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Part 1
The phenomenon of the Energy Poor
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1 The role of energy in economic growth
David I. Stern
Introduction
Researchers differ on the importance of energy in economic growth and development. Toman and Jemelkova (2003) argue that most of the literature on energy and economic development discusses how development affects energy use rather than the reverse. The principal mainstream economic growth models do not include energy (Aghion and Howitt 2009), though macroeconomics pays significant attention to the impact of oil prices on economic activity in the short run (Hamilton 2009). Resource economists have developed models that incorporate the role of resources, including energy, in the growth process, but these ideas have not been integrated into the core economic models and theories. Ecological economists, on the other hand, often ascribe to energy the central role in economic growth (e.g., Hall et al. 2003). Obviously energy is used to produce goods and services, but is it an important driver of economic growth and development? This chapter attempts to answer this question by surveying the literature and synthesizing its more relevant strands.
We cannot understand the role of energy in economic growth without first understanding the role of energy in production. Therefore, I first review basic physical principles and economic concepts that define the role of energy in economic production. The mainstream theory of economic growth is reviewed next. I then discuss ecological economics in the third section. The fourth section presents a simple model that synthesizes mainstream and ecological economics views. Penultimately, I review the empirical evidence on the causal link between energy and growth. The final section of the chapter presents some discussion and conclusions on the role of energy in economic growth.
Energy as a production input
Physical laws describe the operating constraints of economic systems (Boulding 1966; Ayres and Kneese 1969). Conservation of mass means that, to obtain a given production output, greater or equal quantities of materials must be used as inputs, and the production process results in residuals or waste (Ayres and Kneese 1969). Additionally, production requires energy to carry out work to convert materials into desired products and to transport raw materials, goods, and people. The second law of thermodynamics (the entropy law) implies that energy cannot be reused and there are limits to how much energy efficiency can be improved. As a result, energy is always an essential production input (Stern 1997a) and continuous supplies of energy are needed to maintain existing levels of economic activity as well as to grow and develop the economy. Before being used in the production of goods and services, energy and matter must be captured from the environment, and large quantities of energy must be invested to obtain a given amount of net energy (Hall et al. 1986). Before the Industrial Revolution, economies depended on energy from agricultural crops and wood as well as a smaller amount of wind and water power, all of which are directly dependent on the sun. This is still largely the case in rural areas of less developed countries. While solar energy is abundant and inexhaustible, it is very diffuse compared to concentrated fossil fuels. This is why the shift to fossil fuels in the Industrial Revolution released the prevailing constraints on energy supply and, therefore, on production and growth (Wrigley 1988).
Resources in the mainstream theory of economic growth
Despite the facts laid out above, most mainstream economic growth models regard technological change as the primary driver of growth and disregard energy or other resources (Aghion and Howitt 2009). Aghion and Howitt’s (2009) textbook on economic growth does discuss growth and the environment but only in a chapter near the end of the book. Acemoglu’s (2008) textbook does not cover the topic at all. There has been some analysis of the potential for resources to constrain growth in the journal literature but it has mostly been contained within the sub-field of environmental and resource economics.
Robert Solow, who developed the best-known mainstream economic growth model (Solow 1956), in later work introduced non-renewable resources – which could represent fossil or nuclear fuels – into a mainstream economic model (Solow 1974). He showed that sustainability – or the ability of a nation to support a constant level of economic production indefinitely – is achievable under certain institutional and technical conditions. First, even though Solow assumed that resources are essential to production, his model allows the level of production to be maintained with infinitesimally small amounts of these resources as long as enough capital – machines and buildings – is available. Second, policymakers must set policies and make decisions that give equal weight to the well-being of individuals regardless of when they happen to live.
If, instead of Solow’s characterization of the policymaker, we introduce a free market economy into Solow’s (1974) model, the resources are eventually exhausted and the economy completely collapses (Stiglitz 1974a). Dasgupta and Heal (1979) showed that if instead of a free market economy we have a policymaker who tries to make optimal decisions for society but discounts the future at any constant rate,1 then again the natural resource endowment is eventually depleted and the economy collapses. Hartwick (1977, 1995) showed that, if as in the Solow (1974) model, sustainability is technically feasible, a constant level of consumption can be achieved by investing all the rents from the non-renewable resources in other forms of capital, which in turn can substitute for exhausted resources. It is difficult to apply this rule in practice, as the rents and capital must be valued at prices that are compatible with sustainability (Asheim 1994; Stern 1997b; Asheim et al. 2003). Such prices are unknowable given that we have poor understanding of the costs of current environmental damage and resource depletion or of the future development of technology.
In addition to the substitution of capital for resources, technological change might permit continued growth or at least constant consumption in the face of a finite resource base. Solow (1974) did not allow for increases in productivity. Stiglitz (1974b) introduced technological change into this model and showed that under certain technical conditions, technological progress will allow consumption to grow over time. Technological change might enable sustainability even if resources must be used in finite quantities, which is much more realistic for energy given the laws of thermodynamics. But once again, technical feasibility does not guarantee sustainability. Depending on preferences for current versus future consumption, technological change might instead result in faster depletion of the resource (Smulders 2005).
The ecological economics approach
A prominent tradition in ecological economics, known as the biophysical economics approach (Hall et al. 1986), is based on thermodynamics as discussed above (Georgescu-Roegen 1971; Costanza 1980; Cleveland et al. 1984; Hall et al. 1986; Hall et al. 2003; Ayres and Warr 2005, 2009; Murphy and Hall 2010). Ecological economists usually argue that substitution between capital and resources can only play a limited role in mitigating the scarcity of resources (Stern 1997a). Furthermore, some ecological economists downplay the role of technological change in economic growth, arguing that growth is a result of either increased energy use or innovations allowing the more productive use of energy (Cleveland et al. 1984; Hall et al. 1986; Hall et al. 2003). Therefore, in this view, increased energy use is the main or only cause of economic growth.
