Peak Oil & Deficiencies In Risk Assessment Methodologies
February 21, 2011
Serious and sustained disruptions caused by peak oil — up to and including total systemic shutdown — face the food, water, transportation, and other complex systems found in modern industrialized societies. Yet the methods now used to perform risk assessments are too short-term, and too focused on traditionally encountered threats, and too single-organization-centric, to include peak oil as a legitimate threat worthy of serious consideration. This article briefly covers how the approaches used for risk assessment, now found in modern businesses and modern government agencies, must change to properly understand both the seriousness and the pervasiveness of the peak oil threats now facing us. Only after we sufficiently understand the nature of these threats can we have any sort of a grounded conversation about the necessary steps to: (1) shift these complex systems to alternative energy sources, (2) alter existing systems to be less energy consuming, and (3) avoid and/or mitigate the many adverse impacts of peak oil that now loom on the horizon.
Short-Term Perspective: A few days ago, this author attended a lecture delivered by a seasoned senior manager at a Fortune 500 company. This executive described the company’s risk management system, including the process that the company uses to determine which risks are worthy of top management attention and budgetary recognition. This process was considered “best of breed,” and from the audience the presenter received many positive comments during the question and answer session. Nonetheless, the process described had one serious flaw that prevents it from even considering peak oil as a threat: the time horizon for the threat evaluation process was one year. For each prospective threat, managers evaluate the likelihood, or probability if you prefer that word, that the threat would take place within one year. Peak oil is widely considered to be a concern far into the future, perhaps a decade, perhaps several decades, out into the future. And so it was no surprise that peak oil was not even mentioned as a threat to be examined.
Granted, some of this problem has to do with deficient awareness campaigns mounted by government and other sources considered to be authoritative. The effects of peak oil no doubt will be felt much sooner than most members of the public anticipate. Nonetheless, even if the general public shifted the expected arrival date when adverse impacts of peak oil were felt, to be a date much closer to the present, this date would still in most cases be outside the time horizon used by this risk assessment methodology. The widely encountered short-term management decision-making time horizon thus blocks us from taking prudent action in response to peak oil. This is especially worrisome because it took many decades for us to build our current petroleum-dependent systems, and it will probably take many decades for us to retrofit these systems to be reliant on other forms of energy.
This author’s 30+ years of consulting in technology risk management, and his consulting experience with over 125 different organizations, all point to this short-term thinking problem being pervasive, not the unique oversight of this highly respected company. A Ph.D. dissertation by James R. Young, entitled “An Evaluation Of The Readiness Of UK Companies For Disruptions In Energy Supply,” comes to similar conclusions. Specifically Young indicates that there are serious deficiencies in current risk assessment methods used by business, and that these deficiencies blind top managers to the very serious risks posed by peak oil.
Fixed Threat Lists: Another serious problem with most of the risk assessment methods now being used in government and business has to do with scripted lists of acknowledged threat types. Rather than thinking “outside the box” (in creative ways), many of the people performing risk assessments today are simply following scripted procedures, so as to meet contractual, regulatory, or legal requirements. The approach they use is driven largely by compliance concerns and auditor findings, rather than by overall risk management. As a result, the people performing risk assessment are often focused on proper execution of the process, preventing management liability, and other issues tangential to the truly important focus on which they should be riveted: deeply understanding and appropriately preparing for the full spectrum of risks that now face their organization.
Peak oil has never happened before, so the people who are performing risk assessments will not find it on the list of threats that should be examined when performing risk assessments. Ironically, threats which pose much less of a financial risk, such as pandemics, are routinely evaluated by these risk assessment approaches. It is additionally ironic that threats that are much less likely, such as a serious incident of workplace violence, are also routinely included in these risk assessment processes (peak oil is a certainty, the only chronological uncertainty is when it will happen and when its impacts will be felt). Organizations must rewrite the list of threats to be evaluated so as to incorporate peak oil. Some organizations are now including climate change on their list of threats, but peak oil is still almost always missing. This is further ironic in that most organizations will feel the impacts of peak oil much sooner, and much more painfully, than they will feel the impacts of climate change.
Single-Organization-Centric: A third problem with existing risk assessment methods involves a single-minded focus on the impact on the organization in question. Traditional risk analysis methods look at a range of scenarios, such as a major fire in an office building, and the impact of such an event on the organization in question. But the serious risks posed by peak oil do not come from any one specific event like a fire. They arrive over a long period of time, and they come from the interaction of many parties, not just the internal activities of a single organization. Likewise, these impacts are cumulative and multi-directional in their influence. For example, the peak oil event that happened last month to a supplier very well may affect what happens this month to the reader’s organization. Most current risk assessment methods do not embrace this multi-organizational complexity.
Peak oil is thus a systemic threat, and it needs to be modeled accordingly. Aside from the US Department of Defense, and a very few other sophisticated organizations, most have not taken the time or set aside the resources to look at the way that many different organizations will respond to peak oil, and how those responses will make problems better or worse. Such modeling efforts are badly needed in order to increase our understanding of peak oil, how to prepare for peak oil, and how to mitigate the adverse impacts of peak oil.
