Tuesday, October 09, 2007

Severn barrage - flawed economics

Note: this follows an earlier posting on: The case for the Severn barrage - does it hold water?...

Sometimes you can be wading through a report and hit something that abruptly tells you it isn't really worth reading on: the report is mad and you are wasting your time. And so it happened when reading through the SDC report Tidal Power in the UK, and coming across Table 33 on page 119 - see left.

This shows the cost of the Cardiff-Weston Severn barrage for different discount rates (the horizontal lines), compared to other low carbon technologies (the bars). The report declares:

...at an 8% discount rate, [the barrage options] lie at the higher end in comparison to other low carbon technologies; at 15%, they are well above the costs of all other technologies except wave power; but using low discount rates of 2 or 3.5% a barrage becomes highly cost-competitive.

Oh dear...! If you were also to assume a very low cost of capital (discount rate) for the other technologies, they get much cheaper too! So the costs given for offshore wind or nuclear, both highly capital intensive, would be much lower if they had 2-3% discount rates and the bars would shrink below the lines. The chart is distorting and meaningless, but it does rather betray the tendency to appraisal bias that pervades the report. About this there is more to say....



The economics in the SDC report is too much about 'how?' and not enough about 'why?'. The first job of economics is to help with deciding where and where not to invest resources. When things come out hugely more expensive than the alternatives, that should be cause for a searching examination of why we would want to do it. In the SDC report, it instead sets off a concerted effort to justify exceptional treatment. A 16 Km dam with over 200 turbines producing only the output of two Sizewell B power stations for £15 billion (and counting) should set off alarm bells for anyone with the slightest feel for power project costs. It's just a very very expensive way to reduce carbon - about £200/tCO2 on the same sort of assumptions used elsewhere in the energy / carbon market, which is more than 10 times the going rate. Why should society want to tie up its resources in this unproductive way? Could not £15 billion be put to better use?

Severn barrage in context - the alternatives are cheaper and better

The Severn barrage should in the first instance be considered along side other options for reducing carbon emissions. In fact, consideration of available options is a requirement of the Habitats directive, Art 6.4. A common way to do this is to set out the available carbon abatement options from in order of cost and showing potential as the width of the bar, in what is known as a marginal abatement cost (MAC) curve. The chart to the left is an attempt at the MAC curve for the UK from the recent Energy White Paper (see fig 10.2 p286). I've added an estimate for the Severn barrage (£767/tC and 2mtC/year - note the chart uses carbon not CO2), based on SDC figures and the 10% discount rate, which would be typical in this industry (see my last posting: Case for the Severn Barrage - does it hold water). You can see that the barrage is way off to the wrong side of the chart. Note this chart is specific to 2020, so some of the technical potential estimates for other technologies will be constrained by how much can be delivered by 2020 - and it is far from clear a Severn Barrage would be producing anything by 2020, it is far from clear that the positions wouldn't be even worse than this. The main point is that on a like for like basis with other technologies, this is a very expensive way to cut carbon - amongst the most expensive, and not particularly huge potential compared to say wind power.

The case for exceptional treatment... not made

The report tries to escape from this conclusion by making a case for doing something different. In a world in which private sector companies deliver power and, through policy-created markets, deliver carbon reductions, the SDC calls for a some form of taxpayer-funded public sector enterprise which, it argues, would expect or tolerate a very low rate of return on its investment. A scheme that provides low cost of capital is the only way the numbers can be made remotely respectable - so that is what has been attempted. The report moves quickly from 'if' to 'how?' with the only slightest pause for 'why?' in about one and a half pages (p.120-1). The following three sections are subheadings from section 4.8.3:

"Long term public benefits"
. Irrelevant. If a barrage produces power for 120 years and a nuclear power station for 60 years but with lower average ('levelised') cost, you just have two nuclear power stations in sequence. Same applies for other shorter lived and modular technologies like offshore wind etc. In fact, shorter project lives have some advantages: technology moves on, you know more about the problem, society may be richer and better at taking decisions. We are instinctively wary of placing high values on promised benefits far into the future because we feel they may not actually materialise.

