Energy Affordability — Subsidies Deep Dive

Saviour Of The Energy Sector Or Hyped-Up Pocket Money?

Contents

1. Introduction
2. Financing and Interest Rates
3. Strategies To Clean Up Our World
4. Subsidy Dependence
5. Types of Subsidies
6. Concluding Remarks

Bitesize Edition

• We’re currently experiencing a period of higher interest rates when compared to the previous years of ultra-low rates. This has come on the back of inflation returning. As we pursue a cleaner energy sector, how will interest rates and inflation play into this? Will the inflationary pressures remain?
• If we do remain in a period with higher interest rates and inflationary pressures, what strategies can we adopt in our pursuit of a cleaner world?
• Finally, if subsidies are how governments are seeking to expand their energy sectors, when can subsidies become a bad thing? If projects and companies become dependent on subsidies, is the government keeping afloat companies that are potentially unproductive, inefficient, and unprofitable? To me, this isn’t a company that we want subsidies to be propping up. Let’s dive in.

Introduction

Last week, I set a basic introduction to tariffs and subsidies. This week, I’m going to dive more into specific concepts. How do higher interest rates affect the financing of energy projects? Can projects become too dependent on subsidies, and what subsidies can be utilized in different scenarios?

Financing and Interest Rates

The world is entering into a period of potential fracturing. We have the Russia-Ukraine War in Europe, the Israel-Hamas conflict and the Israel-Lebanon clashes in the Middle East. We also have Civil war in Sudan, Syria, and Myanmar. Venezuela is in political turmoil and raising tensions with Guyana, Mexico has a gang crisis, and Haiti has descended into chaos. The list goes on.The conflict is occurring due to shifts in power. Power vacuums are forming and moves are made to take advantage of this. The shape of the geopolitical world is changing, and Middle Powers are rising and gaining influence; Powers such as Turkey, Indonesia, Vietnam, Poland, and India. All this is happening in conjunction with the United States-China superpower conflict which is unfolding through different “hard to see” methods, but not through a hot war. One such way this is unfolding is through the tariff war, which I’ll discuss later on.I bring up the general geopolitical landscape because the breakdown of some geopolitical relations, the emergence of power vacuums, and the rise of middle powers have the potential to spark further geopolitical tension. Trade and resource wars are already a method that has been seen in this new geopolitical world. Be it Indonesia restricting nickel exports, or China limiting the export of Gallium and Germanium, supply chains have been weaponised, and they will be again.In a period where countries are trying to clean up their energy sectors, they often need access to scarce resources. If a country with a large market share of a scarce commodity chooses to hoard its supply, this can incite inflationary pressures. If this resource is one that is vital for the energy transition in developed countries, their options are limited. They pay higher prices elsewhere, establish their own domestic supply chain, or explore other technologies. None of these strategies come without disruption.There are inflationary undertones to our clean energy transitions. There is the potential for fiscal inflation with high spending to fund these projects. There is also supply chain inflation as we saw with energy in 2022 after the decoupling of Russia and Europe.

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One such strategy central banks have taken recently to attack inflation is to raise interest rates. Higher interest rates ensure that borrowing costs more since you have to pay greater interest payments on any debt you take out. Hence borrowing occurs less, and spending falls. The aim of reducing spending is to reduce demand for goods and services. As a result, supply remains fairly constant, while demand falls. The aim from here is that inflation, which is the percentage rate at which prices are increasing, falls with reduced spending and reduced demand. Note, this doesn’t mean prices in the grocery store start to fall. Deflation is needed for this, which is negative inflation. The rate at which prices are rising is what declines.The aim here is to balance supply and demand so inflation reaches the levels of central bank targets, which are currently around 2%. When supply chains are weaponised, especially by those with possession of a high market share of key materials, reduced supply can lead to an imbalance that is reflected in rising prices. Again, this is inflationary.Where we find ourselves in a tough situation, is how we navigate an environment with higher inflation, higher interest rates, and slower economic growth, when we are trying to undergo clean energy transitions that will cost a large amount of capital.Private investment will also fall during this period of higher interest rates, so let’s assume the burden comes from government spending. In developing countries in recent years, high government debts have been in the spotlight. With more debt issuance in an environment of higher interest rates comes larger interest payments on debt. Over the long term, this isn’t sustainable.Have we got ourselves into an impossible-to-manage situation with inflationary pressures and high government debts? In developed countries, this is the reality of the situation. Countries with lower levels of government debt have manoeuvrability. They have options. If they can innovate and build infrastructure during this period, they will establish themselves as a rising geopolitical power.For the United States, possessing the dollar as the global reserve currency is a great advantage. This means if countries hold debt, or purchase anything on international markets, it is usually the dollar that facilitates this. Countries are diversifying away from dollar debt, but the dollar still reigns supreme and will for decades to come. It is the deepest bond market in the world and the most liquid currency by quite a distance. The fact that no other currency today can rival it is why the dollar will continue to reign supreme. A further issue arises when we consider a country without this privilege. Take a country like the UK and the situation grows more difficult. Take a country that can’t freely print its own currency, and the situation grows darker still.

