Friday, 6 July 2012

Do EROEI ratios matter a lot?

I have recently been discussing how important EROEI ratios for economic prosperity. We are soon going to exhaust all high EROEI fossil fuel sources. So we will have really no choice but to switch to lower grade energy sources. Is this a big deal?

Obviously there are big issues with such a transition (mainly due to the more polluting nature of some alternative sources), but is the lower EROEI a source of concern?

I think the standard economic reply to that question is that it would simply stimulate investment. A lower EROEI source requires a higher ratio of capital vs income (or investment vs consumption). This is not necessarily bad, given that most economic models assume that you can accumulate an infinite amount of capital. Lower EROEI requires a bigger physical capital structure and such capital structure is always achievable. Provided the lower EROEI source is infinite, you will reach a new equilibrium, where the higher capital will generate enough return for the previous level of consumption and the investment necessary to renew or expand the capital base. I think that various renewable technologies (solar, algae bio-fuels, etc...) could be that infinite EROEI source.

I think it might be interesting to calculate what rate of return is implied by a certain EROEI. I think I can use the simple model in the previous post. With such a simple exponential decay, EROEI is simply equal to productivity divided by decay.

We can now solve a simple equation to calculate the internal rate of return for such a return profile:

The solution is simply:
What can we say about this equation? Well the first question is what are reasonable values for d. To be honest I am not entirely sure... I would guess between 3% and 10%, corresponding to half-life between 7 and 25 years. Taking 5% as a guess, it gives us a 15% rate of return for a EROEI of 3 (I think this is the current estimates for tar sands). I think that this compares quite well with standard equity rate of return. Certainly EROEIs below 2 look difficult to sustain, especially on very long dated projects. Market real returns have been on a secular down trend, so you never know, but it looks tricky.

The above analysis is implicitly assuming that the energy I put into the project will be worth as much as the energy I take out. Historically this hasn't been the case to be honest, with highly volatile energy prices creating significant uncertainty which stopped investment.

Such rates of return would seem to suggest there should always be massive investment in energy production, but for a large part of recent past, lack of demand for oil was the real bottleneck, with producers in the 1990 having to cut supply in order to maintain prices. The joint effect of slow investment and the physical depletion of known reserves has now change that equilibrium and we are observing an increase in prices and investment, be it wind/solar, tar sands and gas fracking.

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