"Mismatch between risk and reward". This seems to be based on the misconception that government always ultimately bears a range of project risks. In fact, the right people to bear risks are those best able to manage them - meaning construction risks should be borne by constructors, operating risks (ie. low output) by the operators etc. Government has got better at not standing behind big projects - with the Channel Tunnel it was 200 banks that took a bath. Offering low cost capital to a high risk project is just another type of subsidy - only less explicit and transparent than paying for valuable outputs (like carbon reductions) that are beset by market failures.

"Ensuring the public interest". The report argues for public sector involvement to secure public benefits - but why wouldn't the government just specify what it wants and pay a private sector body to deliver those benefits, if they were valuable? That's the standard practice and something like the barrage would probably need its own legislation. The public interest is strangely defined in the report - apparently with no regard for how much of the public's money is spent badly, and how much risk the taxpayer is asked to take on. I think it is also quite naive - and certainly poorly baked with evidence - to believe that public ownership is somehow in the benign public interest. Political and spending pressures to cut corners and make false economies are legion - witness the gross under-investment in water infrastructure by publicly-owned water companies prior to privatisation. Public ownership and direct involvement too easily sets up 'principal-agent' problems, making the Leninist mistake of conflating the interests of the state with the public interest.

Is there an innovation case?
One argument for paying over the odds and subsidising technologies that are way off market is that they will improve in cost-effectiveness and may be replicable and scalable. No such argument plays here. As the SDC puts it:

it would be difficult for the Government to justify treating a tidal barrage as a new renewable technology that requires innovation support (the justification behind the establishment of the RO), as the technology itself is certainly ‘mature’, and there is only limited potential for learning and further replication.
However, there are technologies that do justify innovation support as they are key climate technologies - eg. carbon capture and storage, which might have the all-important result of containing Chinese and Indian coal-related carbon emissions.

I don't see a compelling case for exceptional treatment on any of these grounds at all... but let us just go with the flow and imagine that it was going to be done by the government. Even here, the position is not as the report suggests...

Public procurement - about managing risk and appropriate returns
The crux of the Severn barrage case is that its carbon economics are awful if a commercial rate of return is required for the project. The SDC point to lower rates of return implicit in 'social discount rates' and attempts to justify a 'public sector project'. But if the government wants to buy a construction project, there is guidance on how that should be done. And it isn't by setting up a government building company with cheap capital.

The SDC acknowledges that it it would have to upend current energy policy to make the barrage work, but it would also require rewriting other principles too. One reason is that higher costs of capital or discount rates capture 'risk'. The government's policy is to transfer risk, and it does this through contracting and procurement.

The Treasury Green Book discusses transfer of risk as follows Treasury Green Book Annex 4:
When faced with significant risks, a public body should consider transferring part or all of it to the private sector. The governing principle is that risk should be allocated to whichever party from the public or private sector is best placed to manage it.

Appropriate transfer of risk generates incentives for the private sector to supply timely cost effective and more innovative solutions. As a general rule, PFI schemes should transfer risks to the private sector when the supplier is better able to influence the outcome than the procuring authority.

OGC guidance on procurement require private sector contracting
The Office of Government Commerce publishes guidance through the Achieving excellence guides for government construction procurement, and guide 06 deals with Procurement and contract strategies. This says:
Since April 2000, government policy has been that projects should be procured by one of the three recommended procurement routes (PFI, Prime Contracting or Design & Build)”. (click left to expand definitions)
This means that if the government wanted to buy a Severn barrage it would use a form of procurement that transfers risk to the developer and operator, who would expect a rate of return commensurate with the risk.

What about a central government project?
But what if some sort of Ministry of Works project was authorised? Would it command a low cost of capital simply because it is government. No, actually it wouldn't.

But before we get in further, let's examine another 'stop reading' moment in the report. One of the more extraordinary comments is this:
"the Government can obtain debt finance at very low interest rates, and there would be no need to justify a high rate of return from the project due to the absence of any incentive to maximise short-term profits. For example, HM Treasury recently released index linked bonds at a nominal interest rate of 1.75%."
Er... ever noticed how your bank gives you a lower interest rate on your savings than it charges on your overdraft? The Bank of England's 'base rate' is currently 5.75% and this is the cheapest money available. The 1.75% is paid on 'gilt-edged' bonds that the government issues to finance the public debt - its is government borrowing not lending. The government has the highest credit rating and negligible default risk for the purchaser of the bond. None of these things applies to government lending for a risky capital project in an otherwise private market place.

