The UK government has finally given the go-ahead to build the new Hinkley C nuclear power station in Somerset. It will consist of two European pressurised reactors, a relatively new technology. No EPR plant has yet been completed, with the one in the most advanced stages of construction at Flamanville in France, having experienced many safety and construction problems. This is currently expected to be more than three times over budget and at least six years behind its original completion date of 2012.
The Hinkley C power station, first proposed in 2007, is currently estimated to cost £18 billion. This cost will be borne entirely by its builder, EDF, the French 85% state-owned company, and its Chinese partner, CGN. When up and running – currently estimated at 2025 – it is expected to produce around 7% of the UK’s electricity output.
On becoming Prime Minister in July 2016, Theresa May announced that the approval for the plant would be put on hold while further investigation of its costs, benefits, security concerns, technological issues and safeguards was conducted. This has now been completed and approval has been granted subject to new conditions. The main one is that the government “will be able to prevent the sale of EDF’s controlling stake prior to the completion of construction”. This will allow the government to prevent change of ownership during the construction phase. Thus, for example, EDF, would not be allowed to sell its share of Hinkley C to CGN, which currently has a one-third share in the project. EDF and CGN have accepted the new terms.
After Hinkley the government will have a ‘golden share’ in all future nuclear projects. “This will ensure that significant stakes cannot be sold without the Government’s knowledge or consent.”
In return for their full financing of the project, the government has guaranteed EDF and CGN a price of £92.50 per megawatt hour of electricity (in 2012 prices). This price will be borne by consumers. It will rise with inflation from now and over the first 35 years of the power station’s operation. It is expected that the Hinkley C will have a life of 60 years.
Critics point out that this guaranteed ‘strike price’ is more than double the current wholesale price of electricity and, with the price of renewables falling as technology improves, it will be an expensive way to meet the UK’s electricity needs and cut carbon emissions.
Those in favour argue that it is impossible to predict electricity prices into the distant future and that the certainty this plant will give is worth the high price by current standards.
To assess the desirability of the plant requires an assessment of its costs and benefits. In principle, this is a relatively simple process of identifying and measuring the costs and benefits, including external costs and benefits; discounting future costs and benefits to give them a present value; weighting them by their probability of occurrence; then calculating whether the net present value is positive or negative. A sensitivity analysis could also be conducted to show just how sensitive the net present value would be to changes in the value of specific costs or benefits.
In practice the process is far from simple – largely because of the huge uncertainty over specific costs and benefits. These include future wholesale electricity prices, unforeseen problems in construction and operation, and a range of political issues, such as pressure from various interest groups, and attitudes and actions of EDF and CGN and their respective governments, which will affect not only Hinkley C but other future power stations.
The articles look at the costs and benefits of this, the most expensive construction project ever in the UK, and possibly on Earth..
Hinkley Point: UK approves nuclear plant deal BBC News (15/9/16)
Hinkley Point: What is it and why is it important? BBC News, John Moylan (15/9/16)
‘The case hasn’t changed’ for Hinkley Point C BBC Today Programme, Malcolm Grimston (29/7/16)
U.K. Approves EDF’s £18 Billion Hinkley Point Nuclear Project Bloomberg, Francois De Beaupuy (14/9/16)
Hinkley Point C nuclear power station gets government green light The Guardian, Rowena Mason and Simon Goodley (15/9/16)
Hinkley Point C: now for a deep rethink on the nuclear adventure? The Guardian, Nils Pratley (15/9/16)
Hinkley Point C finally gets green light as Government approves nuclear deal with EDF and China The Telegraph, Emily Gosden (15/9/16)
UK gives go-ahead for ‘revised’ £18bn Hinkley Point plant Financial Times, Andrew Ward, Jim Pickard and Michael Stothard (15/9/16)
Hinkley Point: Is the UK getting a good deal? Financial Times, Andrew Ward (15/9/16)
Hinkley Point is risk for overstretched EDF, warn critics Financial Times, Michael Stothard (15/9/16)
Hinkley C must be the first of many new nuclear plants The Conversation, Simon Hogg (16/9/16)
Nuclear power in the UK National Audit Office, Sir Amyas Morse, Comptroller and Auditor General (12/7/16)
- Summarise the arguments for going ahead with Hinkley C.
- Summarise the objections to Hinkley C.