Sudden Changes: The traditional management approach to serious threats that we don’t know how to address has been to wait until a crisis takes place, and then undertake some intervention. The United States Congress provides a good contemporary example of this management approach. For example, consider the financial system liquidity crisis that began in 2007, which by the way is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. This crisis was not proactively addressed by Congress, even though there were many warnings of serious problems. These ominous warning signs included rapidly rising default rates on sub-prime mortgages, a real estate price bubble, widespread predatory lending, and conflicts of interest on the part of those who rated mortgage-backed securities. In spite of these and other alarming and quite public red flags, Congress did nothing until a systemic failure was upon us.
In defense of the members of Congress, it is true that the world financial system has become incredibly complex, and many members of Congress probably did not fully appreciate the risks. Without markedly improved risk assessment approaches, we can expect that top management in business and government will act the same way when it comes to peak oil. And the public will probably let them get away with it because it will then be true that they did not truly appreciate the risks of peak oil.
Unfortunately, this evolutionary, crisis-management approach, where we try to pick-up-the-pieces after serious damage is already done, won’t work well for peak oil. As was the case with the recent financial crisis, we are now dealing with systemic risks found in many inter-dependent complex systems. The traditional ways of thinking about our complex Internet- and computer-enabled infrastructure will not work because this infrastructure has changed so much in the last few decades. If management tries to use traditional approaches that are incompatible with the new complex computerized and tightly knit systems, these efforts will be ineffective or will fail. Just as the US economic embargo of a country such as Cuba is increasingly ineffective in the modern interconnected world, so too will traditional tactical approaches be ill suited to deal with the problems of peak oil.
In addition, management in government and business is currently far removed from the daily activities of these system components. This distance means that that management does not understand how quickly or how easily a systemic collapse could take place. Likewise, this lack of understanding about the underlying processes means that management believes that we can go back to the way things were. But if we have significantly less resources with to build new systems, and if we have significantly less energy on which to run these new systems, we cannot simply go back to doing things the way they were done in the past.
Much Better Modeling: If business and government do not promptly invest in developing new and more sophisticated risk assessment models — that reveal the reality of our complex interconnected systems in the food, water, transportation and other areas, and how these will be affected by peak oil — we run an additional and largely unappreciated risk. Of course, without these improved risk assessment approaches we will suffer many adverse impacts of peak oil that could have been avoided or prevented if we had understood and proactively dealt with the risks. But we need to understand that, under pressure, and facing a widespread and painful crisis, management will be likely to make impulsive, ill-informed, and maladaptive decisions.
For example, in the midst of the oil embargo of 1973, the US government imposed price controls. Economists now generally agree that price controls further restrict the supply of a particular commodity like oil. And so the US government actually made the 1973 oil crisis worse thanks to price controls. Without much better risk assessment models, we can expect that similar decisions will be made in response to peak oil.
——-
Charles Cresson Wood is an independent technology risk management consultant with Post-Petroleum Transportation in Mendocino, California. He is the author of “Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action” (see www.kickingthegasoline.com).
Peak Oil Is A Serious Business Contingency Planning Issue
October 27, 2009
The Peak Oil Downside Will Be Steeper Than The Upside
September 25, 2009
By Charles Cresson Wood
From many different credible and highly placed sources we are today hearing about the dire energy situation that industrialized civilization faces. Industrialized countries have remained dependent on oil for way too long. As evidence of this consider that fully 50% of the energy consumed in the United States comes from petroleum. Even though the notion of peak oil is now frequently discussed in newspapers, magazines, TV shows, we the industrialized nations are not moving to new sources of energy fast enough to avoid serious and painful adjustment problems. Dr. Fatih Birol, chief economist with the International Energy Administration, accurately summed it up when he recently said: “We must leave oil before it leaves us.”
According to statistics from the United States Energy Information Administration, the worldwide production of conventional oil has been on a plateau for the last several years (about 73 million barrels per day). In spite of a dramatic run up in prices culminating with the price of $147 per barrel in July 2008, producers were unable to bring more oil to market. This fact defies a widely-held but erroneous belief advanced by traditional economists, that producers will bring more oil to market as the price goes up. That of course makes sense if there is an unlimited supply of oil, but as the worldwide production statistics indicate, we seem to have reached peak worldwide production, and it is only down from this point forward. It’s time that the economists started adjusting their theories to incorporate the real world of resource constraints.
Those readers who have some passing familiarity with the concept of peak oil have no doubt seen a picture of the traditional statistical distribution known as a “bell shaped curve.” These bell shaped curves make sense to people, because in a world with finite resources, what goes up, must come down. These symmetrical bell shaped curves are however lulling us into an attitude of complacency, leading us to believe that we have decades to move off of oil. This is just not so, and this article discusses five serious reasons why this erroneous perception needs to promptly be abandoned.
The bell shaped curve customarily applied to peak oil was popularized by the late geophysicist Dr. M. King Hubbert. He predicted the total United States production of oil would peak on or about 1970. His prediction was accurate, and this type of curve did relatively well when it came to describing the total production of oil in the United States. But total world production of oil does not have another source that it can draw upon when worldwide supplies dwindle, as the United States did back in 1970. Social and economic panic and upheaval were avoided when the United States hit its internal peak oil because it could easily purchase additional supplies from the world marketplace. The social and economic upheaval that worldwide peak oil will bring about will be marked by hoarding, stockpiling, speculators cornering the market, long-term contracts pushing spot market buyers out of the market, government corruption, widespread rationing, and a host of other problems. These maneuvers will rapidly remove oil from the marketplace, and the intensifying competition for the remaining supplies will cause the price to rapidly go up.