Apply a social discount rate? One might wish to point to the discount rate used in government policy appraisal as set out in 'Green Book' guidance on policy appraisal... 3.5% and declining over time [here]. But where the output is sold in a competitive market (for example in markets for electricity, renewables certificates, carbon) the government's priority is to avoid excessive distortion. The Treasury Green Book is clear that where the government acts in otherwise private market. The Green Book and related guidance is set out in sequence of quotes below below.

1. Treasury Green Book.
5.54. Some central government bodies sell goods or services commercially, including to the government itself. These activities may be controlled by requiring prices to be set to provide a required rate of return (RRR) on the capital employed by the activity as a whole. Government policy is generally to set charges for goods and services sold commercially at market prices, and normally to recover full costs for monopoly services, (including the cost of capital as defined in the Treasury Fees and Charges Guide [see below].

That means the government should use an appropriate cost of capital, not just the social discount rate.

2. PES (2003) 16 Fees and charges policy
5 (second bullet) for commercial services where there is or may be private sector competition, and a profit may
be appropriate, to replace the required rate of return of at least 8 per cent with an illustrative range starting with 5.5 per cent - we want departments to make their own assessment of the appropriate rate of return for commercial services, but we would expect the rate to fall in a range 5.5 per cent to 15 per cent depending on factors such as the level of risk.

14.b) For commercial services where there is or may be private sector competition departments should make their own assessment of the appropriate rate of return, taking account of the illustrative range in paragraph five above, and the further advice in Annex 3
[see below]. For some this may mean a significant change in the rate of return and level of prices. For some it may be that that the level of charges is already be consistent with the revised guidance and will need no change.

That means that rates of return (discount rate) should be between 5.5% and 15%.

3. PES (2003) 16 annex 3
The assessment of the rate of return may also be assisted by an overview of the weighted average cost of capital (WACC) of competitors in the relevant market. Existing overviews of WACC in the relevant market (or a comparable market – see paragraph 9 above) may be available from relevant organisations such as a competition regulator, or other reputable organisations (but would need to be of reasonably recent date). Alternatively, the public sector body could consider whether there would be value in seeking a new assessment of this type of information.

That means the rate of return (discount rate) should be set with reference to the costs of capital of participants in the related market. In my previous post, I suggested 10% would be a sensible comparator (see table). The SDC suggested 9% in its report on nuclear.

Is this mindlessly following guidance...? What if the guidance is wrong?
Though I've set out what the government says about appraising and funding projects like this in general (not just in the energy sector), there is the possibility that the guidance is inappropriate and an exception justified for the Severn Barrage. If there is a case for an exception, the SDC hasn't made it, and although it draws on 'social discount rates' it doesn't mention the guidance above. The guidance isn't arbitrary and it is designed to implement some sound economic ideas - about distortion of markets, about risk, and about the opportunity cost and scarcity of capital - and a reluctance to transfer resources to the public sector from the private sector so that it can be used in ways that have a lower rate of return. I don't see why these ideas wouldn't apply to carbon policy.

Is there any justification?

The only case I can think of rests on meeting the extreme EU renewables target of meeting 20% of primary energy from renewables by 2020. In this case, a new instrument like the Renewables Obligation, only better designed would be the way to go. If the justification for the barrage flows from this, it simply reflects the poor design and over prescriptive nature of the 'reckless EU renewable target', as I called it in an earlier posting. It's precisely because the target would drive really expensive carbon-reducing projects that I think it is a bad policy.

What should be done?

Long-term low-carbon framework. The SDC do suggest some good ideas for addressing the true market failure - the weakness of the long term price signals for carbon and framework for developing low-carbon technologies (p.123) and I discussed these in my earlier Severn barrage posting. However, there is no case for tying these to the Barrage. I think it would be very good for the government to recognise the immaturity of the carbon market, the fact that it is laden with 'policy risk' (ie. no-one can guess what the policy framework will be in 2025), and the fact that long-term investments are necessary but are inhibited in the current framework. That says to me that a more credible less risky long term carbon framework is needed - perhaps with the government underwriting a long term future carbon price.

