Carol Storey, Manager (Sustainability & Climate Change), PwC and Resource and Environment Research and CPD committee member, explains why a new IFoA working party will be looking at the role of energy in the economy and invites you to get involved.
Nothing happens in our world without energy. Global economic growth has depended on harnessing ever increasing amounts of energy. Since overall investment returns depend on economic growth, changes in the patterns of energy use should be of great interest to actuaries.
Looking back over human history, large scale changes in the production and consumption of energy (‘energy transitions’) have led to big changes in society.
The transition from wood to coal as the dominant source of energy during the Industrial Revolution provides an obvious example. As does the dominance of oil in the 20th century, a shift in part due to the invention of the internal combustion engine and mass production of motor cars.
But there have been many other energy transitions throughout history – some local, others global – and all of them have shaped society in some way.
Today, we’re going through another energy transition as we shift away from fossil fuels to cleaner sources of energy such as wind and solar power to help combat climate change.
However, moving away from fossil fuels is challenging – energy transitions are typically slow and disorderly.
According to Richard Rhodes, a historian and Pulitzer-Prize winning author who has written a book on energy, new sources of energy like renewables have not displaced older ones like coal; they just satisfy “our ever-expanding appetite for energy”.
And even in the most ambitious energy mix projection from the International Energy Agency, one based on “achieving internationally agreed objectives on climate change, air quality and universal access to modern energy”, fossil fuels still make up a significant proportion of the energy mix in 2040.
To grow or not to grow, that is the question?
According to Vaclav Smil, an eminent thinker on the subject of energy, “to become rich requires a substantial increase in energy use”. Energy and economic growth are inextricably linked.
One fiercely debated area is how far we can actually ‘decouple’ economic growth from the negative effects of energy use such as carbon emissions.
For some, renewable energy is the answer. Michael Liebreich, an advisor and speaker on energy matters, believes we can “use unlimited knowledge and clean exergy from solar or nuclear power to drive endless improvements in human wellbeing and flourishing.”
Others see ‘decoupling’ as more challenging. Professor Tim Jackson, Director of the Centre for the Understanding of Sustainable Prosperity (CUSP), points out that capturing solar energy “has a cost, in terms of materials, in terms of energy, and in terms of economic resources”. Follow the CUSP debate.
The efficiency dilemma
Another conundrum, known as the ‘rebound effect’ is that (at least) some gains from energy efficiency are offset by extra energy use. Jevons Paradox is an extreme version of this where gains in energy efficiency actually lead to increases in energy consumption overall.
Energy efficiency tends to reduce energy costs. In response, consumers increase their consumption of energy.
So if, for example, the amount (and therefore cost) of fuel needed to drive to work has decreased due to your new car’s highly efficient combustion engine, you might decide to drive more often or choose to spend the money saved on something else - a morning coffee, new clothes, a flight to Greece – all of which require energy to make, transport or power.
It’s worth highlighting that the rebound effect isn’t easily observed and its size and relevance may vary depending on a number of factors e.g. sector, source of efficiency gain. But its implications for energy policy are interesting.
Failure of economic models
Perhaps all of this would be clearer if we better understood the role of energy in the economic models used today.
Yet one thing has puzzled Professor Steve Keen, one the few economists to have anticipated the 2007-2008 financial crisis: all of the most well-known schools of economic thought fail to acknowledge the role of energy in production. Since the 1970s, following the work of scientists such as Herman Daly and Nicholas Georgescu-Roegen, ecological economics has done so, but it is not yet widely known or taught.
In both Neoclassical and Post-Keynesian models, output (the quantity of goods or services produced in a specific time period) is a function of capital and labour. But this ignores the energy needed to feed the worker, to power the machine – in other words it ignores the very Laws of Thermodynamics.
As Keen puts it: “Labour without energy is a corpse, and capital without energy is a sculpture.”
Without an understanding of the role energy plays in production, how can we properly consider the economic viability of our current energy use and its impact on growth and productivity?
Keen argues that we need a production function in which “energy plays an essential and irreducible role” and he sets out his speculations on an “energy-aware” model of production. Read Keen’s blog.
You might also be interested in his recently published paper (with co-authors Robert Ayres and Russell Standish) “A Note on the Role of Energy in Production”. (You can read the free version of Keen’s paper.)
Keen’s function is a first step to integrating energy into economics. Some other economists question whether the neoclassical production function is the right starting point, or whether an entirely new way of thinking about the economic production is needed, which incorporates the dynamics of the economic system.
Given the potentially disruptive nature of energy transitions, it’s important for our work in the actuarial profession to develop a deeper understanding of how energy impacts economic activity.
If you’re interested in the issues raised above and keen to develop actuarial thinking in this area, we’re currently looking for volunteers to join our ‘Energy in the Economy’ Working Party. You can read more about this on our volunteer vacancy page.
 Exergy is a term used in thermodynamics that describes how much energy is available to be used.