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In a sentence or two, inflation pressures remain, and geopolitical competition will further exaggerate these inflationary pressures through the potential for supply chain disruptions. Couple this with the inflationary pressures of high government spending on infrastructure projects, while interest rates are higher to combat inflation, and we find ourselves stuck between a rock and a hard place.The choice in this situation is between the loss of purchasing power through high inflation, or economic slowdown through high interest rates. Neither is particularly great, but do we have options? Are there any strategies that can pull us out of this mess and incentivize cleaner energy, all while navigating tough economic environments? If we want to clean up our energy sectors, we have to incentivize countries to pursue cleaner energy sources. After all, if costs for some energy sources are high, underdeveloped countries will take energy that is readily available and cheap. That continues to be fossil fuels. How can we improve the affordability of cleaner energy sources so they can’t be denied as the cheapest and easiest to access?

Strategies To Clean Up Our World

• Tax Credits — Tax credits can reduce the tax paid by companies or individuals investing in specific energy projects. The Investment Tax Credit in the United States supports solar energy development, for example.
• Loan Guarantees — If a borrower defaults, the government covers the loan. This can encourage investment in riskier ventures. Is this the best use of our capital, or is this funding inefficient or unprofitable projects?
• Feed-In Tariffs — Guarantee a fixed price for energy produced from renewable sources, paid by utilities to energy producers. The clean energy projects then expect stable revenue.
• Encouraging Regulatory Environment — Streamlining regulatory progress can ensure projects get off the ground quickly and aren’t hindered by red tape when being constructed leading to faster operation. Regulation can’t be restricted too much, or risks rise, but too tight regulation stifles innovation and buildout.
• Green Bonds — Bonds used to raise capital for clean energy projects. These appeal to investors who care for the environment and want to play their part to help fund renewable projects.

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• Public-Private Partnership — Governments and private companies combine resources to develop and operate clean energy projects. Can help utilize private sector expertise, backed by government funding. Similar to blended finance.
• Sovereign Wealth Funds — State-owned investment funds that can be used for clean projects. Norway has utilized its sovereign wealth fund particularly well, funding it through the sale of fossil fuels to finance cleaner projects.
• Development Banks — Such as the World Bank, or Asian Development Bank, they provide low-interest loans or grants to help get renewable projects off the ground in developing countries.
• Securitization of Energy Assets — Funds that bundle together energy assets into purchasable financial projects. This immediate capital can fuel growth and be reinvested.
• Crowdfunding — Small funding for projects. Could be especially useful in underdeveloped countries.
• Carbon Pricing and Carbon Tax — This would put a price on emitting carbon. The aim would be to reduce emissions but a balance would need to be taken here. If pricing was too high, energy production would fall and hence quality of life would retreat or stagnate in many countries. Pricing that is too low would see no clear difference made. Cap-and-trade systems could also limit the total emissions allowed by organisations. The ability for these businesses to still operate, however, should be ensured. Carbon credits can be used here to allow companies to emit more carbon, up to a certain limit. This incentivises reduced carbon emissions while also allowing for flexibility in business operations if needed.

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• Climate Funds — Provides financial support to countries that need it most. Hence, these funds, such as the Green Climate Fund, often target renewable projects in developing countries.
• Multilateral Cooperation — Combining expertise, resources, skilled labour, and innovation among friendly nations can accelerate the transition to cleaner sources of energy while seeing multiple countries benefit in a variety of roles. For example, a nuclear reactor design from the United States could be constructed in another country, benefitting the designer of the US reactor. Or, as we’ve seen with the ICE pact, the US, Canada, and Finland are pursuing the construction of icebreakers to explore the Arctic.
• Aim For Economies of Scale — In the short term, project buildout can be more expensive and slower. However, over time, the skill of the labour force rises, projects become more efficient and costs fall. This is economies of scale, and it comes as a consequence of increased production and deployment of energy technology.
• Circular Economies — In a world where supply chains can be weaponised, considering how we can reuse, recycle, and repair our resources will be useful. It will also reduce waste. Consider nuclear breeder reactors, that produce more fissile material than is consumed. This could create circular economies in the nuclear industry and reduce nuclear waste.
• Hedging Interest Rate Risk — Instruments such as swaps or options can protect against interest rate changes that increase the cost of energy projects.
• Hedging Inflation Risk — Can be hedged by locking in long-term power purchase agreements, or using financial instruments that adjust with inflation.