The second reason why the drop off in world oil supplies will be steeper that the increase was involves exports. A very large percentage of the remaining oil supplies, perhaps half, is controlled by countries in the Persian Gulf (Iran, Iraq, Kuwait, Saudi Arabia, and United Arab Emirates). These countries are rapidly industrializing and in the process, as you might expect, their consumption of oil is rapidly increasing. As their production is declining in the years ahead, an increasing proportion of their production will go to meet domestic needs. This means that a decreasing proportion of their already declining production will be offered for export. At some point, there will be no more exports, as these countries will use all available supplies for internal consumption purposes. Countries such as the United States, that are big importers of oil, stand to be quickly cut off from their oil supplies. Thus the available exports of oil will come to a much more rapid end than total world production of oil, which in turn will be much more rapidly decreasing than the symmetrical bell shaped curve would lead us to believe.
The third reason why world supplies of oil will drop off more rapidly than anticipated involves rapidly developing countries, most notably although certainly not limited to India and China. These countries are working hard to be able to support something like an American lifestyle, including high levels of energy consumption. World oil demand has recently been increasing at about 2% per year, but to fuel the recent economic development of these countries, there will be a markedly increasing worldwide demand for oil. For example, Time magazine reports that China’s oil imports have doubled over the last five years (about 12% compounded each year). Thus the world will soon be drawing down remaining oil supplies at a faster rate than we were drawing down supplies in the recent past. This accelerated demand for, and the accelerated consumption of oil means that the downside slope of the peak oil curve is going to be much steeper than we currently anticipate.
The forth reason why world supplies of oil will decline far more rapidly than we anticipate involves modern technology. We are now able to drill for oil in the Artic, more than 10,000 feet below the sea, and in other inhospitable places that we could not economically drill in some fifty years ago. This fact reflects advancements in modern technology, such as computers to model geological deposits of oil. The fact that we have to go to these inhospitable places to get more oil is another indicator that we’re running out of it. But this impressive new technology allows us to accelerate our extraction of oil, in an effort to meet the accelerating demand mentioned in the last paragraph. Imagine the bell shaped curve except it is going to be pushed out on the upper right side. In other words, we will be producing slightly below peak levels for a brief while, on a plateau of sorts, and this will be a plateau created by this modern technology. Using elementary calculus, which assumes that the area under the curve remains the same, in other words assuming we have only so much oil available in the world, we can readily determine that when this area is pushed out, another area must be pushed in to compensate. Since everything to the left of this current peak moment is history, and therefore cannot be changed, the only thing that can be changed is the height of the curve (production) in the future. Said a different way, by sustaining our high-energy consumption lifestyle, we are prematurely consuming the oil that would otherwise be left for future generations. In other words, the bell shaped curve will in reality look more like a wave moving to the right (through time), and the wave is just about to come crashing down.
The fifth reason why world oil supplies will decline considerably faster than we now generally believe involves the fact that we produced the least expensive oil first. It is simply common sense, that oil producers would initially focus on the removal from the ground of the oil that was easiest to get to, that was the least expensive to refine, that was the easiest to handle, and that was the least expensive to pump. Reflecting this reality, we now see producers mining the “tar sands” of Canada in an effort to cook the oil out of these sands. Not only is this effort tremendously environmentally destructive, but it consumes a great deal of energy in order to produce oil. Thus the cost of producing each barrel of oil is going up. At the same time, the quality of each barrel thereby produced continues to go down. Combining these two trends, we see that the world will reach a point where it is no longer economical to produce any oil. Mind you, this occurs considerably before the point where the world runs out of oil, and so the curve of world oil production does NOT reflect the relationship that individuals have with the gas tank in their cars. We can’t just keep going until we run out. A lot of oil will be left in the ground because it simply won’t make sense to produce it. Certain locations will meet this point sooner than others, but as more and more of locations do reach this point, they will remove themselves from the roster of the remaining oil producers. This in turn will hasten the descent of available oil supplies.
As these five points argue, the day of reckoning is a lot sooner than many of us would like it to be. We do not have decades to transition to alternative energy. It appears as though we have only a few years. We need to get underway with very serious efforts to transition away from petroleum immediately. Government agencies, businesses, non-profit organizations, families, and individuals should all be thinking hard about what their transition to a post-petroleum world looks like, and then promptly get into action with this transition.
—–
Charles Cresson Wood, MBA, MSE, CISA, CISSP, CISM, is a technology risk management consultant with Post-Petroleum Transportation, based in Mendocino, California. His most recent book is entitled Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action (www.kickingthegasoline.com).
This article appeared in the SecureWorld Expo Newsletter, Fall 2009, Vol. 1, available at www.secureworldexpo.com/articles. It was also referenced in the Energy Bulletin Newswire on 25 September 2009, which is available at www.energybulletin.net/node/50221.
More Leaders, Fewer Statesmen Needed
September 4, 2009
By Charles Cresson Wood
During his first term in office, Ronald Reagan was asked in an interview whether he was going to run for the Presidency again. He said that if he did what needed to be done, there would be no need for a second term. He ran for and won the race for a second term, so by implication he did not achieve what needed to be done. But whatever you think about the sincerity of Regan’s remarks, he expressed an important distinction that seems lost on many politicians, government agency managers, and corporation managers. The distinction is between a leader and a statesman (or stateswoman).
