Green Energy Paradox: Hotelling’s Exhaustible Resource and Consequences of Improving the Alternatives

Michael Giberson

The “green power paradox” grabs Hotelling by the ankles, turns him upside down, and shakes the change out of his pockets.

Harold Hotelling’s classic article, “The Economics of Exhaustible Resources,” observes that the owner of an exhaustible resource stock always is making choices in the shadow of the future. If the owner produces and sells a bit today, that necessarily involves sacrificing the opportunity to produce and sell that bit in the future. Given that the resource is exhaustible, we expect the price to increase as the stock of resources nears exhaustion. The resource owner’s choice, then, is whether to sell at a low price today or a higher price tomorrow.

Hotelling’s mathematics says the resource price will tend to increase at the rate of interest, at least under certain conditions (The intuition: if the rate of price increase is below the rate of interest then it will pay to produce more quickly now; if the  price increases are any faster then it will pay to produce more slowly. The adjustments will tend to keep the rate of resource price increases in line with interest rates.)

The green paradox emerges when, in a world of exhaustible energy resources, a new renewable energy supply is introduced. Suddenly, the heavy hand of the future is lifted a little. Therefore, even as the exhaustible energy resource dwindles, no longer can the owner expect ever rising prices. In fact, as the technology of the renewable energy resource improves, the price of all energy resources should drop.

In a world of constantly improving renewable energy technology, the owner of an exhaustible resource may be choosing between a low price today and an even lower price tomorrow. The implication: produce and sell now, before the price drops again!

Paradoxically, government promotion of alternative energy technology as a means to fight global warming may be encouraging the rapid exploitation of fossil fuels!

(This is my optimistic, Julian Simon-esque version of the Green Paradox, with resources becoming cheaper over time. A similar pessimistic version can obtain if owners of an exhaustible energy resource expect that regulatory controls on production will become increasingly onerous over time. Produce now while the controls are light instead of keeping your resource in the ground where future regulations may insist it stay.

And finally, if you are a combination resource optimist and a regulatory pessimist, then you ought to stop reading this post right now and go drill, baby, drill!)

SEE: Hans-Werner Sinn, The Green Paradox, MIT Press (2012). Related Sinn: “Greenhouse gases: Demand control policies, supply and the time path of carbon prices.

HT: Marginal Revolution.

9 thoughts on “Green Energy Paradox: Hotelling’s Exhaustible Resource and Consequences of Improving the Alternatives

  1. This is all very interesting, but a much simpler mechanism exists whereby renewable energy stimulates greater use of fossil fuels. Since renewables such as big wind and big solar are inherently intermittent, they require constant fossil fuel backup. This fossil fuel backup is of a necessarily less efficient type, given the uncertain nature of the demand for spin-up of power production.

    Wind does not blow at peak demand times, as a rule. Wind often blows most at low demand times, leading to the waste of the power produced. Since laws demand that wind producers be paid even for power not used, we see further inefficient uses of fossil fuels.

    Perhaps the most inefficient fossil fuel use of all, is the massive energy expenditures used in building the huge material infrastructure of renewable energy — and infrastructure prone to early breakdown, requiring frequent expensive maintenance and replacement.

    If you are sold on big wind and big solar, and nothing whatsoever could possibly change your mind, then the article above points out an “interesting” paradox. Not necessarily salient to the issues at hand, but “interesting” nonetheless.

  2. It seems there are two effects here. The first is the case that you discuss of Hotelling with a backstop technology, where the new technology shortens the producer time horizon.

    The second is in the same direction (and probably dominating the effect of the backstop) of the Bohn and Deacon result where political instability leads to more rapid rates of exploitation. “Instability” might be overstating the case, but we are observing a world where nuclear power is being decommissioned, and the Pigou Club types are suggesting heavy carbon taxes. Uncertainty could also lead to shorter planning horizons.

    On the other hand, “r” seems to be in the toilet these days, or at least it was last time I checked my 401K.

  3. Now that I think about that, the Bohn and Deacon result was counter-intuitive, because the long-run effects of secure tenure on capital formation dominated the short-run “holy ****, they are going to take my oil” effect. But, that’s still consistent with overall near-term production increases.