- What categories of uncertain costs and uncertain benefits are there for the project?
- Is the project in EDF’s interests?
- How will the government’s golden share system operate?
- How should the discount rate be chosen for discounting future costs and benefits from a project such as Hinkley C?
- What factors will determine the wholesale price of electricity over the coming years? In real terms, do you think it is likely to rise or fall? Explain.
- If nuclear power has high fixed costs and low marginal costs, how does this affect how much nuclear power stations should be used in a situation of daily and seasonal fluctuations in demand?
- How could ‘smart grid’ technology smooth out peaks and troughs in electricity supply and demand? How does this affect the relative arguments about nuclear power versus renewables?
Oil prices will remain below $60 per barrel for the foreseeable future. At least this is what is being assumed by most oil producing companies. In the more distant future, prices may rise as investment in fracking, tar sands and new wells dries up. In meantime, however, marginal costs are sufficiently low as to make it economically viable to continue extracting oil from most sources at current prices.
The low prices are partly the result of increases in supply from large-scale investment in new sources of oil over the past few years and increased output by OPEC. They are also partly the result of falling demand from China.
But are low prices all bad news for the oil industry? It depends on the sector of the industry. Extraction and exploration may be having a hard time; but downstream, the refining, petrochemicals, distribution and retail sectors are benefiting from the lower costs of crude oil. For the big integrated oil companies, such as BP, the overall effect may not be as detrimental as the profits from oil production suggest.
BP – low oil price isn’t all bad new BBC News, Kamal Ahmed (27/10/15)
Want to See Who’s Happy About Low Oil Prices? Look at Refiners Bloomberg, Dan Murtaugh (31/10/15)
Low prices are crushing Canada’s oil sands industry. Shell’s the latest casualty. Vox, Brad Plumer (28/10/15)
Brent spot crude oil prices US Energy Information Administration
BP Quarterly results and webcast BP
- Why have oil prices fallen?
- What is likely to happen to the supply of oil (a) over the next three years; (b) in the longer term?
- Draw a diagram with average and marginal costs and revenue to show why it may be profitable to continue producing oil in the short run at $50 per barrel. Why may it not be profitable to invest in new sources of supply if the price remains at current levels?
- Find out in what downstream sectors BP is involved and what has happened to its profits in these sectors.
- Draw a diagram with average and marginal costs and revenue to show why profits may be increasing from the wholesaling of petrol and diesel to filling stations.
- How is price elasticity of demand relevant to the profitablity of downstream sectors in the context of falling costs?
Ever been to the cinema and found it almost empty? And then wondered why you paid the full price? Perhaps you’ve taken advantage of Orange Wednesday or only go if there’s a particularly good film on? Often it might be cheaper to wait until the film is out on DVD!
Going to the cinema can be an expensive outing. The ticket, the popcorm, a drink, ice cream – it all adds up! Orange Wednesday has recently disappeared and this will definitely have an impact on consumption of movies at your local Odeon, Vue or Showcase. The impact will be on how many seats are left empty.
However, a new app could be set to generate revenues for the cinema and provide cheaper entertainment for your everyday consumer. This new app will allow cinemas to send out alerts to people in the local area advising them that a screening will have many empty seats. What’s the incentive? Perhaps a discount, or some food. But, why would they do such a thing?
If a movie is being shown at a cinema, there will be a large fixed cost. However, what happens as each additional consumer enters the theatre? Does the cost to the cinema rise? Perhaps there is a small cost with more cleaning required, but the additional cost of actually showing the film if there 11 rather than 10 people is almost (if not equal to) zero. That is, the marginal cost of an extra user is zero. Therefore, if there is a screening with many empty seats, wouldn’t the cinema be better to offer the seats for half price. After all, if you can earn £5 from selling a ticket and the additional cost is almost zero, then it’s better to sell it for £5 than not sell it for £10! The following article and video from BBC News considers this new app and other strategies to maximise cinema usage!
Apps in pockets, bums on cinema seats BBC News, Dave Lee (27/2/15)
- What would the budget constraint look like for a cinema where a discount was offered if you purchased two cinema tickets and then received the third ticket for half price?
- Why is the marginal cost of an extra user at the cinema almost zero?
- If the MC = 0, does this mean that a cinema is a public good?
- How will this new app allow a cinema to increase total revenue and profit?