A leader does what needs to be done, and is willing to receive criticism and attack in order to achieve those objectives. A statesman, at least as it is defined here, is not interested in what needs to be done, a statesman is interested only in what people think of him, in negotiating, and in striking deals and compromises. A statesman is rudderless, and buffeted by the changing tides of opinion. This distinction is beautifully depicted in the movie In The Loop (released in 2008). In this movie, the protagonist is driven crazy because everyone around him is a statesman, while he aspires to be a leader. I recommend it for those who have not yet seen it.
As the movie implies, what needs to be done does not get done when statesmen are in charge. That is exactly the situation in the peak oil and climate change areas today. We’re facing one of the most painful and pervasive changes in the technology of modern civilization, and nothing significant is being done. For example recent evidence suggests that nearly every one of the nations that ratified the Kyoto Treaty will fail to meet its targets (and that says nothing of nations like the United States that failed to even ratify the climate change treaty).
There is no more doubt about the legitimacy and reality of both peak oil and climate change — there is plenty of independently verified scientific evidence. What is missing is leadership. The dire and pressing nature of our situation is revealed by the fact that even the most conservative and pro-oil-industry spokespeople are now publicly admitting that something must be done, and be done very quickly.
To take one of many possible examples, consider the recent statements of Fatih Birol, chief economist at the International Energy Agency (IEA). He said that peak oil, and the high oil prices that go along with it, threaten the recovery. He also recently said that, “we have to leave oil before oil leaves us.” In other words, the industrialized world had better wake up now, and had better move away from petroleum with great focus and determination.
Those readers who know about the energy industry, know that IEA has long been a bastion of staid and conservative official positions. In fact it was Dr. Birol, a few years ago, who was indicating that there was a significant amount of time for the world to adjust to peak oil. Why did he change his mind? Because he discovered that rate of production decline in existing worldwide oil fields is now 6.7% — considerably higher than the IEA estimate made in 2007, which predicted this figure would instead be 3.7%. Dr. Birol was willing to tell the truth about what was happening, and take the heat if people were upset about hearing it.
So we come back to the reader’s situation at his or her place of employment. I hear from a number of people that they are afraid to talk about peak oil and climate change with their managers; they are afraid that they will lose their jobs if they rock the boat. I suggest that this fear is exaggerated and ungrounded. If you want to create value for your employer, tell the truth, and take the risk of meeting with a rejection or an unreceptive response. If you urge your manager to seriously investigate this problem, it is not a cause for termination. To the contrary, it shows that you take initiative, it shows that you speak up, it shows that you’re paying attention, and it shows that you care.
So called “yes men” (and by implication “yes women”) are a dime a dozen, because they are essentially servants who simply follow orders. If you want to make yourself more easily replaceable, and therefore more likely to be laid off, don’t show leadership, keep your head down, don’t make waves, and don’t speak up about these important issues. I invite you to seriously consider the implications of broaching these topics with your organization’s management – would it really be so terrible if you were to talk about these things? And if prominent people such as Chevron Chairman & CEO David O’Reilly are now publicly admitting that peak oil is real, doesn’t that give you at least a little bit of additional confidence to press these important issues with your own management?
——-
Charles Cresson Wood, MBA, MSE, is a sustainability management consultant based in Mendocino, California. He assists organizations with the risk assessment, strategic planning, and contingency planning associated with peak oil and climate change. His most recent book is entitled Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action (see www.kickingthegasoline.com).
This Crisis Signals It’s Time To Tell The Truth
March 3, 2009
By Charles Cresson Wood
Based on the many horrific stories appearing in the financial news these days, it appears as though the banking sector is permanently broken. The trend is clearly down-down-down. The Obama White House keeps optimistically talking about a recovery, and how the stimulus package is going to get things back on track. But the medicine that is being proposed is just more of what got us into trouble: extravagant spending, excessive debt financing, and short-term band-aid solutions. The trend will indeed continue to be down-down-down until we can collectively muster the courage to tell the truth: the banking system that we have created is seriously broken, it doesn’t reflect ecological reality, and this system must be changed soon, that is if we are ever going to be able to create a new sustainable society.
It’s time that we acknowledged that the myth of never-ending resource consumption (particularly the consumption of fossil fuels) is in fact a fiction. It has been possible to temporarily support this myth because we have been enjoying the benefits of plentiful fossil fuels, notably petroleum. These fossil fuels provided much more energy than the energy invested to get them, and that bonus meant that we could, for a brief period in history, support an extravagant high-energy-consumption lifestyle. The extensive mining and production of these fossil fuels also allowed us to, for a few generations, maintain the fantasy that this “American” always-better and always-more way to live life would go on forever.
In terms of the banking system, this myth allowed banks, mortgage companies, and other financial firms to pay high interest on money, year after year, allowing investors to make very large amounts of interest over time via compounding. The related mathematics currently taught in business schools have been similar to a continuous motion machine, where we all get richer over time — but we know this is not possible. There must come a day or reckoning, a day when we come to terms with limits. It is no mistake that the Bernard Madoff scandal, and many other large Ponzi schemes, are coming to light these days — they can in fact no longer be sustained. The famous book entitled The Limits To Growth in 1970 talked about a day of reckoning, but its conclusions were, at the time it was published, politically unpopular, and, from an advertiser’s standpoint, certainly they did not help to sell more products and services.
