Monday, June 2, 2014

The sustainable energy transition: the need to reform the financial system

In part 1 of this series, Sgouris Sgouridis has outlined how much of the currently produced energy should be set aside according to the "Sower's strategy" in order to obtain a smooth transition from a fossil based economy to a renewable one. In this post, he discusses how this transition could be obtained in practice, taking into account the characteristics of the financial system and how it should be reformed in terms of an energy based currency system.

Guiding the Energy Transition (Part 2): Bringing the Financial System Back to (physical) Reality: a Case for an Energy Currency

By Sgouris Sgouridis (part 1)

Paying the costs of  the sustainable energy transition (SET) introduced in Part 1 (link) is necessary, but will not be sufficient to overcome the significant coordination problems involved - either on a regional or a global scale.  There are multiple factors at play. Cognitive psychology has repeatedly shown the severe discounting of the future that most (westernized) humans exhibit. As described by Mancur Olson, key regulatory processes are captured by lobby groups and elections are influenced by moneyed interests through media control. There is significant inertia in the habitual and systemic components of everyday behavior - even if we wanted to change our behavior, it requires a rebellious spirit to go against ingrained norms and without the right infrastructure some choices may be impossible (e.g. walkability and public transport in US suburbs). But these factors are in some ways a reflection of the fundamental economic reality - a root obstacle lies in the disconnect between financial and physical economics.

The current financialized economy is the result of a reinforcing process in which wealth seems to become increasingly abstract and with nominal values exceeding the productive capacity of the planet. To a large extent, this is another artifact of our ability to harness energy at will. Before the industrial revolution, societies tended to grow at a much slower pace and when they did enter periods of “irrational exuberance” and debt overextension jubilees, revolutions, migration, or wars managed the debt write-off. This past three-hundred years, though, have probably seen the only time in history where continued economic growth has allowed most of the debt issued to be repaid. It should be clear by now, that the ability to expand the economy at a rate sufficient to repay debt (collectively) is only made possible by the ability to expand the energy source to fuel the economic growth. As fossil fuels peak, we reenter the dynamics of an economy of flows and an alternative path to financialization will be needed.

In Part 1 I focused on the physical requirements for completing a SET (sustainable energy transition). In this second part, I revisit Principle V which I described in the first. The principle states that "Future consumption commitment (i.e. debt) is coupled to and limited by future energy availability".  The question is what could be the economic repercussions of the transition and whether it is possible to avoid an incapacitating economic collapse. More importantly, how it will be possible to obtain the continuity of investment necessary to complete a SET. Based on the fifth principle, we can see that in a post-peak economy the ability to extend debt (that in aggregate could reasonably be expected to be repaid)  would depend on the future energy availability and the rate at which energy use becomes more efficient. It is possible therefore to write this equation for our closed Earthship economy for post-peak as:

This equation ties the amount that new debt a society can be expected to issue to the critical renewable energy investment ratio (epsilon). If the debt to GWP ratio remains below this bound, it would reduce the chances of a financial crisis and of economic depression in the future, caused by unpayable debt. 

Combining the implications of the normative SET principles (see part 1) and their resulting equations, it becomes clear that in order to set in motion an adequate transition, we need to control both the financial system and rapidly increase the renewable energy investment ratio. An ideal option would harness the two in a positively reinforcing dynamic. Realizing that debt is, by far, the predominant mechanism for increasing the money supply, then exploring the idea of an energy currency system becomes a logical inference. There are many flavors an energy currency system could take and they are presented in detail in the recent Frontiers in Energy Policy article. I distinguish two basic types: a system of energy credits, and one where debt issuance (and hence monetary supply) is in part or in its entirety adjusted based on the energy/debt equation above.