- If it is cheaper to buy a DVD rather than go to a cinema, why do people still go to the cinema?
The recent low price of oil has been partly the result of faltering global demand but mainly the result of increased supply from shale oil deposits. The increased supply of shale oil has not been offset by a reduction in OPEC production. Quite the opposite: OPEC has declared that it will not cut back production even if the price of oil were to fall to $30 per barrel.
We looked at the implications for the global economy in the post, A crude indicator of the economy (Part 2). We also looked at the likely effect on oil prices over the longer term and considered what the long-run supply curve might look like. Here we examine the long-run effect on prices in more detail. In particular, we look at the arguments of two well-known commentators, Jim O’Neill and Anatole Kaletsky, both of whom have articles on the Project Syndicate site. They disagree about what will happen to oil prices and to energy markets more generally in 2015 and beyond.
Jim O’Neill argues that with shale oil production becoming unprofitable at the low prices of late 2014/early 2015, the oil price will rise. He argues that a good indicator of the long-term equilibrium price of oil is the five-year forward price, which is much less subject to speculation and is more reflective of the fundamentals of demand and supply. The five-year forward price is around $80 per barrel – a level to which O’Neill thinks oil prices are heading.
Anatole Kaletsky disagrees. He sees $50 per barrel as a more likely long-term equilibrium price. He argues that new sources of oil have made the oil market much more competitive. The OPEC cartel no longer has the market power it had from the mid 1970s to the mid 1980s and from the mid 2000s, when surging Chinese demand temporarily created a global oil shortage and strengthened OPEC’s control of prices. Instead, the current situation is more like the period from 1986 to 2004 when North Sea and Alaskan oil development undermined OPEC’s power and made the oil market much more competitive.
Kaletsky argues that in a competitive market, price will equal the marginal cost of the highest cost producer necessary to balance demand and supply. The highest cost producers in this case are the shale oil producers in the USA. As he says:
Under this competitive logic, the marginal cost of US shale oil would become a ceiling for global oil prices, whereas the costs of relatively remote and marginal conventional oilfields in OPEC and Russia would set a floor. As it happens, estimates of shale-oil production costs are mostly around $50, while marginal conventional oilfields generally break even at around $20. Thus, the trading range in the brave new world of competitive oil should be roughly $20 to $50.
So who is right? Well, we will know in twelve months or more! But, in the meantime, try to use economic analysis to judge the arguments by answering the questions below.
The Price of Oil in 2015 Project Syndicate, Jim O’Neill (7/1/15)
A New Ceiling for Oil Prices Project Syndicate, Anatole Kaletsky (14/1/15)
- For what reasons might the five-year forward price of oil be (a) a good indicator and (b) a poor indicator of the long-term price of oil?
- Under O’Neill’s analysis, what would the long-term supply curve of oil look like?
- Are shale oil producers price takers? Explain.
- Draw a diagram showing the marginal and average cost curves of a swing shale oil producer. Put values on the vertical axis to demonstrate Kaletsky’s arguments. Also put average and marginal revenue on the diagram and show the amount of profit at the maximum-profit point.
- Why are shale oil producers likely to have much higher long-run average costs than short-run variable costs? How does this affect Kaletsky’s arguments?
- Under Kaletsky’s analysis, what would the long-term supply curve of oil look like?
- Criticise Kaletsky’s arguments from O’Neill’s point of view.
- Criticise O’Neill’s arguments from Kaletsky’s point of view.
- Will OPEC’s policy of not cutting back production help to restore its position of market power?
- Why might the fall in the oil price below $50 in early 2015 represent ‘overshooting’? Why does overshooting often occur in volatile markets?
As we saw in Part 1 of this blog, oil prices have fallen by some 46% in the past five months. In that blog we looked at the implications for fuel prices. Here we look at the broader implications for the global economy? Is it good or bad news – or both?
First we’ll look at the oil-importing countries. To some extent the lower oil price is a reflection of weak global demand as many countries still struggle to recover from recession. If the lower price boosts demand, this may then cause the oil price to rise again. At first sight, this might seem merely to return the world economy to the position before the oil price started falling: a leftward shift in the demand for oil curve, followed by a rightward shift back to where it was. However, the boost to demand in the short term may act as a ‘pump primer’. The higher aggregate demand may result in a multiplier effect and cause a sustained increase in output, especially if it stimulates a rise in investment through rising confidence and the accelerator, and thereby increases capacity and hence potential GDP.