Intellectually it seems obvious, but our actions still do not support the fact that we humans must now confront the fact that the earth is a limited place. There are only so many resources such as petroleum to go around. We must get our overpopulation problem under control, and we must stop destroying the earth (climate change is just one of many pressing examples). We must rapidly create a new society that has an energy infrastructure that is sustainable. We now have much of the necessary technology for this new infrastructure, for instance we know about creating sustainable transportation systems with alternative fuels such as renewable natural gas (bio-methane).
The fact that the financial sector is one of the most seriously hard-hit sectors of the economy makes a great deal of sense if one sees these events through the eyes of what is happening ecologically. The financial sector is perhaps the most dependent on the myth of never ending progress, of unlimited natural resources, and continuing advancements in consumer spending over time. In fact, the financial sector is one of the first casualties of peak oil (and the soon-to-be-experienced peak natural resources). No, the financial sector doesn’t use much oil itself — it is profoundly affected by a change in worldview that must go along with the fact that world oil production has now peaked. It is the limits of natural resources such as oil that will break the back of the economic Ponzi scheme, the fictitious perpetual motion machine, that we Americans have been riding.
Before we can get underway with the construction of the new alternative energy infrastructure that we desperately need, we must openly and collectively tell the truth about what’s happening. Notice that the problems that bedevil the financial sector continue to be characterized in the media as a “credit crisis” or a “sub-prime mortgage crisis.” These are just symptoms. We need to acknowledge that the cause is the fact that we have not been living within the realistic limits of the earth. As the writer William Catton put it, we have overshot the capacity of the earth to support us. The sooner we acknowledge this truth, and start to live within the earth’s limits, the sooner we will create a real possibility of a sustainable future.
I hope this time of telling the truth will come soon, and that we will stop believing that we can just once again patch up the junk-heap of a vehicle we call the economy, and hope we can get still more miles out of it. We need to stop proposing band-aid solutions like the current stimulus package, and we need to deal with the underlying infection which is a philosophical disease called refusing to live within one’s limits. It is a disease, an addiction in fact, and we must clearly understand where it will take us, and publicly tell the truth about it, or it will in fact take us all down with it.
—–
Charles Cresson Wood, MBA, MSE, is an alternative fuels management consultant with Post-Petroleum Transportation, based in Mendocino, California. He is the author of the new book Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action. For more information, including his blog, go to www.kickingthegasoline.com.
Using The Right Numbers To Estimate Renewable System Payback
October 8, 2008
By Charles Cresson Wood and Bruce Erickson
When they receive a written proposal for a renewable energy system, many managers balk, saying it’s too expensive. This article explores why many of these managers may be using outdated and irrelevant numbers to come to such a conclusion. The article proposes some alternative numbers that make the shift to renewable energy technologies look a whole lot more attractive.
Many people go about making a decision for or against an alternative energy system with a payback calculation. If a solar system, for example, reduces a monthly electric utility bill, then that reduced expense will be extrapolated over the useful life of the system, in order to come up with the number of years it takes before the system pays for itself.
For example, let’s assume the owner of small business based in California is now paying a flat commercial rate of $0.1147 per Kwh for electricity, and that the owner pays a total of approximately $450/month for electricity for his business’ headquarters building (consuming 3930 Kwh per month). Let’s also assume that this business owner is considering investing in a solar system that would cost $60,000 to install (after the Federal renewable energy tax credit and California renewable energy rebate). The annual operating expense for this solar system would be for distilled water only (for the batteries), and to simplify our calculations, we will say that the water is essentially free.
The building owner wants to use solar technology to reduce his usage of grid electricity by about 50%. In the event of a grid failure, the owner has determined that he could run the business with only the essential machines and office appliances, and this would work out to about half of the current monthly usage. Thus the hypothetical solar system could be a 16 Kw system, which could produce roughly 1920 Kwh of electricity per month on average over a yearly cycle. We also assume that the owner has already installed the most efficient lighting, and made other conservation related changes in the electrical system.
Assuming a flat rate schedule applicable to commercial customers, and assuming the cost of electricity remains the same over the years ahead, the solar system is estimated to pay for itself in approximately 23 years. If that’s as far as the analysis goes, the customer would probably not purchase the solar system. But when we go deeper with this analysis, the payback gets markedly better.
Note that if this were a residential customer, a tiered rate schedule would probably be employed, making the calculations more difficult, but also significantly improving the payback because the grid energy consumed would be purchased at a lower rate per Kwh. In a similar way, this example does not take into consideration the possibility of a time-of-day meter, which involves different buy/sell rates at which the solar system is buying/selling energy from a local utility’s grid. Depending on the usage patterns, time-of-day meters can make a solar system still more attractive from a payback perspective. This is because a solar system is generating during peak electricity usage hours, when electricity is most needed on the grid, when a local utility pays the best rates to electricity generators. Likewise, with a time-of-day meter, electricity can be bought by a small business customer at night, to charge up batteries, when rates are lower. In a similar way, for simplicity’s sake, this example does not incorporate the reduction of electricity demand rates that a commercial user pays. Demand rates are based on the maximum base load energy demand, and a solar system will bring that maximum demand down considerably, especially if a battery bank is a part of the system. Reduced demand rates would therefore markedly improve the proposed system’s payback.