The first type (and the one more likely to be implemented earlier) can be bottom-up. Local and regional complementary currencies based on energy can be fairly easily introduced to support local economies that have specific energy limits. As described also in Sgouridis and Kennedy 2009, energy credits are issued in advance (similar to prepaid phone credits) in a way that they represent the available (or targeted) energy supply for the issuance period. As citizens and companies consume energy services they withdraw from their allotment. In order to avoid either hoarding or imbalanced front-heavy consumption, the credits should be issued at fairly short intervals (daily/weekly) and expire thereafter. An asymmetric market for those credits can support both of these goals and adjust demand to the actual energy supply. This market operates by allowing users to sell their credits to the market if they find the spot price attractive and are willing to adjust their consumption. The spot price is generated algorithmically by comparing the actual cumulative energy curve to the anticipated cumulative curve and increasing (reducing) the price if the actual demand exceeds (is lower than) the anticipated one in an attempt to correct the divergence. A key part of the system is the existence of energy futures (which could act as yield bearing, maturing investments) when an investor decides to invest in a future renewable energy generation. Energy futures would eventually mature and provide as yield a certain amount of normal energy credits.

It is possible that if a number of such energy credit systems emerge, then the futures could act as a more secure substitute to fiat currencies presenting a bottom-up path to a full energy currency system.  

Alternatively, a top-down path for energy currency institutionalization is also possible if the political will to effectively control monetary supply materializes - perhaps as a result of an ongoing crisis. In theory, there are several ways to control debt issuance by governments, but none that is consistently effective (even in a controlled economy like China’s) as bank-issued debt tends to be either more (fueling bubbles) or less (strangling the productive economy) than desired. This problem was noticed in the Great Depression, and a proposal known as the Chicago Plan was put forward by a group of economists led by Irving Fisher. The idea that bank-issued debt should be centrally controlled and fully regulated if it does not utilize investment savings (i.e. deferred consumption) is regaining ground led by IMF economist Michael Kumhoff.

The question though of how much debt to extend remains unclear - what should be the desired level of debt that would allow an economy the right growth? My thesis is that in a post-peak fossil fuel society, it should be governed exactly by the energy/debt equation. If that becomes the case, financial capital suddenly has a clear case to invest in renewable energy generation, so that the amount of extendable credit available increases (the only way of exercising leverage of capital in the financial markets under the Chicago Plan). It should be fairly trivial to tie some preferential terms and prioritize the investors active in the physical energy markets for access to debt to make this a virtuous cycle. Of course, it might be possible that the energy market could overheat and exceed the desired levels of investment, but this is still controllable by the central bank authority that could preset maximum limits.

In summary, while the targets of a carbon budget and the perils of a fossil energy peak have been repeatedly discussed, a coherent, systematic look at the energy economy system allowed us to relate the rate at which we need to invest energy in building the renewable energy infrastructure with social, environmental and economic requirements and constraints. It is clear that the carbon constraints are more binding than the depletion rates, but in either case, a significant acceleration in the renewable energy infrastructure buildup is necessary if we are to avoid the energy trap. Our debt-based financial system still acts as an additional mask of the depletion of easily accessible fossil fuels and if we maintain it intact in the future, it will act as an obstacle in the efforts to reversing the decline in energy availability. A preview of how the trap may operate can be seen today in the countries of the European South. Once the decline in energy availability cannot be masked by debt, infrastructure investment will freeze and the focus shifts to addressing more pressing needs of day to day survival. An energy currency system provides an option worthy of further investigation to negate this vicious cycle and couple the financial system to the realities of an economy based on renewable energy flows. Of course, there may be other limiting factors outside the energy sphere (e.g. pollution) but these would still need energy to be addressed.

(*) Sgouris Sgouridis is Associate Professor at the Masdar Institute of Science and Technology (UAE). His research interests focus on understanding sustainable energy transitions using socio-technical systems modeling. He has been working on the energy currency concept, electric vehicle adoption, sustainable aviation, and local and global sustainable energy transitions. He initiated the development of the  Sustainable Bioenergy Research Consortium at MI and was a member of the Zayed Future Energy Prize review committee for the past four years. He holds a PhD in Engineering Systems (MIT-2007), MSc in Technology and Policy  and MSc in Transportation (MIT-2005) and a BS (Hons.) in Civil & Env. Engineering (1999-Aristotle University).


Ugo Bardi is a member of the Club of Rome, faculty member of the University of Florence, and the author of "Extracted" (Chelsea Green 2014), "The Seneca Effect" (Springer 2017), and Before the Collapse (Springer 2019)