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Can Hydropower Reduce the Transitional Climate Risk of Norway?
Master in Economics
Department of Economics at University of Oslo
Tord Hustveit Submitted May 2021
2 Preface
Writing this thesis has been an interesting, educational, and occasionally stressful
experience. There are some things its hard to understand the value of before its taken away, and writing a thesis during a pandemic has really made me treasure the educational gains from eating lunch with fellow students at Blindern and the academic fellowship. Luckily campus has been open for long stretches of this semester. I would like to give a special thanks to my supervisor Karen Helene Ulltveit-Moe for good advice during the prosses. And to Andreas Økland, Kevin Johnsen, Naomi Røkkum, Torgier Knudsen and Sondre Elstad for valuable discussions and input along the way. All mistakes remaining errors are fully my own.
Abstract
In this master thesis I will investigate the claim that hydropower can reduces the transitional climate risk of the Norwegian economy. I find that there could be gains from looking at a broader portfolio of the national wealth when assessing Norway’s climate risk. I also find that’s plausible stricter climate policies increase the value of hydropower while it decreases the value of petroleum. However, this depends on the policies that are implemented in Europe. Finally, I find that this change in value could affect the optimal regulation of the petroleum and hydropower sector and that it could be optimal to reallocate some capital from the petroleum to the hydropower sector.
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Innhold
1) Introduction ... 3
2) Climate Risk and National Wealth... 7
2.1) National Wealth... 7
2.2) The Norwegian National Wealth. ... 8
2.3) Climate Risk ... 10
2.4) Potential Effects of Climate Risk on the Norwegian National Wealth. ... 12
2.4.1) Transitional Climate Risk for the Petroleum Industry. ... 13
2.4.2) Increased Uncertainty About the Return From the Norwegian National Wealth. 15 3)Arguments for a Broader Portfolio Perspective on National Wealth ... 15
3.1) Optimal allocation of assets when taking both financial and non-financial assets into account ... 16
3.2) Gains from Looking at a Broader Portfolio. ... 17
3.3 Limitation to Hedging Climate Risk in the Market. ... 21
3.4) The Norwegian National Wealth and Optimal Allocation in the Face of Climate Risk. 22 4) Energy Markets ... 23
4.1) The Historical Correlation Between Electricity and Oil prices ... 23
4.2) Supply and Demand in the European Energy Market. ... 25
4.2.1) Europe: The Most Important Market for Norwegian Energy. ... 25
4.2.2) Pricing of Energy in the European Market... 26
4.2.3) Energy supply. ... 27
5) The Effect of Climate Policies on the Energy Market – Will it Break the Historic Correlation Between Petroleum and Electricity Prices? ... 29
5.1) Climate Policies in the Form of Subsidies: ... 32
5.2) Climate Policies in the Form of Carbon Tax: ... 33
5.3) Indirect Effects of a Higher Share Renewable Energy in the Energy Market ... 34
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5.4) The Policy Mix in the European Union. ... 37
5.5) A Mix of Different Policies. ... 38
6) Potential Policy Implications ... 41
6.1 Assumption Underlying the Analysis. ... 41
6.2) Optimisation of capital in a mean-variance framework. ... 44
6.3) Possible policies to relocate capital ... 48
7)Conclusion ... 51
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1) Introduction
Norway has a resource rich economy with a large petroleum sector, and significant
hydropower resources. These resources have been intertwined with the development of the Norwegian economy and gives the state large revenues. In the coming decades, however, stricter climate policies can significantly reduce the demand for petroleum while the
demand for renewable energy could increase (IEA,2020). The risk this poses for the value of petroleum resources is often referred to as transitional climate risk and there is a growing academic literature about how fossil fuel exporting countries should handle this risk.
As Norway is rich in both fossil energy and hydropower it could be that the total climate risk of the Norwegian economy is smaller than it might appear if we only look at the petroleum sector separately. This has been pointed out by the Official Norwegian Reports NOU 2018:17
“Climate risk and the Norwegian economy».
There is a growing economic literature suggesting the use of a broader portfolio of national wealth when assessing the optimal allocation of assets in commodity based sovereign wealth funds. However, this literature has mostly looked at the sovereign wealth fund and the commodity the fund is based on. For instance, Van den Bremer et all 2016 recommend that the asset allocation of commodity based sovereign wealth funds also takes account of the risk to the resources still in the ground as a part of a broader balance.
This leaves the intriguing questions if there are additional gains from looking at an even broader portfolio by including additional parts of the national wealth in a broader balance.
Looking at an even broader portfolio could be of special interest to Norway in particular, since stricter climate policies is a significant risk to the future price of petroleum, while it can increase the value of hydropower. This makes Norway a unique case as a country with both large fossil fuel reserves and resource rent from renewable energy. This could have
implications for the optimal allocation of assets in the wealth fund and it could have
implications for the optimal allocation of capital between hydropower and petroleum. In this thesis I will look at the implications for allocation of capital between hydropower and
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petroleum, an idea for further research could be to look at the optimal allocation of assets in the sovereign wealth fund when we look at an even broader balance.
If hydropower reduces the Norwegian transitional climate risk, it could be optimal for the state to increase investments in hydropower to hedge a potential fall in petroleum revenues due to stricter climate policies. As far I am concerned this idea has never been thoroughly investigated.
In this thesis I will investigate the claim that hydropower might reduce Norway’s transitional climate risk.
I attempt to answer this question in three stages:
1) What is the proper analytical framework to investigate the climate risk of a broader portfolio of national wealth?
2) Is it plausible that the value of hydropower increases with stronger climate polices as the value of the petroleum reserves decrease and thus contributes to lower Norway’s transitional climate risk?
3) If the second question above is true, are there way to reallocate capital between the petroleum and hydropower sector? And could it have policy implication to the way Norway should regulate these natural resources?
In 2019 the Norwegian states revenues from taxes and ownership in the oil industry was 283 billion kroner (NOK) and expected to be 122 billion kroner in 2020 (Meld. St. 1 (2020 –
2021)). The large difference is mainly due to falling oil and gas prices under the COVID-19 pandemic. The oil revenues are deposited in a sovereign wealth fund and around one fifth of the state’s budget is covered by revenues from the fund, following a fiscal rule. The resource rent from hydropower has on average over the last ten years been 18 billion kroner annually or around 2 percent of the state budget, part of this revenue goes to local governments (SSB).
Norway can also in the coming decades expect significant income from natural resources.
The net present value of the remaining petroleum resources is assumed to be 4200 billion kroner and the net present value of the resource rent from the hydropower is estimated to be 600 billion kroner (NOU 2019:12).