You could view many of the strategies on the list above and interpret that I have likely forgotten my first section on inflationary pressures and high interest rates. I assure you, I haven’t. I mention many of these strategies because, in an ideal economic world, these are options we would be able to pursue. We aren’t in an ideal world, because we don’t spend efficiently. Productivity has been stagnant for decades, and we allowed it to remain this way. We got comfortable, and now we’re paying the price.Efficient energy projects give us more energy for the cost we incur. Inefficient projects become burdens, often seeing cost overruns and schedule overruns. If these projects are allowed to continue to be inefficient through subsidies, we see them become subsidy-dependent.

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Subsidy Dependence

When a sector becomes too reliant on subsidies to remain in operation or remain competitive, it can be due to subsidy dependence. This maintains inefficiencies for longer than the market usually would naturally allow, and markets remain distorted. In the energy sector, this can lead to inefficient use of resources and capital.Some forms of energy can be made artificially cheap through subsidies. This can slow innovation and competition, with other more competitive energy resources being delayed due to a lack of resources and capital that are subsidised heavily into unproductive, inefficient technologies.These subsidies can also be a fiscal burden for governments, especially those with high government debts, who should be using capital as efficiently and affordably as possible to gain the greatest benefit for the most people.This is where opportunity cost comes into play. Consider an electric car versus an internal combustion engine. When filling up a car with fuel, it takes two minutes. However, when charging an electric vehicle, I can be stuck in place for much longer than two minutes. It’s all well and good that people purchase electric vehicles as a lifestyle choice, but the utility needs to be improved if they are to compete with ICE vehicles, especially with less wealthy consumers.

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This highlights another key issue: We have to be careful of the conditions of subsidies. If a subsidy is offered, and a person is valid for one, they will take it. What if this person is a multi-millionaire? In the current environment, this doesn’t matter, because it’s offered and so the multi-millionaire will take it. Hence our subsidies need to be conditional on specific criteria.Subsidies could be based on income, and capped at a certain level to ensure subsidies are used by those who need them, and those who don’t need them aren’t straining the pot of available subsidies.In pursuing the correct allocation of subsidies, countries could perhaps create an organisation or a branch of government to do this efficiently. Otherwise, the risk of social inequality worsening could occur. One question we need to ask ourselves is, what is the cost of not investing these funds elsewhere? This should be communicated transparently from governments, and be open to discussion and criticism. After all, through thoughtful conversation, these programs can be adjusted and improved.Other potential strategies to avoid subsidy dependence could be time-limited subsidies so that the end of the program is clear. Importantly, all subsidies should be frequently reviewed to ensure their continued efficient use.After all, the aim of subsidies should be to eventually reduce reliance upon them, and then not need them at all. If this isn’t occurring, warning lights should be seen.

Types of Subsidies

• Direct Financial Subsidies
• Tax Incentives
• Price Controls and Tariffs
• Capital Subsidies
• Low-Interest Loans
• R&D Support
• Infrastructure Development Subsidies
• Consumption Subsidies
• Carbon Pricing Subsidies
• Strategic Reserves
• Storage Subsidies
• Electricity Price Guarantees
• Loan Guarantees
• Waste Disposal Subsidies
• Decommissioning Cost Reserves
• Limitation of Liabilities

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Concluding Remarks

With countries pursuing subsidies heavily to build out their own cleaner energy sectors, we risk a race to the bottom. This occurs when a subsidy war breaks out. Countries seek to provide increasing domestic subsidies to gain a competitive advantage in global markets. Consequences include overproduction, market distortions, and retaliatory tariffs. As discussed earlier, these increased subsidies can lead to inefficiencies being maintained for much longer. The aim should be for these sectors to eventually function without subsidies, not to rely more on them. The supply-demand imbalance felt by subsidies will be reflected in prices. We can debate if falling prices are a good thing or a bad thing. It’s certainly good for consumers, but not as pleasant for producers. The key issue here is the supply-demand imbalance, and the time and effort needed to correct the imbalance isn’t instant. With this comes volatility.China is pursuing a large buildout of energy infrastructure domestically, subsidised through local government funding. This was laid out in the Made In China 2025 Strategy. China also possesses a large market share in many key industries. Will this lead to overproduction in China?It certainly has led to tension between China and the United States, and the United States has been pursuing legislation such as the Inflation Reduction Act in response. Next week, I’ll discuss tariffs in more detail, and delve into the tariff war the US and China find themselves embroiled in.

Thanks for reading! I’d greatly appreciate it if you were to like or share this post with others! If you want more then subscribe on Substack for these posts directly to your email inbox. I research history, geopolitics, and financial markets to understand the world and the people around us. If any of my work helps you be more prepared and ease your mind, that’s great. If you like what you read please share with others.

Key Links

Sources:

• chatgpt.com