Innovation strategy - carbon capture and storage. There is a good case for investing at over the market rate in technologies that will play a role in the future or that would allow for some diversity in the response. Things like the wave hub and London array looking promising. I'm particularly keen on seeing a kick-start for carbon capture and storage. We have 8GW of new coal plant awaiting licensing in the UK (far more output and carbon than the barrage). Devoting resources (£15 billion!) to CCS would be a far better approach - a lower cost of carbon, and a scalable critical technology.

Long-term abatement cost curve / surface - the 'why now?' question. We should be paying much more attention to the 'marginal abatement cost curve' as this should guide the focus of policy - telling us where the most cost-effective carbon savings are. However, this 2D curve (as shown above) should really be visualised as a 3D surface, with an axis for time... costs and technical potential will change over time for each technology, and so will the depth of cuts required in emissions and the 'strike price' for carbon (ie the cost of the marginal tonne saved). It is possible that a barrage will become a cost-effective at some point in the future as better options are exhausted. Equally possible is that new options will appear or costs and potentials of existing options will continue to improve. Another question not addressed (or asked) in the SDC report is 'why now?'. We have an option on the barrage and it might be that the right to do it will be in 60 years time in a more carbon constrained world.

Summary
I could go on, but let me draw this together.
  • The Severn barrage costs too much for too little. On a like for like basis with other low carbon technologies, it creates extremely expensive carbon savings - more than 10 times the going rate.
  • The case for some sort of exceptional treatment is very weak - with a poorly defined case for the public interest, market failure or innovation
  • Even if it was built as an exceptional public sector project, the procurement would need to transfer risk to the private sector and use something like a PFI, which would reintroduce financing costs commensurate with risk
  • Even if an exception was made to this and the government somehow builds the project itself, guidance on policy appraisal requires a commercial rate of return to be used where the government is intervening in a market where there are private sector actors delivering the same things (energy, carbon savings)
  • The Habitats Directive (92/43/EEC Article 6.4) has three levels of test before a designated area can be disrupted:
1. consideration of alternatives...
2. assessment of 'over-riding public interest'...
3. specification of acceptable compensating measures...
  • The barrage fails the first two of these, and so the third should not arise. There are clear alternative low carbon technologies that are cheaper and more widely applicable. There is no over-riding public interest in upending energy policy in order to develop an extremely expensive renewables project. These tests are supposed to be sequential, so discussion of compensating measures should not arise.
  • A better strategy would be to establish a long-term framework for rewarding carbon savings, promote innovation in technologies that will matter for the future and keep the option of the barrage open until we have exhausted better approaches - if that ever happens.

14 comments:

Alex said...

Channelling my inner technocrat, it may be an expensive way of saving CO2, but it's certainly a big chunk of base-load power; in fact, couldn't we use it to pumped store wind power as well?

Clive Bates said...

It's not actually baseload Alex, it is a predictable peaking load that only sometimes coincides with the peak demand. Does it matter if there a lot of it if it is very expensive - in fact, I'd rather have less of something that is bad value for money...

There's not much point in storing wind power until its intermittency is a problem... and we are some way from that. It's not obvious that the barrage would be a good pumped storage system - probably better to use a conventional high-head hydro plant... or maybe some new technology will come along - super-conductors or something, when we need it.

I've always thought a wind mill driving a compressor (instead of a turbine) to charge a tank of compressed air - with the compressed air turning a generator turbine to meet variable demand would be a good way of storing wind power. Several compressed air wind mills could be connected to a single large tank and electricity generator set.

Given that compressors are cheaper than generator sets, there might even be some savings, though I think there are losses in heat etc.

Matthew said...

Spot on Clive. The only argument left is that of political opportunism. If politicians were minded to spend £15 billion of our money on this scheme instead of spending it on equally flawed non carbon outcomes e.g that weird eating allowance for pregnant women, then it might be worth grabbing these very expensive carbon savings as an unexpected windfall for the planet. It is very unlikely for the reasons you give - I think the government is just enjoying being able to show itself to be more open minded to renewables than the green lobby, and it therefore suits them to prolong the process with another study.