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Energy prices are volatile, so these estimates are uncertain. There is written extensively about how energy rich economies specifically, and commodity rich economies in general should handle the risks associated with volatile commodity prices. Volatile commodity prices are identified as one of the effects that leads to the so-called resource curse, in which
resource rich countries end up poorer than comparable peers without natural resources (Peszko et al 2020). Strategies that have been suggested to reduce the fiscal impact of price risk in the commodity market are for instance: Precautionary savings, using tax policies to diversify the government’s revenue base, strengthening institutions and transparency (IMF, 2016).
Over the coming decades the global effort to combat climate change will change the energy market. This represents a risk for the Norwegian economy, and other economies with large fossil intensive industries (IEA,2020).
In addition to the increase in risk to an important part of the Norwegian national wealth, demographic changes are expected to put increased stress on Norway’s public finances.
With an aging population the expenditures for pensions, health and elderly care are set to increase. Forecasts indicate a gradually tightening of the government’s fiscal position and a deficit of 5,6 percent of GDP in 2060, if there is no significant policy changes (Meld. St. 14 2020-2021).
This tightening of the fiscal position comes at the same time as the petroleum revenues are expected to fall due to decreasing production. If the fall in petroleum revenues is pushed forward by lower demand, for instance due to climate policies, it will put additional strain on the Norwegian public finances. Understanding the risks that stricter climate policies cause to the Norwegian national wealth, could lead to better decisions today and higher welfare in the future.
To stabilise the global temperature the flow of greenhouse gas emissions into the
atmosphere must reach net zero. In order to achieve this fossil energy must be replaced with zero emissions solution in all sectors of the economy and any remaining combustion of fossil fuel must be captured or offset by negative emissions. Historically there has been a
correlation between the prices of different forms of energy (Asche, 2006). If stricter climate policies increase the demand for renewable energy while the demand for fossil fuel falls this
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could break the historic correlation between the value of hydropower and petroleum. If the correlation changes hydropower could reduce the total climate risk of Norway by working as a hedge against transitional climate risk.
Both petroleum and hydropower are tightly regulated sectors in Norway with resource rent taxes, large share of public ownership, and a licensing system where there is conducted economic cost-benefit analysis. Insights gained from a broader wealth perspective could lead to changes in the optimal regulation of resources, and there might be ways to hedge
transitional climate risk by reallocating some capital from petroleum to hydropower.
To investigate these topics, I will firstly study the background and relevance of the research question in chapter 2. In 2.1 and 2.2 I will give an account of the concept of national wealth in general and look specifically at the Norwegian national wealth, showing that Norway’s large petroleum wealth sets it apart from similar developed economies. Followingly, in 2.3 and 2,4 I will then introduce the concept of climate risk and look specifically at transitional risk for the petroleum industry.
In chapter 3 I try to answer the first question, what is the proper analytic framework to investigate the climate risk of a broader portfolio of national wealth? I will build my analysis on the literature of optimal allocation of assets in commodity based sovereign wealth funds when including the value of remaining resources in the balance and expand it to look at a portfolio of hydropower and petroleum. In 3.1 I examine the literature on asset allocation in sovereign wealth funds when including the resources that were the origin for the fund. In 3.2 I will argue that there is no principle different between looking at a balance comprising a sovereign wealth fund and one natural resource and a broader balance of national wealth and that there are potential gains in the form of more efficient management of resources from using a broader perspective. In 3.3 I discuss the possibility for a state to hedge climate risk in the market, and in 3.4 I look at how a broader portfolio perspective has been usen on the Norwegian national wealth. I will argue that it is of special interest for a petroleum rich country like Norway to look at a broader portfolio of both renewable energy and petroleum, since hydropower potential could hedge a fall in the value of petroleum due to climate policies. And that there is limitation on a state’s ability to hedge transitional climate risk to the petroleum wealth in the market.
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Chapter 4 and 5 will investigate if it is plausible that hydropower increases in value with stronger climate policies. To analyse this, I use a simple static model founded in economic theory to discuss how different climate policies would affect the use of fossil fuel and hydropower. Then I will expand the model by introducing flexibility to show that climate policies can increase the value of hydropower through different channels. To complement the intuition in the theory I will look at the results from energy modelling.
In chapter 6 I will look at potential policy implication if the correlation between petroleum and hydropower changes, and if there are ways the government can reallocate capital between the petroleum and hydropower sector. I will first use a mean-variance framework to investigate possible implications of change in covariance between hydropower and petroleum, for instance because of stricter climate policies. In 6.1 I will explain the
assumptions I do regarding covariance, variance, and expected return for the portfolio. In 6.2 I look at the effect of changes in covariance on the efficiency of the portfolio and potential effects of reallocating some capital between sectors. And in 6.2 I will look at ways the Norwegian state could reallocate capital between the two sectors.
I find that there could be gains from looking at a broader portfolio of the national wealth when assessing Norway’s climate risk. I also find that’s plausible stricter climate policies increase the value of hydropower while it decreases the value of petroleum. However, this depends on the policies that are implemented in Europe. Finally, I find that this change in value could affect the optimal regulation of the petroleum and hydropower sector and that it could be optimal to reallocate some capital from the petroleum to the hydropower sector.
2) Climate Risk and National Wealth
2.1) National Wealth
One way to assess the future climate risk facing the Norwegian economy is to look at ways climate change can affect the national wealth. This is one of the perspectives used by The Official Norwegian Reports “Climate risk and the Norwegian economy» (NOU 2018: 17). The World bank uses a similar framework to assess the progress of nations in a series of reports:
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“Where Is the Wealth of Nations? Measuring Capital for the 21st Century (2006)”, “The Changing Wealth of Nations: Measuring Sustainable Development in the New Millennium (2011)” and “The Changing Wealth of Nations Building a Sustainable Future (2018)”.
By using a national wealth perspective, it is possible to go beyond simpler macroeconomic indicators like GDP and make broader assessment on the health of the economy by looking at depreciation of assets, capital per capita or whether the mix of assets is consistent with a country’s development goals (World bank 2018).
The national wealth is composed of four elements (World bank, Building the World Bank’s Wealth Accounts: Methods and Data 2018) (Finansdepartementet, 2017)
- Produced capital is manufactured and build assets like factories and infrastructure. It calculated as the total replacement value of the nation’s capital stock.
-Net foreign assets are the cross-border assets and liabilities owned by a country’s residents.
-Natural resources are calculated as the net present value of the expected resource rents from a country’s resources.
- Human capital is the discounted lifetime earnings of the country’s population.
The Norwegian ministry of finances only include the resource rent of petroleum in their natural resource wealth calculations (Finansdepartementet, 2017). The World Banks calculations include energy, minerals, agricultural land, protected areas, and forests as a country’s natural resources (Building the World Bank’s Wealth Accounts: Methods and Data).
2.2) The Norwegian National Wealth.
