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The article below is an excerpt from our Q1 2024 commentary.
In the wake of the 1929 stock market crash and the Great Depression, the Securities and Exchange Commission (SEC) embarked on an ambitious journey to formalize accounting rules and practices for publicly listed companies. This decades-long endeavor culminated in establishing Generally Accepted Accounting Practices (GAAP) in 1970—a robust framework that standardized financial calculations and reporting, thus bringing clarity and order to the corporate financial landscape.
Yet, no such standardization exists in the domain of the energy transition. The trillions of dollars we believe have been squandered on wind, solar, and electric vehicles highlight the critical need for a standardized framework. Such a framework is not merely desirable but essential for avoiding malinvestment on a grand scale.
In earlier essays, we delved into the concept of Energy Return on Investment (EROI), a principle advanced by Professor Charles Hall in the 1970s. EROI gained prominence in the early 2000s amid the specter of peak oil, serving as a tool to measure the energy intensity of oil production, particularly from the Canadian oil sands. Analysts fretted that the increasing energy consumption required to extract oil from these sands would diminish EROI, thus stymying economic growth.
The shale revolution in the United States momentarily dispelled these fears and EROI studies receded into the background. However, in 2016, we reignited the debate, applying Hall’s framework to the emergent wind, solar, and electric vehicle industries. Professor Vaclav Smil, in his critically acclaimed 2017 book Energy and Civilization: A History, chronicles humanity’s relentless pursuit of greater energy efficiency. Historically, every new energy technology adopted has surpassed its predecessor in efficiency. We used the EROI framework to test whether wind and solar could outperform crude oil and natural gas. If they did, these renewables would inevitably displace hydrocarbons, prompting a shift in our investment strategy. If not, the transition away from hydrocarbons would stand as one of history’s greatest misallocations of capital, rendering traditional energy stocks extraordinarily undervalued.
Our analysis revealed that wind and solar energy offer an EROI markedly inferior to traditional hydrocarbons. Similarly, the total energy required to power an electric vehicle using renewable sources for a distance of 100 miles significantly exceeds that of an internal combustion engine. Our previous letters detail these findings.
At first, our views were outliers. However, the mounting challenges energy transition companies face have sparked renewed interest in our conclusions. In our exploration of “The Norwegian Illusion,” (4Q2023 G&R Commentary) we recently debunked many claims championed by the renewable power and EV industries.
While our arguments have primarily been well-received, some questions linger about the precise calculation of energy efficiency and EROI. The variability in data and conclusions among analysts necessitates clarification and reconciliation of misconceptions.
The crux of the ambiguity lies in the calculation of EROI itself, hindered by a lack of standardization. The “energetic boundary” problem encompasses two key issues: where to stop tallying energy inputs, analogous to Scope 1, 2, and 3 emissions in carbon accounting. For instance, in a wind project, one must account for the energy required to mine iron ore, smelt steel, and construct turbines. But should we include diesel for transporting the workforce or energy in their food and housing? Establishing a consistent boundary is vital, as undercounting total energy requirements is expected. Yet, the substantial energy required in upstream and manufacturing processes means minor boundary errors are usually immaterial.
A more significant issue is categorizing energy requirements. Here, GAAP can be instructive. EROI is typically the ratio of usable energy output to energy input. Consistently distinguishing operating energy costs from capital energy costs, just like what is done in financial accounting, is essential for calculating consistent and comparable EROI figures.
Consider a hypothetical financial investment: a manager commits $100 million to build a factory producing 100,000 widgets annually for twenty years. The widgets sell for $800 each, with direct operating costs of $700, generating $80 million in annual revenue and $10 million in profits. With an initial $100 million capital expenditure, the factory yields a 10% return on investment, doubling the company’s initial outlay over twenty years—a sound investment.
However, if viewed as “money in” versus “money out,” an analyst might mistakenly conclude the facility barely covers its costs. Total revenue generated over twenty years is $1.6 bn compared with $100 mm to build the facility and $1.4 bn to produce the individual widgets. Such faulty reasoning would suggest $100 mm of profit (“money out”) and $1.5 bn of cost (“month in”). Dividing the two would yield a twenty-year total return of only 6%, or 0.33% per annum. GAAP principles clarify that the former analysis is correct; the latter is flawed. Properly distinguishing operating cost from capital cost correctly predicts the company ends with twice the cash after the facility’s useful life.
Unfortunately, no comparable framework exists for studying energy systems. This lack of standards leads to ill-informed decisions and inconsistent calculations across different technologies, hindering like-for-like comparisons.
For example, calculating oil’s EROI begins with the energy for exploration, drilling, and well completion. The wellhead EROI might be 60x, meaning 6,000 units of energy produced from 100 units invested. However, oil must be transported and refined, consuming 15% of its energy content – or 900 units. This reduces the net EROI to 50x. If, instead, we misclassified the 900 units used to refine crude into gasoline as simply “energy out,” we might erroneously conclude the oil well delivered 6,000 units of energy against costs of 1,000 units (100 units at the wellhead and 900 units downstream), suggesting an incorrect EROI of 6x, a nearly 90% drop for the very same system.
Energy analysts inconsistently apply these principles to renewables. For instance, a wind turbine might generate twelve times the energy needed to build it, resulting in a gross EROI of 12x. If the turbine required 100 units of energy, it would produce 1,200 units over its life. With 15% power loss to grid interconnections, the net available energy would be 1,020 units. Analysts often subtract line losses from the generated renewable power, concluding an EROI of 10x, inconsistent with how they treat oil wells. We have seen many studies that suggest gasoline has a societal EROI of 6x compared with wind power of 10x, suggesting wind is the better choice. A consistent methodology instead confirms gasoline’s EROI as 50x compared to wind’s 10x – suggesting gasoline is far preferred.
GAAP offers guidance on whether a cost should be expensed or capitalized. Costs for acquiring, upgrading, or extending a long-lived asset’s duration should be capitalized. Average operating costs incurred in the same period as the output should be expensed. Direct operating costs, attributable to production units, are always expenses, never capital charges. Using this framework, energy used for crude transportation and refining and line loss from wind turbines are all clearly operating charges and should be treated as such.
Correctly calculating returns is crucial for assessing future surplus. Just as a manager can predict cash surplus from a widget factory, we must determine future energy surplus from investments. Misguided methodologies have contributed to today’s energy crisis. Professor Hall, a pioneer in EROI studies, is now working to standardize these issues. Adhering to GAAP-like principles for energy calculations can help us better navigate the energy transition and ensure that investments yield sustainable, long-term returns.
Intrigued? We invite you to download or revisit our entire Q1 2024 research letter, available below.
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