1/31/16

The energy diversification benefit

One of my favorite courses from university was in my last semester and on the topic of energy engineering. Different from earlier engineering courses, the content in this one was not all technical. The goal of the course was to encourage us to think about energy systems from a scientific, political, and economic perspective. The bulk of our grade was determined by a deceivingly simple final exam question: "Describe the ideal energy mix in the future, and why?"

Many years later, I still find myself thinking about this question in passing. With energy being such an integral part of our everyday lives, I'm constantly reminded that the decisions we make today with respect to energy, will have significant implications for our future. Unfortunately, the challenge ahead of us presents no black-and-white answers.

If I was to summarize the course into one key learning, it was that finding the right energy supply mix to meet demand was a very complex optimization problem. It involved considering everything from how energy impacts people, its affect on the environment, the technology to produce/distribute it, through to the economics embedded within building business cases. This is complicated by the fact that the frequency at which you could "re-optimize/re-balance" the energy system was very choppy; given the longterm nature of investment decisions made today. For example, planning, operating, and decommissioning of a nuclear power plant could easily be a combined 100-year commitment.

If I was to take a shot at answering that final exam question again, 5 years later, I would have said that the ideal energy mix, is not universal. Tuning your optimization starts by identifying the sources of energy supply (available in a specific location), modeling out the demand profiles, setting environmental constraints, and optimizing the entire system for energy resilience.

Different energy supplies shouldn't be viewed in isolation; and instead should be viewed as part of an entire system. Using the analogy of building an investment portfolio, each available energy supply should be viewed as an energy asset; with the energy being produced like the cashflows generated off the asset. I would think of building energy resilience the same as building a diversified investment portfolio. I would evaluate the my energy mix on a risk-adjusted basis (reducing volatility per unit of energy return), rather than just looking on an absolute basis.

This would create a focus on segmenting energy assets based on risk-tiers and levels of correlation. The idea is that a diversification benefit is produced for various combinations of energy assets, where on average, you’ll realize more value from the sum of the parts, than any one individual component.

Only in this way can we avoid making decisions based purely on overly simplistic assumptions and cost-benefit project analyses. The case and point here would be with the discovery of abundant shale supply in the US a few years ago. On the surface, a shale supply boom makes any cost/benefit analysis based on current day oil prices conclude that other energy sources are not viable. This type of short-term thinking has the potential introduce substantial concentration risk into our energy systems and substantially weaken it's resilience to shocks.

We need to understand the diversification benefit that each energy asset brings. Going a step further, and quantifying this benefit is paramount to allowing for a meaningful conversation about the future of energy, the policies introduced to recalibrate the marketplace, and the unifying the role of different players. Those involved in different aspects of the energy industry should realize that they’re all tracking the same goal, and that everyone has a role to play. To succeed, we need to stop thinking of energy sources in silos, and to approach it more holistically as a true system.