Norway is one of the wealthiest countries in the world and the Norwegian national wealth is estimated to be 16,1 million kroner per capita. On a per capita basis it is composed of
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produced capital 2,2 million kroner, financial capital 1,6 million kroner, human capital 11,4 million kroner, petroleum 0,3 million kroner (Meld. St. 14 (2020–2021)). The ministry of finance does not have updated numbers for hydropower but using the net present value of the resource rent calculated for NOU 2019:12 it is 0,1 million kroner per capita.
Using numbers for national wealth in dollars and on a per capita basis from the World Bank (World Bank,2018) we can compare the Norwegian national wealth with other countries.
The composition of Norway’s national wealth is different from similar countries in several ways. Table 2.1 contains the national wealth calculations of Norway and some comparable OECD countries. The category natural capital is also subdivided into forest, protected areas, cropland and pastureland and subsoil assets. Note that hydropower is not included in this table, and numbers are denoted in dollars per capita.
Table 2.1:
Economy Total wealth
Produced capital
Sum of Natural capital
Forest Protected areas
Cropland + pastureland
Subsoil assets
Human capital
Net- Foreign assets
Norway 1671756 423905 103184 5 059 10081 4 803 83251 1004649 140018 Netherlands 792396 234415 9528 311 177 4815 4224 516543 31910 Sweden 886129 285792 27890 11916 2875 4088 9010 576521 -4073 Switzerland 1466757 356075 8531 2381 985 6064 0 1022950 79200 United
Kingdom
647694 193456 7592 475 1145 2967 3005 457223 -10577
Finland 726422 248986 18037 7264 2964 4926 2883 460082 -630 Germany 729064 236891 7701 2030 12338 3795 738 467668 16804
The per capita wealth of Norway is significantly higher than most neighbouring countries. It also shows that Norway is endowed with more valuable natural resources than its
neighbour. And finally, Norway has large positive net-foreign assets.
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The large petroleum sector set the Norwegian economy apart from most other developed economies. In 2017 5,1 percent of the total Norwegian workforce worked directly or
indirectly in the petroleum sector (von Brasch 2019). Export of oil and gas was 42 percent of Norway’s total export in 2020 (SSB). Norway is one of the countries in the world with largest fossil fuel wealth on a per capita basis and in absolute terms (World bank 2018).
Table 2.2
2.3) Climate Risk
Risk can be described as consequence + uncertainty. In modern risk science this has been formalised as (A`,C`,P) with A` refers to some specific event, C` defines the consequences of that event and P the probability (Aven 2020). In climate risk the causal chain runs from human emission that changes the atmospheric concentration of greenhouse gases and leads to changes in weather conditions that changes the climate and from the changing climate to risk for the individual through the physical effect of a changing climate and policy responses
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aimed at reducing greenhouse gas emissions. (Smith and Stern 2011). Where A` is events that can arise from changing climate, like rising sea level, C` is the consequences of rising sea level and P is the probability that we see rising sea level.
Risk can be measured with associated probability distribution or it can be of a more
subjective form. This was first formalised by Frank Knight (Knight 1921). In his framework we have ‘risk’ in the case that an objective probability distribution can be obtained, and
‘uncertainty’ otherwise. The intergovernmental panel for climate change (IPCC) measures the risks in the form of “confidence” based on judgment of confidence from scientific experts and probability and likelihood that an event will occur (Aven 2020).
Since there is no historical parallel to the current rapid increase in greenhouse gas emission the ability to forecast the effect in higher emission scenarios is limited. So, a lot of the potential damage is in the form of what Knight defined as uncertainty. Another confounding element that makes it hard to assign probability to climate risk is the presence of threshold values in the climate system (Weitzman,2009).
In a much-cited speech in 2015, Mark Carney, at that point Governor of the Bank of England, laid out three broad channels through which climate risk threatens financial stability. The Official Norwegian Reports “Climate Risk and the Norwegian Economy» (NOU 2018: 17) uses the same framework to assess how climate risk can affect the Norwegian economy.
-Physical risk is the risk that changing climate leads to damage to physical capital for instance through more severe flooding.
-Liability risks are the risk that some parties who have suffered losses from climate related events could seek compensation for their losses through legal means.
-Transition risks are the risks that arise from policies set to mitigate emissions.
There are several ways the physical effects from climate change could incur large economic damage. Changing climate will affect the global food system. Climate change without
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adaptation could negatively impact production of major crops. (IPCC, 2014: Future Risks and Opportunities for Adaptation). Several studies find that climate change already affects crop yields negatively in some regions. (IPCC, 2019). Rising sea level could severely damage coastal communities. A warmer climate will contribute to more extreme weather events.
Higher temperature rises could compromise normal human activities, including growing food or working outdoors in some parts of the year (IPCC, 2014: Future Risks and Opportunities for Adaptation).
The effect will vary between regions and with total cumulative emissions in the atmosphere.
But the existence of unknown thresholds in the climate system can trigger events that lead to severe damage even at only a small increase in global temperature. There could also be tipping point that triggers a self-enforcing process in the climate system locking the world into even higher temperature rises (IPCC, 2014: Climate Change 2014: Synthesis Report).
2.4) Potential Effects of Climate Risk on the Norwegian National Wealth.
All parts of the national wealth are somehow susceptible to risks related to climate change both to physical and transitional risks.
Since the net present value of future work is the largest part of the national wealth. The largest impact on future welfare would be if some climate related events lead to a fall in labour productivity. Both extreme heat and spread of diseases are examples of climate induced events that can decrease labour productivity. Produced capital would be affected by more extreme weather that could damage infrastructure and increase the depreciation of capital. Changes in demand due to climate policies can render some assets stranded, lowering the value of the capital stock. On the other hand, some assets might increase in value due to changes in the economic structures or higher demand.
In Norway, the most likely effects of climate change will be heavier rainfall, more frequent and larger floods due to rain, raising sea level and more mud- and landslides (CICERO Report;2018:14). Climate change could also trigger events where the overall long term economic cost is uncertain but that requires potentially painful adjustments. For instance, a
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warmer climate would change the spawning sites of important fisheries like the Northeast Arctic cod, the largest cod stock in the world (Sandø et al 2020). For Norway climate change could deliver some positive results. One of the effects of a changing climate will be an increase in precipitation. This could for instance increase the potential production from Norwegian hydropower. While melting of glaciers could reduce the value of some power plants (NVE, 2020)
Compared to other countries Norway is relatively well suited to tackle the physical effects of climate change. Higher prevalence and more severe heat waves and spread of tropical diseases is often pointed to as the most severe effects of climate change on labour
productivity, both effects will be relatively moderate in Norway compared to other countries (Folkehelseinstitutt and Helsedirektoratet). Due to post-glacial rebound the effect of rising sea level affects Norway less than the global average (Simpson et al,2015). Norway also has capabilities to adapt to a changing climate (NOU 2018: 17).