Captain Flint said...

It's very disappointing that the SDC have chosen to fiddle the figures in this way. Listening to J Porritt on Radio 4 the other day, his line was that the environmental movement had been saying "no" to so many things that it was time to say "yes" to something. Even if the sums don't add up.

I can just imagine the conversation down at SDC Towers:

"I say, Mr Porritt, this Severn Barrage thingy looks a bit pricey"

"That's as maybe. But we can't just go on saying no to everything"

"So how do we spin it, boss?"

"Look, you're the economist, you'll think of something."

"Hmmm ... I'm not sure, Boss"

"Listen! It's renewables and renewables are great! Just find a way to make it look cheaper than nuclear!"

It's profoundly depressing that so much policy development on energy is being carried in such an economically illiterate fashion. Opportunity cost is such a basic concept, they teach it on the most elementary economics courses.

There are so many ways of spending this money more effectively that would displace more carbon. Why in the name of the wee man are so many otherwise intelligent people dazzled by big shiny projects when a bunch of small boring ones would deliver the goods more effectively and more cheaply?

Keep it up, Clive.

Alex said...

The compressor thing has been done, but there's better; flow batteries are actually being deployed at some wind farms.

Clive Bates said...

Thanks Alex for the pointers on flow batteries and wind-powered compressed concept (and here)

It's just so difficult to keep up!

Peter Ullman said...

Assuming the STPG were telling the truth in their 1988 Energy Paper #57, the summary of the 14 years (65m GBP)of studies on the same Severn Barrage, the cost was about 8b, resulting in a power cost of 8.2p/kWh (their figures). Doubling the capital cost to 16b (2007 pounds) makes the cost of power about 21p/kWh, not 10p as SDC claims. BTW, SDC tidal experts include the editor and one of the authors of the 1988 report on the Severn Barrage.

In contrast, tidal lagoons are privately funded and cost of power estimates range from 2.5p/kWh (AEA Technology) to 6p/kWh (OFGEM). The same Severn Barrage study author mentioned above did a study for DTI that resulted in a 17.5p/kWh! Wildly out of step with OFGEM, AEA, Rothschild, WS Atkins, MWH Engineering, and Delta Marine estimates.

Why is SDC selling the Severn Barrage? Aren't they a publicly-funded commission intended to give the public a straight answer?

Paul Buchanan said...

Dear Economists,

There is a bigger and better argument for the Barrage than just energy production.

IPCC states that the Greenland Ice Sheet IS melting (they hope it'll tke 1000 years, but the rate of melt has doubled twice in the last ten years - now in excess of 200km3 per annum!!), as a consequence there will be a global sea level rise of approx 7m (23 ft).

All the habitat protection legislation in the world iss not going to save the mudflats on the Severn...so, now that we all know that we have to cut the arm off to save the body, let's stop argueing over how many fingers we really want to save.

It is battle field triage....the battle is man's survival into the next century on this planet....

It's simple...spend the money, build the thing, save approx 1m homes from flooding and generate about 10% of the UK's entire need with the 'outer barrage' option.

Clive Bates said...

Dear Paul - of course, there is a possibility of of a 7m sea level rise. And as you say the signs are that this may happen sooner than expected. Even very rapidly.

But if the objective was flood protection, we wouldn't use a barrage - barrages let water through and try to get as much water on the other side as possible. The current barrage design does not anticipate a 7m sea level rise, and it would be a different beast if it did. If the objective was flood protection against a 7m sea level rise (rather than electricity generation), we'd design a solution to deal with that... (though it would be extremely difficult) not retrofit a project designed for something else entirely. The current barrage would fail (ie. it would over-top) with a few metres of sea level rise (I don't know its design limit), though I guess it could be designed to be raised in height over time.

I think there is some merit in doing scenario work on a 7m sea level rise... what if we discover (plausibly) over the next ten years that the Greenland ice cap will melt over the next 60 years - perhaps due to some new melting mechanism? What would we do?

