control is another part of the underlying issue. It is the point at which the marginal analysis of decision-making in power supply and demand balancing has broken down. If humans don’t control the amount of electricity being produced, they have a rather large problem.
You see, the demand and supply of electricity must match to an extraordinary degree of precision for a power network to function. And so, we must be able to control it for it to function at all.
At 10% or 20% uncontrollable renewable energy, that’s doable by dialling fossil fuels up and down to adjust for renewables. But the higher the share of renewables, the messier things get.
There are all sorts of considerations and reasons for this. For example, given the potential for wind and solar to cut out, we need an entire backup system ready to fill the void or face blackouts. But would you invest in such a backup if it only gets used selectively to make up for wind and solar unpredictability? How would such a system be compensated for its patience? By being able to sell power at politically incorrect prices on rare occasions?
More importantly, how do we link the true costs of wind and solar power to their revenues to ensure marginal analysis can make sense of what’s going on? We can’t even account for the costs properly in this system. This is because the costs of wind and solar intermittency are born by the fossil fuel sector’s periodic lack of revenue — their downtime while wind and solar produce too much power.
If wind and solar installations had to compensate fossil fuel stations for their downtime to keep a backup in reserve, the cost of wind and solar would soar.
Again, the point is that the link between prices, supply and demand which enables marginal analysis breaks down. If a person’s stomach sent them false signals about pie, they’d starve or burst. That’s what’s happening in the power system. It’s getting bizarre information.
My hyperactive thyroid constantly tells me I’m hungry until my third mouthful when I’m full…for about 15 minutes. It also tells my metabolism to work harder than the rest of my body can handle. The false signals cause a complete lack of body fat to keep me warm in winter — precisely the problems renewable energy systems cause too…
All this is already a problem where renewables are a small part of our grid and a significant problem where renewables are a larger part of the grid, such as in California, Germany and SA.
It’s worth noting that power prices are forecast to rise next year in Australia, despite the ever-growing wind and solar installations that supposedly produce ‘free’ energy. This is not a surprise given an entire backup grid of fossil fuel energy must be kept ready to cover for the poor timing of wind and solar.
Alongside the issue of intermittency and control, we have the issue of location. The need to shift renewable power from where it’s generated to where it’s used has been masked by our existing electricity grid. But it turns out that our existing grid is creaking under strain as renewables reach certain thresholds. And the cost of upgrading and adding infrastructure is soaring as fast as…all government cost estimates do.
Again, this defies the information flow which makes marginal analysis function. Solar and wind projects are not bearing the cost of necessitating vast upgrades to transmission which new fossil fuel power wouldn’t. But the cost is still real.
The gap is the problem. Because the grid upgrade cost is not being tied to renewable energy projects, they look like a better option than they are. They produce power for almost free on a marginal basis…which ignores all the other costs — precisely the ones that are large for renewables specifically.
The result is a glut of renewables. According to the UK’s Telegraph, the Renewable Energy Foundation ‘warned that consumers are left to foot the bill for wind farm operators having to reduce their output as a result of an “excessive” number of turbines in Scotland leaving the electricity grid unable to cope on occasions such as when there are strong winds.’
All these costs were passed on to consumers or taxpayers, worsening energy bills and the cost-of-living crisis. But at least we had the fossil fuel grid as a backup. What if we hadn’t?
But this only creates an alternative issue. An entire energy system must be kept ready to jump in when renewables fail. The UK had this happen in March 2023 when it returned to coal. The Germans kept their fossil fuel system in backup too and needed it this past winter. The cost of maintaining an entire backup grid is high. That’s why German power prices are very high. But the cost is not born by the renewables industry which is creating the problem in the first place.
The challenges of the energy transition, then, include a far greater degree of complexity in pricing and incentives. That, in turn, means more cost and more fragility, neither of which is laid at the feet of wind and solar. At least, not where it matters — their prices. Because it’s almost free to produce a marginal until of renewable energy.
What has happened here is a sleight of hand. We measure the cost of producing energy by way of marginal analysis — the cost of producing one more watt. This makes sense for fossil fuels because the cost of producing one more watt is tied to using up fuel. But that same measure makes no sense for renewable energy. The marginal cost is near zero.
The real cost for renewables is the upfront fixed cost. Building the farm, the transmission network and the backup, whether it’s power storage or a fossil fuel system that lies in reserve.
Because those costs don’t feature in our definition of ‘the cost of producing power’ on a marginal basis, the true cost of renewables isn’t revealed when making economic decisions about how to produce our power, where and with what infrastructure.
Our power grid is going haywire, led by false price signals.
Enough about electricity. In the end, it’s just a bill we pay, right?
Well, prices are where Adam Smith’s invisible hand meets the road in our day-to-day decision-making. Prices create order out of disorder by guiding which results we come to when doing our marginal analysis. The wrong price leads to the wrong economic decision — a loss. And power prices impact almost all economic activity.
Some more than others, though. According to one University of Cambridge professor, the UK’s progress in cutting emissions has come from shifting emissions-intensive industry overseas and importing its goods. That is, higher power prices made it more economical to use a lot of power outside the UK.
The result is a trade deficit and higher emissions — a bad outcome.
In other words, high power prices completely reshape our entire economic structure. (Mining, by the way, is highly power intensive and tends to run 24/7, so intermittent power is not ideal.)
The result of higher power prices won’t just be a misaligned energy system, but an entire economy led astray.
Editor, The Daily Reckoning Australia Weekend