The most efficient way to reduce the physical climate risk is through abatement of
greenhouse gas emissions (NOU 2018: 17). But faster transition away from fossil fuel could increase the transitional risk for fossil intensive sectors. One of the areas where Norway is more exposed than similar countries is the climate risk is the effect of climate policies on the petroleum sector.
2.4.1) Transitional Climate Risk for the Petroleum Industry.
The focus of this thesis is on the transitional risk and the effect on the value of Norwegian natural resource wealth. Petroleum constitutes the largest part of the national resource wealth. NOU 2018:12 estimates that the resource rent of remaining resources to be 4200 billion NOK. In a low-price scenario, it is assumed to be 2500 billion kroner and in a high price scenario 6000 billion kroner.
Limiting global warming in line with the target set in the Paris agreement would require massive changes in the economy over the next decades. This creates opportunities in the
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form of new industries and supply chains. But also, risks for incumbent industries
(FANKHAUSER 2008). Although all parts of the economy will be affected by a transition in line with the Paris agreement, carbon intensive industries will be especially vulnerable to policies to instigate a quick decarbonisation. This also represents a risk for countries with large fossil intensive sectors (Manley, 2017)
If the global community delivers on the pledge to keep the temperature rise well below two degrees and towards 1,5 degrees, the emissions of greenhouse gases must be net zero around the mid-century or use large negative emissions to take greenhouse gases out of the atmosphere. Large economies like the European Union, Great Britain and South-Korea have pledged to achieve net-zero by 2050. During the presidential campaign Joe Biden pledged to commit the USA to a net zero by 2050 target. And China has pledged to achieve net-zero by 2060 (ECIU, 2021).
The idea of stranded assets in the fossil fuel industry was popularised by the NGO Carbon tracker initiative who in 2011 released the report “Unburnable Carbon – Are the world’s financial markets carrying a carbon bubble?” where they showed that there are already discovered more fossil fuels than it is possible to burn while limiting global warming below two degrees. Some assets might not be stranded but would lose value due to lower demand and falling prices. In a scenario where the world keeps global warming bellow 2-degree oil prices could be as much as 50 percent below a business-as-usual scenario. (Klevnäs, 2015).
For petroleum producing countries this could put the public finances of stress (Jaffe,2020)
There are of course large uncertainties about any long-term price estimates. The effect climate policies will have on oil and gas demand will depend on technological and social development in the coming decades and to which degree the targets are met (IPCC 2018). If value chains for carbon capture and storage proves to be cost competitive it leaves room for a larger share of fossil fuel in the energy mix. Cost efficient technologies for taking emission out of the atmosphere would also give a larger room for fossil fuels in the carbon budget. A quick transition away from coal would also make it possible to burn more oil and gas within the limits of a given climate target and corresponding carbon budget.
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2.4.2) Increased Uncertainty About the Return From the Norwegian National Wealth.
A large share of the economic rent from petroleum and hydropower is captured by the Norwegian state, and for hydropower also partly by local government, through taxes and direct ownership. This helps financing a large public sector with a relatively low tax rate on the rest of the economy. (OECD, 2020)(OECD, 2019). From 2001, to 2019 the government has been able to increase the budget, on average, with almost 12 billion kroner annually.
Giving a large fiscal room to increase different forms of spending and cut taxes. In the same period there has also been a demographic dividend with a large share of the population inside the labour market. From 2023-2030 it is expected that the growth of the sovereign wealth found on average will only increase the budget with between 3-6 billion kroner annually, while staying within the fiscal rule. In the same period, it is expected that demographic changes, with an aging population, will increase social spending, including pension, with an increase of 11 billion kroners annually towards 2030, up from 9 billion annually the last decade. Without policy changes the government expects the fiscal room on the budget to be 4 billion annually toward 2030, down from 21 billion annually over the last years. After 2030 the fiscal situation would tighten even more and towards 2060 there would be a need to cut spending or raise taxes with 5,6 percent of GDP to balance the budget (Meld. St. 14 2020-2021).
These forecasts are uncertain and do not provide any exact numbers, but they can tell us that Norway’s fiscal position will be weaker in the coming decades. Limiting the
government’s room to respond to unforeseen events. If the price of oil and natural gas is lower than anticipated the fiscal situation would be even tighter.
3)Arguments for a Broader Portfolio Perspective on National Wealth
By looking at the Norwegian national wealth as a portfolio, I will argue that we can gain valuable insights on how Norway may optimise their disposition of resources and framework to assess how and under what assumption hydropower reduces Norway’s transitional climate risk. There is a growing literature applying modern portfolio theory on the asset
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allocation of resource based sovereign wealth funds when including resources still in the ground as a part of a broader balance. I will argue that its possible to use the same framework to asses the allocation of capital between other parts of the national wealth.
Since the government captures a large share of the economic rent from petroleum and hydropower, the analysis is restricted to the public sector’s financial position. This is a simplification, as the national wealth is the sum of the net wealth of all economic units in a country, including both private individuals, companies, and more. But it gives us a useful framework to assess potential welfare gains from a potential changing correlation between hydropower and petroleum. To expand the analysis further, future research could look at the effect beyond the cash flow by including employment, transitional costs, and other potential effects.
3.1) Optimal allocation of assets when taking both financial and non-financial assets into account
It is well established in financial literature that an optimal capital allocation should take all financial and non-financial assets into account. For instance, university endowments should include the broader university assets and cost of running the universities in the balance and hedge against unanticipated changes in those costs (Merton 1993).
It has been suggested that an investor with non-financial assets in addition to the market portfolio could use different forms of hedging to reduce the risk (Merton 1993). A hedge is an investment that reduces the risk of adverse price movements in an asset. There exist several strategies for hedging, but the most basic form is to find an investment with return that correlates negatively with the risk you want to avoid (Mack,2014). Other strategies to hedge risks in the market could be to buy options or future contracts.
There is a growing literature on how economies with large sovereign wealth funds should manage their assets. Two thirds of the sovereign wealth fund industry (by size) have been funded by selling below-ground assets such as oil, natural gas, copper and diamonds and for
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most of these countries the sovereign wealth funds as well as the remaining resources in the ground constitutes a large share of these countries national assets (Van der Bremer et al 2016). By looking at a broader portfolio that includes both the financial assets and natural resources, states with sovereign wealth funds should allocate their assets in a different way than in a situation where they only look at financial assets by also taking the potential risk of the remaining resources into account (Van der Bremer et al 2016) (Gintschel, 2008).
Gintschel et al 2008 looks at the relationship between resources in the ground and optimal allocation of assets in the sovereign wealth fund. They find that the optimal allocation of assets in a sovereign wealth fund for a state with oil wealth is to buy assets that hedge the oil price. The amount of hedging assets is decreased as the oil is extracted.
