Plugged In With Jed Dorsheimer—Understanding Energy’s Relationship to Our Economy

Energy serves as the foundation for the functioning of the economy, and limiting access to it poses a risk of societal dislocation and conflict. In this episode of Plugged In, William Blair energy and sustainability sector group head Jed Dorsheimer interviews Dr. David Murphy, associate professor of environmental studies at St. Lawrence University, to discuss the energy transition, the relationship between energy and our economy, and how the laws of thermodynamics can inform capital allocation strategies.

Podcast Transcript

[00:00:00] Jed: Good afternoon. My name is Jed Dorsheimer, and I'll be the host of the Plugged In Podcast, brought to you by William Blair. The purpose of this podcast is to help educate the relationship that we have to energy. We'll bring you some of the most knowledgeable experts in the world across all different types of institutions that understand the key relationships that energy has with, well everything.

[00:00:24] Jed: Now, most people tend to think of energy. Whether it be gasoline or heating oil or propane or even electricity that turn on your lights. While all these are forms of energy, it doesn't explain the relationship in terms of how energy flows through everything in our world, and then to go further the relationship to what's produced and also consumed.

[00:00:52] Jed: We outline much of this in our Red Pill report published last year at William Blair. And we'll be publishing an annual energy report to continue on this theme. Now, today it is my pleasure to speak with Dr. David Murphy, also my technical advisor, and helped on the Red Pill report. David's an ecology professor at St. Lawrence University in upstate New York, although he's taken a semester abroad in London. He has published numerous peer reviewed abstracts, including his work on the harmonization of EROI or Energy Return on Energy Invested a key metric we have built our methodology around. In this podcast, we're going to discuss three key points.

[00:01:37] Jed: The first is how energy explains the real economy. The second because of Energy's role, how we can then apply the laws of thermodynamics, which have never known to be broken to economics and the relationship between EROI, that's energy return on energy invested, and ROIC, return on invested capital.

Lastly, we'll talk about the importance of optimizing energy efficiency in the current energy transition. So welcome and I look forward to bringing you a monthly podcast, which hopefully you'll find useful.

[00:02:14] Jed: Dave. Welcome. Good morning.

[00:02:16] David: Thanks for having me, Jed. I'm excited to be here.

[00:02:18] Jed: Well, I think you're the, you know, given the amount of work that we're doing together in this particular area, I think, uh, you are the perfect person to have on our first one.

[00:02:28] Jed: I mean, you're over, I think in the UK. Doing a semester abroad teaching at St. Lawrence. But, is there anything you want to talk about before we jump into energy here?

[00:02:39] David: We’ve been working now, you and I, on some reports about how to integrate, what we broadly call biophysical economics and our net energy analysis into, what  we, in academia called the real world, right? where the actual investment decisions are being made. So it's a very exciting time to think about the energy transition, to think about all the changes that are occurring in the macro economy and to think about how, the research that that we've been doing, um, can, can add value for people that are just trying to make decisions. So that's it really awesome.

[00:03:12] Jed: Well, just as a little plug for those interested, you can check out more resources at the Biophysical Economics Institute, www.bpeinstitute.org. Something that Dave and I are both involved in on the advisory board. So Dave, let's just start at the beginning in terms of briefly, how do you think energy. Fits within the economy, or perhaps maybe said differently. How does energy explain the economy?

[00:03:40] David: Yeah, I think it's critically important, especially in today's world, that we think about energy as explaining the economy, not money. And once you're able to think of the, the economy as an energy system, it gives you a different perspective,  and, if one's already familiar with the financial perspective and the money side of the economy, learning about the energy side can be revelatory, and can, it can help people think about decisions they make in, in vastly different ways. We can start just with the definition of the economy, right?

[00:04:12] David: How do you define economics, right? It's the allocation of goods and services amongst competing ends. That's the definition you'll find in most textbooks. And, realistically, if we think about goods and services, what are those? Well, a good is anything in the economy, right? But fundamentally, what is required to make that good?

