What to do when energy prices are low?

When I worked repairing solar hot water heaters, I noticed our business got press coverage whenever the price of oil or gasoline went up. The idea seems to be that it makes sense to invest in saving energy when you feel the pinch of high-energy costs. Today i will convince you that the contrary is true; the time to invest in saving energy is when the cost of energy is low.

Energy saving things, like solar panels, insulation, efficient light bulbs and refrigerators, and even light rail systems all have relatively large up front costs with potential savings that accrue over time. Economists spew out formulas for determining whether or not businesses (and households) should make these investments. The formulas take into account all sorts of prices, like the future price of energy, the interest rate (the future price of money), the lost opportunity of not investing in something else, and avoided taxes. The base principle of all these formulas is the goal of making an investment that is profitable; making money. For the purposes of example, suppose you buy a solar hot water heater that costs $4000 dollars, and saves $40 per month in energy bills. Its “payback” period is then 100 months, or about 8 years. So if the heater lasts 20 years, then it is a good investment.

As an aside, the first question a household (as opposed to a business) might ask about these analyses is “Why does this have to be a good investment?” We buy lots of things for our homes that are “bad investments”, like lawn products, lampshades, TVs, swing sets, and cat food. In other words, what if your solar hot water heater brings you pleasure? Let’s accept for a moment that we take no pleasure whatsoever in reducing pollution and our dependency on oil imports, and only look at the cold dollars involved.

Suppose a person argues “Well, if the payback period is 8 years, I will wait for the price of energy to go up, and then the payback period will be less years, and I will be making a better investment.” They wait, the price of energy goes up, and they read another article in the paper about solar hot water heaters. Now the cost of the solar water heater is $6000 and it will save them $60 per month in energy bills: the payback period is still 8 years! And why did the cost of the hot water heater go up so much? Because when energy prices increase, so does the price of the raw materials to make solar panels, and the cost to ship them, and the rates of the contractors who install them (who pay more to fuel their trucks). In the parlance of economists, the price of energy and the price of solar hot water heaters are “positively correlated.” This is true of many energy saving investments; their high initial cost gets higher as energy prices get higher.

So what do businesses do when faced with positively correlated risks? They hedge! Again, without getting complicated, a hedge is a money losing investment that protects you from the risk of other moneymaking investments. My simple goal is to convince everyone that energy saving investments should be thought of as hedge investments protecting against the future uncertainty of energy prices. I use the word “investment” but leave open the possibility that for you saving energy might be a fun hobby, or an ethical imperative, and therefore doesn’t have to be profitable. Nevertheless, for society, for businesses, and for governments, energy saving is a hedge. This means it will likely be a bad investment, but if our other endeavors don’t go the way we hoped, it will save us from greater financial pain.

What are the consequences of thinking of energy saving as a hedge? The first and biggest consequence is that saving energy doesn’t have to be profitable, just part of a bigger strategy that we hope is profitable. Another consequence is that we should make regular small investments in saving energy, rather than putting all our chips down on it. What is small? Ask an investor. Maybe 10% of a portfolio is a hedge. It depends on how risky the rest of the portfolio is. How risky is a belief in perpetually cheap fossil fuels?

So when should we take a big step like a solar hot water heater (or a light rail system)? When we have a little extra money in hand, such as when energy prices are low!

At this point a reader familiar with investing might ask, “If the idea is to hedge against future energy prices, why not just buy energy futures contracts?” For an airline or parcel delivery service, it makes sense to use the futures market as a hedge. However, for a small business or household the transaction costs prohibit this. Also, if everyone seeks futures, then the price of futures goes up. If everyone buys solar hot water heaters, then the price of energy actually goes down as less is needed, which helps others to save on their energy bills and spend the extra money (hopefully) on more solar hot water heaters (which also get cheaper with mass production). In other words, investments in real energy saving things rather than financial instruments actually create value for society (a novel concept! But not so hard to understand — if the bridge you use to get across the alligator pond is rickety you want to fix it, not insure yourself against its collapse).

Some day I hope businesses, municipalities, and households make energy saving investments because it is ethical to not pollute, and because it is fun to save energy. But in the meantime we have a cultural (and possibly pathological) desire to seek economic rationalizations for what to do. Well, here is one then.