There has also been suggested that adding natural resources in the form of farmland and timberland to the portfolio of a resource based sovereign wealth fund would improve the return-risk characteristics of the portfolio (Martinez-Oviedo,2017).
For a country endowed with more than one natural resource this raises the question if there are possible welfare gains from looking at an even broader portfolio including the sovereign wealth fund, the resource that gave origin to the fund and additional resources. For Norway hydropower can be of particular interest if the value of hydropower increases in value as petroleum falls in value with stricter climate policies.
3.2) Gains from Looking at a Broader Portfolio.
The idea of diversification has its origin in modern portfolio theory, and it builds on an assumption that asset owners are risk averse and want to balance returns and risks. A household with risk averse preferences wants to smooth consumption over time and
different states of the world. When the fiscal rule regulating spending of the wealth from the sovereign wealth fund was implemented, consumption-smoothing was one of the stated goals of the rule. Both intergenerational justice and the cost of sudden and large fiscal
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tightening with corresponding cuts in public spending was stated as arguments for implementing the rule. (St.meld. nr. 29 (2000-2001)).
In modern portfolio theory a risk averse investor would want to hold a portfolio that maximises expected return for a given level of variance. (Markowitz, 1952). A portfolio is efficient if it provides the best possible expected return on a given level of risk, or
alternatively, the minimum risk for a given expected return. The expected return of a portfolio is the weighted average of the expected return of the assets in the portfolio. The variance of a portfolio is generally smaller than the weighted average of variance of the individual assets (Danthine&Donaldson, 2015). By diversification of the portfolio an investor can gain a better trade-off between mean-variance and higher utility. No rational investor would want to hold a portfolio where it is possible to achieve the same return with lower variance by diversifying. A portfolio of assets where there is not possible to decrease variance without lower return is called an efficient portfolio. The set of portfolios that gives the highest possible return at any given level of variance is called the efficient frontier.
One such portfolio is to hold a weighted average of all assets proportional to its share of the total market. This portfolio is called the market portfolio.
The idea that investors would prefer to hold the market portfolio lays the foundation of the Capital asset pricing model. CAPM is an equilibrium model in which the expected return depends on the risk of the asset measured as the covariance of return compared to the market portfolio (Sharpe, William F. 1964). Here 𝐸(𝑟̃𝑗) is the expected return form asset j, 𝑟𝑓is the risk-free interest rate and (𝐸(𝑟̃𝑚) − 𝑟𝑓) is the expected risk premium from holding a risky asset. 𝛽𝑗is the correlation between asset j and the market return.
𝐸(𝑟̃ = 𝑟𝑗) 𝑓+𝛽𝑗(𝐸(𝑟̃𝑚) − 𝑟𝑓) (1) And 𝛽𝑗 = (𝜎𝑗,𝑀
𝜎𝑀2) (2)
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An asset that correlates negatively with the rest of the market would add value to the portfolio of a risk averse investor, since it increases in value when the rest of the market falls, allowing the investor to smooth consumption. Since the investors value this, they would be willing to accept a lower return from an investment that correlates weakly or negatively with the market portfolio.
CAPM gives us the insights that through a well-diversified portfolio we could diversify away from unsystematic risks, while we would still be susceptible to systematic risks like a collapse in the market. Unsystematic risk is a risk that is unique for a specific company or business and systematic risk is a risk that could affect the entire market. Some studies find that it is possible for investors to hedge against transitional climate risks at a low cost by following a decarbonized index (Andersson at all 2016). Other finds it is only partly possible for investors to hedge against climate risks (CISL, 2015). There has been argued that climate risk
represents a systematic risk. Especially low probability, high impact events in the form of the physical effects of climate change could be impossible to diversify away from, and thus represents a form of systematic risk (Litterman, 2013).
CAPM can also be used to value the cash flow of a non-traded asset (Danthine&Donaldson, 2015). This could be used to value the future cash flow of the resource rent for instance hydropower and petroleum for the Norwegian state.
The traditional approach to value an investment is either through looking at the net present value of the investment or by looking at the internal rate of return of the investment. The net present value approach discounts the future cash flow at a rate that reflects the risk-free interest rate and the risk premium, and if the net present value is positive the investment is carried out. With the internal rate of return method an investment must have a return over a given threshold to be considered. Both methods use a discounted future cash flow and discount the cash flow with the risk-free interest rate plus some rate to compensate for the risk of the project(Sending, 2009).
The CAPM can estimate the appropriate interest rate to use for discounting the cash flow from the project when taking the correlation of all the assets into consideration.
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To illustrate how the optimal level of investment would change when looking at a broader portfolio we could use the standard CAPM equation and consider a one period project j at time t with price 𝑝𝑗,𝑡 and a cash flow in period 𝑡 + 1 that is 𝐶𝐹̃𝑗,𝑡+1 :
t t+1
−𝑝𝑗,𝑡 𝐶𝐹̃𝑗,𝑡+1
If the initial cost of the project is −𝑝𝑗,𝑡 then the return to the project is 𝑟̃𝑗,𝑡+1= (𝐶𝐹̃𝑗,𝑡+1−𝑝𝑗,𝑡
𝑝𝑗,𝑡 )
The expected return of the project is then:
1 + 𝐸(𝑟̃𝑗) = 𝐸 (𝐶𝐹̃𝑗,𝑡+1
𝑝𝑗,𝑡 ) =𝐸(𝐶𝐹̃𝑗,𝑡+1)
𝑝𝑗,𝑡 (3)
We then use the fact that CAPM defines the expected return and inserting for 𝐸(𝑟̃𝑗) from equation (1) and have the following equation:
1+𝑟𝑓+𝛽𝑗(𝐸(𝑟̃𝑚) − 𝑟𝑓)=𝐸(𝐶𝐹̃𝑗,𝑡+1)
𝑝𝑗,𝑡 (4)
If we solve equation 4 for the price we get:
𝑝𝑗,𝑡= 𝐸(𝐶𝐹̃𝑗,𝑡+1)
1+𝑟𝑓+𝛽𝑗(𝐸(𝑟̃𝑚)−𝑟𝑓) (5)
As we can see from equation (5) the initial value of the project is determined by the
expected cash flow discounted with the risk-free interest rate plus a risk premium. The risk premium is decided by 𝛽 that we know from equation (2) is the correlation between the asset and the market portfolio.
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The Norwegian state does not hold the market portfolio, so the value of a cash flow is not decided by the correlation between the asset and the market portfolio but between the asset and the rest of the Norwegian portfolio. This portfolio also includes petroleum and hydropower. Where the subscript N denotes the Norwegian portfolio and M the market portfolio.