In this approach, value is derived from the action of energy that is directed by capital and labor. Energy flows into the economy from fossil fuels and the sun. In some biophysical economic models, geological constraints fix the rate of energy extraction so that the flow rather than the stock can be considered as the primary input to production (Gever et al. 1986). Capital and labor are considered as intermediate inputs that are created and maintained by the primary input of energy and flows of matter. The level of the flows is computed in terms of the embodied energy use associated with them. Prices of goods should then ideally be determined by their embodied energy cost (Hannon 1973) – a normative energy theory of value – or are seen as actually being correlated with energy cost (Costanza 1980) – a positive energy theory of value (Common 1995). This theory – like the Marxian paradigm – must then explain how labor, capital, etc. end up receiving part of the surplus. Energy surplus must be appropriated by the owners of labor, capital, and land (Costanza 1980; Gever et al. 1986; Hall et al. 1986; Kaufmann 1987) with the actual distribution of the surplus determined by relative bargaining power.
However, because the quality of resources and technology do affect the amount of energy needed to produce goods and services, it is difficult to argue for a model where energy use alone explains the level of production. For example, the quality of resources such as oil reservoirs is critical in determining the energy required to extract and process fuels. As an oil reservoir is depleted, the energy needed to extract oil increases. On the positive side, improved geophysical knowledge and techniques can increase the extent to which oil can be extracted for a given energy cost. Odum’s energy approach (Brown and Herendeen 1996) and the framework developed by Costanza (1980) address the resource quality issue by including the solar and geological energy embodied in natural resource inputs in indicators of total embodied energy. An alternative approach is to measure material and energy inputs on the common basis of their exergy2 (Ayres et al. 1998; Ukidwe and Bakshi 2007).
However, both approaches seem too reductionist. For example, other services provided by nature such as nutrient recycling, the provision of clean air and water, pollination, and the climate system, that make economic production – and life itself – possible should also then be accounted for. Georgescu-Roegen (1971) formulated a more flexible approach with a variety of different types of production inputs. The neo-Ricardian models developed by Perrings (1987) and O’Connor (1993) also allow any number of inputs while complying with thermodynamic and mass-balance constraints.
A key concept in biophysical economics is energy return on investment (EROI), which is the ratio of useful energy produced by an energy supply system to the amount of energy invested in extracting that energy. Lower quality energy resources have lower EROIs. Biophysical economists argue that the more energy that is required to extract energy, the less energy is available for other uses and the poorer an economy will be. In this view, the increase in EROI allowed by the switch from biomass to fossil fuels enabled the Industrial Revolution and the period of modern economic growth that followed it (Hall et al. 1986).
Thus, declining EROI would threaten not just growth but overall economic output and, therefore, sustainability. Murphy and Hall (2010) document EROI for many energy sources, arguing that it is declining over time. Wind and direct solar energy have more favorable EROIs than biomass fuels, but worse than most fossil fuels. However, unlike fossil fuels, the EROI of these energy sources tends to improve over time with innovation (Kubiszewski et al. 2010). Declining EROI could be mitigated by substituting other inputs for energy or by improving the efficiency with which energy is used. However, biophysical economists argue that both these processes have limits.
Substitution can occur within a category of similar production inputs – for example between different fuels – and between different categories of inputs – for example between energy and machines. There is also a distinction to be made between substitution at the micro level – for example, within a single engineering process or at a single firm – and at the macro level, i.e., in the economy as a whole.
The long-run pattern of energy use in industrial economies has been dominated by substitutions from wood and animal power to coal, oil, natural gas, and primary electricity (see Figure 1.1) (Hall et al. 1986; Smil 1991). Meta-analysis of existing studies of interfuel substitution suggests that the long-run substitution possibilities at the level of the industrial sector as a whole are good. But there seems to be less substitutability at the macro level (Stern 2012).
Ecological economists emphasize the importance of limits to inter-category substitution; in particular, the substitution of manufactured capital for resources including energy (Costanza and Daly 1992). Thermodynamic limits can be approximated by a production function with an elasticity of substitution significantly below one (Stern 1997a).3 A meta-analysis of the existing empirical literature finds that the elasticity of substitution between capital and energy is less than one (Koetse et al. 2008).
In addition to this microeconomic limit to substitution, there may also be macroeconomic limits to substitution. The construction, operation, and maintenance of tools, machines, and factories require a flow of materials and energy. Similarly, the humans that direct manufactured capital consume energy and materials. Thus, producing more of the “substitute” for energy – manufactured capital – requires more of the thing that it is supposed to substitute for. This again limits potential substitutability (Cleveland et al. 1984).
The mainstream economic argument that technological change can overcome limited substitutability would be more convincing if technological change were really something different from substitution. Changes in technology occur when new techniques are developed. However, these new techniques represent the substitution of knowledge for other inputs. The knowledge is embodied in improved capital goods and more skilled workers and managers. But there are still thermodynamic restrictions on the extent to which energy and material flows can be reduced in this way. Although knowledge is non-rival in use, it must be used in conjunction with the other inputs, such as energy, and the productivity of knowledge is limited by the available quantities of those inputs.
Figure 1.1 Composition of US primary energy input 1850–2013
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