I guess a mixture of coastal realignment (bureaucrat-speak for moving settlements) and defences... but where the lines would be drawn and where defences would be constructed to give most cost-effective risk reduction.... that's another matter. It's not obvious that running a defensive structure across the Severn estuary is the way to protect settlements inland.

Paul you sort of imply that 'economists' (I'm not one, by the way) perhaps miss the point or that major risks maybe transcend economics. Actually, I think when you have really big expensive threats to deal with (like a 7m sea level rise), economics will be paramount. You will need a robust transparent discipline to decide fairly and effectively what to do (and not do)... Otherwise we just wont be able to do it...

By the way, the Severn barrage would generate about 4% of UK electricity.

Clive

Anonymous said...

Does it become affordable if you put a motorway on top? I'e always expected that to follow at some point - and how about an airport at each end too. Should offset any irritating cuts in our CO2 emissions from the barrage.

Clive Bates said...

A motorway on top... yes, an interesting thought.

The current figures do not include a major transport link - road or rail. I don't think the SDC handled this question at all well - they argue that it should be seen as an electricity project first and other benefits evaluated separately. ie. if it works as a barrage, then see if the addition of a road looks cost-effective.

In fact, it is possible that a barrage would be not cost-effective, a road built on an existing foundation provided by the barrage very cost effective, and the combination of the two evaluated as a whole quite cost effective... but taking the SDC approach, you wouldn't do either. That's not a very SD sort of a way to looking things in my view.

In practice, I doubt either would be cost effective - a motorway is such a huge thing and would probably mean the barrage would have to be much larger for the thing to sit on it. Nor do I know if the marginal cost of a road scheme would be better spent on alternatives - alternative bridge crossings over the Severn, strengthening the M4/M5 system, Bristol's dreadful public transport and congestion etc etc.

I think there is a danger of herding the white elephants here!

Clive

Tim J said...

Apologies for what is going to be quite a long comment, but as Economics Commissioner for the Sustainable Development Commission, I guess it falls at least partly to me to respond to charges of ‘flawed economics’ in our SDC tidal position!

So, here goes..

First, I think I would accept Clive’s criticism that the report itself didn't make quite as clear a case for the 'why' of public ownership as it might have done. Or at least, that there was so much other stuff in there that it was quite easy to miss the case we were making.

A significant part of that case rests on 'conditionality'. We set ourselves the task of asking, what conditions might have to be in place before it was possible to say yes to a barrage (given a prima facie argument in favour of renewables as a source of low carbon energy but huge concerns about habitats and the impacts of development). Public ownership and leadership was one of several conditions we identified along with: no derogation from the directives, development of a wider low carbon policy and the sustainability of ancillary investments.

It's true that public ownership doesn't in itself guarantee the sustainability of ancillary investments or the replacement of habitats, which is why we made those separate conditions in their own right. But the logic of our position was that these other conditions would be severely compromised under private ownership, which would in any event require huge public subsidy. By contrast, and this is something that I will come back to in relation to one of the points in your blog, our position is not about asking for public subsidy, it is asking for public investment: an outlay of public money which leads to both direct (monetary) and indirect (carbon, habitats, infrastructure) public benefits.

This need for infrastructure investment is key to our arguments. It is clear that much of our existing long-term, large-scale infrastructure was built under conditions of public investment at low (implicit) rates of return. It is difficult to see where such large-scale infrastructure investment is going to come from in the future. What we tend to have seen under market conditions is the systematic sweating of previously public assets for private benefit - tantamount to an institutionalised running down of infrastructure (Dieter Helm has made this argument convincingly in relation to the energy utilities). And attempts at private finance for large infrastructure investments have been hounded by confusion - Channel Tunnel finance now lies floundering in European hedging funds; ill-defined Public-Private Partnerships, as the Financial Times has remarked, fail to solve the problem of public-private subsidy and make for 'poor management and blurred accountability'. (By contrast, there is some very recent precedent for public investment at this scale in Crossrail which is publically owned joint venture between Transport for London and the Department for Transport.)

From these understandings it is quite a short step to suggest that here, at least, in the case of a large scale infrastructure investment with very long term carbon and energy supply benefits, there is a case to consider the public sector as project developer and asset owner. Assignation of the public sector as asset owner is necessary precisely because it places the long-term financial benefits (electricity sales) of this investment in public hands.