The complicating factors in the prior paragraph aside, let’s consider some alternative numbers to get a better idea of the true economics of the proposed solar system. We will challenge a number of the assumptions contained in the analysis above. Let’s start with the most unrealistic of these, the assumption that the cost of electricity will continue to be $0.1147 per Kwh in California some 23 years in the future. Examining the statistics from the US Energy Information Administration, we see that the national average commercial cost of electric power has gone from $0.0764 per Kwh in 1996 to $0.0957 cents per Kwh in 2008, an increase of slightly more than 25% over the last 12 years.
If we were to assume that this same increase in the price of electricity (1.023% per year) were to be experienced again over the next 23 year period, the payback for the proposed solar system would be improved. This means that the expected annual foregone electricity payment some 23 years in the future would be $4,358, much better than the $2,643 ($450/month) mentioned above. For the sake of easy calculations, assuming a steady year over year increase compounding at 1.023% per year, the solar project would now have a payback of about 18 years.
But this assumption about the cost of electricity is probably still way too optimistic. In 2008, Pacific Gas & Electric, one of the larger local California utilities, asked the California Public Utilities Commission for a 4.5% rate increase. PG&E cited the increasing cost of natural gas, which is the primary source of energy used to generate electricity in California, as well as declining supplies of hydroelectric power provided by the states of Oregon and Washington. The utility pointed out that natural gas prices have increased 30% in 2008 alone, and that it must now pass some of those increased costs along to its customers.
So if a 4.5% annual compounded increase in the price of electricity were used in these solar system calculations, the payback period for this installation moves down to 16 years. Things get really interesting if the rate of increase in the price of electricity follows what has been happening to the price of natural gas. If a 30% annual increase in the price of electricity were used in these calculations, then the payback becomes about 8 years. This should not be surprising to those of us who remember that Pacific Gas & Electric rates went up 46% in 2001. Perhaps those of us with some gray hair remember that in 1974, right after the oil embargo, PG&E increased its rates almost monthly.
Note that this analysis does not explicitly incorporate the rate of inflation. Although the August 2008 numbers indicate that inflation has been around 5% per year, let’s use the average rate over the last 10 years, which has been more like 3% (using the Consumer Price Index, which notably does not incorporate the price of energy or food). Whatever numbers for inflation you use, when buying a renewable energy system, it’s like getting a fixed rate mortgage because you lock in your future costs. Adding a 3% inflation rate to the 30% annual increase in electric rates brings the payoff down to 7 years.
Perhaps still more realistic is the assumption that the cost of electricity will, in the near term, in rough terms follow the cost of petroleum, which is the most widely used fuel in the world, and which has recently been driving up the prices for all other fuels. According to statistics from The Wall Street Journal, as of May 2008, the cost of oil, on a per barrel basis, went up 95% over the prior year. With a 95% compounded increase in the cost of electricity, and a 3% compounded annual inflation rate, the solar project now has a payback of just under 5 years.
Even the 95% compounded annual increase in the cost of electricity may be conservative, if one believes that peak oil will have a serious and adverse impact on electricity rates. Evidence of the “peak oil theory” can now be found all around us, if we care to look at it. According to the US government’s Energy Information Administration, worldwide statistics for oil production show that total production has been effectively flat at about 74 million barrels per day since 2005. This is surprising given that world demand has, in the recent past, been increasing at about 2% per year. This is doubly surprising given OPEC’s stated objective is to keep oil prices relatively low in order to have production be profitable to its member states, but at the same time not put a damper on the economic growth of consuming states. Meanwhile, the Saudis have not been able to substantially increase their crude oil production, in spite of the fact that the world has been looking to them to ramp up production in order to keep the price of oil relatively low. For more on the inability of the Saudis to step in and provide much more oil, see the book entitled Twilight In The Desert by Matthew Simmons.
The continued disparity between supply and demand in the oil market may cause the price for oil to shoot up even more than 95% per year in the next few years. This is because the demand for oil is what the economists call inelastic (consumption doesn’t go down much when the price increases). Until the infrastructure changes associated with using other sources of energy can be completed, many users of petroleum will be forced to pay escalating prices. For example, changing the energy-generating infrastructure in a natural gas electricity generating plant is a giant job, certainly something that takes a considerable amount of time. Reflecting this, in some cases, utilities abandon or mothball uneconomical generating plants, and then build entirely new ones.
Wars over oil (such as the Iraqi war), political problems (such as the 1973 oil embargo), terrorist attacks (such as 9/11), disruptions in the very complex and long distribution chain for oil, and many other unstable risk factors mean that the demand for oil is going to be increasingly unreliable in the years ahead. Perhaps the unavailability of power is the greatest reason to move ahead with an on-site renewable energy proposal, such as the one mentioned above. This way of looking at the decision makes the renewable system look more like an insurance policy rather than a cost reduction proposal, although no doubt both benefits can be obtained. If one were to go out and buy insurance against electrical grid failures, if such a type of insurance were to be available, what would a small business owner pay? Probably a great deal of money, maybe $10,000/year. Maintaining the 95% annual increase in the cost of electricity, plus 3% annual inflation, and adding in the cost of this annual insurance premium forgone, the payback for the solar project mentioned above is now just over 3 years.
