Blog-Normal Distribution - Analytic lessons and random observations by John Sall, JMP creator and SAS co-founder

I had the privilege to lead off a press event this morning for North Carolina Gov. Bev Perdue at the SAS Solar Farm in Cary, NC. It was a beautiful photo event on a small hill overlooking the field. Here are my remarks:

Good morning and welcome to the SAS Solar Farm. I am John Sall, co-founder of SAS Institute.

This field of solar panels was completed last December; it has 5,040 panels, generates 1 megawatt of electic power at peak and is projected to produce 1.7 million KWH per year. The panels swivel to track the sun across the sky. This solar farm will eliminate 1,600 tons of carbon emissions annually.

The solar field occupies 4.8 acres of land -- and we also use the field as a pasture for Dorper Sheep (short sheep that fit better under the panels).

Eventually, the revenues from this facility will repay our investment, but only because of the generous state and federal tax credits and NC GreenPower electric rates. Without the incentives, this solar-generating facility would not have been built.

I hope that federal legislation will be forthcoming to make alternative energy and energy conservation economic by a federal charge on fossil carbon energy sourcing; this would be the most effective, efficient and ultimately the least painful way to a sustainable energy future. Until that becomes politically viable, other measures, such as alternative energy subsidies and quantity limits will at least move us in the right direction toward sustainability and energy security.

This solar farm is one of several energy initiatives at SAS. We aim to conserve energy use as we grow more jobs here:

• Our next building, under construction over there behind those trees, is designed to achieve LEED certification at least at the Silver level.
  
• Elsewhere, our forthcoming cloud computing facility will use energy-efficient computer systems.
  
• We recently published our second annual corporate sustainability and social responsibility report, which summarizes these and other efforts.
  

SAS is happy to call North Carolina home, with the state’s support for business, research and higher education, all of this enabling better jobs, better health and long-term sustainability.

North Carolina has many opportunities in alternative energy: in solar, in biofuels and in wind. Recently, the federal Department of the Interior, under Ken Salazar, made the first step to unlock leasing for offshore wind farms, and North Carolina has some of the best opportunities.

North Carolina is a home for energy research, too. We congratulate NC State University, which last year was appointed the lead institution for a smart grid NSF grant, which led to the FREEDM Systems Center (Future Renewable Electric Energy Delivery and Management).

We welcome everyone here to this new energy farm, and we look forward to our governor’s announcements on the subject of sustainability.

It is my privilege to introduce the Governor of the State of North Carolina, Bev Perdue.




Dale Carroll, Deputy Secretary of NC Department of Commerce (left); Hilda Pinnix-Ragland, Vice President of Corporate Public Affairs for Progress Energy (second from left); and NC Gov. Bev Perdue (center) join Jerry Williams of SAS (second from right) and me (right) at the SAS Solar Farm this morning. The Dorper Sheep are in the background.

Photo by Steve Muir, SAS

In my Earth Day blog post last week, I introduced some claims that actions on price were better than actions on quantity in the carbon market. Now it is time to back up those claims.

The main tool of economic thinking is supply and demand curves. Let's draw hypothetical supply and demand curves for carbon in carbon fuels. Economists reverse the usual X and Y and put price on the Y axis and quantity on the X axis. At low prices, people are willing to buy more carbon; and at high prices, people will buy less, substituting other goods (alternative energy) or withdrawing (energy conservation).

Thus, we have the red demand curve. Supply has the reverse slope, with low prices reducing supply and high prices increasing supply (the blue line). Where the curves cross, we have where the price and quantity are determined, at point A, with quantity 50 and price 50.





Now consider a charge on carbon sourcing. OK, it is a carbon tax, but please don't let the word tax scare you.

The carbon tax just shifts the supply curve upward by the amount of the tax, 20, resulting in a new supply curve, the orange line. The new supply curve crosses the demand curve at point B now, resulting in a smaller quantity (40) and higher price (60).

The alternative to a carbon tax is a carbon cap, restricting quantity to not exceed a cap of 40, the green line. Actually, the supply curve is the gray-shadow that begins with the blue line, but then turns straight up at the green line. The new capped supply also crosses the demand curve at quantity 40 and price 60. We have constructed the lines to show that you can set the tax at an amount that would be equivalent to some cap.





Suppose that we have fluctuations in the economy, business cycles, booms and recessions. These things do happen, you know. In recession, the demand curve shifts down, with less quantity demanded at a given price. In a boom, the demand curve shifts up, with more quantity demanded at a given price. This variation is represented by the three red demand curves below.

Now see how the different supply curves change the solution. With a carbon tax (orange supply curve), we have the price quantity solution varying from B up to D1 in a boom, and down to D2 in a recession -- resulting in prices varying between 55 and 65.

If we have a cap (the green line) instead of a tax, then the three demand curves change the solution from B down to C2 and up to C1 -- resulting in prices varying between 50 and 70.





