San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Economic Effect of
Alternate Sources of Energy

There is a great deal of intellectual ferment about the need to develop alternative energy sources to replace the use of petroleum. Most of this thinking is incredibly naive. As shown below the economic effect of an energy source cheaper than the current price of petroleum would be for the immediate future merely to lower the price of petroleum. There might well be no replacement of petroleum. Thus private developers of such energy sources would get no revenue to compensate them for the development of such alternative energy sources.

There is a great deal of wishful thinking concerning the proposed public policies for sources of energy other than petroleum. There are two stocks of petroleum that are relevant. The discovered and developed reserves and the undeveloped reserves. The marginal cost of retreiving a barrel of oil from the first is minimal. The cost of tapping the second is probably on the order of magnitude of the current market price. There is said to be about two decades of oil that is developed and has a production cost far, far below what any conceivable alternate energy cost would be. The amount of petroleum available for developed sources is over one trillion barrels. Currently the world is using about 84 million barrels per day. If the rate of use held constant at 84 million barrels per day the world would have 1000000/84=11,900 days of use left, which is 13.5 years. The rate of use currently is increasing a rate of about 3 percent per year. Thus if that rate of increase continued the trillion barrels of petroleum would be used up in 11.5 years.

Therefore until the developed petroleum reserves are used up no alternate energy source is financially viable. The other price that would be relevant is the value of the petroleum for petrochemical production.

Consider the following diagram which depicts the supply curves for energy from the already developed petroleum reserves and from alternative energy sources. As shown the supply of energy from already developed petroleum is some fixed amount as long as the price of energy is above a particular level. This level reflects the pumping and distribution cost and is likely to be very small.

The supply curve for energy from alternative sources is shown as requiring at least a minimum price.

When the two supply curves are combined and the result confronted with the demand curve for energy the result is as shown below. In this case there is a balance between the quantity demanded and the quantity supplied at a price P0 which is too low to elicit any supply of energy from the alternate sources. Thus the energy still comes entirely from petroleum.

Now suppose the government subsidizes the alternative energy production. The effect of a subsidy on the supply curve for energy from alternative sources is to move it vertically downward by the amount of the subsidy. This is shown in the following diagram.

As shown the subsidy results in a lower price of energy for energy users but no decrease in the amount of energy used from petroleum. The effect on the energy market is simply to stimulate the use of energy from sources whose cost was greater than the market price of energy. In other words the only effect of the subsidies is to subsidize alternative energy sources; there is no effect on petroleum utilization. The petroleum in the deposits that have already been developed is not going stay there.

There are many other confusions about energy policy. One such confusion is between sources of energy versus means of storing energy from other sources. For example, if hydrogen is derived by electolyzing water (H2O) then any energy derived from burning that hydrogen is merely retrieving the energy that went into the electrolysis of H2O. Often there is a great deal of the energy lost in such processes but it is worthwhile because of the convenient form of the substance being used to transfer energy. A battery is a prime example of this. Hydrogen is in the nature of a battery rather than a source of energy.

Ethanol derived from the fermentation of organic material such as sugars and starches might not a net source of energy because the distillation requires such a large amount of energy.

Wind power is a potential alternate source of energy, but at the present the cost of production of the generators makes wind power uneconomical. Subsidies are required to keep such operations producing. However, note that the cost of production of the generators is too high to make wind power economical; it would be even more uneconomical if the cost of energy were as high as wind power would make it.

Photovoltaic cells are the great dream, but at the present they are too expensive to make them economical. If photovoltaic cells were the only source of energy then they would be even more expensive.

Let PO be the price of energy from petroleum and PE the price of energy from an alternate energy source. Right now we are looking at

PE = c0 + c1PO

where cc0 is the cost of a unit of energy which is unrelated to the price of energy. The parameter cc0 + c0

However, a source of energy must be evaluated for economic feasibility on the basis of its cost of production including the cost of the energy involved in its own production.

PE' = c0 + c1PE'

Clearly PE' is greater than PE.

The crucial consideration is that if some source of energy were cheaper than the present cost from petroleum it would not end the use of petroleum. It would bring about a reduction in the price of petroleum. The end result would be that petroleum would still be used. The alternate energy source would not be utilized until the existing reserves of petroleum are exhausted. This of course would mean no return to the developers of alternative energy sources until sometime in the distant futurer.

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