So the numbers reflecting the cost of energy that many people are using for their calculations are seriously out of date. Entirely different decisions can be reached if people instead use numbers reflecting the current costs of energy. This rudimentary example illustrated that point, but did not incorporate two additional factors that may be important. The first factor is accelerated depreciation that is often available on systems such as these, and that can markedly bring the purchaser’s taxes down. The second factor is the increasing price of commodities such as steel and lead, commodities that are used in the production of renewable energy systems. As energy costs go up, so too will the costs to mine, smelt, fabricate, and transport these commodities. This means that certain types of renewable energy systems, such as the solar system mentioned above, will be considerably more expensive to purchase in the future than they are today. The demand for renewable energy systems will probably also escalate in the years ahead, and this increased demand may additionally drive up solar system prices. All these factors underscore how it is wise to invest now in a renewable energy system, rather than wait to see what the future will bring.
——-
Charles Cresson Wood is an alternative energy consultant with Post-Petroleum Transportation, in Sausalito, California. His most recent book is Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action. Information about the book, information about his alternative fuel blog, and a way to contact him can be found at www.kickingthegasoline.com.
Bruce Erickson is the president of Mendocino Solar Service, a local provider of solar electricity and solar water pumping systems in northern California. He can be reached at 707-937-1701.
Quantitatively Estimating The Cost Of Converting Now Or Later
August 14, 2008
By Charles Cresson Wood
Once management at business firms, government agencies and non-profit organizations acknowledges that there is a substantial body of evidence to support the “peak oil theory,” as some people refer to it, they will soon thereafter be asking: “When should our organization transition away from petroleum?” In other words, given the assumption that an organization will at some future point in time be forced to transition to alternative sources of energy, at what future point in time would it be most prudent to make this conversion? This question can be answered quantitatively, with a formal decision making model using decision trees and/or influence diagrams.
Generally the most difficult part of this process is convincing management that such a model should in fact be developed. But if you look for it, the quantitative evidence supporting the “peak oil theory” is readily available. For example, the Energy Information Administration web site shows that worldwide production of oil has been effectively flat at about 74 million barrels per day since 2005. Making reference to the actual historical total world petroleum production data by year, actual number of discoveries of large oil fields by year, and similar indisputable quantitative data is the recommended strategy. Discussion of how it is likely that the total world oil production curve is expected to show up something like the historical United States total oil production curve is also helpful. Stick with the facts, and avoid estimates and projections. This means avoidance of estimated remaining petroleum reserves, number of years of estimated supplies remaining, etc.
The development of a model to provide guidance about the timing of a transition away from petroleum can be approached as a capital budgeting decision. Since such a project involves a considerable amount of time and money, it deserves a detailed analysis. To simplify the model development process, we can focus on the date when substantially all of an organization’s critical business processes are converted away from petroleum. This approach assumes the organization already knows which critical business processes are dependent on petroleum-based fuels such as gasoline and petro-diesel (if it does not, an inventory of these dependent business processes is advisable).
For example, five specific conversion projects could be proposed to top management. They could involve a completed transition within (1) one year, (2) two years, (3) five years, (4) ten years, and (5) twenty-five years. The net present value, internal rate of return, payback or some other financial measure of expected value can be calculated for each of these five projects. The project with the greatest expected value would then indicate the timeframe when it would be best to have transitioned away from petroleum. To get to this single numerical ranking of the alternative projects, the analyst developing a model will need to gather additional information. While a listing of the additional information needed in order to construct such a model is clearly beyond the scope of this brief article, a number of data points that will be important to the model are provided below.
Such a model’s structure could involve two major segments. The first segment could be a traditional managerial accounting delineation of the costs of a conversion project. The second could involve a decision making model, including the expected dollar value outcomes and expected probabilities.
In this first major segment, the analyst could note that the costs to convert will be rapidly rising over the years ahead. This could reflect an expectation that commodities such as steel and lead will become considerably more expensive in the years ahead, and also that the energy required to manufacture new alternative energy equipment will most likely be more expensive in the years ahead. Likewise, these higher costs to convert in the years ahead could reflect the expectation that competition for resources and expertise in the alternative energy field will be considerably more intense in the years ahead.
Alternatively, in the first of these major segments, the analyst may specify that the costs to convert would go down in the years ahead. He or she may have great faith in the new technology currently being developed, for instance that which converts algae into bio-diesel fuel. Undertaking a transition away from petroleum further in the future would then allow these new lower-cost technologies to be utilized, while converting now does not allow that option. In such a model, the analyst may reason that the organization could switch directly to the prime successor(s) to petroleum, rather than going through one or more transitional technologies. For example, perhaps five years from now, an organization may be able to buy fully electric vehicles that have sufficient driving range to meet business needs. But if a transition was to be made right now, then the organization may at best be able to convert to plug-in hybrids, which would then later need to be traded in for fully-electric vehicles. A series of conversions could be incorporated into such a model, although this author recommends against it — a transition directly to a sustainable and renewable energy technology is a lot more predictable and manageable.