𝛽𝑗,𝑁 = (𝜎𝑗,𝑁
𝜎𝑁2) ≠ (𝜎𝑗,𝑀
𝜎𝑀2) (6)
If we use the intuition from equation 5 and look at two identical investments where the only difference is the correlation between the assets and the portfolio they hold, the investor with the portfolio that correlates less with the cash flow from the project would value the cash flow higher. As we can see from the equation a higher 𝛽 gives a higher discount rate and a corresponding lower net present value of the cash flow.
𝐸(𝐶𝐹̃𝑗,𝑡+1)
1+𝑟𝑓+𝛽𝑗(𝐸(𝑟̃𝑚)−𝑟𝑓) < = 𝐸(𝐶𝐹̃𝑗,𝑡+1)
1+𝑟𝑓+𝛽𝑁𝑗(𝐸(𝑟̃𝑀)−𝑟𝑓) (7)
This implies that looking at an even broader portfolio than just the sovereign wealth fund and petroleum, but also including other natural resources would give a better understanding of the risks profile of the portfolio. It also implies that the state could value the cash flow from natural resources at a different rate than the market, since the state is holding a different portfolio than the market portfolio.
Fossil fuel exporting countries are especially vulnerable to changes in fossil fuel prices and could benefit by holding a portfolio that hedges the non-financial assets by exploiting the correlation between financial and the non-financial assets, instead of only looking at the financial assets (Gintschel et al, 2008). Transitional climate risks are one especially severe threat to long term fossil fuel prices (Klevnäs, 2015). But as I will argue in the next paragraph the long-time horizon of climate risk makes it hard to hedge in the market.
3.3 Limitation to Hedging Climate Risk in the Market.
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An investor worried about climate risk can sell assets to diversify. For a country with
significant fossil energy resources, it is harder to monetise the fossil fuel wealth (World Bank, 2018). If all producers faced with stronger climate policies want to increase their production to monetize the in-ground fossil energy wealth it would lead to a fall in prices. A version of this argument is known as the green paradox (Sinn 2008). There are examples of nations turning to the financial market to hedge price risk to fossil fuel export. Mexico has for two decades hedged the oil price risk one year ahead by buying a put option with 12 months maturity (IMF Working paper 2018). Most petroleum producing countries would need an instrument with longer maturity to fully hedge their risk. Oil rich developing countries would on average need 21 years to deplete their oil reserves with the current phase of production.
Estimates for Norway are that it will take 37 years to produce the remaining estimated resource with a level of production of 2019 (Aune mf 2020). The Chicago Mercantile Exchange offers trade of oil futures up to nine years, but the volumes of contracts with maturity past 12 months are minimal (Manley, 2017).
3.4) The Norwegian National Wealth and Optimal Allocation in the Face of Climate Risk.
The use of a national wealth perspective that extends beyond financial assets has in a Norwegian context been done by both NOU 2016:20 and NOU 2018:12 when assessing the optimal allocation of asset in the sovereign wealth fund. Norges Bank Investment
Management (NBIM) also used a broader perspective on the states wealth when advising the Norwegian ministry of finance to drop oil and gas stocks from the benchmark index to reduce the states total exposure to oil price risks (NBIM, Letter to the Ministry of Finance, 16 November 2017). This is a break with the historical practise of mainly looking at the optimal allocation of the fund alone, see for instance St.meld. nr. 24 (2006-2007) or “Norges Banks brev til Finasdepartementet 10. februar 2006”.
NOU 2018:17 suggest using a national wealth perspective when assessing climate risk facing the Norwegian economy to better understand how different parts of the national wealth are affected by climate change.
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Norway’s large petroleum resources is especially vulnerable to stricter climate policies and thus increasing the transitional climate risk of the Norwegian economy. If hydropower increases in value with stricter climate policies, it could reduce the climate risk. By looking at the natural resource part of the national wealth as a portfolio we could gain a better
understanding of the risks facing the Norwegian economy. And It could also provide the government with additional ways to hedge climate risk outside the market by reallocation of capital to the hydropower sector. This could be of particular interest if the possibility to hedge transitional climate risk to the petroleum price in the market is limited, as I have discussed it might be in 3.3. For hydropower to be a good hedge against transitional climate risk it has to increase in value relative to petroleum with stronger climate policies.
4) Energy Markets
In 4.1 I will show that there has been a historic correlation between the electricity- and oil price. I will then argue that this historic correlation is a bad predictor for future correlation – especially if there is implemented strong climate policies. In 4.2 I briefly go through the market structure of the market for oil, gas, and electricity to set the stage for chapter 5 where I will discuss how and under what conditions climate policies can change the correlation between hydropower and petroleum.
4.1) The Historical Correlation Between Electricity and Oil prices
A simple regression using monthly data from year 2000 to 2020 for Brent Crude price and the system price in the Nordic electricity market shows that there historically is a positive and statistically significant correlation between the electricity and oil price.
24 Table 4.1
Brent Crude Coefficient Standard Error T-value P-Value Price per MWH
electricity
0,74 0.083 8.97 0.00
Figure 4.1
Historical data is of limited use for predicting the future relationship between oil and electricity prices. Most countries are on an early stage of decarbonising their economy. For instance, one third of EUs emission reduction between 1990 and 2018 has taken place in the electricity and heating sector. In the same period the emission from road transport has increased in the EU (EEA Report No 03/2020). With the increased ambitions of reducing emissions by net 55 percent by 2050, the EU would have to strengthen climate policies in sectors like transport and heating. With the adoption of national targets in the non-ETS sector this prosses has already started.
0 20 40 60 80 100 120 140
00 - Jan 00 - Aug 01 - Mar 01 - Oct 02 - May 02 - Dec 03 - Jul 04 - Feb 04 - Sep 05 - Apr 05 - Nov 06 - Jun 07 - Jan 07 - Aug 08 - Mar 08 - Oct 09 - May 09 - Dec 10 - Jul 11 - Feb 11 - Sep 12 - Apr 12 - Nov 13 - Jun 14 - Jan 14 - Aug 15 - Mar 15 - Oct 16 - May 16 - Dec 17 - Jul 18 - Feb 18 - Sep 19 - Apr 19 - Nov 20 - Jun
Brent crude and electricity price over time
MWH/dollar Brent crude
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4.2) Supply and Demand in the European Energy Market.
To understand how climate policies affect energy markets we first have to understand the market structure. I will give a brief account of the markets for oil, gas, and electricity in Europe. The sectors that demand the different forms of energy and, how they are priced and supplied.
4.2.1) Europe: The Most Important Market for Norwegian Energy.
Markets for oil, natural gas and electricity vary both between the commodities and between regions.