We still have to ask of course: under what conditions might the public sector accept such an investment as favourable? Answering this question has several different dimensions to it. First of all let me just correct a misconception in your blog, where you suggest that we are talking about government 'lending capital' at low interest rate. We're not at all suggesting that. On the contrary, we are asking at what rate is government borrowing possible. As a trusted borrower, as you yourself point out, Government can attract capital at quite low rates of return. Treasury bonds are one example of that.

So in other words, it is within the bounds of currently accepted raising of public sector funds to consider a low interest rate. And at such an interest rate, the project does in fact become feasible - noone disagrees on that. But to be clear, there is no suggestion of Government lending money at a reduced rate, or indeed of subsidising private interests in any way at all. On the contrary, our strategy is designed explicitly to avoid that.

It remains an interesting and important question whether a low discount rate has a theoretical justification in this case. My personal view is that we do not yet have a convincing economics of the long-term, yet alone a convincing economics of climate change. There are certainly strong theoretical arguments in favour of re-appraising the impact of discounting practices on infrastructure projects. Discounting works where project lifetimes are congruent with commercial lending terms. In other words, where funds have to be matched quite precisely against the flow of benefits that technologies provide. It is deeply problematic where large upfront costs are to be matched against either very long-term benefits or indeed against very long-term costs. Both tend simply to disappear under anything approaching commerical interest rates, and leave us very little way of meaningful project appraisal over the long-term. This is well explored in both academic literature (lovely paper by David Collard that was formative in my thinking about this some twenty years ago) and the policy literature (to wit lots of complex discussion in the Stern report).

In pragmatic terms, the recognition of the problem has led to some slightly unsatisfactory but nonetheless interesting suggestions, amongst which the idea (in Treasury guidance and indeed in CEGB guidance predating privatisation) that it is appropriate to assess very long term cost-benefit streams at low discount rates.

So at the very least, our position has some precedence. The heart of the matter is that discounted cash flow analysis is too recent and too limited to tackle the challenge of long-term infrastucture investment in the context of issues like climate change.

And in case this all sounds too much like special pleading, let me just reiterate two points. Firstly, existing procedures have clearly militated against long term investment decisions. Secondly, from a purely pragmatic point of view, a low interest rate on borrowed public sector capital clearly does have a precedent.

In the context of this complexity, I am much less inclined to be swayed by your arguments about accounting procedures and practices. I'd like to emphasise at the very least that we have to distinguish clearly between a) what is understood as common practice b) what is laid down in formal guidelines and c) what is properly reflective of the complexity of economic priorities. I have a number of issues in relation to your particular citations of Green Book and Treasury guidance. But in the broadest terms, I would want to question the context of these guidelines. They reflect a broadly market-based ideology, attempting to construe government as simply another private sector player and more importantly they suffer, as the conventional methodologies suffer, from being designed for much narrower circumstances. When we have a truly green Green Book (one of our SDC objectives), then perhaps the guidance will be worth following by rote. Until then, it's our job to think beyond it.

Next, let me come to your point about marginal abatement curves. Since I was one of the original architects of this concept (back in 1988 I produced what was then an unprecedented report based on this idea for Friends of the Earth’s case to the Hinkley Point Inquiry) I could scarcely fail to understand your point here, that tidal is not the most cost-effective thing to do in when assessed from a simple and commensurate set of economic conditions. The trouble is - and this was something I explored in detail in a subsequent FoE report in 1992 - this set of conditions just doesn't exist in practice, and has existed less and less in an increasingly privatised market. The lovely concept of integrated resource planning - tested in 1989 in a couple of places in the UK - in which it makes sense to invest even-handedly on both demand and supply, no longer pertains. Marginal rates of capital availability in energy efficiency can be as high as 25% or higher. What you should do from a 'pure' social discounting perspective just doesn't play out in practice. After a number of years thinking through this, I favour a pragmatic approach to this problem. Understanding how options stack up under similar financial considitions is useful for government. And there is clearly a strong argument in favour of stimulating appropriate conditions for comparability. Hence for example the arguments in favour of ESCOs, which again have a long pedigree but have proved difficult to implement in the liberalised energy markets of the UK.