The second major segment of the model could include the anticipated scenarios that materially affect the organization in question. A decision tree or influence diagram can include a series of probabilities associated with a particular scenario or outcome. For example, the probability that the world has now reached peak oil production can be combined with the probability that the organization in question will suffer volatile oil supply relationships, oil shortages, oil rationing, and rapidly escalating oil-based fuel costs. The dollar value of the impacts can then be assessed, and when combined with the net result of these probabilities, the expected value of a particular segment of the decision tree or influence diagram can then be calculated. The future availability of and price of oil is a very serious matter because, in some instances, the impacts mentioned above will threaten the very survival of organizations. Some small trucking firms and some large airlines are now coming to appreciate this fact.
We now have a significant amount of quantitative data about the petroleum situation, so that we can build credible versions of mathematical decision-making models about the best timing of a transition away from this energy source. Thus management does not need to make an intuitive decision, throwing up its hands in frustration because there are too many unknowns and too many unquantifiable variables.
For example, we can now make estimates of the future price of oil. These estimates can include a variety of assumptions, such as a reversion to historical prices, or the extrapolation of the rising prices experienced during the last few years. We can factor in the future prices for oil found in the futures market, as well as the opinions of technical experts who have studied these matters at great length. For instance, Dr. Robert Hirsch, author of a very influential report* prepared for the US Department of Energy, which is informally known as the Hirsch Report, has been talking about $500/barrel oil in the next few years.
Probabilities can then be attached to each of these possible future price points for oil. The clarification of, and explicit documentation of these and related estimates, and the assumptions that going into making these estimates, is absolutely critical in the development of a useful decision-making model. This is not only because it will increase the likelihood of making the best decision, but also because it will illuminate the perspectives held by experts who have studied the facts. It is likely that top management in many organizations hasn’t yet been exposed to the latest information, and their familiarity with these reports, such as that one by Dr. Hirsch, will most likely change the way they are looking at the conversion process. This changed perspective will then most likely markedly alter the probabilities that management assigns to different possible future oil price points, as well as other numbers used in these models.
Another important quantitative assumption in such a decision-making model is the time when the availability of oil will rapidly decline. A variety of expert oil geologists are now suggesting that the total world oil supply will go down 5-10% per year for the next decade or so. Factoring in different scenarios about the availability of oil, and the adverse impacts of shortages on the organization in question, this too will be a critical part of a successful decision-making model. For example, the oil available to consumers in oil-importing countries may fall off quite rapidly if oil-producing countries choose to use increasing percentages of their oil production for their own internal populations. According to data from the Energy Information Administration, this increased domestic consumption is already happening in a number of oil-producing countries such as Saudi Arabia.
One of the great parts about preparing a model such as this is the ability to perform sensitivity analysis. Thus the model’s inputs can be altered and the results calculated again to see if a materially different result is obtained. A sensitivity analysis could thus be performed on a completed model to see at what points the result would be different. For example, if management believed that such a conversion three years from now would be most prudent, a sensitivity analysis could be conducted to determine which of the input factors must change, and by how much, before it would be clear that the most prudent course of action would be a conversion one year from now. The results of such a sensitivity analysis may surprise management, and cause them to rethink their assumptions. For example, if oil prices escalate a lot faster than expected, the target completion date for a conversion project may need to be moved forward considerably.
In summary, it is now possible for organizations of all types and sizes to calculate the best date for a conversion of all major business processes away from petroleum. When top management actually goes through this important exercise it will, most likely, become considerably more aware of the urgency of this transition.
——-
Charles Cresson Wood, MBA, MSE, is an alternative fuels management consultant with Post-Petroleum Transportation, in Sausalito, California. His most recent book is Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action. To learn more about the book, to read his alternative fuels blog, or to contact him, go to www.kickingthegasoline.com.
* This highly recommended report, which is written in non-technical language, can be found at: http://www.netl.doe.gov/publications/others/pdf/Oil_Peaking_NETL.pdf
The True Costs Of Using Petroleum-Based Fuels
August 13, 2008
By Charles Cresson Wood
In business circles, the discussion about adopting alternative transportation fuels these days revolves largely around finances. While it is important to fully understand the finances of this new and rapidly evolving area, it is also important to understand the business interruption implications of continuing to rely on petroleum-based fuels. Yes, some alternative fuels do now provide lower per mile operational costs than petroleum-based fuels, but this benefit may very soon be completely overshadowed by the business interruption related losses suffered because deliveries cannot be made to customers, raw materials cannot be shipped from suppliers, salespeople cannot visit customers, etc. If you have not yet researched the geological data related to the peak oil discussion, I highly recommend two books: Richard Heinberg’s The Party’s Over and Matt Simmons’ Twilight In The Desert. click here to read more
Thirty Serious Reasons Why Organizations Must Get Off Petroleum Now
August 13, 2008
By Charles Cresson Wood
Don’t get me wrong — I am very concerned about global warming and climate change. In the long run, that’s one of the most serious challenges that humans face as a species. But in the short run, the world is no longer able to produce petroleum in sufficient volume to satisfy its demand. Soon it will not be able to produce petroleum in sufficient volume to satisfy its needs. click here to read more
Asking The Right Business Questions About High Gas Prices
July 30, 2008
By Charles Cresson Wood
The notion of “peak oil” — which holds that the world’s production of oil is at it’s all-time high this year, or within a few years — has recently become credible in the business community. While most everybody will agree that petroleum is a depleting resource with a limited supply, the question many now wrestle with is: “How much more oil is there left in the ground?” Considerable debate wages about the real level of petroleum reserves, and how many more years it will last. click here to read more