[00:04:30] David: Well, there are two universal inputs to anything, right? And that is, Matter and energy, you have to have those two things to make any good, whether it's  a chocolate bar, a tire or anything else in the economy. Some matter and some energy has to be utilized. So when you think about these, what I call ultimate inputs to production as opposed to like the proximate inputs, which the economics tends to focus on, which would be the, the actual input materials that might go into building a tire or something like that.

[00:05:03] Jed: Sorry, when you mean proximate, so this would be like the Cobb Douglas production function of labor and capital being the starting point, and what you're getting at is, is that labor without energy would be a corpse and capital without energy would be a sculpture.

[00:05:18] Jed: So if either are productive, we need the matter to kind of drive those. Is that the right way to think about it?

[00:05:25] David: That’s exactly the right way to think about it. Economics traditionally thinks of output as equaling some function of labor and capital. But both labor and capital themselves require energy and material to operate.

[00:05:40] David: So if we think about that right then, then it is really no surprise. When we look at the data and we see that energy explains basically economic productivity almost perfectly over the last 50 years, the Cobb Douglass production function has massive air in it. When they try to do the, the actual analysis and that error they allocate to total factor productivity.

[00:06:02] David: They call it the residual. It's like the model isn't perfect. So technology that, you know, that's the, that's the effect of technology in the economy. But Ayres and Warr did a ton of work on this, and they actually measure exergy, which is useful energy, and they said that you can look at the graphs they've put together.

[00:06:20] David: You can estimate output from the economy very, very accurately over time. If you just use energy or exergy as the main input. And that's because energy undergirds every, all production processes, we have energy to produce something. So it stands to reason, right, that when you do the math, that they're correlated.

[00:06:42] David: So...That's why bigger economies tend to consume more. Historically this consumption's been fossil related, so that's why the biggest economies also tend to have the most greenhouse gas emissions, right? So that's kind of the macro perspective on how to think about like the relationship between productivity and energy.

[00:07:04] Jed: I have done some work and you've done some work in published papers on. This concept that our friend Charlie Hall really developed around, taking ecology in the concept of energy return on energy invested and applying it to oil. Now you've gone a bit further in harmonizing some of the contemporary work of EROI and bringing that to.

[00:07:31] Jed: Point of use so that we can get some type of standard measure, to benchmark we want to just touch on that in terms of what you've done there. Because that seems like a pretty good starting point, that if we're saying that energy is kind of the basis. How do we measure we're going to be able to need to measure that.

[00:07:52] Jed: And what does that mean in terms of this EROI whether PRU or just EROI vernacular means?

[00:08:02] David: Yes. So, energy return on investment is a measure of the energetic profitability, right? It's, it's akin to a cost benefit analysis you would do in the financial world, like a return on invested capital.

[00:08:17] David: Yeah, exactly. And so, it's energy out  from an energy producing process. If you want to think about it, it would be oil produced from an oil well. And you would divide that by the amount of energy required to produce it. So it's very kind of like simple in arithmetic, right?

[00:08:39] David: It's just  a division and it gives you this ratio. So if you produced a hundred barrels and you invested one, you'd get a ratio of a hundred to one, right? The devils in the details in some of these analyses. There's boundary issues. We want to make sure we're, we're comparing apples to apples when we do these analyses.

[00:08:57] David: And that was really the motivation, to put together the harmonization report we did this past year, which examined the energy return on investment for a broad swath of technologies and energy resources harmonized them, which means we brought in all the boundaries together and we tried to make them as comparable as possible.

[00:09:21] David: Utilizing the lifecycle analysis database, there's this massive database from Eco Invent which is curated out of Switzerland. And what we found was pretty interesting, right? We focused both on two different boundaries. One would be the point of extraction for coal, that would be like the mind mouth.