But the fall in the oil price is only partly the result of weak demand. It is mainly the result of increased supply as new sources of oil come on stream, and especially shale oil from the USA. Given that OPEC has stated that it will not cut its production, even if the crude price falls to $40 per barrel, the effect has been a shift in the oil supply curve to the right that will remain for some time.
So even if the leftward shift in demand is soon reversed so that there is then some rise in oil prices again, it is unlikely that prices will rise back to where they were. Perhaps, as the diagram illustrates, the price will rise to around $70 per barrel. It could be higher if world demand grows very rapidly, or if some sources of supply go off stream because at such prices they are unprofitable.
The effect on oil exporting countries has been negative. The most extreme case is Russia, where for each $10 fall in the price of oil, its growth rate falls by around 1.4 percentage points (see). Although the overall effect on global growth is still likely to be positive, the lower oil price could lead to a significant cut in investment in new oil wells. North sea producers are predicting a substantial cut in investment. Even shale oil producers in the USA, where the marginal cost of extracting oil from existing sources is only around $10 to £20 per barrel, need a price of around $70 or more to make investment in new sources profitable. What is more, typical shale wells have a life of only two or three years and so lack of investment would relatively quickly lead to shale oil production drying up.
The implication of this is that although there has been a rightward shift in the short-run supply curve, if price remains low the curve could shift back again, meaning that the long-run supply curve is much more elastic. This could push prices back up towards $100 if global demand continues to expand.
This can be illustrated in the diagram. The starting point is mid-2014. Global demand and supply are D1 and S1; price is $112 per barrel and output is Q1. Demand now shifts to the left and supply to the right to D2 and S2 respectively. Price falls to $60 per barrel and, given the bigger shift in supply than demand, output rises to Q2. At $60 per barrel, however, output of Q2 cannot be sustained. Thus at $60, long-run supply (shown by SL) is only Q4.
But assuming the global economy grows over the coming months, demand shifts to the right: say, to D3. Assume that it pushes price up to $100 per barrel. This gives a short-run output of Q3, but at that price it is likely that supply will be sustainable in the long run as it makes investment sufficiently profitable. Thus curve D3 intersects with both S2 and SL at this price and quantity.
The articles below look at the gainers and losers and at the longer-term effects.
Where will the oil price settle? BBC News, Robert Peston (22/12/14)
Falling oil prices: Who are the winners and losers? BBC News, Tim Bowler (16/12/14)
Why the oil price is falling The Economist (8/12/14)
The new economics of oil: Sheikhs v shale The Economist (6/12/14)
Shale oil: In a bind The Economist (6/12/14)
Falling Oil Price slows US Fracking Oil-price.net, Steve Austin (8/12/14)
Oil Price Drop Highlights Need for Diversity in Gulf Economies IMF Survey (23/12/14)
Lower oil prices boosting global economy: IMF Argus Media (23/12/14)
Collapse in oil prices: producers howl, consumers cheer, economists fret The Guardian (16/12/14)
North Sea oilfields ‘near collapse’ after price nosedive The Telegraph, Andrew Critchlow (18/12/14)
How oil price fall will affect crude exporters – and the rest of us The Observer, Phillip Inman (21/12/14)
Cheaper oil could damage renewable energies, says Richard Branson The Guardian,
Richard Branson: ‘Governments are going to have to think hard how to adapt to low oil prices.’ John Vidal (16/12/14)
Brent crude prices U.S. Energy Information Administration (select daily, weekly, monthly or annual data and then download to Excel)
Brent Oil Historical Data Investing.com (select daily, weekly, or monthly data and time period)
- What would determine the size of the global multiplier effect from the cut in oil prices?
- Where is the oil price likely to settle in (a) six months’ time; (b) two years’ time? What factors are you taking into account in deciding your answer?
- Why, if the average cost of producing oil from a given well is $70, might it still be worth pumping oil and selling it at a price of $30?
- How does speculation affect oil prices?
- Why has OPEC decided not to cut oil production even though this is likely to drive the price lower?
- With Brent crude at around $60 per barrel, what should North Sea oil producers do?
- If falling oil prices lead some oil-importing countries into deflation, what will be the likely macroeconomic impacts?