Price discovery, risk transfer and energy finance

Good morning. My name is Sam Schulhofer-Wohl. I am senior vice president and senior advisor to the president at the Federal Reserve Bank of Dallas, and it is my pleasure to open this conference.

Thank you to the University of Houston, the Bauer College of Business and the Department of Finance for partnering with the Dallas Fed on this event.

And thanks to all of you for participating. It’s truly exciting to bring together so many leaders in this field, and particularly to connect academic and business perspectives.

The Federal Reserve’s role

I have a few thoughts to offer on the topic of the conference, but first let me emphasize that the views I share are mine and not necessarily those of the Dallas Fed or the Federal Reserve System.

I also want to take note of the Federal Reserve System’s role in this space. The Federal Reserve is the nation’s central bank. We support a strong economy for everyone in the United States. We do that by supervising banks, promoting financial stability, operating parts of the payments system, promoting community development and setting the nation’s monetary policy.

To help advance our mission, we conduct research and organize conferences on numerous aspects of finance and the economy, including today’s topic, the connections between energy finance and the energy transition. The knowledge developed through these activities helps us to more effectively carry out our responsibilities and serve the public. However, as Fed Chair Jerome Powell has said, “… it would be inappropriate for us to use our monetary policy or supervisory tools to promote … climate-based goals,” and we do not make climate policy.

Aspects of energy finance

Much of the public conversation around finance and the energy transition centers on the large amount of investment that is expected to be needed. McKinsey, for example, has estimated that reducing global carbon emissions to net zero by 2050 would require an increase of $3.5 trillion per year in capital expenditures in energy and land use systems. While one can debate the exact numbers, assumptions and methods of estimation, I think there’s little doubt that significantly expanding the world’s capacity to produce lower-carbon energy and to decarbonize existing energy sources will require meaningful investment.

Meanwhile, the world is also expected to continue using significant amounts of fossil fuels for years to come. Producing those fuels and ensuring energy resilience and security will require meaningful investment in traditional projects as well.

But perhaps because the investment numbers are so large, I think they sometimes distract people from the many other ways that the energy transition and the financial system will interact. After all, and as our agenda today and tomorrow shows, finance is about much more than investment. I would particularly highlight two other aspects of finance where significant evolution appears likely in connection with the energy transition and where I expect more research and dialogue will be valuable. Those two areas are price discovery and risk transfer.

Price discovery

In a market economy, prices provide the fundamental incentives for producing, consuming or conserving goods and services. The efficiency and sufficiency of energy supply through the transition will therefore depend in part on how well price discovery works.

Commodity traders have known at least since the development of the Dojima Rice Exchange in Osaka, Japan, three centuries ago that properly pricing a commodity requires describing not only its physical attributes—the quality of the rice or the chemical makeup of the oil—but also the place and time that the commodity will be delivered. (Nobel Prize winners Kenneth Arrow and Gerard Debreu discovered this same result in economic theory somewhat more recently.) The more difficult the commodity is to transport or store, the more essential the specification of the delivery place and time becomes.

The energy transition is expected to entail a significant increase in the use of electricity (though I am told that tomorrow’s speakers may question just how large that increase might be). Electricity is quite homogeneous in its physical characteristics: A light bulb glows just as brightly whether the electricity flowing through it is generated from coal, natural gas, nuclear fission, wind or the rays of the sun. But relative to energy embodied in fossil fuels, electricity can be significantly more difficult to transport and store, at least with current battery technology.

Moreover, while end users purchase many forms of energy in fixed quantities, a connection to the electric grid can sometimes be more akin to a call option. End users often expect to be able to draw electricity as and when they need it, without committing to a quantity in advance. Yet, with today’s technology, the power plants that can respond most flexibly to changing demand or to dips in supply from sources like wind and solar are typically gas fired. As electrification and the use of renewables increase, effective price discovery for electricity may require new thinking about how to specify the place and time of delivery in appropriate detail, and how to contract not only for the spot delivery of power, but also for the reliable option to draw power when needed. I understand our speakers tomorrow morning will delve into these topics, and I hope those discussions will lay a foundation for further progress.

The energy transition may also call for advances in price discovery in other commodities. Greater use of electricity is expected to increase industrial demand for metals such as nickel, copper, lithium, cobalt and rare earths. The energy transition is also expected to encompass increased use of novel fuels, such as hydrogen, as well as transactions in carbon credits. All of these will need to be priced.