[00:09:43] David: Or for an oil well. And then really what we've focused even more on was this point of use. So like, society doesn't run on crude oil, right? It  runs on refined petroleum products, gasoline, diesel, and these things. So, it made more sense to us at least to think about the energy return on investment when that fuel actually makes it to, to the economy.

[00:10:06] David: It's delivered in a useful form, so that's at the point of use.  That would include harmonizing values so that it included the cost of running a refinery. And, some of the results we found were pretty interesting, right? Renewable energy actually fared pretty well in this analysis.

[00:10:24] David: It showed that at the point of use, wind and solar had fairly high euro ROIs above tent. And, it also showed how, how energy intensive the fossil fuel economy is, right? How expensive it is on a per unit basis to refine oil and to ship natural gas and coal as well.

[00:10:50] Jed: I want to come back to the complexity of the system and how that fits in. But I do think….the Eco invent database… I think this is an important point because we're in an era of big data and data sets, what a lot of people might not realize  is maybe one of the  greatest things from the ESG movement or, an awareness of climate change is you've got a very established lifecycle analysis that's governed by ISO.

[00:11:25] Jed: That's created a lot of  these data sets, and the data sets are what we're pulling from in doing  this same EROI analysis to kind of get this harmonized data. Is that the right way to think of that?

[00:11:43] David: Yeah. Yeah, certainly lifecycle analysis has existed mainly in the environmental engineering world for, for decades.

[00:11:49] David: And what we've done in the net energy analysis world, or what we've tried to do is basically utilize some of the methodologies from the LCA and the vast databases that they have to bolster our own research. 20 years ago, a lot of the energy analysis research was done just collecting data sets wherever we could.

[00:12:10] David: And if we can backstop those or, add to them by using  these huge databases  that are curated and really accurate, we can get values for return on investments that are much better than the ones that were, that we used to be able to do. It's really kind of increased the rigor with which we can do some of these analyses.

[00:12:34] David: And therefore, the value of the output.

[00:12:37] Jed: Okay, so we've got this harmonized methodology. We've got a big data set to pull from that allows us to  get an energy footprint or fingerprint, if you will, on, on any good or service that's being produced now.. How does that fit within our economy? How do we think about sort of the metabolic clearing rate of the economy.

[00:13:09] David: So this is where you have to think of where the insight of understanding the economy as an energy system is really important, right? If we think of the economy as an energy system, which it is?

[00:13:20] David: There are some rules that apply to it… And these rules are the laws of thermodynamics, which means the energy cannot be created. Within the economy, it can't be created or destroyed. So the economy has to be fed energy from outside. Let's call that the energy producing sector. And it also means that energy can't be recycled, right?

[00:13:37] David: That's the entropy law. Once we use energy, it's converted into a lower quality form. Basically, most energy ends up being waste heat. And that just means literally what I'm talking about. Think of a car, you put gasoline into a car. Gasoline's burned in the engine and the engine heats up, right?

[00:13:55] David: All of that heat, that's the inefficiency of the burning of the fuel and it heats up. So you lose some of the energy as that waste heat. But then also once you've utilized some of the, the gasoline to move the vehicle, right? You can't just collect the CO2 coming out the back and make more energy without putting in a lot more energy into that system. Right? You can't recycle that energy. It's gone. So what does this mean? It means that the economy needs a constant throughput of energy. It has to continually be fed high-quality energy to run all of the various. Parts of the economy, right, to keep the lights on, to keep buildings heated, to keep buildings cool, to operate, trains and cars.

[00:14:36] David: All of these things require energy, right? So we have to constantly, the energy producing sector has to constantly be feeding that energy into the economy. And then that economy uses it and that energy is lost, and then more energy has to come in, right? So there has to be some sort of profit, right? The energy sector itself has to harvest this energy from nature, and that's where we calculate that energy return on investment.

[00:14:59] David: Let's say the average across the energy sector is five to one, right? So for every unit it invest, it gets five units out and it's going to deliver four of those units to the economy. And that economy can use those that that energy to keep the lights on right? As we produce new energy producing technologies.