In 2019 96,2 percent of Norwegian oil and natural gas export went to the EU (SSB,2019). 95 percent of natural gas is exported through pipelines to Europe, the rest is mainly exported as liquified natural gas from Melkøya. Event through most of Norway’s oil export goes to Europe the oil market is more global than the gas market and the price is less dependent on changes in Europe.
Norway is part of a Nordic electricity market that is tightly connected to continental Europe.
The net export of electricity varies from year to year and is highly dependent on the
weather. In dry periods Norway is a net importer, while periods with large rainfall Norway is a net exporter. Since the electricity market is connected to the European market the price is highly dependent on changes in the European market.
Figure 4.2 (source SSB, a)
-15000 -10000 -5000 0 5000 10000 15000 20000
25000
Net export in Gwh annually from 2000-2019
2000 2010 2019
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The demand for natural gas in Europe mainly comes from residential and commercial buildings, industrial use and electricity production. Natural gas is used for heating in homes and commercial buildings. The industrial use of natural gas is both for heating and as feedstock in industrial processes (IEA, 2018).
Demand for oil in Europe is mainly driven by the transport sector. In 2018 47 percent of EU demand for oil comes from road transport, 9 percent from aviation and 9 percent from shipping (Eurostat 2020).
The largest consumers of electricity in the EU in 2018 was industry, household, and service sector. The production of electricity in the EU is in 2019 was 42,8 percent conventional thermal, 26,7 nuclear, 13,3 percent wind, 12,3 percent hydro and 4,4 percent solar (Eurostat, 2020)
4.2.2) Pricing of Energy in the European Market.
In Europe, the price of oil, natural gas and electricity is mostly prices in the spot-market.
Although there is also use of long-term contracts.
For oil there is relatively low transport costs, and the market is global. Oil is not a
homogenous commodity and there is variation in quality and characteristics the price is set at different benchmarks (Fattouh,2011). The most dominant benchmarks are Western Texas Intermediate and Brent crude. Most of the oil is sold at longer terms contracts, but the price is usually linked to the price in the spot market. The spot price is determined by the supply and demand at the different benchmarks (Mckinsey, Energy perspective).
The natural gas market has traditionally used longer term contracts negotiated between supplier and customers. Due to the high price of transport the natural gas markets has been regional. But over the last decades there has been an increased supply of liquified natural gas that is sold on a global market. Another important change is reforms in market design, decoupling the owners of infrastructure from the users of the infrastructure. In the
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European Union, a common natural gas market has been an important political goal. Over time this has increased the share of natural gas sold in the spot market and it has been more common to link the price of long-term contracts to spot hub prices. In 2005, almost 80 percent of European gas was sold on an oil-linked basis but by 2018 that figure had to around 25 percent with 75 percent of European gas sold at spot or hub prices (Stern, 2020)
Electricity has in many ways had a similar development as natural gas, with a decoupling of infrastructure from producers. In the European economic area electricity is sold in a market where the price is set on the margin between buyers and sellers. One significant difference between electricity. and oil and gas are that electricity is an immediate commodity since balance between supply and demand must be equal at all times to keep the frequency of the grid.
In all markets the trend over the last decades has been a more market-based pricing where prices are set on the margin.
4.2.3) Energy supply.
In the oil and gas market the short run marginal cost is the price need to keep onstream assets cash flow positive. The long-term marginal cost is the price needed to break even investments in new assets. If the price is below the long-term marginal cost of an asset’s investments will be deferred or dropped (Wood Mackenzie Ltd, 2016).
Traditionally OPEC has worked as the short-term swing producers for oil, using its market force to avoid the price dipping to low. The over the last decade OPEC’s role as swing producer has been challenged by shale producers in the United States (Newell, 2017) Over time the supply will be determined by the long-term marginal cost of developing new assets and the willingness to pay in the market.
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Figure 4.3
Electricity markets are distinct from other markets by the fact that there has to be a balance of supply and demand to keep the utility frequency at the right level. To cover demand the producers with the lowest marginal cost are the first to turn on production. If demand is higher than production prices increase and producers with higher marginal cost turns on production (OECD,2020). This gives a merit order of production ranging from low to high marginal cost.
The long run the marginal cost curve is determined by the kind of generating technologies available in a region, the cost of production and the price it can achieve in the market. For instance, if there is a lot of variable renewable in the market with a correlated production, it can depress prices in periods with high production. For instance, there have been periods with negative electricity prices in Germany on windy days (Götz, 2014).
The price for different forms of energy will vary between regions. Safety regulations, interest rates and fuel costs are examples of factors that differ between regions. For most forms of renewable energy like hydropower, solar and wind there will also be variations in weather and geography that determine the price. In general hydropower is among the cheapest ways
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to produce electricity when looking at the price per kwh produces (IRENA, 2019). In addition, Hydropower with dams can shift production to periods with higher price and are therefore able to reap a higher price in the market than per kwh produced compared to solar and wind.
Table 4.2 (Source: IRENA, 2019).
5) The Effect of Climate Policies on the Energy Market – Will it Break the Historic Correlation Between Petroleum and Electricity Prices?
In this chapter I will investigate the assumption that hydropower increases in value relative to fossil fuel with stricter climate policies. To formalize the arguments and illustrate under which assumptions the value of hydropower increases with stricter climate policies I have set up a simple model. The aim of this is to clarify the arguments and structure the
discussion, and to show that the choice of policy instrument could impact to what degree stricter climate policies change the correlation between hydropower and petroleum.
There are several policy instruments available for a government intended to reduce greenhouse gas emissions. Carbon pricing, subsidies, regulations and standards, voluntary agreements, information instruments and research and development are some examples (Gupta, S 2007). A cost-efficient mitigation path in line with the Paris agreement would require a mix of different policies (Rogelj, 2018).
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I will focus on this discussion the effects subsidies and carbon pricing have on the market. I choose to focus specifically on those two instruments because they are among the most widely used and have the most impact on markets. Direct regulation is also an important and much used tool in climate policy, but its effects are often in the form of a shadow price and it is something in between explicit prices and subsidies.
In 5.1 I will look at climate policies in the form of subsidies and in 5.2 I will look at climate policies in the form of carbon pricing. In 5.3 I will investigate how increased use of variable renewable energy in the energy mix could affect the value of stored hydropower. Before I in 5.4 give a brief account of the climate police instruments used in the European Union, the most important market for Norwegian energy to illustrate that there are a multitude of different policies used to mitigate greenhouse gas emissions. In 5.5 I look at what forecasts from the International Energy Agency and the European Commission find about the future demand for renewable and fossil energy if climate policies are stricter.
The argument that hydropower resources reduce the climate risk for Norway rests on an assumption that the value of electricity produced from hydropower increases with a strict climate policy while other parts of the portfolio decrease in value with a stricter policy. This is the case if a transition that leads to lower demand for oil and gas gives higher demand for renewable energy and increases the value of Norway’s hydropower.