In thinking about price discovery, it’s also necessary to consider the role of externalities. The energy transition stems from growing recognition of the externalities associated with carbon emissions. For price signals to provide correct incentives for the efficient production and consumption of energy, they will need, in some way, to incorporate the relevant externalities. And this is true as much for renewables as for fossil fuels.

Futures markets

By standardizing contract terms, centralizing trading and mitigating counterparty risks, futures markets often provide a particularly efficient venue for price discovery. In turn, efficient price discovery supports a market’s growth. It is perhaps no accident that the development of the groundbreaking Dojima rice futures market accompanied Osaka’s evolution as a port for shipping rice to the rest of Japan … or that the wheat and corn futures markets in Chicago grew up alongside that city’s rise as a hub for shipping grain from the Midwest to the world … or that oil futures markets developed rapidly in the 1980s as spot trading of petroleum replaced long-term, locked-in contracts.[1]

Well-developed futures markets already exist for some commodities whose importance will increase during the energy transition, but not for others. And one of the more substantial derivatives markets that does exist—for nickel—experienced marked dysfunction last year. As the energy transition proceeds, practitioners and scholars of energy and finance will face questions of how best to organize price discovery for a growing range of commodities—whether in futures markets or in some other way.

Risk transfer

Futures markets are also employed, of course, for managing and transferring risks. The energy transition appears likely to create significant needs for risk management through financial markets.

One very broad driver of the likely demand for risk transfer is uncertainty about how the energy transition will unfold and what the different possible paths may imply for various renewables, fossil fuels and economic activity overall. Financial markets can enable people to hedge these risks—that is, to transfer the risks to others more capable of bearing them.

More narrowly, producers and consumers of all those newly demanded commodities I mentioned will likely want not only to discover prices, but also to hedge price fluctuations for them. A power producer that is developing a large battery storage facility told me about financial challenges they faced. The project requires an immense number of lithium-ion batteries. It will take a couple of years after the final investment decision to install all of them. During that time, fluctuations in the world price of lithium could change the cost of acquiring the batteries and, therefore, the potential return on investment. The price risk couldn’t be hedged on an exchange, though: Lithium futures are nascent and thinly traded. Instead, the price risk had to be incorporated into the project’s financing, which significantly limited the availability of loans.

This connection between capital expenditure and markets’ capacity to facilitate risk transfer brings us full circle to the investment considerations that I started with.

Conclusion

The role of financial markets in price discovery and risk transfer is not merely a matter of academic interest or useful for turning a profit in business. It can matter for the health of the economy as a whole.

Last spring, after Russia’s invasion of Ukraine disrupted global commodity supply chains, the Federal Reserve’s semiannual financial stability report included a special box examining the resulting stresses in related financial markets. We emphasized in the report that these stresses had the potential to “disrupt the efficient production, processing and transportation of commodities by interfering with the ability of commodity producers, consumers, and traders to lock in prices and hedge risks.”

Market participants ultimately managed through the episode. Nonetheless, the developments provided a clear reminder of financial markets’ critical role in discovering prices, transferring risks and thereby helping to ensure that energy and other commodities are put to their highest and best use.

The conference program illustrates the many ways that finance will continue to play this role during the energy transition. Among other topics, the academic papers will cover the implications of decarbonization for bank lending and commodity markets, how the transition may influence prices of equities and different forms of energy, and how market incentives in turn may influence the transition. We will also have panel discussions with industry executives from both traditional and renewable energy sectors and a keynote speech by Bobby Tudor, chair of the Houston Energy Transition Initiative.

I hope this conference will enhance understanding of these issues and inspire further learning. More comprehensive knowledge of the interplay between finance and energy—including, but not only, the energy transition—will be invaluable for policymakers, industry and scholars. That is true for the world and the nation, and it is especially true here in Texas, where energy forms such a large share of the economy.

The Dallas Fed is committed to fostering this learning through our research program, our support for conferences, our surveys and our engagement with business leaders. Indeed, I firmly believe that interaction between industry practitioners and academic scholars, as we’ll have at this conference, yields deeper insights than either group can generate alone.

Thank you for letting me share these thoughts with you, thank you for joining us here and best wishes for a productive conference.

Notes

I thank colleagues in the Federal Reserve System for helpful comments.

1. See Nature’s Metropolis: Chicago and the Great West, by William Cronon, New York: W.W. Norton, 1991, and The Prize: The Epic Quest for Oil, Money & Power, by Daniel Yergin, New York: Free Press, 2008.