[00:15:18] David: As we develop new fossil fuel resources, if the energy return on investment is lower than what the economy's already operating on, well then it's meaning would be, in this example, less than five to one. It's increasing the cost of the energy producing system, and therefore it's actually increasing the cost of the entire system and.

[00:15:40] David: Kind of bringing it down in that sense, making it less efficient. Right? And the converse is true, right? If  we have technologies that have higher ROIs, well then it's adding more profit energy to the system and increasing the energy returns of that system. Does that make sense?

[00:15:53] Jed:  Yeah, it does to me. So,  maybe I'll just frame it for our audiences a little bit differently.

[00:16:00] Jed: Let's say we didn't have money, we just traded things right, in terms of goods and services would be closer to a one-to-one. But as complexity increases in our modern society, the ability to have electricity at any time. It's going to make the system less efficient or require more energy to support the needs of that system.

[00:16:24] Jed: And if we're putting things into that system that are below whatever the clearing rate is, it actually increases the hurdle rate because it's making the system less efficient. Is that maybe just a different way.

[00:16:41] David: Yeah, you got it.  Exactly. So basically, as society grows,  it's mostly growing outside the energy sector.

[00:16:47] David: So the energy costs of that society are increasing over time. So think about it as  we have more buildings, as we have more connections between different societies, right? Like the energy costs of societies tend to grow over time, which means the energy sector has to keep providing more and more energy to support that.

Right? And, and this is where the tension is now. Is that like as society is growing, we're having  the energy costs go up. And now we have this, also this transition occurring in the energy sector, right? Which is changing the, the, the energy profitability of that sector, changing energy flows to society.

[00:17:31] David: And the question is whether or not those are in sync. Is the energy transition going to be able to pay for all of the increased complexity that society also requires at this point?  And that's, that's kind of the big question.

[00:17:45] Jed: Let's bring this back to renewables for a second because I think this is a great place to interject.

You know, we see where you fall on the political spectrum that  renewables tend to either be good or they tend to be bad. And I think what you and I have been talking about more recently is that subjective view of right or wrong, good or bad, is probably the wrong way to look at an objective technology.

[00:18:17] Jed: But if you don't understand, you're starting from a point where you don't understand energy's role and you put a new technology that changes the system dynamics and you try and. Let's say for example in Germany, you shut down a nuclear plant and replace it with an intermittent renewable, you are  then you don't adjust the system to accommodate.

[00:18:41] Jed: Then you've just made the overall economy in said Germany less efficient or require more energy to actually clear. So the problem then isn't with the underlying technology that you're putting in, but the problem then becomes, the system that you're not changing. And then I think widespread, this is one of the big challenges with the energy transition, is if you don't understand the problem to begin with and you start adding in a bunch of changes in terms of the input, energy technologies, which you run the risk of.is making the system less efficient, therefore collapsing the economy where it will ultimately clear at a lower rate or require more energy to, to clear. That might be a good place to sort of unpack what we're doing in terms of EROI to ROIC too.

[00:19:39] David: Yeah, I think you're right, and I think it's really important, like a lot of people just think about, they might read something called like a levelized cost of solar or something like that.

[00:19:48] David: There's a lot of different estimates you can get out there for the cost of generation, but that is just a point estimate of what the cost of one technology is. The question really is about, about the energy system is how, what is the overall cost going to be for, for transitioning the system to utilize those technologies?

[00:20:05] David: Efficiently, right? If we just build out generation and nobody's. To be sure nobody's like just proposing this, but if generation just gets built out by itself, right? When renewable generation is fundamentally, you know, then we're trying to fit renewable generation into a system that is built for centralized generation.

[00:20:22] David: And those two don't necessarily, um, you know, they're not going to be used that effectively. So you're end up, you end up spending a ton of money and a ton of capital. Building out all of. All of generation capacity, and then you're underutilizing it, right? So that's not an effective strategy going forward, but it's a lot.