First consider an economy where demand for energy 𝐷(𝐸) are exogenously given. This is a strong assumption as price changes also affect the demand for energy. I do this
simplification to look at the first order effects of different policies.
Supply of energy could either be met by renewable energy or by fossil energy. In this economy fossil and renewable energy are perfect substitutes. This is currently a strong assumption, but over time an important role of climate policies is to facilitate the use of renewable energy in sectors that use fossil energy today.
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The supply of fossil fuel are a function F(c,p) of the long term marginal cost of providing fossil energy and the market price. The supply of renewable energy is a function R(C,P) is a function of the long term cost of providing renewable energy and the market price.
There exists a market for energy and the total supply of energy is a sum of energy supplied from fossil fuel and renewable energy:
𝑆(𝐸) = 𝐹(𝑐, 𝑝) + 𝑅(𝑐, 𝑝). (8)
We assume the long-term supply curve of both forms of energy has a positive first
derivative. For the fossil fuel producers this assumption could be justified on the ground that fuel for fossil energy production is limited and with higher demand more expensive sources must be used to meet demand. For renewable energy it rests on an assumption that the best geographic spot for renewable energy is built first and that land is constrained (Duponta, 2018). We assume that in the initial situation the market is supplied by both renewable- and fossil energy. In this economy both producers and consumers are price takers, so the price is set at the margin.
In equilibrium there is a market price that clear the market so that
𝐷(𝐸) = 𝑆(𝐸) (9)
The profit for energy producers is the amount of energy they sell times the price they achieve while selling the energy minus the cost of production.
If a social planner decided to reduce emission in this simple economy, she would have to decrease the use of fossil fuel. Since we assume that the demand for energy in this economy is constant with 𝑆(𝐸) = 𝐷(𝐸) the use of renewable energy would have to increase to meet the constant demand.
Since renewable energy has an increasing marginal cost, 𝑅′ > 0 the price of energy would have to increase to incentivise new investments in renewable energy.
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𝐷(𝐸) = 𝐹(𝑐, 𝑝) + 𝑅(𝑐, 𝑝) if ∆𝐹(𝑐, 𝑝) < 0 then ∆𝑅(𝑐, 𝑝) > 0 (10)
Under the assumption that the demand for energy is constant and the marginal cost of renewable energy is increasing, lower demand for fossil energy due to stricter climate policies would give higher energy prices and the resource rent of existing hydropower would increase. While the fossil energy producers gain a higher price in the market for the products they sell, but their market share is diminished.
This naïve argument has several flaws. For instance, in the real world the choice of policy instruments used to reduce emissions will have a great influence on the price in the energy market. This can be illustrated by a small extension of the model.
5.1) Climate Policies in the Form of Subsidies:
Subsidies give support to activities and technologies that have positive external effects, in this case reduction of greenhouse gas emissions. Subsidies lowers the cost of adapting green technologies for consumers, firms, and other decision makers. This gives lower prices for low and zero emission products and gives a higher demand for low emission solutions (Parry, 1998).
The use of subsidies indirectly replaces fossil fuel through a replacement effect where more abundant renewable energy due to subsidies replace conventional production. In a market where the price is set on the margin it is the fossil fuel producers with highest marginal costs that retires production to balance supply and demand, so there is also a price effect with reduced prices (Abrella et al 2017).
With subsidies s for new production the cost of investing in new renewable energy would be 𝑐 − 𝑠
Supply of energy when subsidies for new investment in renewable energy is used to reduce emissions:
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S(E) = 𝐹(𝑐, 𝑝) + 𝑅(𝑐 − 𝑠, 𝑝). (11)
When the producer of renewable energy gain a subsidy for new production, they would like to invest until the long-term marginal cost for new investments with the subsidy is equal to the market price. When the producers of renewable energy increase their production with
∆𝑅(𝑐 − 𝑐, 𝑝) the price decreases and the fossil fuel production with highest marginal cost is taken out of production. With constant demand for energy this would give a lower market price.
A lower market price for energy would reduce the value of existing hydropower. So, if climate policy is mainly conducted using subsidies for renewable energy climate policies could reduce the value of hydropower.
5.2) Climate Policies in the Form of Carbon Tax:
Carbon pricing sets a price on emissions forcing emitters to internalise the negative externalities from greenhouse gas emissions. A tax that forces producers to internalise externalities is a type of Pigou tax (Pigoue,1920). There are two ways to implement a carbon price. On is to introduce a tax on the distribution, sale or use of fossil fuels based on the carbon content of the activity. Another is to cap the amount of greenhouse gases that can emit in a jurisdiction and let emitters trade permits to emit, thus establishing a price.
With a price on emissions, products with a production, transport or use that leads to greenhouse gas emission, increase in price. Giving producers and consumers incentive to decrease demand and substitute to lower emissions products.
Carbon pricing increases the cost of investing in fossil technology and the new fossil fuel supply function is 𝐹(𝑐 + 𝑡, 𝑝) where in addition to the cost of investment and production there is now a carbon tax on the emissions from the use of fossil fuel. This increases the marginal cost of fossil fuels. With carbon pricing the supply function for energy is:
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𝑆(𝐸) = 𝐹(𝑐 + 𝑡, 𝑝) + 𝑅(𝑐, 𝑝). (12)
Since we have assumed that demand is constant the increased marginal cost for fossil fuel would lead to a higher price. The price rise would be mitigated by increased investment in renewable energy, that is now profitable with a higher price.
From equation 12 we see that when the cost of fossil fuel is increased the price in the market will also increase. With a higher price its more profitable to invest in new renewable energy. The value of existing hydropower would also increase since the price of energy is higher. If some of the new investments in energy are in hydropower resources, there could be an additional increase in the Norwegian hydropower wealth.
An example of this type of mechanism has been illustrated by using the fact that Germany relied heavily on subsidies combined with a weak carbon pricing in the form of the EU emission trading system (EU ETS) while Great Britain used an additional carbon price floor (Gugler et al, 2020) show that a higher carbon price changes the merit order by giving a higher marginal cost for coal and natural gas. Supporting the intuition in this chapter.
5.3) Indirect Effects of a Higher Share Renewable Energy in the Energy Market
So far, we have looked at the direct effects of stricter climate policies. But this approach misses one important aspect of stored hydropower: the flexibility of production. Norway has around half of Europe’s hydropower reservoir capacity and 75 percent of the Norwegian hydropower production is adjustable (energifaktanorge.no, 2021).
Most of the new renewable energy built the last decade is variable (Frankfurt School-UNEP Centre/BNEF, 2019.). Both solar- and wind power varies with the weather and since
electricity is a momentary commodity where there must be a continuous balance between