But its also essential - in the absence of those conditions - to take a pragmatic approach to investment all the way along the supply curve. For instance, government can learn from a marginal carbon abatement cost curve that there is little need to stimulate investment in Combined Cycle Gas Turbines. The market will do that for them. There is a massive need to facilitate the flow of capital into demand side measures, because these are cost-effective (from a social point of view) and the market clearly won’t do that for them. And within the package of interventions appropriate for government is the potential to take on what appear (on private financing conditions) to be costly interventions, but which under conditions of public sector finance could be justifiable, indeed profitable interventions for government. Tidal is one of those cases.

To return, to where I started, none of this is to suggest that any individual technology should override core social or environmental concerns. We have been very clear about this from the start. We attempted to define conditions under which it might be acceptable to build a barrage. None of them is sufficient on their own. But in our view all of them are necessary.

Clive Bates said...

Tim - thanks for the substantive reply.

It's a great pity that more of this argument is not reflected in the SDC report itself, as it as central, not incidental, to the case for or against the barrage. However, I don't find your argument at all persuasive...

First, as far as I can see, the only circumstances in which SDC would reject the barrage would be if it could not be made compatible with the Habitats and Birds directive. That I guess is why I’m uncomfortable with your approach – I really can’t see any point at which you would regard it as too expensive or the carbon savings better sourced in some other way. It’s not obvious that the barrage has passed any economic appraisal at all. All your argument about 'investment along the curve' basically is an open door for every technology advocate. At what level of cost would you say 'no' to the barrage? £20bn, £30bn, £100bn... and when you decide that level, how do you decide it?

Secondly, I find the idea of 'public ownership; as being synonymous with good governance absolutely amazing. Governance in the utilities has improved hugely since privatisation and much great clarity in the principal-agent relations among the various actors. A cynic, and I am becoming one about this, would say that SDC wants public ownership because the only place that very low returns on capital are accepted, and without this the numbers are obscene.


Thirdly, it's more than a sematic point – but cheap capital is a form of subsidy, just like soft loans etc It may be semantics, but in saying the govt can borrow at 1.75% I felt there was a strongly implied suggestion that this could be its required return for lending or investment, whereas the risk profile of a large capital project is completely different to bonds. If you are pursuing that argument I would have thought the Bank of England’s base rate would be a more realistic starting point.

Fourthly, on abatement cost curves… these are interesting and important. However, I don’t think that having defined the concept one can just say that we need a “pragmatic approach to investment all the way along the supply curve” without saying what the pragmatism would be trying to achieve at the more expensive ends of the curve. The danger with that is opening up the cheque book to every technology advocate. In fact I think the MAC curve is best visualised as a surface with the additional axis being for ‘time’. That way, one might see which technologies will benefit from scale and investment – the barrage wont, but others will. .. so if you were going for expensive options, you'd be looking for replicability and future proofing - eg. offshore wind.

Fifthly, I wouldn’t hold up the Green Book and other guidance as inviolable and do not think it should be applied uncritically – but they aren’t just 'accounting procedures'. They are an attempt to apply some microeconomic principles to policy appraisal and show how to apply them in practice. As you say, I think there is a rich discussion to be had about the role of government as a ‘social arbitrageur’ between the low discount rates of the Green Book and the relatively high rates applicable in the private sector. But for an organisation making policy recommendations in the UK I would take it as a starting point and argue a case for exceptions or an alternative framework. The report devotes next to nothing to this argument, yet it is absolutely central to the case for the barrage.

Finally, my suggestion is that SDC writes a follow up paper on all this so that the economic arguments you are making are more transparent and open to public examination. In my view, the case is far from made, and SDC needs to do more work to make its case.

Cliven1

John said...

Certainly your monetary conclusions make sense. Surely government is about wasting money! If you want government money they only back projects that will collapse. Like I knew the SDC would recomend go ahead for the Barrage they are probably likely to fund the barage because it won't work.

Incidently Carbon Capture is called planting trees. 3.5 tonne per acre per yr. Shift this to land that is undergoing desertification & its all bonus points, that is why our governments is not doing it.

Planting trees creates industry & wealth. Desert creates F all.
John