[00:20:43] David: But that is kind of the strategy that some people think about that don't understand kind of the challenges presented by the system. Right?

[00:20:51] Jed: So, well, Dave, you seen one of the nobody's  explicitly suggesting this, but implicitly, if you are. If you're funding, let's take the IRA for example. So you take a lot of money and you're going fund the actual technologies to make them more efficient.

[00:21:07] Jed: If you don't understand that, the problem isn't with the technology, but the problem is with the system and adoption, you're implicitly doing exactly what you might not explicitly be doing. Think of a plumbing mechanism. You're putting more water in the system than the system can hold. Because you haven't adjusted how the system operates or the size of the pipes that the water's going through.

[00:21:30] David: Yes, I would agree with that.  What some of the studies that show there's no technological barrier to achieving, I said this earlier, like a 60, 80% grid system. We can do it with the technologies we have right now, but like the most recent report for NRE right in, in a bunch of their scenarios.

[00:21:48] David: It requires two, three, 400 billion in investment in transmission infrastructure to go along with all of the other buildouts. Right? So it's not just one, you can't do one, or you, we shouldn't be trying to do one without the other. And I would agree with you that there, it is an implicit kind of suggestion there.

[00:22:05] Jed: And I just went through this personally. I went through this experience putting solar on the farm and I gotta say it was the most difficult experience. And painful dealing with my local utility because what they really don't want solar, even though that they publicly are saying, Hey, we want, we support renewables,, from an explicit perspective. Implicitly, they really don't want it.

[00:22:32] Jed: That's what I learned because the permitting process and the interconnection was so onerous what they would actually allow me to put on my roof. Was much smaller, particularly if I went with batteries and the, in my case, the transmission system in terms of the transformers that were on the pole, which they wanted me to upgrade and pay for. They're trying to use their constituents dollars to try and make the burden less on them. That comes back to just a pure misunderstanding of what their business model should be.

But if you don't understand how that's going to operate, you voice that upon the constituents, which can only result in, in my opinion, the baby getting thrown out with the bathwater, which it probably shouldn’t.

[00:23:28] David: Yeah, I mean, I hope not, right, that that would definitely be a bad,  unintended consequence. But I mean, you can see your experience scaled up at the interconnection level for some of the utility scale projects too that there's just these massive queues now. For various projects to get approved,  to interconnection being like when you interconnect a project with, uh, just for the listeners, with the transmission infrastructure that's out there, right?

These, these are probably two different entities that own these things. And, then they're queued up. So there's almost as much capacity in queue right now that we would need for some of the scenarios for these 60, 70, 80% renewable. It's already in the queue, but the success rate for these projects  is sometimes in single digits in different areas.

[00:24:19] David: So a lot of them get canceled for, for various reasons. But, but these queues, right? The, to get these interconnections are, are part of the issue. And that comes down to understanding the system. We have to be able to upgrade the system, and figure out how  these two products--not just transmission-- but like transmission's a big part how transmission and renewable and variable,  renewable energy kind of articulate and can work best together so that we don't just spend a ton of money increase the cost of the energy system in general.

[00:24:50] David: Right. Which would, which of course, increase the clearing cost for, for the energy sector and society, like you were talking about.

[00:25:00] Jed: I just want to come back to a point that I don't think we made explicitly clear yet. Capital can only come from the transformation of energy, which is why I think you and I have started with energy in terms of the basis to build  this framework.

[00:25:17] Jed: And the beauty of energy is it's governed by laws that have never known to be broken. And so one of the things I think we found in, in some of the work that you did and that things or technologies with a high EROI also tended to have a high ROIC because you're more efficiently using the energy.

[00:25:39] Jed: And the capital that's coming from that energy resulting  in a higher return on that invested capital. That's a linkage that I think is pretty important in terms of, you know, because most of our listeners will be investors. And as you're thinking about how do I find higher ROIC or greater alpha generation  with less beta risk.