I don't know the true locations of carbon supply and demand, but we don't have to know to make some conclusions. A vertical supply curve (the cap) will always produce more-variable prices than any positively sloped supply curve. The cap produces the maximum price variation possible for any non-negatively sloped supply curve.

What about total carbon consumed between a cap and a tax? The cap's quantity will be fixed, assuming the economy is not so bad that demand is less than the cap. The tax's quantity will be variable, but it can be designed so that the average quantity produced is the same as the carbon cap. Just imagine the variations between the three red lines, and the quantity solves between 35 and 45, with a long-run mean of 40, the same as the cap. Carbon goals are long term. We need to limit the average carbon emitted; we don't care whether carbon emissions vary some from year to year.

So the mean carbon emitted is the same between cap and tax, but the price variation is much higher for the cap. The goal is to limit carbon emissions. But the way you get to the goal is through alternative energy and energy conservation. There is no other mechanism. And the economic driver for alternative energy and energy conservation is price. We have to have higher energy prices to solve demand to lower quantity, whether through a cap or a tax.

Energy conservation and alternative energy are structural changes driven by investments. For example, when gasoline prices are high, like a year ago, we tend to buy high-mileage cars. And when gasoline prices are low, like now, we tend to buy bigger cars. When prices are high, we make long-term investments in solar and wind energy. When prices are low, we don't. It's not good business. But investments are decided on variability as well as price. Why invest in a solar farm if prices are so variable as to make that investment risky? We need stable prices, as well as high prices to make the structural change happen.

Carbon taxes produce more stable prices than carbon caps do. History on previous caps back that up. The CBO study, "Policy Options for Reducing CO2 Emissions," which I referred to in my previous post, notes that sulfur-dioxide emission permits had prices that varied much more than the economy. And EU carbon credits collapsed to half the price that prevailed six months earlier, as reported in the issue of the journal Nature that I also mentioned last week.

The Waxman climate-change bill only specifies a cap of 3% below 2005 levels by 2012. Will that make prices high enough to stimulate investments in energy conservation and alternative energy? 2005 was a huge boom year, and we are unlikely to demand that much energy unless we have another huge boom economy. Therefore, I would expect almost no price support by then for alternative energy or energy conservation.

Of course, support for alternative energy and energy conservation can be in the form of subsidies. Subsidies are an inefficient manipulation of the market. The economy adjusts far more efficiently to real prices than it does to subsidies. We want people and businesses to invest in energy conservation and alternative energy because energy prices are high enough for that to make solid business sense. Let the market do what it will. Let taxes that account for externalities (commons costs) make the adjustments we need to supply.

What happens later when the economy booms again? Then we have a huge price impact from a cap, and this is so worrisome that the Waxman bill has a strategic carbon reserve ready to unload more emissions credits to auction when needed. This makes for an unpredictable wiggle to the right of the cap. It is better than not having it, but a smooth supply curve would be much better.

You still might not want a carbon tax because it is new tax burden. Well, a cap is even more of a burden; you either have ineffective limits or even higher energy prices. Carbon taxes can be returned to taxpayers, per capita, to make them revenue-neutral. Caps could also, if the emissions credits were auctioned and the proceeds distributed, but that is not the current plan. The current plan needs to be changed.

There is much more to say in future blog posts about the reserve, market manipulation, time-banking, operational considerations and international issues.

I suggest you spend some time on Earth Day reading about environmental policy.

First, you should get the most recent (April 19, 2009) issue of The New York Times Magazine and read the article "Why isn't the brain green?" by Jon Gertner. The most powerful force in environmental policy is the public’s opinion, and the shaping of this opinion is extremely important. The article profiles the work of CRED, the Center for Research on Environmental Decisions, and the work of Elke Weber and her colleagues. In particular, the work of David Hardistry and the thinking of Baruch Fischhoff could make a huge difference in how to frame the current debate. The article says it could be very politically palatable to act on price, rather than quantity, in climate legislation.

Second, you should be aware of the issue of Nature dated Jan 22, 2009. Notice the article titled “Not so sunny after all” to see that the solar energy market is deeply depressed now, though it was booming a year ago. Then notice the article “Prices plummet on carbon market” to see that the price of a ton of CO2 emission went from more than 30 euros in July 2008 to only 11.65 euros in January 2009. The direction now is not good.

Third, you should read Tom Friedman’s book Hot, Flat, and Crowded. Tom has great insight into most current issues, and his insight into solving the climate problem is very good. He basically says that most actions have very small leverage. If you want effective change, we need to change the laws and policies we operate under.

Fourth, you should read Carbonomics, by Steven Stoft, which puts an economist’s perspective on the current debate. An alternative to buying that book would be to read last year’s economist report by the Congressional Budget Office, “Policy Options for Reducing CO2 Emissions.”

There are two approaches to addressing the climate problem: one is price-centered, the other is quantity-centered, the P and Q approaches, respectively. Most economists say the P approach is better because it is effective, efficient and gradual. The proponents of the Q approach say their way is more politically palatable and has certainty.