  4. The biggest problem with Hotelling’s analysis is when later is. If you are producing an oil reservoir, any oil you produce today doesn’t increase the amount of oil you can produce next year by much. It really just increases the amount of oil you can produce at the end of the reservoir’s life. Since that end of life is usually 20-30 years out, and at any reasonable discount rate the value of that oil today is essentially zero, then you will always produce whatever you can today.

  5. Alice: not always the case, but what you say is sometimes true. If the wind or solar power capacity is small relative to the power system it is connected to then it is likely no additional spare capacity will be needed (that is to say, the power system will already need to maintain a significant amount of spare capacity for reliability reasons, and it isn’t always the case that more is needed as wind or solar is added). In addition, I’m not aware of any law that requires wind power to be paid when it is not used. The typical Production Tax Credit for wind only pays when the wind power is generated and therefor used.

    David: I’ll have to go back to Bohn and Deacon and think about your point. I mean, the basics are simple but I think they have a little more to their story. Only I forget what more they had.

    Scott: You raise a good point, though in the oil and gas case a little more subtle. Even if we assume the quantity of the exhaustible resource is fixed, a second dimension is the maximum production rate from the resource (roughly speaking in the oil and gas case, a function of natural pressure in the reservoir and capital investment in wells and collection systems). Holding off on production this year probably means I can produce a little more next year (and a little more the year after, etc.) compared to the time path of production in which I do produce this year. In short, this year’s foregone production is returned a bit each year over the life of the well.

    But in practice I guess you are right. Typical economic evaluation of a reserve doesn’t assume Hotelling-style increasing prices in the distant years. Rather, industry practice usually assumes a fixed price (or Monte Carlo analysis with randomness around a constant mean). And SEC reserve reporting guidelines essentially require you to evaluate the reserves using a fixed price for the life of a project.

  6. I just realized that the “regulatory uncertainty” argument in the post is perhaps grounds for giving President Obama credit for increasing oil and gas production. The Obama administration swept into power with claims to wanting to raise the price of gasoline, impose greenhouse gas controls or taxes, and otherwise limit oil and gas development. Given that any such ambitious pursuits would take time, the fearful owner of oil and gas resources would want to rush to market anything that could be profitably rushed.

    I doubt there is much to this story, but it might be testable (did oil and gas production ease a bit after the Waxman-Markey bill failed?).

  7. Michael Giberson said “I just realized that the “regulatory uncertainty” argument in the post is perhaps grounds for giving President Obama credit for increasing oil and gas production.”

    If you’re right, doesn’t that suggest that the recent increase in U.S. oil production represents a bad thing, as it represents a distortion of incentives toward overproduction of fossil fuels in the near-term? In that case, perhaps “credit” isn’t the most appropriate thing to give to Obama. Instead, “blame” may be more fitting.

    Now, railing on Obama for effectively encouraging too much oil drilling may not the hottest political soundbite these days, but it might just well be true.

  8. Support for renewable energy is not the only policy that can (in theory) trigger a green paradox. Any environmental policy that induces owners of stocks of coal, oil or gas to increase near-term supply does so:
    – announcing now that you’ll restrict CO2 emissions in the future (gives an incentive to extract now);
    – rising CO2 price paths (if a resource owner knows that he will be ‘punished’ more in the future, it makes sense to sell more now);
    – perhaps unilateral policies (i.e. emission reductions by a group of countries that excludes big polluting ones like China or the US).
    They all have the (theoretical) potential of inducing a near-term increase in fossil fuel production, resulting in a lower price for fossil fuels, more fossil fuel consumption, and eventually higher emissions. [Check the issue of the International Review of Environmental and Resource Economics that will appear (hopefully) in March — — for an overview article.]

    But I think the green paradox is more interesting for theoretical economists — and politicians who don’t like climate change mitigation policies — than any others. Capacity constraints for resource owners (increasing coal production at the mine; increasing oil/gas production at the well; opening new mines/wells) as well as for resource users (power plants; car owners) will make it hard to increase supply and demand respectively.

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