[00:26:02] Jed: That's the basis for a good investment, or getting greater returns. And that's the linkage  that we've found in our writing about  this point. And we should be having another paper  here soon as well.

[00:26:19] David: There's two sides to this, right?

[00:26:22] David:  The first part  is conceptually how are these two things related? And there's a lot to be said about energy, return on investment, energy out over energy in, compared to something like ROIC, return on invested capital and kind of comparing that to weighted average cost of capital or something like that.

[00:26:41] David: These are analogous metrics. One using financial units and one using energy units, o they play by slightly different rules. And when you map them kind of on a Cartesian plane or something, you can get different insights about investment opportunities about technologies because the financial side may indicate something that the energy side does not.

[00:27:01] David:  And you can think of examples of like corn-based ethanol as being like a very, a really interesting case study. And this is an older one, right? But it applies to things like hydrogen, and Europe right now, which may be doubling down on synthetic fuels again. But, the idea of being basically like, well, what does it mean if a technology has a really low EROI but is financially profitable? What insights can be gained by understanding both of those two metrics together, and then going beyond that. And hopefully what we'll develop in the future work  is literally tying these two things kind of in an algorithm together, , to really just not be like the measure, of course.

[00:27:48] David: Because there's a ton of measures out there, but to be another measure and a valuable one that w that people can use when making decisions.

[00:27:56] Jed: Yes if you have a profitable low EROI, to me that suggests that you have to have an exogenous source of capital to fund that i.e., subsidies, which has been the case with  the case study you mentioned in terms of.

Ethanol. I think  we funded that in the U.S. for over a 15 year period of time to roughly 80 billion. And the sad part about that is the technology never improved. And the question then becomes, what could we have done with that 80 billion had we used that in a more productive way?

[00:28:39] Jed: And I think that's kind of the hope is that by using these metrics, we can help educate those that make decisions on the institutional side in terms of which technologies should have a lower cost of capital because they're more efficacious in terms of input within the overall system, or even,  I have a little hope here having done some policy work myself, but maybe our politicians can  understand this better and have better policy

in the combination of  those two things should be able  to help us in this massive transition; Which is not new, right? The energy transitions, energy's always transitioning, right? The idea, it's a bit of an oxymoron that we have to accelerate that in terms of, from an existential perspective.

[00:29:33] Jed: And if we go about this wrong, we do run the risk of collapsing the system in upon itself, even if it's well-intentioned.

[00:29:45] David: Yes. And I hope that's not, obviously, I hope that doesn't, doesn't come to fruition and that doesn't happen. But,…

[00:29:53] Jed: that's why the work so important, Dave, like, you're saving humanity,

[00:29:58] David: Right!

[00:30:02] Jed: I, a little bit of joking and cheekiness, but I, in a way it really is, I mean, it starts with the education and understanding of, of what's actually. Going on, seeing the world as it is objectively is really important. So that we can have a foundation to, to build off of.

[00:30:22] David: Yes, completely agree.

And, like, the opportunity costs shouldn't be dismissed, right? I mean, like what you're talking about, the $80 billion that we spend in corn, ethanol, or however many billions we're spending in other efforts in the IRA right now, right. How else could we use those? Right? How else could we utilize that?

[00:30:40] David: I mean, we do have to build out transmission infrastructure and some of the money's allocated for those purposes. But  we should really be careful that we don't just allocate money to things that are going to increase the cost of supporting our system. And hydrogen is a big question mark right now for me, but, maybe in some particular case studies, but across the board. We just have to be discerning about the way in which we spend this, because there are consequences.

[00:31:14] Jed: Agreed. All right. Well, thank you for coming on.

[00:31:17] Jed: I want to have you back  where we can go through some of those details, but this has been a great, first podcast to kind of level set around the work that we're doing in EROI that you're doing in EROIPOU and, what we'll be doing together in terms of connecting the EROI and ROIC and, and what that framework looks like.

[00:31:37] David: Thank you. Awesome. Yeah, thanks for having me!

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