The current climate legislation, the Waxman bill, is a Q-side approach of “cap and trade.” It is the work of scientists and politicians, who value certainty and palatability. Power companies don’t object to a Q approach as long as they get a lot of free emissions credits in the deal. Most NGOs, such as the ones that are in USCAP, strongly favor a Q approach, for a variety of reasons. A Q approach did work for sulfur dioxide.

But how is a climate policy supposed to actually work? With a Q approach, you cap Q, auction or give emissions credits, trade them; as limits take hold, there is an artificial scarcity that will raise prices. With higher prices, you get energy conservation and alternative energy generation.

With the P approach, you put a charge on carbon sources to raise prices, leading to energy conservation and alternative energy generation. The P approach is much simpler. The prices in a P approach are much more stable, and stable increasing price is the key to the changes we need in energy conservation and alternative energy.

A Q approach leads to speculation and potentially wild fluctuation in prices, such as we had in the Enron-induced electricity price spike in California some years ago. The Waxman bill specifically fears fluctuations, creating a reserve of credits to sell when the price goes too high, and also ostensibly prohibiting “speculation.” It also leaves blank how credits are allocated, i.e., who gets free credits, which will be arbitrary and political. I don’t think a Q bill can ever be as good as a P bill, even if you load the Q bill down with gimmicks to make it more P-responsible.

SAS Institute made a large investment last year in solar energy: Last December, we started generating electricity from an $8 million, nearly 5-acre 1-megawatt solar farm. For SAS, it is actually economic. We will eventually get a small return on the investment. So is the current system really working? Not really. It is artificial. The only reason that it is economic is due to large tax credits we get on the initial investment, together with favorable green-power rates you can get, as pressured by alternative-energy incentives to power companies. Do we actually use any of that solar electricity at SAS? No. If we had to use it ourselves, it would displace the cheap electricity we buy, and the project would no longer be economic. There is no way we could operate off the solar power, anyway -- it would supply only about 3% of our needs and obviously would not work at night or on cloudy days. If the subsidies and credits went away, we would not invest in solar.

Alternative energy could develop naturally if the price of carbon-based electricity were to rise to several times its current level. That is what we really need: more expensive carbon electricity and more expensive carbon fuel. That is what will be effective in efficiently adjusting to the new future. We need a P signal. A P signal is so much more efficient and businesslike than subsidies and limits.

I happen to care a lot about environmental issues. I remember my first Earth Day in 1970 when environmental conscience-raising seemed new. I was in college and lived in a special-interest house on campus called Ecology House. In the mid-nineties, I became involved with The Nature Conservancy (TNC) and traveled to many conservation sites all over the world with TNC or WWF, including Bolivia, Peru, Venezuela, Mexico, Alaska, Panama, Costa Rica, Brazil, China, Indonesia, Malaysia, Zambia, Namibia and Botswana. My interests led to joining the Board of Directors of TNC, serving under a variety of chairs, including Hank Paulson and John Morgridge, and now I am chair of the Audit Committee there. Between my wife and me, we serve on the boards of TNC, WWF, CARE, and the Nicholas Institute for Environmental Policy Solutions, and I am joining the National Council of Environmental Defense Fund. So that’s my “green card.”

However, all these organizations are on the Q side of the current debate, and I feel a little lonely being a P advocate. But I am an economist and businessman in my head and my heart. So I will stay respectfully opposed to the current Q bill and hope the realism provided by the recession will help focus opinion on better policy.

The front page of the Wall Street Journal on March 13 highlighted an "$11 Trillion Hole" and said "Americans See 18% of Wealth Vanish." I looked at the chart, and the 2008 number indeed looked as if it had fallen off a cliff.

But then I looked at the rest of the curve and remembered the two big bubbles that were going on, the Internet Bubble in the 1990s and the Housing Bubble in the 1990s and 2000s. I thought I should just exclude those points from the long-term trend.

So I got the data from the Federal Reserve's Web site and tried to reproduce the Wall Street Journal plot, adding a trend line that excluded the bubble points.

So how does our current net worth look with respect to the long-term trend? Not bad at all. We are not in a $11 trillion hole but are back on track after some roller-coaster years.





Legend:
green = used to estimate the regression line, 1985 to 1996
red = the points in the bubbles
blue = the current value that was the subject of the Wall Street Journal article

I don't want to deny in any way that we are in an economic crisis. But I do want to remind everyone that portfolio valuation drops are not quite as bad as they seem if you consider that the last few years of huge yields were somewhat artificial, and just returning to normal valuations will look like a crash.

Sources:

• Flow of Funds Accounts of the United States, 1985-1994 [PDF]
  
• Flow of Funds Accounts of the United States, 1995-2004 [PDf]
  
• Flow of Funds Accounts of the United States, 2005-2008 [PDf]
  
• Balance Sheet of Households and Nonprofit Organizations, March 12, 2009 [PDF]